Investment Strategies

Let’s travel back to 2021 when Blackstone created history by raising almost $1.1 billion to finance its acquisition of Mphasis.

Of course, the private equity giant had already invested in Mphasis – in April 2016, it bought about a 60% stake from Hewlett Packard for close to $800 million. But Blackstone had its eye on loftier goals. The company bided its time and waited a few years.

In 2021, Blackstone, along with a consortium of other investors, made an offer to buy an additional 26% stake in the company. This would take the jointly held stake to over 75%!

The trick was to fund this lofty ambition. For this, Blackstone roped in JM Financial to finance and execute the strategy.

How?

They used something called a leveraged buyout. It is one of the commonly used investment strategies that help private market firms and their investors earn handsome returns on their investments.

The modern buyouts became popular in the 1980s when one of the biggest deals – RJR Nabisco – was completed. In 1985, RJ Reynolds merged with Nabisco in a merger worth $4.9 billion. 3 years later, RJR Nabisco was acquired by KKR for $25 billion!

In this module, we’re going to delve into the details of the different strategies that private market funds commonly use. This chapter is dedicated to leveraged buyout strategies. Let us understand how and why this investment strategy is so widely and commonly used by the big players.

In simple terms, the LBO strategy is used to acquire a company almost entirely with borrowed funds, using the target company’s assets as collateral. The finance ratio for this transaction is usually around 90% debt and 10% equity.

Now, the question is, how can one only invest 10% of the total investment required and buy a company? Let’s understand this with the example below.

On 1st December 2015, a company named ABC was acquired for an enterprise value of $1.0 billion by a PE firm. This acquisition was funded by $750 million worth of debt (75% of the capital structure) and $250 million worth of equity (25% of the capital structure).

The PE firm used ABC’s assets as collateral to acquire loans worth $750 million. This means that in case the PE firm fails to repay the loans, the lender of the funds can sell the assets of ABC and recover the capital.

A few years later, when the PE firm believes that their investment, company ABC, has appreciated in its value, it decides to exit from this investment.

On 1st January 2019, the PE firm sold ABC for an enterprise value of $1.5 billion. The outstanding debt of $750 million is repaid from the $1.5 billion, leaving the firm with $750 million.

Comparing this with the initial investment of $250 million, this gives us an IRR of ~44%.

Basics of Leveraged Buyout Investment Strategy

Average transaction size in US LBOs (in $Bn)

Source

Now that we understand what is an LBO strategy, let’s look into why is it so commonly used:

First and foremost, it gives the buyer the advantage of acquiring a company with minimal investment. As we discussed, a company valued at 100 can be acquired with an investment of 25 from the buyer.

This strategy is highly favoured in a bullish market scenario where a little increase in enterprise value can give heavy returns due to the advantage of high leverage. On the flip side, in a bearish market scenario, the high leverage may cause a severe impact on the returns even with a slight decline in the value.

The PE firm initially lost some money but things drastically changed when the company focused on debt restructuring and went public in 2013, making $12 billion. This made the Hilton Hotel acquisition one of the most profitable private equity deals. In 2018, Blackstone sold its stake in the hotel chain and unloaded 15.8 million shares. It was estimated that the sale would generate $1.32 billion.

Another reason why this strategy is commonly used is that interest on debt is tax-deductible and lenders’ expected returns are lower than those of equity investors. Thus, reducing the cost of capital required for the acquired company’s operational efficiency.

Lastly, since the investment is heavily leveraged, the company’s cash flow has to strictly be used for interest payments and debt. Owing to this, the management is focused on optimal capital expenditure and proper cash flow efficiency.

Buyouts mainly happen because the acquirer believes that the target company is undervalued. Other times a buyout may happen because the acquirer believes that they can gain financial and strategic benefits from the target company such as new market entry, operational efficiency, higher revenues, and/or less competition.

In certain situations, buyouts may happen to avoid extreme conditions such as a hostile takeover. Safeway’s buyout is a classic example of such a scenario.

After the required improvements in its financials, Safeway went public again in 1990. KKR earned almost $7.2 billion on its total initial investment of $129 million.

We’ve understood the basics of what an LBO is, now let’s dive into understanding how it works and how PE firms imply it and earn larger-than-life returns.

Identifying Target: First, the buyer identifies a company with great potential for restructuring and improvement. The buyer, usually a PE firm or a group of companies/investors, creates an entity (which pools all the money from the firm and investors) with capital equal to the buyout capital.

Debt Financing & Acquisition: The acquiring entity borrows funds (loans or other forms of debt such as selling bonds, bills, or notes) to finance a large percentage of the purchase price and uses the target company’s assets as collateral for this debt. These borrowed funds allow the acquiring entity to complete the acquisition of the target company.

Operational Improvements: Post the acquisition, the acquiring entity focuses on operational improvements within the target company. This may involve implementing strategic changes for streamlining operations and increasing profitability.

Exit Strategy: The end goal of an LBO strategy is to increase the value of the target company, and eventually exit the investment with high returns. This exit could occur through selling the company to another entity, taking it public through an initial public offering (IPO), or a sale to a financial or strategic buyer.

Debt Repayment: The profits generated throughout the operational improvements and the eventual exit are used to repay the borrowed funds. Once the debt and other costs are repaid, whatever remains from the profits represents the return on investment for the private equity firm and/or investors.

Leveraged Buyout (LBO) strategies, though potentially lucrative, may face significant limitations.

• High financial risk from accumulated debt, makes companies vulnerable to economic downturns as they might not be able to pay the interest payments on time.
• The acquiring entity, with limited access to debt markets, may not be able to acquire additional funding after borrowing funds initially against the collateral assets.
• Economic changes, such as policy changes, may hinder operational improvements and market conditions, and reduce the rate of return initially anticipated.
• Cyclical industries and limited exit options pose additional risks, while management ineffectiveness impacts outcomes.
• Industry-specific risks and the potential for overpaying during acquisitions further complicate LBOs success.

Thorough due diligence, risk assessment, and strategic planning are critical to overcoming these challenges and optimising returns in LBO transactions.

Now that the strategy is fairly established, we must wonder what kind of companies make potential candidates for an LBO.

• Strong management potential: Strong management is the key to growth and driving cost management, which would lead to margin expansion and an increase in the enterprise value.
• Stable cash flows: The company needs to have stable cash flows since the buyout will be highly leveraged and the debt will be regularly paid up through it.
• Market leadership: A mature company, that reflects leadership among its peers, will ensure stability in cash flows and require relatively less capital expenditure for growth.
• Strong exit opportunities: The target company should be convincing enough for the financial investor that it has strong exit opportunities in the form of an IPO or any other strategic trade sale.

Purchase Price (Entry Multiple)

The price you pay for a business is a key factor in determining your ultimate success. If you can find a bargain opportunity with an attractive entry multiple, it can make all the difference. Competition can make this difficult, but occasionally a buyer will find an overlooked asset that can provide a great return.

Capital Structure

Private equity firms typically acquire companies with a combination of debt and equity. While higher leverage multiples can lead to higher returns, increased leverage also creates risk. A big part of the underwriting process is to confirm that the company can comfortably manage the debt load and associated interest and principal payments. Creating a projection to confirm that the company can manage debt service payments is also a big focus of the LBO model-building process.

Cash Flow Improvements and Growth

As the market grows more competitive, a private equity firm’s ability to scale a company becomes increasingly important. If the firm can improve operations and efficiency or scale the company beyond the growth it was achieving at the time of acquisition, it will substantially improve the return profile of the business.

Exit Multiple

Multiple arbitrage occurs when the exit multiple is higher than the entry multiple. This generally happens when the company’s financial performance significantly outperforms what the market thought it was capable of at the time of acquisition.

For example, if a company was growing at X% per year at the time of acquisition and 2X% at exit, the next buyer is likely to place a higher multiple on the earnings of that business. A higher exit multiple can have a big impact on valuation and returns.

Rewards

• Increased Returns: LBOs offer the potential for big returns on investment. By using borrowed funds to acquire a company, investors can amplify their gains when the company’s value goes up.
• Efficiency Improvements: Private equity firms often make changes to improve a company’s efficiency after an LBO. These changes can lead to increased profitability and value creation.
• Alignment of Interests: In an LBO, the acquiring party’s interests align closely with the target company’s success. Investors have a vested interest in driving positive changes and growth, which benefits everyone involved.
• Privatisation Benefits: Going private through an LBO allows companies to avoid the pressures of quarterly reporting and public scrutiny. This gives management the freedom to focus on long-term strategies without the short-term demands of public markets.

Risks

• Financial Leverage: One of the main risks in LBOs is the high level of debt used to finance the acquisition. If the company doesn’t perform as expected, the debt load can become too much to handle.
• Operational Challenges: Making operational improvements is key to success in LBOs. But if these changes don’t work out, the company’s performance can suffer, impacting profitability and investor returns.
• Exit Strategy Constraints: LBOs often have a specific timeline for exiting the investment. If market conditions aren’t favourable during this window, investors may have to sell at a lower valuation than expected.
• Limited Liquidity: LBOs involve tying up capital for a long period, which can limit access to funds when needed.
• Management and Cultural Fit: Post-acquisition integration and management changes can cause cultural clashes and employee disengagement. It’s important to ensure the management team and company culture are aligned for success.