The LBO: Buying a company with its own debt

Imagine buying a building, and having the loan repaid by the building's own rent. That is the idea of an LBO.

LBO stands for leveraged buyout. A fund buys a company with a little money, and a lot of debt.

Say a company bought for one hundred million euros. The fund puts in thirty million. The banks lend seventy.

The detail that changes everything: this debt is not carried by the fund. It sits inside the company bought.

The target's profits repay the debt of its own purchase. You buy with the target's money.

Five years later, the debt is down to forty million. The company is sold for one hundred million, without having grown.

For the fund: sixty million back for thirty invested. It has doubled its stake, at a constant price.

If it sells for one hundred and thirty million, it gets ninety back. Three times its stake.

Nineteen eighty-eight. The most famous battle in LBO history: RJR Nabisco, the tobacco and biscuit giant.

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The fund KKR won it for about twenty-five billion dollars. By far the biggest buyout on credit of the time.

The story became a book, then a film: "Barbarians at the Gate".

How do you measure an LBO's success? Funds love one number: the IRR, the internal rate of return.

It is the yearly return that turns what you put in into what you got back, taking the dates into account.

Doubling your stake in five years is an IRR of about fifteen per cent. In two years, more than forty-one per cent.

The IRR rewards speed, not wealth. Returning money early pushes it up, even if you earn the same in total.

Hence a technique: the recapitalisation. The company borrows again, to pay the fund a big dividend.

Say after two years, it borrows thirty million and pays it to the fund. The fund already has its stake back.

On the sale, it gets another thirty million. Still twice the stake. But the IRR goes from about fifteen to nearly twenty-four per cent.

The fund shows a much better number. The company carries thirty million more debt.

And if business slows, it is the company that can no longer pay. Not the fund, which has already cashed in.

An LBO is neither good nor bad by nature. The pressure of debt can also force a company to manage itself better.

But faced with an IRR, always ask two questions. How many times the stake? And how much debt to get there?