When investors want to complete a leveraged buyout of a company -- an acquisition in which the purchaser invests just a small amount of equity and then relies on a larger amount of borrowed money or debt to finance the rest of the transaction -- they often first perform a leveraged buyout, or LBO, analysis. This analysis provides investors with a look at a business's expected five-year future performance and tells investors whether they stand a good chance of making a solid return on their investment. The LBO analysis is a good tool, but it's not perfect. It comes with its own advantages but also has its own limitations.
Because investors rely so heavily on borrowed money when making a leveraged buyout acquisition, they want to be as certain as possible that they'll earn a high-enough return when selling the company that they'll be able to pay back their debt and be left with a profit. To do this, investors first determine how long they want to hold onto the company before selling it, perhaps five years. They then study a company's historic sales and the percentage that they have grown each year. Next comes the tricky part; investors must predict how a company's sales growth for the years in which they'll own it. To do this, investors will consider a company's past history and factors such as the growth taking place in its overall industry.
An LBO analysis, if performed correctly, provides investors with a detailed snapshot of a company's historic growth and the strength of its financial fundamentals. The predictions of future performance provide investors with information that can help them determine a fair acquisition price for the company and also help them determine how much debt it makes financial sense to take on in order to close the transaction.
An LBO analysis is far from an exact science. The biggest negative is that a company's past performance does not indicate future success. Things can change quickly in the world. Maybe a company has grown quickly because it faces little competition. A more innovative competitor might arrive, quickly cutting into a company's profit potential. Maybe an entirely new product will come out that makes a company's services or goods obsolete. Maybe the most-talented people in a company, the people who have helped spur its growth, will leave the firm to work for a competitor, gutting the company in the process.
An LBO analysis is a useful tool for investors considering a leveraged buyout. But these investors must understand that, as with any investment, there are no guarantees that a company that looks good during an analysis won't regress. It makes sense, then, for investors to carefully study the LBO analysis of any company they which to acquire in a leveraged buyout. But these investors must be prepared in case their assumptions about a company's future performance turn out to be incorrect.
Don Rafner has been writing professionally since 1992, with work published in "The Washington Post," "Chicago Tribune," "Phoenix Magazine" and several trade magazines. He is also the managing editor of "Midwest Real Estate News." He specializes in writing about mortgage lending, personal finance, business and real-estate topics. He holds a Bachelor of Arts in journalism from the University of Illinois.