LBO Model Concept: Leveraged Buyout and Buying a House (13:16)
Learn the concept behind a leveraged buyout (LBO), and why and how an LBO Model works.
The most common analogy used to explain an LBO is: “Buying a house with a cash down payment and a mortgage.”
But that is a misleading way to think about it – because an LBO is more like buying a house to rent out to *tenants* i.e. an asset that you earn cash flow from, as opposed to a place to live in yourself.
An LBO “works” mathematically because leverage reduces the UPFRONT cost of buying a company (or a house)… and then you use the company’s cash flows to pay off debt principal and interest rather than collecting them for yourself.
You still have to repay debt at the end when you sell the company… just like repaying a mortgage when you sell a house…
BUT it still benefits you to use debt in the beginning because money today is worth more than money tomorrow, and because it’s MUCH easier to get a high return on, say, $150 invested than it is on, say, $500 invested.
In this example with purchasing a house, we see how 100% cash used for a $500K house produces an IRR of 9% with a 1.5x returns multiple.
By contrast, when only 30% cash is used, the IRR increases to 15% and the returns multiple increases to 1.9x.
Most private equity firms aim for IRRs of at least 20% (sometimes less than that in a weak market), so normally you can come close to or exceed 20% only by using leverage.
Exceptions apply for fast-growing companies and cases where the exit multiple or margins have expanded, but in general most PE firms rely on leverage to achieve IRRs in that range…
Well, assuming the company doesn’t blow up and go bankrupt due to the high debt load – but that’s another lesson for another day…