Basic leveraged buyout (LBO) | Stocks and bonds | Finance & Capital Markets | Khan Academy

Basic leveraged buyout (LBO) | Stocks and bonds | Finance & Capital Markets | Khan Academy

Let’s say that many years ago, you started yourself a
nice little business. You have no debt and
your business every year generates a pre-tax income of a million and a half a year and a third of that goes to taxes. So you get a nice one million dollars a year of net income and
it’s a super stable business, nothing risky over here. Just by virtue of what your business does, the odds of this one million a year changing for the better or
the worse isn’t that likely. So this is essentially your …
This is what your balance sheet would look like. These are your assets. You have no debt. Let’s assume you have no liabilities and so you own all of the equity. You essentially own all of the assets, but you’re nearing retirement and you want to kind of cash out. You don’t necessarily want
to sell to your competitors or maybe there aren’t any
natural competitors to sell to because you’ve been comp
… Well, you don’t want to sell to them if they exist
because you’ve been competing with them for your … for your whole life and this isn’t the type of
business that you can IPO because it’s not quite big enough. So maybe we bump into
to each other and I say, “Hey, this business looks
interesting. I like the idea that” “your business is stable and
can generate a lot of income” “year after year after year.” So what I say is, “Hey,
would you be willing to take” “10 million dollars for your business?” So I offer … I offer 10 million dollars. And to you that sounds pretty good. That’s about ten times …
That’s exactly ten times your yearly net income. This isn’t a growing
business, just very stable. Seems like a reasonable deal to you. On the other hand for
me, I’m like you know paying 10 million dollars
and getting a million dollars a year, that’s kind of 10% on my money. That’s okay, but maybe I
can get some leverage here. Maybe I don’t have to put
all of the 10 million in maybe I could borrow some of it and maybe I’ll get a
better return that way. So when it comes time to closing
… When it comes time to closing, so I’m buying the assets. So these are the same
assets that I’m buying and I’m gonna give them …
and the money that I raise for these assets are gonna go to you, the person who started this business. So here are the assets. So instead of me putting up
the entire 10 million dollars, what I do is I put up one
million dollars myself So I put up one million dollars myself, one million from … from me. And I go to a bank and I say, “Look, will you lend me 9
million dollars? I’m going to “put a million dollars of my
own money. Will you lend me” “9 million dollars to
help borrow … to help” “buy this business for
10 millions dollars?” and the banks says, “I don’t know. That’s a lot of money.” “We’re putting a lot of money at risk.” and I’l say, “Look, you can
charge me a decent interest rate,” “maybe a 10% interest rate
and this is a super stable” “business, so clearly I’ll
be able to pay the interest” “on that money from the business
and if for whatever reason” “I’m not able to pay you the money,” “you can get the business. So,
I’m essentially giving you” “the business as collateral.” So you find some bank to agree to it and so they will lend
you 9 million dollars. They will not lend you 9 million dollars. Nine million dollar loan and let’s say that it is at
a 10% … 10% interest level. So now, after I have …
So 9 million from the bank, one million from me. That goes to you. You can now retire and buy your dream home or whatever else you
might have needed to do with that money. You could leave it for your
children, whatever you might … Donate it to charity,
whatever floats your boat but now the capital
structure of the business looks like this. I now do have a lot of debt. I bought you out using leverage. This is a leveraged buyout. So now, there is one
million dollars of equity that came from me and there’s 9 million dollars
of debt that came from the bank. That’s 9 million dollars of debt. Assets, at least what I paid
for it was 10 million dollars. Liabilities are 9 million dollars. So what’s left over is one million. And let’s think about how this investment, assuming the business keeps
generating a million a year, let’s think about how good
of a payoff this might be for my one million dollar investment. So before I had a pre-tax
income of 1.5 million. So 1.5 million pre-tax. Pre-tax before. Now I’m going to have
to pay some interest. So now I’m going to have to
pay … So 9 million dollars at 10%, that is $900,000 in interest. So now my pre-tax won’t be 1.5 million. I’m also going to have
to pay 900k in interest. So minus 900k means that I have 600,000, so 1.5 – 900k is 600,000
per year pre-tax income, 600,000 per year in pre-tax income and then I will pay taxes on that. The cool thing about corporate interest is that it’s tax-deductible. It’s deducted from your pre-tax income. So you take the 900 from
the 1.5, you have 600,000 leftover and then you pay taxes on that and let’s say it’s
still the same tax rate, so roughly one-third of
it goes to the government and so that you are left
with 400,000 net income and if you look at the
math, this is actually a pretty good deal for me or
I should … I was saying you, but I’m the guy who bought it. You’re the guy who sold me the business, so this is me now. I am left with $400,000
net income per year, which is pretty good because I only made a one million dollar investment. So even though this looks
like a sleepy business, even though it looked
like it was only getting a 10% yield on it, because
I was able to leverage up. I was able to do this leveraged buyout, I’m now able to make $400,000 per year on a one million dollar investment and now all of a sudden that is
a not so sleepy annual return.

75 thoughts on “Basic leveraged buyout (LBO) | Stocks and bonds | Finance & Capital Markets | Khan Academy

  1. @ExquisiteDoom Please stop spewing statistics you made up. The facts are that most companies grow even more successful when somebody has bought the owner out – primarily because the new owners typically are very experiences at running businesses. How come all this pessimism? Are you mad at Sal for not calling Capitalism the work of the devil?

  2. @Frostpako The terms of the loan can be negotiated and the size of the installments varies from business case to business case. You cannot conclude based on the video whether or not the installments are larger than the net income.

  3. @TheHumanAgenda
    Wow, a lot of economic illiteracy going around here.
    1) What prevents an indebted company from reinvesting its proceeds? Virtually no company these days operate without debt; in fact, debt makes possible ventures otherwise impossible because not a lot of people have or is willing to pay out of pocket the expense.
    2) The word "leverage" is meant to be taken outright; leverage magnifies the invested amount – the profit is quadrupled as a result, in this case.

  4. @Frostpako Actually most corporate debt is interest only and you pay most or all the principal at once (usually taking out a new loan to pay the principal on the old one). Also, principal payments do not get accounted for on your income statement.

  5. @TheHumanAgenda Really? Well, f*ck me then.
    1) When companies or individuals use leverage in their investments, two scenarios are applicable:
    1.1) The company/investor do not have the sufficient funds to pay the whole expense out of pocket. Loans thus generates competition, as more individuals or entities can compete in the marketplace.

  6. @TheHumanAgenda (con'td)
    1.2) The company or investor DO have the available funds, but are unwilling to lock p the money in a single project. As a result, the rest of the money is freed up for other investments or furthering the one already in business.

  7. @TheHumanAgenda (cont'd)
    2) A 40% return is better than a 10% return. If you are unable to see this, not even Sal can help you understand. If 10 people lever up their investments, they get a total return among them of 4m, compared to 1m if they did not lever up. Everybody wins!

  8. @ExquisiteDoom See my replies to TheHumanAgenda. You are welcome to reply as were they directed towards you.
    Furthermore, you said that most companies undergoing management change fail. That's a made-up statistic – and not only is it made-up, it's factually untrue and logically unsound.

  9. @TheHumanAgenda I'm sorry, but that's not how demand works – especially not when we're talking million-dollar corporations. The value of the firm is carefully calculated (be it on a stand-alone basis or with synergies taken into account) by potential purchasers. What loans generates is liquidity. Liquidity in markets does not drive prices to explode or otherwise create inflation; liquidity results in prices being MORE accurate to the true value/NPV, and it helps attract the best people/managers

  10. @TheHumanAgenda If you were able to produce a worked-though example of your claim, maybe I'd consider what you're saying. Until then I'll have to regard your comments as nothing more than empty claims. If, for instance (as Sal also mentions), the loan is a bullet loan (i.e. principal repayment in one installment at maturity), there are no gradual repayments.
    But it seems you've figured it all out; but what makes you smarter than virtually every single company that disagrees with you?

  11. This is an interesting presentation. But nobody structures leverage buyouts like this. Well not anyone that knows what they're doing. You borrow less than the assets. So you can actually sell the assets to payoff the loan. Or you bring in other investors since banks only lend to about 10% of deals.

  12. @TheHumanAgenda

    They don't like taking on risk. And they don't want to run a business or deal with real estate. They will just end up selling it at probably a lost. If you have a triple A rating or lots of collateral. Sure they will give you a good deal.But most deals are funded through other sources along with banking or instead of bank loans.Like a private equity firm already has millions,billions in capital from investors.But there are plenty of financial sources.

  13. good explanation but no bank would give you 90% leverage, maybe 50% if you are lucky on a small private company – if it has hard assets.

  14. I have thoroughly enjoyed reading your comments, sir. As an 18 year old (accounting) college student trying to make sense of everything financial, I would love to have a smart, good-American advisor like you. Many thanks!

  15. so what happens to you if when you take over the company, the company goes belly up after the second year? the bank is gonna come looking for the 9million right? how do they get paid? do you have to raid your company's pension fund and start firing workers?

  16. What if i take whole of the money as loan which is 10 million, I will pay 1 million interest which will be deducted from pretax income leaving 500K. Now if I deduct 1/3rd of the tax which leaves aprrx 360000 as Net Income without even investing a single penny. Correct me if I am wrng.. Just curious if its right..?

  17. Yes you are right, the problem is when you goto 100% debt, the interest payment wont be the same, as the bank now is taking more risk, because there is no 1M equity buffer to cushion losses

  18. I am not sure but I think the return may be even higher, as you will need to add back the tax shield you received from the interest payment…someone correct me if I am wrong

  19. ok… even still if I raised my debt… still I they will leave atleast something to me… the point I am making is none of my equity I have invested.. but I still earn a profit…

  20. yea, you are absolutely right, its the same as 'margin lending' where you borrow a lot of money to trade with, so none of your own equity, but the interest payments are high…if you can find a return that is far greater than those payments, then you can definitely go for a 100% debt financed model

  21. you are correct. but no bank in the world would do that. and also, you equity equals zero, which more or less means that you don't own the company. it has to have an equity share.

  22. I've always wondered – why it is the target company which is saddled with the debt used to fund the acquisition, and not the purchaser company itself? Shouldn't it be the purchaser who borrows from the bank and adds in some of the purchaser's own money to buy over the target?

  23. ya, but if you already have money why would you want to borrow more money that requires you to pay interest?

  24. so.. You a a partner in a private equity fund and you are looking at a BASIC leveraged buyout video.. Must be a very good partnership..

  25. lol, you got me! instead of trying to imply something about me, you haven't addressed the issue which is no senior debt with an lbo is interest only, never. ever. never ever ever, so you're misleading in your video. why not get it right? if you're going to put something out there, why not get it right?

  26. and we're getting quoted senior at L + 325 (assuming you know what that means) so this 10% nonsense is also pretty nuts. look im a big fan of what you're doing generally speaking, i think you are a force for good in the universe, but you're just wrong about this one thing.

  27. Hey I didn't mean to mislead you, I am not the author of the Video. I was simply studying for the CFA and therefore was not in a very good mood. My comment was me being sarcastic, didn't mean to infer anything about you 🙂 Sometimes you have to sacrifice realism to be able to make sth understandable, I think that is what the author did here.

  28. So, for this example, what kind of principal payment do you think we'd be looking at? I can't imagine it being high enough not to make it worth it because you are receiving an annual income. You'd get back the $1 Mil in a couple of years and from there on would be making money right?

  29. well you're mixing it up a bit. Typically LBO senior secured debt is 36month to 48 months in term. this is dictated by banks, as a fund we don't have any say in this. we want a longer term they want a short term. No bank would allow you to do this deal at 10x ebitda without putting in 4-5x ebitda of equity. then there would be interest only 1-2x mezz and 3-4 senior which is amortized.

  30. I mean i wish we could get just interest only stuff, but banks don't allow that. in theory you could do a deal with all mezzanine rates, but they are 12-15% + warrants so about 20% per year. Thats way to high. Senior debt right now is 4-6*%, so its a drastic difference in cost of capital.

  31. Hmm. OK. That makes sense.(I think; I was a science major so I had to look up most of that) I can see why sal dumbed it down a lot as an introduction video.

  32. no business sells at 10 times earnings…practically….and no bank will lend you 10 times your money down. This isnt forex.

  33. I dont understand or must be missing something. The only person i see who could possibly lose in this deal would be Khan ( the buyer). Not the bank or seller. Khan still owes the bank 9 Million w/ interest on top of that.


  35. Wow! You know everything! Lol Im pretty sure you are the one who taught me Photosynthesis and Cellular Respiration years ago when I was in college. Now I land on this topic years later and you are teaching me this! Amazing! 😂😂

  36. why not just pay the seller with the companys profits? you have him take out a loan from the company … lefs say 200k as downpayment then you pay him X dollars per year for seceral years.

    You get the business for zero money.

  37. The $400k is not the ROI. It's the firms new net income. So yes there is a 40% return if you are comparing net income over investment, however the investor will only claim a portion of that income if they are interested in growing the firm or refinancing, it may be possible to reach a 40% return after several years if the loan is refinanced and structured to maximize investor earnings potential.

  38. Excellent introductory video, for anymore looking to learn more about the LBO transaction and how different parties are involved in the transaction, check out the LBO video on my channel. Let me know if you have any questions!

  39. So what about paying the investment bank back the £9m? I assume it's when you sell the business to another private equity firm and use that money?

  40. Wow, what a beautiful and concise explanation. It's great to see how LBOs can be so attractive; it's also interesting to note how they can go awry for the purchased company when the income isn't as consistent as previously thought (Toys-R-Us). Thanks for sharing!

  41. so they liquidate the assets if they turn out they don't have the money to pay back the principal or if the business isnt generating the amount of income one would have hoped? Thats when companys go bust and employees start losing their jobs.

  42. pretax income of 1.5 million only you took there isn't a need of taking another 1 million and 9 million we took? and how did 400 k came please explain it sir

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