Buyout funds and management buyouts: how LBOs, MBOs and MBIs work

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Buyout funds buy majority stakes in established companies, pay a large part of the purchase price with debt and sell the company again after a few years. In a management buyout (MBO), the company's own management buys in alongside them; in a management buy-in, an external team does. This article explains the forms of buyouts, the capital structure and the incentives for management, works through a simplified LBO model with MOIC, IRR and a value creation bridge, and summarises what research knows about value creation, jobs and defaults.

What a buyout is

In a leveraged buyout (LBO), a private equity firm takes over a company and, according to Kaplan and Strömberg (2009), typically finances 60 to 90% of the purchase price with debt. The acquired company then carries the debt; it is serviced from the company's cash flows and repaid from the proceeds when the company is sold. The fund holds the stake for a few years, steers it through the supervisory bodies and then sells. The main forms:

Capital structure: who finances what

According to Kaplan and Strömberg (2009), the senior secured loans come from banks and institutional investors; junior debt is often high-yield bonds or mezzanine. In addition, private debt funds provide direct loans, frequently as a unitranche (direct lending). From top to bottom in order of seniority:

With sweet equity, management pays a small amount, though one the managers feel, and in return receives a larger share of the gain in value per euro invested than the fund, for example because the fund provides part of its money as a senior shareholder loan or as preferred equity. According to Kaplan and Strömberg (2009), the median CEO in US buyouts receives 5.4% of the gain in value (shares and options), and management as a whole 16%.

Worked example: a simplified LBO model

A fictitious company with EBITDA of 100 (€ million) is bought at 8 times EBITDA, 60% financed with debt. EBITDA grows by 5% a year, half of it remains as cash flow before interest (after capital expenditure and taxes), interest is 7%, and everything left over repays debt. It is sold after five years, again at 8 times EBITDA; fees and transaction costs are ignored.

Where the return comes from

The value creation bridge breaks down the gain in equity value into EBITDA growth (revenue and margin), multiple expansion (a higher sale price than purchase price per euro of EBITDA) and debt reduction (deleveraging). With buy-and-build, there is the added effect that small add-on acquisitions can often be bought at lower multiples than the larger group fetches when it is sold. Part of this is multiple expansion, not operating progress. Kaplan and Strömberg (2009) distinguish three levers used by the funds: financial engineering (high leverage imposes discipline and lowers taxes through deductible interest), governance (smaller, more active boards, faster replacement of management) and operational engineering by industry and operating experts. Guo et al. (2011) break down the returns of public-to-private buyouts from 1990 to 2006: higher industry multiples and the tax benefits of leverage were each about as important as the operating improvements, which turned out only about as large as those at comparable firms or slightly larger.

Leverage: an amplifier in both directions

Using buyouts from 1980 to 2008, Axelson et al. (2013) show that leverage hardly depends on the characteristics of the firms, but on credit conditions in the economy as a whole. More leverage went hand in hand with higher purchase prices and lower fund returns. When credit is cheap, buyers apparently pay too much. Because leveraged loans and direct loans mostly carry floating rates, the sharp rise in interest rates from 2022 fed straight through to the interest burden: interest cover falls, repayment and deleveraging stall, and maturing loans have to be refinanced on more expensive terms.

The role of management and incentives

In 1989, the economist Michael Jensen predicted that buyout organisations would become the dominant corporate form, according to Kaplan and Strömberg (2009) because of concentrated ownership, strong incentives for managers, lean organisation and active monitoring. After the collapse of the high-yield market and the defaults of the early 1990s, the prediction proved premature. The basic idea: debt forces management to pay out cash flows instead of wasting them, and their own stake turns managers into co-owners. For early buyouts, Kaplan and Strömberg (2009) summarise: the ratio of operating profit to sales rose by 10 to 20%, and that of cash flow to sales by around 40%; employment rose, but less than at other firms in the industry.

An MBO is a special situation: as the buyer, management negotiates the price of a company that it knows better than anyone. In a corporate sale or a succession, this calls for a clean separation of roles and an independent valuation.

Exit routes

According to Kaplan and Strömberg (2009), the most common exit is a sale to a strategic buyer (38% of exits), followed by a sale to another fund in a secondary buyout (24%) and an IPO (14%); the median holding period was around six years. There are also continuation funds, into which the manager sells holdings from its old fund. According to ILPA (2023), the manager sits on both sides of the transaction in this case (see secondaries).

What the research shows

• Value creation: in public-to-private buyouts from 1990 to 2006, the median market- and risk-adjusted returns were 72.5% on pre-buyout capital and 40.9% on post-buyout capital; the deals were more conservatively priced and less leveraged than in the 1980s (Guo et al. 2011).
• Jobs and productivity: Davis et al. (2014) tracked 3,200 US target firms from 1980 to 2005: slight net job losses, but a lot of job creation and destruction and productivity gains, mainly through closing weak establishments and opening productive ones. In their follow-up study (Davis et al. 2019), employment fell by 13% relative to comparable firms within two years after buyouts of listed firms, and rose by 13% after buyouts of private firms.
• Defaults: firms owned by private equity are more highly indebted and default more often than other borrowers in the leveraged loan market, but they restructure faster, avoid bankruptcy court more often and are liquidated less often (Hotchkiss et al. 2021).
• Returns for investors: against the S&P 500, buyout funds performed well (Harris et al. 2014); against leveraged small-cap value stocks, they were on average below or level (Phalippou 2014; L’Her et al. 2016). More on this under Private equity.

Risks

• Interest rates and refinancing: floating rates make rising policy rates expensive immediately; maturing loans have to be replaced on new terms.
• Covenants: if a metric such as debt to EBITDA breaches the agreed limit, the lenders can renegotiate; with covenant-lite loans, the warning comes later.
• Insolvency: high leverage leaves little buffer; in the downturn example, two thirds of the equity are gone.
• Exit market: the return depends on the exit multiple, i.e. on equity and credit markets at the time of sale.
• Concentration: a fund usually holds only a limited number of companies; individual defaults weigh heavily.

For advanced readers: the bridge as a formula

• Order matters: if you apply the multiple change to the initial EBITDA, part of the effect shifts between growth and multiple; the order chosen should therefore always be stated.
• MOIC and IRR: the same MOIC of 2.12 means 16.2% a year after five years, but only 11.4% after seven. An early sale raises the IRR, but not necessarily the profit.
• Taxes: interest reduces the tax burden; Guo et al. (2011) find these benefits about as important as the operating gains. Rules such as the German interest barrier (Zinsschranke) limit this.
• Equity risk: with 60% debt, the equity beta rises to 2.5 times the asset beta, provided the debt beta is zero (see public proxy).

Limits and common mistakes

• Counting growth twice: if you assume growth and rising multiples at the same time, you are banking on two lucky developments.
• Confusing cash flow with EBITDA: capital expenditure, taxes and working capital eat up a large part of it; in the example, half remains.
• Forgetting fees: the model shows the return of the deal, not the investor's return after management fee and carried interest.
• Booking leverage as skill: part of the return is market return with leverage; a fair comparison uses a leveraged benchmark.

How Portfolio Lab calculates it

Portfolio Lab does not calculate an LBO model with company figures. You can, however, roughly model the risk of buyouts: in the Backtest, choose an asset class such as Equities US small cap value and give it a leverage per security of between 0.1 and 5. The app then calculates L times the return for each period and deducts the money market rate plus a spread for the borrowed part (default 1% a year); because the leverage is reset in every period, the result is path-dependent. A factor of around 1.67 corresponds to the example in the article Measuring private markets. Listed private equity companies are available as the asset class Listed private equity under Asset classes.

This article explains a method; it is not investment or tax advice. Worked examples are simplified and rounded. All terms in the glossary.