Required Rates of Return in MBOs

Leveraged or management buyouts (LBO/MBO) often are financed with 75% or 80% debt. Typically, the rest of the purchase is financed by the buyout or private equity firm (80% to 85% of the remainder) and the new management team (15% to 20% of the remainder). The company is taken private, so the stock is no longer traded on any stock exchange. Once private the new owners usually sell some assets to repay some of the debt. Good buyout candidates have strong stable cash flow and limited growth opportunities. Initially most to all of the companys cash flow goes to debt reduction. Buyout firms often have a portfolio of dozens of companies, so each company is being added to a somewhat diversified portfolio. To simplify thinking about this question assume that the buyout firm either has a very well-diversified portfolio of companies.

Buyout firms have a very high required rate of return or hurdle rate, 30% to 40%. They evaluate deals assuming that they will exit after about 4 years. Often the exit strategy is to take the company public again through an IPO (Initial Public Offering). If the average asset beta (that is the average beta of an unlevered firm) is about 0.80, can you explain the high hurdle rate buyout firms apply to their deals? To give the problem some structure assume that the historic risk-free rate is about 6.0% and the historic market risk premium is 7.5%.

A.What problems would occur if a buyout firm just picked a number as its required rate?

B. How would you explain the 30% to 40% required rate of return used in buy-outs? Is it theoretically correct?