What Is a Leveraged Buyout (LBO)?

A leveraged buyout is like getting a student loan to pay for college...

Most people expect that, if they graduate from college, they’ll end up making more money than they would with just a high-school diploma. Since many students don’t have the cash to pay for college upfront, taking out loans is common. They take on a lot of debt now, with the expectation that their investment will allow them to pay it off in the future. That’s how leveraged buyouts work — Companies acquire other companies with debt, banking on the fact that they’ll be profitable enough to pay off that debt later.

A leveraged buyout involves a buyer (usually a company or private equity firm) purchasing another company with a large share of debt, often secured using the acquired company’s assets. Putting up little of its own money can allow the purchasing company to maximize return on investment and commit few of its own resources to make the purchase.

When one company buys another, it almost always uses some debt to do so. What makes leveraged buyouts different is that they rely on a far higher debt-to-equity ratio than most acquisitions.

Suppose that a fictional fast-food restaurant, Sandwich Shack, wanted to acquire a competitor called, Burgers N Stuff through a leveraged buyout. To make the purchase, Sandwich Shack would borrow against Burgers N Stuff’s assets rather than its own. This setup can reduce the risk the acquiring company takes on. If it defaults on the debt, the bank will come after Burgers N Stuff’s assets instead of Sandwich Shack’s assets.

Some leveraged buyouts involve acquiring an entire company. Others involve just buying a company’s assets and creating an entirely new corporate entity to absorb them. This structure can be beneficial because it may allow the company to make a fresh start, rather than taking on potential liabilities of the company they’re acquiring.

For example, suppose that a fictional local retailer HomeStop was purchased in a leveraged buyout. The acquiring company takes on HomeStop’s assets, but not the corporate entity. If a former customer comes out of the woodwork to sue HomeStop, the buyer may not be liable.

A key characteristic of leveraged buyouts is that they consist of a significant amount of debt. Let’s talk about a few ways that acquiring companies might finance their leveraged buyout:

• Bank loan: Getting a loan from a financial institution is a common way that companies take on debt to finance leveraged buyouts. The company pays back the loan over a specific number of years.
• Seller financing: In some cases, the acquiring company might rely on seller financing to pay for their purchase. This type of financing requires the seller of the acquired company to essentially loan money to the buying company for the purchase.
• Bonds: Bonds are a popular debt instrument, and companies can use them to raise capital to fund a leveraged buyout. Buyers lend money to the issuer by purchasing the bonds, and then the issuer pays them back by the maturity date, potentially with interest along the way.

A leveraged buyout is one route that a private equity firm (or another buyer) could take to acquire another company.

Companies often use leveraged buyouts for a particular purpose: To acquire a company they can restructure or improve in hopes of selling it later for much more. When companies enter into a transaction with a leveraged buyout, they usually have an exit strategy in place.

Let’s talk about a few of the strategies a private equity firm might use:

• Privatizing and repackaging a public company: Private equity firms often use leveraged buyouts to purchase public companies. The acquiring firm might make some changes to the acquired company, then take it public again through an initial public offering (IPO). An example of this strategy is the hotel company Hilton Worldwide. A private equity firm bought Hilton in 2007. Six years later, the firm took Hilton public again with a new IPO.
• Breaking up a large company: A company might use a leveraged buyout to purchase a large company and either break it into small companies to sell, or sell off its assets separately.
• Saving a failing company: If a company is underperforming, a buyer might purchase it through a leveraged buyout to turn it around. This strategy can allow the acquirer to purchase the target company at a discount because it isn’t currently performing to its full potential.

One advantage of using a leveraged buyout is that the acquiring company can maximize its return on investment. One way it does this is by leveraging the assets of the company it is acquiring, rather than its own assets, to finance the purchase. Another is that it can avoid tying up a lot of its own money in the investment, instead relying on a large amount of debt. Usually, the company hopes to sell the firm at a higher price just a few years later.

Leveraged buyouts can also be advantageous for the seller. If the target company’s current owner wants to sell the business, a leveraged buyout is one way to do that. Once the owner sells the company, the future of the business and its debt doesn’t affect him or her.

While there are upsides to leveraged buyouts, potential pitfalls exist as well. First, the result of this type of purchase is that the acquiring firm now owns a company that is in a lot of debt. If cash flow disappoints, the company might find itself unable to repay what it borrowed.

Some critics also say leveraged buyouts are predatory. Private equity firms can use leveraged buyouts to purchase companies without taking on much risk themselves. As a result, they might not care as much about the outcome. However, the target company has employees and managers who are counting on its success.

The first step of a leveraged buyout is for the acquiring company, often the private equity firm, to identify a target company. Usually, the purchaser looks for a company that has a lot of assets, but may have been mismanaged or otherwise not achieved its full potential.

Before a leveraged buyout, the purchasing company gathers information to determine a fair purchase price for the target firm. It comes up with this valuation based on the target company’s assets and cash flows, among other factors.

Leveraged buyouts usually take place in one of two different ways. In a “hostile takeover,” the acquiring firm takes its offer — usually one well over the market price — right to shareholders. It bypasses the company’s leadership with a deal that shareholders may find difficult to pass up. If the target company’s leadership wants to sell, the two companies negotiate a deal.

The acquiring company then secures financing. Historically, companies typically issued bonds to finance buyouts. Today, most firms rely on bank loans to finance leveraged buyouts. They buy enough shares to have a controlling stake in the business, before purchasing the outstanding shares to take full ownership. At this point, the company goes from a public one to a private one.

Once the leveraged buyout is complete, the purchasing company must update its balance sheets to account for the new debt and equity it has taken on.

The purchasing company, usually a private equity firm, can then start planning its exit from the investment. Private equity firms don’t often purchase a company to hold it indefinitely. Especially in the case of a leveraged buyout, the buyer usually intends to either take the firm public again or resell within about five years.