What is a Leveraged Buyout (LBO)?

The historically low interest rates of the last couple of years has led to an increase in mergers and acquisitions. Now, the leveraged buyout is coming back in fashion after dropping off the M&A scene post-2008.

This post will explore the various types of leveraged buyouts and models for financing.

What Is a Leveraged Buyout, or LBO?

The LBO is a type of acquisition where one company buys another using borrowed money. Percentages vary by deal, but it's common in the leveraged buyout model for the buyer to provide as little as 10% in equity and finance the rest.

Due to the significant amount of borrowing that must takes place in order to complete the leveraged deal, the buyer is often required to put up company assets as collateral, including assets from the company they’re purchasing.

When Does the Leveraged Buyout Model Make Sense?

Leveraged buyouts can seem aggressive or even ruthless, particularly when the buyer plans to use the target company's assets as collateral within the deal. There were times in the past when companies that were acquired via leveraged buyout were driven into bankruptcy after the close of the deal due to the high amount of leverage committed to finance the deal.

However, there are times when this deal structure makes sense. Leveraged buyout financing may be the best option for deals that:

• Acquire a major competitor: Smaller companies can borrow money to buy much larger companies who are direct competitors
• Take over a weak company for the purposes of improving it: By combining resources, the weak company can be improved by the M&A process
• Divide a large company into smaller subsidiaries: In this scenario, a larger company can be split into parts, which can then be sold off
• Take private a company that is currently operating publicly: A company can be sold to a private entity and restructured
• Rescue a failing company: New ownership make be the solution to transform a flailing company

Types of Leveraged Buyout

A leveraged buyout can take several forms, including:

• Management buyout: A company's existing management can purchase the company, essentially seeking to transform it from the inside out through new leadership
• Management buy-in: Management from outside the company effectively buys their way into the target company and seeks to transform operations
• Secondary buyouts: Any time a private equity firm orchestrates an LBO for one of the businesses in its portfolio, it's called a secondary buyout

Benefits/Risks of LBOs

When done right, the LBO can benefit the buyer and the seller.

Buyers appreciate LBOs because they do not have to put up a lot of their money in order to acquire the target company. This positively affects the rate of return: Because the company doesn't need to put much down to proceed with the deal, the deal is often quite profitable!

For the target company, LBOs often mean nice returns for selling the business. If they had to accept a cash offer without financing, they might get less for the business. Financing, however, can fill the gap between what the seller has to invest and what the market price dictates.

When public companies are taken private and reorganized, it offers the chance to re-envision the company's role. Often these companies are returned public via IPO or other listing method after the LBO. The new company might better align with market demands, and there is often more public interest as a result.

LBOs also makes sense for businesses that have become too large to compete. By breaking up a business into smaller, more focused entities, it can often be more profitable. These are just some examples of when the LBO benefits both parties.

That said, the critics of LBOs have valid points.

Interest rates are set to rise. Companies will be forced to pay higher rates for money they're borrowing, which increases the risk of the proposition. An LBO may not always make sense financially, and the buyer may not be willing to bear the risk needed to make the transaction work.

In an extreme scenario, the business could see its credit rating lowered or even be forced to declare bankruptcy should they experience problems post-acquisition. This risk is increased in industries that are hyper-competitive.

Often, there is a need to make the new company profitable and scale back costs by any means necessary. LBOs can lead to public blow back if they are accompanied by mass layoffs. For many businesses, a loss of public faith can negatively impact market position and could lead to loss of customers.