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What is a leveraged buyout in simple terms?
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What Is A Leveraged Buyout
A leveraged buyout, or LBO, refers to an acquisition method where the acquiring company will borrow a significant portion of the funds necessary to complete the acquisition.
It’s called a “leveraged” buyout as the acquiring company uses borrowed funds to acquire the target thereby using financial leverage to cover the cost of acquisition.
In many leveraged buyout scenarios, the acquirer will use the target company’s assets as collateral to secure the necessary funds to complete the acquisition.
This provides the acquiring company further leverage as it is able to acquire the target without consuming its own capital or creating encumbrances on its own assets.
Historically, leveraged buyouts do not have a good reputation where the acquiring companies are perceived to use predatory tactics in taking over the target company.
In many cases, hostile takeovers are leveraged buyouts.
Why Leveraged Buyouts Take Place
Leveraged buyouts tend to occur for three principal reasons: to take a public company private, to spin off a portion of a business, or to transfer private property.
Leveraged buyouts gained significant popularity in the 1970s when many companies used borrowed funds to acquire other companies.
However, in the 1980s, the hype cooled off when several leveraged buyout acquisitions ended up with the bankruptcy of the business entities when they had taken too much debt to finance the transaction.
Unable to generate enough operating cash flow to be able to service their debt, many companies went bust following a leveraged buyout.
Today, you continue to see leveraged buyouts in the market but the acquiring company will exercise more diligence in ensuring that it could satisfy its debt obligations.
For this reason, most leveraged buyouts require the target company to be profitable and cash-flow positive.
Leveraged Buyout Characteristics
Fundamentally, a leveraged buyout is when a company uses debt in a much larger proportion than equity to acquire another company.
As a result, the first important characteristic of leveraged buyouts is the source of funds used to cover the cost of the acquisition.
When debt is used to fund over 70% or 80% of the acquisition cost, we could consider the transaction to be a leveraged buyout.
Since debt has a lower cost of capital than equity, some companies will prefer funding the acquisition using debt as opposed to using equity interests.
Another important characteristic of a leveraged buyout is considering the type of target company acquired.
Typically, the companies that are good candidates for a leveraged buyout are those with stable cash flows, relatively low fixed costs, relatively low levels of debt, good valuation, and a strong management team.
The target company must be carefully assessed in a leveraged buyout to ensure that it produces enough cash and is sufficiently profitable allowing the acquirer to meet is debt obligations.
How Leveraged Buyouts Work
A “leveraged buyout” is when a company uses debt or bonds to acquire another company.
Typically, the debt-to-equity ratio in leveraged buyouts is in the range of 90% to 10%.
Since leveraged buyouts are considered more risky transactions, the bonds that are issued to fund such acquisitions are considered junk bonds (meaning that they are not investment-grade bonds).
For example, if Company A wants to acquire Company B for a total sum of $100,000,000, it will borrow $90,000,000 of the acquisition cost through traditional loans or by issuing bonds and will put up $10,000,000 of its own capital.
What’s unique about leveraged buyouts is that the target company’s success is used against it to take them over.
In other words, since the target company is usually profitable and cash flow positive having a strong balance sheet, the acquirer will use that balance sheet to provide the necessary collateral to the creditors when borrowing funds.
In this perspective, the target company’s assets are used to fund the acquisition of its own shares.
Types of Leveraged Buyouts
There are different types of management buyouts in the market.
The most common leveraged buyouts are: management buyouts (MBO), management buy-ins (MBI), secondary buyouts, or tertiary buyouts.
It’s also common to see leveraged buyouts in restructuring scenarios and cases where there’s an insolvency issue.
A management buyout is when the company’s current management team acquires the company from its current owners.
The management buy-in is when the business is purchased by an external investor who then replaces the management team, directors, and officers.
A secondary buyout is when a private equity sponsor takes control of the business through a leveraged buyout and sells the business to another firm.
A tertiary buyout is when a company that was acquired in a secondary buyout is sold to another financial sponsor.
Pros and Cons of Leveraged Buyouts
There are several advantages to acquiring another company by way of a leveraged buyout.
One important advantage of a leveraged buyout is that the acquirer will only need to use 10% to 15% of its own capital to fund the acquisition of another company.
This means that the acquirer will only have to dish out $10,000,000 for a $100,000,000 acquisition.
Another advantage of leveraged buyouts is that the cost of capital is typically lower than equity.
Since the payment of interest on debt is tax-deductible, a leveraged buyout will allow the acquirer to reduce its tax liability.
On the other hand, payment of dividends on equity is not tax-deductible and will not offer the same tax advantages.
A leveraged buyout is also a great way for an acquirer to purchase a much larger company enabling it to get the benefits of scale from the target company.
However, leveraged buyouts are inherently risky.
Since the acquiring company must take on large amounts of debt, the company may run into liquidity issues if it is unable to generate enough cash flow to pay its debt obligations on time.
In addition, lenders tend to perform a more thorough due diligence before lending any money in the context of a leveraged buyout.
The extensive due diligence can be quite costly and, in the end, the lender may not provide enough funding to cover the acquisition cost.
How Leveraged Buyouts Are Financed
There are many ways a company can raise the necessary capital to fund the cost of an acquisition in the context of a leveraged buyout.
Depending on the size and complexity of the transaction, different types of financing options can be available.
For smaller leveraged buyouts, you can have the seller finance the deal, SBA loans, conventional pans, or get financing from small investors.
For larger leveraged buyouts, you can issue senior debt, mezzanine and subordinated debt financing, and seller financing.
Following the leveraged buyout, it’s important that the acquirer and target company generate enough cash to pay off their debt.
Sometimes, post-acquisition financing may be obtained from banks or even factoring companies through the financing of accounts receivables.
Leveraged Buyout Examples
Here are a few real-life examples of leveraged buyouts.
In 1986, Kohlberg Kravis Roberts, famously known as KKR, acquired Safeway for a total of $5.5 billion.
This transaction was done as Safeway’s board wanted to avoid a hostile takeover from Herbert and Robert Half of Dart Drug.
One of the largest LBOs was the acquisition of Hospital Corporation of America by Kohlberg Kravis Roberts (KKR), Bain & Co, and Merrill Lynch for a total of $33 billion in 2006.
In 2007, Blackstone completed a leveraged buyout of Hilton Hotels, right before the financial crisis.
However, although Blackstone initially lost money, they were able to turn things around in Hilton and bought the company public for $12 billion.
In 2014, BC Partners, a British buyout firm, acquired Petsmart for $8.7 billion as they believed that could significantly improve the company’s market share.
So there you have it folks!
A leveraged buyout or LBO is a phrase used to refer to one company acquiring another company using a significant amount of borrowed funds to fund the acquisition cost.
In essence, a leveraged buyout allows a company to acquire another company using very little amounts of equity in the process.
Very often, the transaction is financed using high levels of debt secured by the target and acquirer’s assets.
Now that you know what is a leveraged buyout, when it’s used, and how it works, good luck with your research!
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