Moneyzine
/Investment Guides /Leveraged Buyout (LBO)

Leveraged Buyout (LBO)

Moneyzine Editor
Author: 
Moneyzine Editor
6 mins
January 23rd, 2024
Advertiser Disclosure
Leveraged Buyout (LBO)

The economic recession that began in late 2007 brought about an end to the boom of leveraged buyouts (LBO). The same problems that plagued the mortgage industry, slowly made their way to private equity firms operating in the financial markets. As the economy began to lift in 2009, the return of the LBO would not be far away.

In this article, we'll be discussing the topic of leveraged buyouts. As part of that discussion, we'll provide a brief history of LBOs as well as a definition of the term. Next, we'll talk about how these deals are structured, including the attributes of the ideal target company. Finally, we'll talk about the pros and cons of these takeovers.

Leveraged Buyouts

Also referred to as bootstrap financing, or a highly leveraged transaction (HLT), a leveraged buyout is defined in terms of its structure, since those characteristics are unique to this type of activity. Characteristics of the transaction would include:

  • A financial sponsor, or private equity firm, that wishes to purchase a controlling interest in a target company.

  • A significant portion of the acquisition price paid for the target company is financed through debt / leverage.

  • The assets of the target company, as well as the acquiring company, are used as collateral.

  • Due to the risk of these arrangements, the securities issued are normally rated as junk bonds (non-investment quality).

History of LBOs

Following the stock market crash of 1929, companies strived to keep debt ratios low. Decades later, as corporations began to build large conglomerates of operating companies, novel ideas began to emerge with respect to how buyout deals could be structured. In the early 1960s, investors such as Warren Buffett began using publicly traded holding companies to amass large portfolios of investments.

Through the 1970s and 1980s, the techniques used by corporate raiders such as Jerome Kohlberg and Henry Kravis were refined, as undervalued companies were identified and purchased. This succession of leveraged buyouts was strictly motivated by the thought of excess profits, and entire companies were purchased, dismantled, and sold in pieces.

The boom era of these business transactions continued during the decade of the 1990s through the year 2007; stoked by low interest rates and generous lending practices.

Structure of Leveraged Buyouts

The process typically starts with a private equity firm looking to buy a company using a combination of equity and debt. The interesting twist in the LBO structure is the use of the acquired company's assets to secure a portion of the debt used in the buyout. The private equity firm also uses the cash generated by the acquired company to pay down the debt.

A successful leveraged buyout results in abnormally high returns to equity holders. Once successful, equity holders typically decide to execute an exit strategy that includes options such as:

  • Recapitalization: by replacing equity with additional debt, it may be possible to extract even more money from the acquired company.

  • Complete Sale: it's possible to sell the entire company if a strategic match can be found among potential buyers.

  • Initial Public Offerings: while it's not always possible to sell the entire company, an IPO allows equity holders to realize a gain on their initial investment.

Transaction Financing

The cost of the LBO can include transaction and lender's fees, bank expenses, and sponsor costs. Most buyouts involve three sources of funding: private equity, mezzanine debt, and senior debt.

  • Private Equity: typically funds 25% of the total transaction. This is also the most expensive source of financing. Sources of this equity can include the target company's management team, a pool of funds held by LBO firms, as well as investment banks. Equity structures may include preferred stock held by the LBO firm, while employees and management teams receive common stock.

  • Mezzanine Financing: typically funding 25% of the total transaction, this type of financing fills the gap between equity and senior debt. Mezzanine financing is junior to all other debt. For this reason, it carries a higher level of risk and interest rate to compensate investors for that risk.

  • Senior Debt: also known as term debt, this will usually fund approximately 50% of the total transaction. This debt is frequently secured by assets of the acquired company, and is the least costly way to fund the buyout.

Identifying LBO Candidates

At a high level, potential LBO candidates would be undervalued stocks with strong cash flows, and relatively low debt. Other characteristics of target companies include:

  • Large asset base

  • Low future capital requirements

  • Potential for process improvements or cost reductions

  • Strong market position

  • Relatively low enterprise value

Finally, the ideal candidate would be a company that can be easily separated into logical subdivisions and / or presents the acquirer with a clear exit strategy.

Pros and Cons

The big advantage of using financial leverage is that by increasing the debt held by the company, the equity portion often decreases to the point where the private equity firm only needs to supply around 25% of the total transaction price.

The large interest payments also force the company's management team to increase operating efficiency. For example, the company might be obligated to implement a number of cost-cutting measures that might otherwise go untapped. Since interest expense is tax deductible, and dividend payments are not, the LBO can also create a valuable tax shelter for the target company.

If mismanaged, a leveraged buyout can expose the acquired company to significant risks. That's one of the reasons private equity firms usually work closely with the existing management team to achieve their goals. If the private equity firm can convince the management team to invest in the transaction, they are certain to gain the full support of the management team too.

The real risk of a leveraged buyout is the financial pressure the debt places on the company. If some unforeseen event occurs, it is possible for all the investors to lose their entire stake in the deal. Buyouts are also dependent on precise calculations of the future cash flows required to satisfy creditors. Finally, economic downturns, or an increase in costs, can result in the company's inability to meet all their financial obligations. Deals can turn sour very quickly when this happens.

Additional Resources

  • The DuPont Equation
    One of the more interesting measures of a company's financial performance is the DuPont Equation. This model allows stock analysts and investors to examine the profitability of a company using information from both the income statement as well as the balance sheet.
    Moneyzine Editor
    Moneyzine Editor
    November 6th, 2024
  • Insider Trading Information
    It's unfortunate, but the publicity around the Martha Stewart scandal has resulted in a misunderstanding of insider trading. In fact, not all insider trading information is bad news for a company, and it can even be useful when researching stocks.
    Moneyzine Editor
    Moneyzine Editor
    November 6th, 2024
  • One of the variables investor-analysts should understand when conducting research is the reporting of stock ownership figures. This data provides not only a glimpse into the major shareholders in a company, but also the recent changes in shares held by those same institutions or individuals over time.
    Moneyzine Editor
    Moneyzine Editor
    September 21st, 2023
  • Anyone owning shares of stock in a company that's involved with a proxy contest needs to understand how that contest can affect the price of their securities. Over the last ten years, there have been notable examples of proxy contests such as Carl Icahn's attempt to replace Yahoo Inc.'s board of directors.
    Moneyzine Editor
    Moneyzine Editor
    November 6th, 2024
  • Buy and Hold Strategy Explained
    The buy-and-hold strategy is a long-term, passive investing strategy in which shareholders continue to hold onto their stocks regardless of market conditions. This is in stark contrast with an active investing strategy, which involves almost constant monitoring of market conditions and frequently entering and exiting positions.
    Idil Woodall
    Idil Woodall
    January 9th, 2024

Contributors

Moneyzine Editor
The Moneyzine editorial team consists of writers and content specialists with diverse backgrounds.
Moneyzine 2024. All Rights Reserved.