A Leveraged Buyout (LBO) is a strategy where a company is acquired by another entity using a significant amount of borrowed money (leverage) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans along with the assets of the acquiring company.
The goal of a leveraged buyout is to allow companies to make large acquisitions without having to commit a significant amount of capital. In an LBO, there is usually a ratio of 60-90% debt (bonds or loans) to 10-40% equity.
This strategy is commonly employed by private equity firms and often involves taking a publicly traded company private. After the buyout, the private equity firm attempts to improve the financial performance of the acquired company, with the goal of reselling it at a profit or taking it public again in the future.
However, LBOs can be risky because they increase a company’s debt burden. If cash flows or asset sales aren’t sufficient to repay the debt, the company could end up in financial distress or bankruptcy. But if the strategy works well, it can deliver substantial returns to the private equity firm and other investors.
Example of a Leveraged Buyout
Let’s consider a simplified example of a leveraged buyout.
Suppose that Private Equity Firm XYZ wants to purchase Company ABC, a publicly traded firm. Company ABC has been evaluated and its market value is deemed to be $200 million.
Private Equity Firm XYZ only has $40 million in available capital for the acquisition. Therefore, to facilitate the buyout, Firm XYZ secures $160 million in debt financing from a bank or other lending institutions. The debt is usually collateralized by the assets of Company ABC and, potentially, additional collateral or guarantees provided by Firm XYZ.
With the $40 million in capital and the $160 million in borrowed funds, Firm XYZ purchases all the outstanding shares of Company ABC, thus acquiring the company. Company ABC is then delisted from the stock exchange and becomes a privately held company.
After the acquisition, Firm XYZ implements a variety of operational and financial improvements in an attempt to increase Company ABC’s profitability. If successful, these improvements will increase the value of Company ABC.
- Sell Company ABC to another company or investment firm. If Firm XYZ can sell Company ABC for more than $200 million, they can repay the debt and the remaining profit will be a return on their initial $40 million investment.
- Conduct an Initial Public Offering (IPO) for Company ABC, effectively making it a publicly-traded company again. If the market capitalization of Company ABC after the IPO is higher than the original $200 million, Firm XYZ can sell its shares in the open market, repay the debt, and pocket the difference as profit.
This is a simplified example, but it shows the basic process and financial structure of a leveraged buyout. In reality, LBOs can be much more complex and may involve multiple layers of debt and equity financing.