What is a leveraged buyout?
A leveraged buyout, or LBO, is the process of buying another company using money from outside sources, such as loans and/or bonds, rather than from corporate earnings. Sometimes, the assets of the company being acquired are also used as collateral for the loans (rather than, or in addition to, assets of the company doing the acquiring).
LBOs by the numbers
To be considered an LBO, the debt-to-equity ratio on an acquisition is typically between 70% to 30% to as much as 90% to 10%. That means the acquiring company invests 10-30% of the cost and borrows the remaining 70-90% to be able to make the purchase.
That’s a risky deal, mainly because the cost of the monthly loan payments, called debt service, on such a deal can be huge. Because of that, it can be difficult for some buyers to stay current.
Enormous loan payments are what caused the downfall of many firms engaged in LBOs in the 1980s. Back then, LBOs were so popular that, in some cases, the debt-to-equity ratio was 100% to 0%, meaning companies were putting no money down and financing the entire deal. (Yes, car dealers also offer those “no money down” opportunities, which can get buyers in trouble because the monthly payment is quite large.)
These no-money-down offers also became popular in the mortgage industry and are what caused many homeowners to go bankrupt, many homes to be foreclosed on, and many banks to go under, after having financed too many homes for which borrowers couldn't manage the huge monthly payments.
Advantages of an LBO
Despite their risky nature, there are some pros to LBOs:
- More control. Once the acquisition is converted to private ownership from public, the new owners can completely overhaul the company’s operations and cost structure, making it easier for the venture to succeed.
- Financial upside. Since, by definition, LBOs require acquiring companies to put up little to nothing of their own money, as long as the company being acquired can generate more than enough cash to fund its purchase, investors win.
- Continued operation. Sometimes a company’s financial situation becomes so dire that it is at risk of being shuttered altogether. When a buyer comes in, the company has the opportunity to keep its doors open.
Disadvantages of an LBO
Of course, for every upside there is a downside. Here are some related to LBOs:
- Poor morale. Especially in cases of a hostile takeover, where the company has no interest in being acquired, unhappy workers may convey their disappointment by slowing down or stopping work, further hampering the company’s efforts to succeed.
- Bankruptcy a big risk. If the acquired company’s finances cannot, on their own, cover the cost of the loan payments needed to buy the company in the first place, it’s possible the company will end up declaring bankruptcy. Weak finances are extremely risky.
- Deeper cuts. While employees may hope that a new owner will help turn the acquired company around, in many cases, only cost-cutting can return a company to profitability, which may involve serious job cuts and other unpopular measures.
Due to stricter banking laws introduced after the wild 1980s, LBOs are not nearly as popular as they once were, simply because it’s very difficult to obtain financing.
What Is Leveraged Buyout? FAQ
What is a leveraged buyout example?
How does a leveraged buyout work?
Is it good to do a leveraged buyout?
What are the three types of leveraged buyout?
- Management buyouts: This type of leveraged buyout involves the management of a company buying out the company or a majority stake in the company.
- Public-to-private buyouts: This type of leveraged buyout involves a publicly traded company being acquired by a private investor or a group of private investors.
- Financial sponsor buyouts: This type of leveraged buyout involves a private equity firm or other financial sponsor purchasing a company through the use of borrowed funds.