What Is A Leveraged Buyout
A leveraged buyout (LBO) is the process of a company purchasing another business using a large amount of debt financing. While LBO financing typically involves some equity, it is usually a low amount compared to the debt.
Why Conduct an LBO?
As with all things leveraged, LBOs allow companies to get a lot for a little. LBOs allow companies to by other businesses which they find attractive without initial committing too much capital. If preformed successfully, the acquired company’s cash flows will provide ample coverage for the debt burdens taken on during the acquisition. This is why LBOs are typically preformed on very stable, mature businesses as opposed to young, sporadic ones.
Financing an LBO
As stated before, leveraged buyouts are financed using a majority of debt, as opposed to equity. However, there are several ways in which a company can split debt and equity and several ways in which a company can issue debt. Below is a list of a few components to LBO financing.
- Owners Equity – A company typically uses equity to pay for less than half of the LBO.
- Seller Financing – As opposed to an institution, in seller financing, the seller provides a loan.
- Senior Debt – Senior debt is a very strict form of debt which uses a company’s assets as collateral. Senior debt has low interest rates to other forms of debt.
- Mezzanine Debt – Mezzanine debt is a hybrid security which allows the lender to convert its debt into an equity share of the borrower. Mezzanine debt is subordinate to senior debt.
Why Are LBOs Considered Risky?
Leverage buyouts are highly risky. When a company takes on large amounts of debt, they of course run the risk of default. If the acquired company fails to provide cash flow, the purchaser may fail to repay its debt or it may be required to liquidate some of its assets. As can be imagined, the higher the debt-to-equity ratio is in an LBO, the more risk this transaction entails. Due to the uncertainty of LBOs, the effective interest rates on the newly issued debts are typically higher than normal. These interest payments present a significant risk if they are not covered by the company’s operating cash flows. To provide safety against bankruptcy, it is vital that the acquiring company can maintain a strong interest coverage ratio.
LBO Modeling
Due to the extensive research which is required to conduct a leveraged buyout, LBO models have been popularized. Similar to discounted cash flow or net present value models, LBO models aim to conservatively value a business. However, LBO models also account for variables which are specific to the transaction itself such as the debt-to-equity ratio, the interest on this debt, and forecasted cash flows. LBO models allow companies to better gauge how the target business’s future cash flows will help meet debt obligations. Some LBO models also include projections of the price the company may be sold for in the future. This allows the purchaser to predict the total return on investment of the LBO.
History of LBOs
The first leveraged buyout is believed to have been preformed in 1955. However, LBOs saw a significant increase in popularity in the 1980s. This was due to the ‘Junk Bond Era’ in which high-yielding bonds were a very prevalent source of corporate financing. From 1979-1989, there were believed to be over 2,000 LBOs. This LBO craze was harshly criticized by legendary former chairman of the Federal Reserve, Paul Volcker. At the time, LBOs were being preformed with very high debt-to-equity ratios. This LBO craze came crashing down and led to several bankruptcies. This very much negatively affected several asset classes and led to the loss of many jobs.
