What Is a Leveraged Buyout? (Definition and Examples)
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Conducting corporate acquisitions requires a large amount of money. A leveraged buyout is a type of financial transaction in which the buyer commits a small portion of the required capital and uses debt to cover the difference. If you're interested in entering the field of corporate finance or are involved in it, it's important to understand how leveraged buyout can be profitable. In this article, we explain what a leveraged buyout is, discuss how it works, outline when companies use them and share an example to help you better understand what it is.
What is a leveraged buyout?
A leveraged buyout, or LBO, is an instance of using leverage to buy out a business or company. In business terms, leverage means borrowed capital, such as a loan from a bank. In an LBO, the leverage makes up a large percentage of the buyout price. The buyer covers the balance with their own equity and usually uses their own assets or the assets of the acquired company as collateral.
For instance, imagine you buy out a business whose net income is $5 million per year. You acquire it for $20 million, using $15 million in loans and $5 million of your own funds. The loan interest is 15%, so you owe $3 million per year to the lender. Because the net income of the company is $5 million, your return in the first year, after taxes, might be around 20%, and you can predict a complete return in five years. If you experience an economic recession and can't meet the debt requirements, you may sell the collateral assets.
How does an LBO work?
An LBO is an acquisition strategy that allows a company to take ownership of another company while minimising personal capital investment and maximising potential returns. Specifically, using the least amount of their own equity as possible allows for higher profitability and a larger expected annual rate of growth from an investment. An LBO can also increase risk, especially if the buyer uses the acquired company's assets as collateral. If the buyer fails to pay the debt, the acquired company might go bankrupt.
A typical LBO has four separate stages. These include:
1. Finding the company to be acquired
Finding the right company to be acquired isn't easy, which is why acquiring companies often evaluate their own financials and the potential risks that their balance sheet can withstand. If a company takes on too much risk, it may fail. A good acquisition is one that has the equity and capital to grow from additional assets. The acquiring company can use the assets to produce a new line of business or catalyse a new market condition.
2. Finding the right kind of financing
There are a variety of financing options that an acquiring company can choose to complete an LBO. These include the following:
With a bond, the borrower receives money from an investor for a fixed amount of time. In return, the investor earns interest in the loan until the bond expires or it reaches maturity. In an LBO, there's usually a ratio of 10% equity to 90% debt. Because of this high equity to debt ratio, the bonds issued in the buyout are often not investment grade and are called junk bonds.
Subordinated debt is an unsecured bond or loan that ranks below other, more senior securities. In other words, it's a way to obtain a loan without offering collateral. If the borrower is unable to service the debt, the lender can acquire partial ownership of the property proportional to the balance on the loan.
Both the buyer and the private equity firm may borrow from a bank. Banks use a revolving credit line, which the borrower pays back. The borrower may also borrow from the credit line again when needed.
Private equity firms
A private equity firm is an investment company. It uses its own capital or capital from acquired from investors. They normally require a high rate of return or may want control in the management of the acquired company.
Mezzanine financing is a hybrid of equity and debt financing that gives the lender the authority to convert the debt to an equity interest in the borrower in case of default. Its benefits include no personal guarantee from the owner and a higher amount of funding. These benefits make Mezzanine financing an ideal acquisition finance option.
3. Receiving the capital
For a lender to provide the capital to the LBO, the acquiring company often provides sufficient financial information to prove their financial strength. This may include cash flow statements, profit-and-loss statements and balance sheets. Lenders often do due diligence to make sure that the projections and assumptions specified by the acquiring company are plausible. They also verify that the underlying transaction data has integrity and that the acquiring company consistently utilises accepted accounting procedures.
4. Completion of the acquisition
The final stage is the legal documentation of the acquisition. This is where the buyer works with their lawyer to finalise the loan agreement with the lender and the purchase agreement with the seller. In this stage, the buyer also ensures that the purchase agreement covers all salient business points. The lender may review all the relevant purchase agreements.
When do companies use LBO?
The motivation behind an LBO is often to gain the revenue, market share or assets of the acquired company. This allows the buying firm to grow more quickly and add resources, such as skilled personnel, that weren't previously available to them. On the seller's end, LBOs can be attractive to exit a business while gaining a financial reward. This strategy is common among business owners entering retirement or pursuing a new venture, who see it as a way to cash out on the investment they initially put in.
There are also other instances when a company might want to pursue an LBO. These include:
Breaking up and selling a company
With some companies, growth results in inefficiency, and an LBO is a chance to divide it into manageable parts before selling them off. Commonly, the buying firm breaks up the company into smaller companies, each with a narrower focus. For example, they may break up a company that manufactures various types of clothing accessories into a belt manufacturer, a hat manufacturer and a bag manufacturer. The buying firm can then offer these small companies for sale so they can pay off their debt.
Improving a company
Sometimes, the buying firm feels that the acquired company can perform much better than it has, and the LBO presents an opportunity to realise its potential. In this case, the buying firm may work to improve the acquired company with the aim of generating greater profits than before. The belief is that the profits generated by the newly improved company can exceed the amount needed to service the debt.
Privatising a public company
Privatising a public company means consolidating and transferring public shares to private investors. The investors remove the shares from the market, take on majority or complete ownership of the company and also assume debt liability. This can be an effective strategy in a couple of ways. For one thing, private companies have fewer regulatory requirements to meet, which frees up resources they can put towards profitable ventures such as R&D and fixed assets. Also, privatisation is an opportunity to repackage the company as a more marketable entity before reintroducing it to the market as an IPO.
Example of an LBO
Consider the following example to gain a better understanding of LBOs:
A small restaurant chain generates $3 million a year. An investment firm believes the chain is capable of greater profitability and wants to buy it out to make improvements. The owner of the restaurant chain agrees to the buyout, and they agree to a price of $50 million. The investment firm puts up $5 million of its own capital. A bank provides a loan for the remaining $45 million, with a 15% interest rate.
After reforming the restaurant chain, the investment firm generates a $10 million profit. Minus the interest on the loan, the total amounts to $3.25 million. In the second year, the chain increases its profit, and the investment firm gains on its investment. After several years of growth, the investment firm sells the chain for $100 million, double the initial sale value.
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