What Is a Leveraged Buyout?
A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money (bonds or loans) 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.
- A leveraged buyout occurs when the acquisition of another company is completed almost entirely with borrowed funds.
- Leveraged buyouts declined in popularity after the 2008 financial crisis, but they are once again on the rise.
- In a leveraged buyout (LBO), there is usually a ratio of 90% debt to 10% equity.
- LBOs have acquired a reputation as a ruthless and predatory business tactic, especially since the target company's assets can be used as leverage against it.
Understanding Leveraged Buyouts (LBOs)
In a leveraged buyout (LBO), there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the bonds issued in the buyout are usually not investment grade and are referred to as junk bonds. LBOs have garnered a reputation for being an especially ruthless and predatory tactic as the target company doesn't usually sanction the acquisition. Aside from being a hostile move, there is a bit of irony to the process in that the target company's success, in terms of assets on the balance sheet, can be used against it as collateral by the acquiring company.
The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.
LBOs are conducted for three main reasons:
- To take a public company private
- To spin off a portion of an existing business by selling it
- To transfer private property, as is the case with a change in small business ownership
However, it is usually a requirement that the acquired company or entity, in each scenario, is profitable and growing.
Leveraged buyouts have had a notorious history, especially in the 1980s, when several prominent buyouts led to the eventual bankruptcy of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100% and the interest payments were so large that the company's operating cash flows were unable to meet the obligation.
Example of Leveraged Buyouts
One of the largest LBOs on record was the acquisition of Hospital Corporation of America (HCA) by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch in 2006. The three companies valued HCA at around $33 billion.
Although the number of such large acquisitions has declined following the 2008 financial crisis, large-scale LBOs began to rise during the COVID-19 pandemic. In 2021, a group of financiers led by Blackstone Group announced a leveraged buyout of Medline that valued the medical equipment manufacturer at $34 billion.
How Does a Leveraged Buyout Work?
A leveraged buyout (LBO) is when one company attempts to buy another company, borrowing a large amount of money in order to finance the acquisition. The acquiring company issues bonds against the combined assets of the two companies, meaning that the assets of the acquired company can actually be used as collateral against it. Although often viewed as a predatory or hostile action, large-scale LBOs experienced a resurgence in the early 2020s.
Why Do Leveraged Buyouts Happen?
Leveraged buyouts (LBOs) are commonly used to make a public company private, or to spin off a portion of an existing business by selling it. They can also be used to transfer private property, such as a change in small business ownership. The main advantage of a leveraged buyout is that the acquiring company can purchase a much larger company, leveraging a relatively small portion of their own assets.
What Type of Companies Are Attractive for LBOs?
Equity firms will typically target companies in established industries and mature for leveraged buyouts, rather than fledgeling or more speculative industries. The best candidates for LBOs typically have strong, dependable operating cash flows, well-established product lines, strong management teams, and viable exit strategies so that the acquirer can realize gains.