Understanding Leveraged Buyouts: A Complete Guide | Caplinked (2024)

Mergers and acquisitions (M&As) come in many shapes and forms. From straightforward M&As, where two entities combine into one, to more complex ones, like one company acquiring another and then absorbing it, the landscape is very diverse. One you might find quite interesting is the leveraged buyout (LBO). This M&A model stands out in particular because it involves acquiring a firm primarily through borrowed funds.

In this guide, we’ll tell you everything you need to know about LBOs, including how the leveraged buyout model works, the scenarios and types of companies for which they are most suitable, and their potential risks and rewards.

What Is a Leveraged Buyout?

“Leveraged” refers to the use of leverage (debt) to amplify the potential returns of an investment, while “buyout” indicates the acquisition of a company. Therefore, a leveraged buyout refers to the acquisition of a company (the target) by another (the acquirer) using a significant amount of borrowed funds to meet the acquisition costs. The borrowed capital can be in the form of bonds/and or loans, with the target’s assets usually serving as collateral for the debt.

There are several types of leveraged buyouts:

• Management buyout: This is an LBO type where the management of a firm buys it out from the owners or current shareholders.
• Public-to-private buyout: A type of LBO where a private equity firm or group of investors buys a publicly traded company and then takes it private, with the goal of increasing its value and then taking it public again or selling it at a profit.
• Spinoffs: This is where a private equity firm or investor group buys a spinoff from a larger corporation.

How Does an LBO Work?

This LBO model allows the acquiring party to make large acquisitions without having to commit a significant portion of its own capital, instead relying on the assets of the target company — as well as potentially its own — to secure the necessary debt. In a typical LBO model, the ratio is usually around 70%-90% debt and 10%-30%.

Historically, several top-tier companies have been part of notable leveraged buyouts, including:

• RJR Nabisco (1989)
• Clear Channel (2006)
• Hilton Hotels (2007)
• PetSmart, Inc. (2014)
• X (formerly Twitter, 2022)

How Do LBOs Differ From Other M&As?

Leveraged buyouts (LBOs) are usually employed by private equity firms. They differ from other mergers and acquisitions (M&As) primarily in their financing structure.

As mentioned, in a leveraged buyout model, the acquisition is heavily financed through debt, with the acquired company’s assets serving as collateral and with the expectation that its cash flow will cover the debt payments. This contrasts with typical M&A transactions, which may rely more on equity financing or a mix of equity and less aggressive debt levels.

Additionally, LBO tends to be more return-driven. Their goal is to rapidly improve the target’s performance and value (like through restructuring or operational improvements), to pay down the debt, and ultimately realize a high return on equity investment upon exit.

Why and When Do LBOs Happen?

Private equity firms might opt for LBOs for various reasons and under certain circ*mstances, including the following:

• Improving underperforming companies: LBOs can provide the necessary capital and strategic oversight to revitalize companies that are currently not reaching their full potential.
• Ownership change or succession planning: LBOs are often used to facilitate a change in ownership. An example is a management buyout (MBO), where the existing management team buys the company. Family-owned or closely held businesses may also resort to LBOs as a means to transition ownership smoothly without disrupting business operations while also providing liquidity to the existing owners.
• Taking advantage of strategic growth opportunities: For companies with solid fundamentals but lacking the resources to expand, LBOs can provide the capital needed for growth.
• Market consolidation: LBOs can facilitate the acquisition of competitors or complementary businesses, allowing for market consolidation and enhanced competitive positioning.

Benefits and Risks of LBOs

Like any other major investment, there are both benefits and risks to leveraged buyouts. Understanding what these are can help you navigate these transactions more effectively.

Benefits

• Maintain cash reserves: LBOs allow a company to preserve its liquid cash (crucial for day-to-day operations) by using borrowed funds for the acquisition instead. This is particularly beneficial for small and medium-sized enterprises with limited capital.
• Enhanced returns: The leverage used in LBOs can significantly amplify the returns on equity. As the company repays its acquiring debt, the equity value — representing the residue interest in the company — increases in value, assuming the company’s earnings are stable or growing. The successful full reduction of debt over time can significantly enhance the equity’s stake worth, leading to substantial gains when the company is eventually sold.
• Operational efficiency: LBOs often lead to a rigorous review of the company’s operations and financial statements, identifying inefficiencies and implementing cost-cutting measures to boost profitability.
• Increased purchase capacity: An LBO enables a company to make a bigger acquisition than it otherwise would. This enables quicker business or portfolio expansion.
• Tax benefits: The interest payments on debt used in LBOs are tax-deductible. This can lower a company’s tax burden and free up funds for other important uses.
• Strategic restructuring: Post-acquisition, LBOs offer the opportunity to implement strategic changes that can enhance the company’s value, including divestiture of non-core assets, financial planning, financial restructuring, or marketing repositioning.

Risks

While LBOs offer several advantages, as seen above, they also come with significant risks that companies must carefully manage.

• Financial risk: The high level of debt financing increases the company’s financial risk, particularly the risk of default on loan obligations if cash flows are insufficient. This can lead to financial distress or even bankruptcy in extreme cases.
• Market risks: LBOs are sensitive to market conditions. For instance, an increase in interest rates can raise borrowing costs, while an economic downturn can diminish revenue. Both of these can jeopardize the company’s ability to service its debt.
• Reputation and customer perception: The aggressive nature of LBOs and associated cost-cutting measures can sometimes damage the company’s reputation and relationships with customers, suppliers, and other stakeholders, affecting business operations and sales.
• Short-term focus: The pressure to meet debt obligations can lead to a focus on short-term financial performance at the expense of long-term strategic initiatives and investments. This can stifle growth and innovation, with companies potentially underinvesting in essential areas such as research and development or employee training.
• Lower credit rating: Incurring too much debt can negatively affect a company’s credit rating. Lenders may view a highly leveraged company as risky, which can make it difficult to secure debt in the future. This reduced borrowing capability can adversely impact its ability to grow and expand.

What Types of Companies Are Good LBO Targets?

Identifying suitable targets is crucial for the success of leveraged buyouts (LBOs). Here are a few primary traits that make companies ideal candidates for LBOs:

• Stable cash flows: Firms with predictable and stable cash flows are ideal because these cash flows can service the debt incurred during the LBO.
• Strong market position: Companies that hold a strong market position or have a unique market advantage are also attractive, as they are likely to sustain profitability over time.
• Growth potential: Companies that operate in industries with high growth potential or that have clear paths to growth, such as through market expansion, product development, or operational improvements, are also prime for LBOs.
• Skilled and experienced management: The presence of a skilled and experienced management team increases the likelihood of a successful LBO. Effective management can navigate the company through post-acquisition changes and drive growth.
• Low debt: Companies with little to no debt are appealing because the focus post-LBO can be on servicing the newly acquired debt rather than juggling pre-existing financial obligations.
• Asset-rich: Companies with valuable tangible assets are preferred as they offer collateral for debt financing, providing a layer of security for lenders.

Steps of an LBO

The leverage buyout process typically involves the following steps:

1. Identifying company: This entails the PE firm conducting thorough market research to find a company that matches the criteria for a successful LBO — e.g. stable cash flow, solid market position, growth potential, and so on.
2. Preliminary assessment: Once a target company has been identified, the next step is to conduct preliminary due diligence to assess the risks and opportunities associated with the acquisition. This might include reviewing public financial statements, industry positions, and competitive advantages.
3. Financing: The acquirer then devises a financing strategy or financial modeling, determining the mix of debt and equity that will be used to fund the purchase. Subsequently, they make arrangements to secure the necessary funds, possibly by reaching out to banks or other financial institutions.
4. Making an offer: After securing financing, the investor makes an offer to purchase the target company. This might be done through a letter of intent.
5. Negotiation: If the target is interested, negotiations commence. This involves a detailed discussion of the price, conditions, and structure of the deal.
6. Final due diligence: Following a tentative agreement on the terms, the acquiring company undertakes a more detailed due diligence process. This step involves an in-depth review of the target company’s financial records, legal issues, operational processes, and market position to confirm the initial assessments.
7. Closing the deal: With due diligence complete, the deal is finalized. This involves executing legal documents, transferring funds, and then finally officially transferring ownership to the acquirer.

Conclusion

Leveraged buyouts enable the acquisition of companies without the need for substantial equity capital upfront. The use of strategic debt to fund the transaction increases the potential returns on investment. This high-risk strategy, however, comes with its share of potential challenges and failure points, the biggest of which is the risk of financial distress if the company is unable to service the debt, such as because of market downturns.

If your firm is considering an LBO, ensure you weigh the pros and cons carefully and assess your current business circ*mstances to determine if it’s indeed the right move for you. If you choose to proceed, one vital tool to have in your arsenal is a virtual data room (VDR). This is an online location where all parties can securely store and share the documentation required for the transaction.

CapLinked is a leading provider in the VDR space, offering solutions tailored for a wide range of M&A transactions, including LBOs. With features like military-grade encryption, granular permission settings, audit trails, instant messaging, and live document editing, CapLinked ensures that all sensitive information remains secure while also facilitating easy and efficient collaboration with potential partners.

Sign up for a free trial today to discover how CapLinked can support your firm’s next LBO.

Sources

Investopedia: 10 Most Famous Leveraged Buyouts

Corporate Financial Institute: Management Buyout (MB0)

Sean LaPointe is an expert freelance writer with experience in business, finance, and tech. He has written for several well-known brands and publications, including The Motley Fool, Angi/HomeAdvisor, and Finder.