Leveraged BuyoutDefined with Model, Examples, Companies & Types

Written By:
Adiste Mae

When something is leveraged in business, it usually means to borrow capital for an investment with the expectation that the profits made will be greater than the interest payable and eventually, the principle balance.

A Leveraged Buyout (LBO) is actually a type acquisition strategy used to acquire another company using an amount of borrowed money to cover the cost of the acquisition.

Any time you leverage yourself in business, you are essentially putting your business at risk should you default on the loan.

Most of the time, the assets of the company will be used as collateral for the loan, which means that if you are unable to pay the loan, the lender can seize your business assets.

However, this is not necessarily the case with a Leveraged Buyout because the target company actually assumes the debt used in the acquisition.

Keep reading to learn why and see how this acquisition method can be effective in certain scenarios.

What is a Leveraged Buyout (LBO)?

A leveraged buyout is the acquisition if another company using a significant amount of borrowed money.

The ratio of debt to equity in a leveraged buyout scenario is usually 10% equity to 90% debt and the borrowed loans can be either in the form of loans or bonds.

Because a leveraged buyout has such a high debt to equity ratio, the bonds issued are usually called junk bonds because they are not investment grade.

If the purchaser is buying a company for $100 million, they will borrow $90 million and pay the remaining $10 million out of their own cash.

A leveraged buyout is considered a hostile takeover because often times the target company hasn’t sanctioned the acquisition.

This type of acquisition is also interesting and somewhat ironic because the target company’s assets are used as collateral by the acquiring company.

In other words, the assets on the target company’s balance sheet are used as collateral for the acquiring company to obtain borrowed money for the acquisition.

The company being acquired basically assumes the debt.

Companies that use the LBO strategy often have access to large banks or capital who can fund the acquisition capital needed, but more commonly, leveraged buyouts are conducted by other investors and companies.

Advantages of a Leveraged Buyout

Almost everything single type of corporate acquisition requires significant debt.

Even if the purchases has enough cash to fund the acquisition, there are benefits to using debt rather than cash.

For example, using debt for corporate acquisitions has tax advantages and gives the purchaser the option to write off bad loans if the company they acquired doesn’t do as well as they had planned.

But leveraged buyouts are different in a couple of ways:

• The debt to income ratio is much higher (90% debt to 10% equity)
• The debt is secured with the acquiring company

These are also perhaps the biggest advantages of a leveraged buyout.

They require much less up front capital and if the deal doesn’t work out, the acquired company is stuck with the bad debt.

That being said, attractive target companies usually have strong and dependable cash flows, product lines that are well established, strong managerial structure, and a solid track record.

Example of Leveraged Buyout

Roger owns an investment firm and has found an interest in acquiring a retail chain called HomeCo.

The purchase price is agreed upon at $100 million.

In order for the leverage buyout to happen, Roger needs to put in $10 million of his own firms money and find a bank or investors to fund the remaining $90 million.

Roger was able to successfully find the funding needed to make up the purchase price of $100 million and proceeds with the acquisition.

The loan is structured in such a way that HomeCo is going to be responsible for the payments on the debt Roger used to buy it once the deal closes.

In other words, HomeCo will have debt of $90 million to repay and if they default on the loan, the lender can seize HomeCo’s assets which include land, inventory, etc.

Reasons for a Leveraged Buyout

A leveraged buyout doesn’t work for every acquisition, but there are three main scenarios where this is the best option:

Privatize a Public Company

In 2016, SolarWinds was acquired by affiliates of Silver Lake Partners and Thoma Bravo, LLC and was taken private.

In order for this to happen, affiliates of Silver Lake Partners and Thoma Bravo , LLC had to purchase all of SolarWinds stocks, which they did for $60.10 per share in cash.

The acquisition was valued at approximately $4.5 billion.

Because all of SolarWinds’ stock was purchased, with the closing of the transaction, SolarWinds common stock ceased trading on the New York Stock Exchange.

Privatizing a public company requires enough capital to purchase all or most of the company’s shares, or net value.

Break a Larger Company Apart

Sometimes when a company grows and becomes too big, it may have divisions that are inefficient.

A leveraged buyout is often used to purchase a larger company and then break it apart and sell it as a series of companies.

Purchase an Under-performing Company

When a company is under-performing, investors may look at the potential to acquire and improve said company.

An under-performing company can become a target for acquisition if the acquirer sees the potential to improve the under-performing company.

If this is the case, the acquirer can purchase the target company at a price that is lower than what the company may eventually be worth.

They can then “turn the company around” to its full potential.