What Are Leveraged Buyouts? A Comprehensive Guide to LBOs

An infographic explaining what leveraged buyouts are, reasons FOR LBOs, and types of LBOs.

What Are Leveraged Buyouts? 

A leveraged buyout (LBO) occurs when one company is acquiring another company, the target company, using a significant amount of debt to subsidize the purchase. The deal is often structured, so the target company’s assets and cash flows are used to pay for most financing costs. As a result, leveraged buyouts have a very high debt-to-equity ratio. The total debt is usually 90% of the total acquisition price, with the equity being only 10%. In most leveraged buyouts, the acquired company’s assets are used as collateral.

The main purpose of leveraged buyouts is to offer companies the opportunity to acquire large companies without having to invest a high amount of their own capital.

Reasons for Leveraged Buyouts 

Typically, leveraged buyouts occur for one of the following 4 reasons: 

Public to private 

In a public-to-private or a going-private LBO, a public company is acquired by a private equity firm or group of firms that will take the target company’s shares off the market and officially delist the company. Most of such transactions are financed by borrowing substantial amounts of debt. The acquiring company will now own the company, and the new company will become responsible for the debt-financing of this transaction. 

In some cases, a going-private leveraged buyout is agreed upon by both parties, which makes it a friendly takeover. Friendly takeovers can create significant financial gain for all shareholders and the formerly public company’s management team. The acquiring firm usually pays at least a 20% premium over the current stock price.

The acquiring firm benefits from the deal because private companies have fewer regulatory and reporting requirements. This will reduce costs and leave more time to focus on long-term goals. Sometimes, the investors are people from the acquired company’s management team who believe that the company will be more successful as a private company than a public company.

In other cases, the investors will not involve the management team or the board of directors of the target company. Instead, the investors will directly go to the company’s shareholders to approve the acquisition. This is called a hostile takeover.

To break up a company 

This usually happens to large companies that become somewhat inefficient due to their size. Some nvestors believe that the company will be worth more in pieces than as a whole. Therefore, the PE firm will purchase the company and sell off the “smaller units” to others. In this circumstance, the acquirers might be the previous management team of one of the smaller units sold.

To improve performance

A private equity firm might undertake a leveraged buyout when it sees an opportunity to take over a struggling company with excellent assets and future potential. Unfortunately, this often involves a company going bankrupt or is close to bankruptcy. In this case, the LBO will offer them a feasible way out of chapter 11.

The acquiring firm’s goal will be to improve the target company’s operations and earnings, turn the company around, and hope the company’s assets will increase in value.  If this happens and the firm can sell the target company for a significant profit, the financiers stand to benefit because of the increase in the company’s value. If not, the investors can lose their equity investment and still be liable for the outstanding debt in leveraged loans.

To transfer private property​

Leveraged buyouts can often make it possible to transfer a smaller company to individuals or a group of individuals who normally would not have the money to finance such a purchase. In this case, the leveraged buyout can provide financing to sell the business for a fair price. An example would be if a small business owner wants to retire, and some of his employees or friends want to buy the business.

Why Financing Leveraged Buyouts Can Be Risky?

Leveraged buyouts can work out very well for both the acquirer and the acquired. The chances of an LBO being successful are much higher if the target company is in good financial health because the risk premium on financing the purchase will be lower.

When a lot of cash is available for investments during an economic boom period, many new private companies will emerge from leveraged buyouts. These companies will then be revitalized and restructured by the Private Equity firms that acquired them. Finally, when the time is right, and the private companies have increased in value enough, the PE firms will sell these companies or even take them public in an IPO. 

However, the more debt a company has, the riskier the investment is, and the more likely it is to default on that debt.

The biggest risk of leveraged buyouts is the company’s unbalanced capital structure, where the debt far outweighs the equity. In addition, these leveraged buyouts are based on future projections. So if even the smallest thing goes wrong or the company’s actual results do not meet expectations, the company can get into serious financial trouble.

For example, if a few of the company’s biggest customers leave, it could create a cash flow problem. The company might not be able to cover the principal and interest payments of the loans. This can also happen when there is a downturn in the economy, and a financial crisis is looming, or when the costs of doing business suddenly go up. Investors can lose their investments in a short period of time, and the company might have to file for bankruptcy.

Leveraged buyouts are risky, even when financially everything is going well. A takeover is inherently risky because of all the changes that need to happen. This is especially true when it involves a large company with employees and many other stakeholders.

Financing Options for the Purchase of a Leveraged Buyout

For an LBO to take place, the buyer needs money to purchase the company. The PE firm will only put in a little bit of their own money and finance the rest. The type of funding used often depends on the size of the transaction and the financial health and reputation of both the PE firm and the target company.

Seller Financing 

This type of financing is often used when the seller is very keen on making the deal. The seller generally gives the buyer a secured loan that is amortized over a period of time to finance part of the company’s purchase price. Seller financing is common in smaller purchases and Management BuyOuts (MBOs). In an MBO, the management team of the target company acquires the company.

Assumption of debt

This is all or part of the target company’s debt that the acquiring company agrees to take responsibility for after purchasing the target company. This is a pretty common form of financing in leveraged buyouts.

Asset financing​​​​

This type of financing is where the lending is secured by using specific assets of the target company as collateral. If the loan is not repaid, those assets will be taken. This type of financing is common in purchases of companies that own heavy equipment and machinery that has been paid off or in purchases that include real estate.

Subordinated deb: 

Subordinated debt is any debt with less priority than senior debt but more priority than preferred and common equity in case of bankruptcy. An example is a mezzanine debt which has embedded equity instruments attached, often known as warrants. Mezzanine debt is a very high-risk debt that is subordinate to pure equity but senior to pure debt. Interest rates on subordinated debt are high because of the increased risk and range from 12 to 20%. It is used when normal financing cannot be obtained for the full amount needed.

Bank loans

The buyer takes out a bank loan to finance part of the purchase price of the target company.

Key Characteristics of an LBO Candidate

When private equity firms look for companies to invest in, they will weigh the risks against the potential returns. They focus on the target company’s key strengths and risk areas. However, they mostly focus on the target company’s ability to pay back the debt plus the associated interest costs. The target firm’s cash flow from operations has to be large enough to cover that debt. Here are some characteristics that private equity firms will be looking for in potential LBO candidates:

  • A mature industry/company with well-established products and a steady cash flow
  • A clean balance sheet with no or very little debt
  • A strong management team
  • Show potential for future growth and a high rate of return
  • Strong asset structure to be able to procure affordable financing
  • The availability of divestible assets to generate quick cash when needed
  • Feasible exit options

Advantages of Leveraged Buyouts 

An infographic explaining the advantages and disadvantages of leveraged buyouts.

Return on equity – The main advantage to the buyer is the return on equity. By using a lot of debt, the buyer can increase returns by leveraging the seller’s assets. 

Lower taxes – The high levels of debt decrease the company’s taxable income. Lower taxable income means lower tax payments.

Revitalization of a mature company -Underperforming or badly managed companies can benefit from an LBO. The acquirer will improve the company’s operations and increase its efficiency to make the company more valuable. This will result in increased revenue and earnings.

High motivation – Stakeholders and management involved in the LBO will often be very motivated for the LBO to succeed.

Provides an exit strategy to the seller at a fair price – Often, the acquiring firm will pay a premium over the stock’s market price.

Disadvantages of Leveraged Buyouts

High risk because of high levels of debt and high-interest payments – If the acquired company’s cash flow and the sale of some of its assets are insufficient to cover the debt cost, the LBO is likely to go bankrupt. Companies in a competitive industry are especially vulnerable. Volatility in the overall economy can result in a decrease in the company’s revenue and its inability to cover the debt costs. Some company employees might lose their jobs, and some company suppliers will lose part of their business.

A high debt/EBITDA ratio hurts a company’s credit rating – When an issuer’s debt/EBITDA ratio is high, agencies downgrade a company’s credit rating because of the increased risk of its ability to make payments on the outstanding debt. EBITDA stands for Earnings before Interest, Taxes, Depreciation, and Amortization. 

Leveraged buyouts are a time-consuming process – The due diligence part of the leveraged buyout process takes a lot of time and effort. Sometimes, one of the parties changes their mind just before the deal gets closed, and then the deal is off.

Examples of Leveraged Buyouts

Hilton Hotels – successful LBO

In 2007, the Blackstone Group purchased Hilton Hotels in a $26 billion LBO. Together with co-investors, it put $6.5 billion in equity into the deal. The acquisition was 80 percent leveraged with financing from Bear Stearns. Not long after the deal was struck, the economy crashed, and Bear Stearns collapsed. This could have easily been the end of the company. However, Blackstone’s continued commitment kept the company alive and turned it into one of the most successful leveraged buyouts ever. 

During the financial crisis, Blackstone wrote down the investment by 70 percent, put in infused cash, and restructured the debt. Then in 2013, it took the company public again. 

In 2018, Blackstone sold its last stake in Hilton Hotels, and the 11-year investment ended up returning a total profit of $14 billion.

Harrah’s Entertainment – failed LBO

In 2006,  Harrah’s Entertainment, the world’s largest casino company, was taken over in a $31B leveraged buyout by Apollo Global Management and Texas Pacific Group, two private equity groups. They paid a 31 percent premium because, during past recessions, casinos had not been affected and were resilient. However, not long after the buyout, the housing market collapsed, and the tourism industry slumped. A speech by President Obama in 2009 in which he said, “You can’t go take a trip to Las Vegas or go down to the Super Bowl on the taxpayer’s dime” worsened the situation for the casino industry.

Harrah’s changed its name to Caesars Entertainment. In 2010, the company withdrew its filing for an IPO and lost $831 million.

In 2015, the legendary gambling empire weighed down by $24B in debt, filed for Chapter 11 bankruptcy. Convention business, which used to be a large part of the business in Las Vegas, disappeared as the financial sector was no longer taking business trips to Nevada. Casino owners never forgot President Obama’s speech and partially blamed him for their financial problems.

Conclusion

Leveraged buyouts have been around for quite a while and are most likely here to stay. In some cases, leveraged buyouts can be very successful. This is especially true in times of economic growth when private equity firms have large amounts of cash. PE firms will revitalize the newly emerged private companies, so they become more efficient and more profitable. This is beneficial for the private equity firms because it increases the new company’s value and will provide the PE firm with a high return on its equity after selling the company or taking it public. Simultaneously, the LBO can be good for the new company and its stakeholders, as it will be more successful. 

However, in times of an economic downturn and market crashes, leveraged buyouts often fail and go bankrupt. Leveraged buyouts have a lot of debt, which is very risky. Besides the large debt, private equity firms are often accused of cutting costs in any way they can, including through massive layoffs. By cutting costs, they can make the new company look more attractive to buyers and investors. They often also pay themselves dividends and fees for which the new company may have to take on more debt.

These predatory practices where the private equity firms extract the maximum amount of value and then dumps the company on the market often result in companies going bankrupt. Especially in the distressed retail industry, where many companies are leveraged buyouts, the number of bankruptcies is likely to increase.

So, are leveraged buyouts good or bad? That is a hard question to answer and depends on your perspective.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.