What is a Leveraged Buyout? – Private Equity’s ‘go-to’ Investment

What constitutes a leveraged buyout (LBO)?

An LBO refers to a financial maneuver wherein an investor consortium (typically a private equity group) acquires a company with limited cash investment in equity, relying heavily on borrowed funds to finance the transaction.

This strategy seeks to optimize debt financing, thereby bolstering returns on the equity stake or enabling the acquisition of a company with insufficient capital, necessitating additional borrowing to finalize the deal.

Financial leverage (debt), the cornerstone of an LBO, involves utilizing money borrowed from a bank or non-bank commercial lender to minimize the cash outlay required from investors in an acquisition.

The leveraged buyout approach enables the acquisition of larger investments than would otherwise be feasible by only paying with equity (cash).

While leverage can amplify returns on equity, it simultaneously increases financial risk by introducing debt service obligations. Oftentimes these debt service obligations can be 30% or more of the company’s cash flow.

The primary aim of an LBO is to service the debt utilizing cash flow generated from the company’s operations, supplemented by potential asset sales or divestitures.

Consequently, the company’s equity is anticipated to appreciate over time, delivering gains to investors. Ultimately, private equity investors seek to exit either through the sale of the company or its public offering.

While these private equity investments have downsides such as illiquidity and the possibility of the target companies underperforming, investing in private equity has historically been a more profitable venture than investing in larger, publicly traded companies.

Why do Private Equity Firms Use Debt (Leverage)?

Leverage is a common tool employed by both investors and corporations to amplify equity or shareholder returns. Examples include purchasing stocks on margin or acquiring real estate through mortgages. However, the use of leverage must be carefully weighed against the heightened financial risks associated with debt obligations and the imperative of maintaining a steady cash flow to service the debt.

PE firms opt for leverage because it can augment equity returns for their investors. These firms often possess specialized expertise essential for identifying lucrative leveraged buyout (LBO) opportunities, orchestrating acquisitions, securing requisite debt financing, implementing necessary restructuring measures, and ultimately pursuing various exit strategies such as public offerings, strategic sales, or alternative methods to divest their positions.

The typical stages involved in an LBO investment encompass:

 

  1. Deal Sourcing: A private equity (PE) firm finds a deal that is represented by an investment banker, like us here at Raincatcher.
  2. Preliminary due diligence & modeling: The PE firm conducts comprehensive due diligence on the target and constructs financial models to assess its ability to sustain the required debt load and what their ability to grow the business further is.
  3. Strategy formulation: A comprehensive strategy is devised, encompassing the acquisition process, equity fundraising, debt procurement, and potential divestitures to alleviate debt.
  4. LOI: The PE sponsor initiates discussions with the target company for a potential acquisition. This typically culminates in a completed letter of intent (LOI).
  5. Debt Raise. Most PE groups have their own equity capital, but they’ll have to speak to bank and non-bank lenders to source the debt (leverage).
  6. Execution: The investor proceeds with the acquisition and implements any subsequent strategies.
  7. Liquidation: The investor exits the investment by selling the company, this is typically 3-5 years down the road for most PE firms.

Given that the ability to manage the debt burden is pivotal to success in an LBO, companies with consistent and predictable cash flows, minimal debt, and low capital expenditures are deemed favorable candidates. Typically, these are mature, non-cyclical companies with high profit margins.

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What are the Advantages of a Leveraged Buyout?

The advantages of a leveraged buyout are that the business buyer has to put in less equity (cash) to acquire a business than they would if there was no leverage being used. This means that if the business is successful in paying off the debt, the business owner acquires a business for a fraction of what it would have cost if they did not use debt.

What Are the Risks of a Leveraged Buyout?

The risks of a leveraged buyout are that if the business’s performance falters, it may not be able to pay off its debt. In this scenario, the bank (or other lender) that financed the transaction could take the business away from the buyer and they would lose the equity that they put into the business.

How do Leveraged Buyouts Create Shareholder Value?

Leveraged buyouts create shareholder value by allowing the purchaser of the business to invest less equity (cash) to acquire the business compared to a scenario where they purchase the business with all cash. 

For instance, a business worth $20M could hypothetically take only $8M cash to purchase if the buyer was able to get $12M in debt financing from a bank or private credit fund. Once the debt it paid back, the shareholders would own the business outright.

Who Benefits From Leveraged Buyouts?

The purchasers of the business stand to benefit the most from a leveraged buyout.

It’s worth noting that leveraged buyouts are typically practiced by private equity groups that are comprised of both a general partner (active money managers) and limited partners (passive investors). In a well-executed LBO, both benefit.

You can learn more about LPs, and GPs and how they both make money in an LBO by reading our alternative investments article.

Additionally, the lender who finances the leveraged buyout stands to make a strong return assuming the target company can pay back its debt with interest.

Who Pays Off the Debt in a Leveraged Buyout?

The debt goes onto the balance sheet of the business that is being acquired and is paid off by that company’s cash flow over the coming years.

In a scenario where the leveraged buyout is to finance a merger or bolt-on acquisition where two or more companies are being combined to make one larger company, the debt will typically go onto the balance sheet of the largest company (holdco.) and be paid off by the cash flow of all of the entities.