A leveraged buyout (LBO) is the acquisition of a company financed by debt.
The use of debt multiplies both the potential return and risk.
LBOs require active and liquid credit markets.
Stable, mature businesses with predictable—and ideally recurring—revenues are generally the best LBO targets.
LBO returns are maximized by buying low and selling high, properly capitalizing the buyout, and maximizing profitable and high-quality growth during the hold period.
A leveraged buyout (LBO) is the acquisition of a company financed by debt. It is not unlike the typical purchase of a residence where the majority of financing is derived from a mortgage, and the balance from cash (equity) contributed by the buyer.
The use of debt in an LBO leverages the equity return, providing the equity holder with the possibility of higher returns at the cost of higher risk. Debt levels have averaged 72% of total capital from 1996 to 2008, according to Standard & Poor’s. Debt levels vary due to numerous factors, including the vibrancy of credit markets, the ability of the company to support debt, and the strategy of the given LBO.
Although select transactions that could be considered LBOs occurred prior to the 1980s, this acquisition strategy grew in popularity in the 1980s when ample debt financing became available, in particular with the rise of the sub-investment grade, or “junk” debt market. Over the past decade, the strategy has seen even more activity with more than US$100 billion raised by private equity funds. Buyouts have, in fact, become a material element in mergers and acquisitions. From 2004 to 2008, US buyout volume was US$1 trillion, according to Standard & Poor’s, though activity has of course significantly decreased with the recession of the world’s economies and credit markets.
LBOs can involve the acquisition of an entire company or a division of a company. In some cases, management, usually with the financial backing and transactional expertise of a private equity group, buys out its own entity, which is then more specifically referred to as a management buyout (MBO). Yet another permutation is leveraged recapitalization, whereby some equity plus debt are used to provide liquidity to shareholders, either to buy their shares outright, or provide cash to them (not unlike a residential mortgage refinancing).
Although the leveraged buyout entails risk, given the challenges of servicing debt, significant returns are possible without the need for material growth.
Furthermore, the need to generate sufficient cash flow for debt service imposes discipline. Companies that, pre-LBO, were inefficient, or overloaded with expenses are forced to streamline their operations and cost structure to succeed. At the same time, the need to service debt can generate short-term decision-making that may not always be in the best long-term interest of the business. However, the World Economic Forum’s “Global impact of private equity report 2009”1 estimated that the extra productivity from 1,400 private equity transactions of US manufacturing concerns raised output by US$4 billion, to US$15 billion per year from 1980 to 2005 (expressed in inflation-adjusted 2007 dollars).
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