What is a Leveraged Buy-Out?

A leveraged buy-out (LBO) is when a controlling interest of a corporation is purchased through highly leveraged financing. The financing is secured by borrowing against the assets of the corporation being acquired and possibly even the assets of the company making the buyout. The advantage of a leveraged buy-out is that it allows a corporation to make a large acquisition without putting up a lot of their own capital. Leveraged buy-outs are also referred to as highly-leveraged transactions (HLT) or bootstrap transactions.

The term leverage, in finance, is often used to describe borrowing. When a corporation is described as being heavily leveraged, or highly leveraged, it is referring to the fact that the corporation has a high level of debt finance that it must repay. The reason the term leverage is used,is due to the fact that the creditors, who have provided the financing, exercise a significant amount of power over the corporation.

In a leveraged buy-out situation, significant amounts of funds have been borrowed against assets to raise the finances. As a result, the corporation is now highly-leveraged, due to the level of debt acquired. This is the main reason why the media has depicted leveraged buyouts as being “predatory” in nature. A leveraged buyout can have four strategic intents:

  • Repackaging is when private equity is used to purchase a currently public company. The purchased company is then taken private for a few years and “cleaned up” before being returned to the market as a fresh new IPO.
  • Splitting up happens when a company is deemed to be worth more if divided or sold off in pieces. An LBO occurs and then the acquired company is dismantled. This is the most feared form of LBO and is commonly seen with conglomerates.
  • Aggregation or leveraged build-ups are when a company uses an LBO to acquire a competitor and thus enhance or add to its portfolio. This is risky because the acquired company must show a return on invested capital that exceeds the cost of acquisition.
  • Employee salvation is when the management and employees of a company borrow money to save a failing company. This is the least common form of leveraged buyout because to turn a failing company around generally requires changes in management and employees.

Therefore, the positive and negative aspects of an LBO depend on which side of the fence you are on and the strategic intent of the buyout. Companies often use mezzanine debt to fund a leveraged buyout because of its lower cost when compared to equity and it’s less stringent structure when compared to senior debt.