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What Is a Leveraged Buyout? A Simple Explanation

You've probably heard the phrase "leveraged buyout" tossed around before, but do you actually know what it means? Don't worry, you're not alone. Leveraged buyouts sound complicated but they're actually not as intimidating as they seem once you understand the basics. In this article, we'll walk through what a leveraged buyout is in simple terms, who's involved, and why companies or investors might go this route. Whether you're just curious what all the leveraged buyout buzz is about or you're considering being part of one yourself when selling or acquiring a business, you'll learn the key things you need to know to get up to speed on the leveraged buyout process.


What Is a Leveraged Buyout? Definition and Overview

A leveraged buyout, or LBO, is when a company is purchased with a significant amount of borrowed money.


How It Works

The acquiring company, often a private equity firm, secures loans to fund the majority of the purchase price. The assets of the target company are then used as collateral for the loans. If all goes well, the acquirer can then sell the company later at a profit.


Why Do a Leveraged Buyout?

There are a few main reasons leveraged buyouts happen:

  • The acquirer believes the company is undervalued and they can improve operations to increase the value. They aim to sell later at a higher price.

  • The acquirer wants to take a public company private. By borrowing money instead of issuing equity, they maintain control.

  • The company wants to restructure its operations or balance sheet. The acquirer can make drastic changes before re-listing the company or selling to another buyer.

  • Tax benefits. The interest on the acquisition debt can offset the company's profits.

Leveraged buyouts are risky but potentially high-reward deals. If the acquirer's plans to improve the company don't work out, they can struggle to pay off the debt and end up defaulting. But with the right strategy and execution, LBOs can also lead to very high returns.

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How Does a Leveraged Buyout Work? The Process Step-by-Step


A leveraged buyout allows a company to be acquired without requiring a huge amount of capital upfront. Here's how it works:


Find an Investment Bank

The first step is finding an investment bank to advise on the deal. The bank will value the target company to determine a fair offer price. They'll also help raise debt financing and find equity investors.


The acquirer takes out loans to finance 60-70% of the purchase price. This maximizes leverage while still ensuring the loans can be repaid. Interest payments on the debt are tax deductible, reducing costs.


Find Equity Investors

The acquirer puts up 30-40% of the equity. Private equity firms often invest in leveraged buyouts. Equity investors get ownership and potential big returns if the company's value grows.


Make an Offer

With financing in place, an offer is made to the target company's shareholders. If accepted, the deal moves to due diligence where the acquirer reviews the company's finances and operations in detail.


Close the Deal

If due diligence checks out, the deal closes. The acquirer gains control of the target company using mostly borrowed money. The equity investors own a controlling stake, while the acquirer aims to boost the company's value to generate a big return when they eventually sell their shares.


Leveraged buyouts allow acquirers to gain control of companies without investing too much of their own money upfront. With the potential for high returns and tax benefits, it's easy to see the appeal of LBOs for investors and acquirers alike. For the target company, an LBO can provide an opportunity to gain investment and new leadership to accelerate growth.


Pros and Cons of Leveraged Buyouts: Should You Consider an LBO?


A leveraged buyout can be appealing for both buyers and sellers. As a buyer, you can acquire a company with less upfront capital. As a seller, you can potentially get a higher selling price. However, LBOs also come with significant risks that you need to consider.


Pros for Buyers

The main advantage for buyers is that you can gain control of a company by putting up only a fraction of the purchase price. The rest is financed through debt that you repay over time using the company’s cash flows and assets. This allows you to buy companies that would otherwise be out of your reach.


Pros for Sellers

Sellers often get premium prices in an LBO because buyers are willing to take on more debt. Sellers can also get their money upfront rather than waiting for installment payments over several years. For owners looking to exit, an LBO provides an opportunity to cash out their equity quickly.


Cons

The heavy debt burden in an LBO leaves the acquired company vulnerable. If cash flows decrease or interest rates rise, the company may struggle to make debt payments. This could force bankruptcy or restructuring. LBOs also often lead to job losses and cost-cutting as new owners try to generate more cash to pay off loans.

For both buyers and sellers, LBOs introduce a lot of financial risk. But with proper due diligence and conservative financing, an LBO can be a rewarding transaction for those able to stomach the volatility. Whether the pros outweigh the cons for you depends on your risk tolerance and investment goals.

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