What is a leveraged buyout? Definition and common scenarios
By Indeed Editorial Team
Updated 19 October 2022
Published 19 May 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Conducting corporate acquisitions requires a large amount of money. A leveraged buyout is a financial transaction in which the buyer commits a small portion of the capital and uses debt to cover the difference. If you're involved in corporate finance or have an interest in entering the field, it can be helpful to understand how a leveraged buyout can be profitable. In this article, we answer, 'What is a leveraged buyout?', explain how it works, discuss why companies may want to conduct leveraged buyouts and provide examples of common leveraged buyout scenarios.
What is a leveraged buyout?
Understanding the answer to, 'What is a leveraged buyout?' is essential to pursuing a successful career in finance and investment. A leveraged buyout (LBO) is the process when one company decides to acquire another company using money that they obtain through bonds and loans. That borrowed money is what allows the organisation to meet the cost of acquisition. Typically, in a leveraged buyout, there's a ratio of only 10% equity and up to 90% debt.
How do leveraged buyouts work?
Leveraged buyouts are an investment and acquisition strategy, through which a business can take ownership of another company while minimising personal capital investment. Leveraged buyouts can also help businesses maximise any potential returns. There are several methods that companies use to finance an LBO:
Private equity firms
A private equity firm is an investment management company that offers companies financial backing. Firms of this type often invest in the private equity of a startup or existing business. They can do this thanks to implementing various investment strategies, including leveraged buyouts. In return, private equity firms require a high return rate or may want to take control over some part of the management of the company after its acquisition.
Banks are often LBO lenders for smaller companies. It may be a good option because both the buyer and the private equity firm can borrow money from a bank. Banks then use a revolving credit line, which the borrower pays back. They often use term debt, which is a form of fixed-rate loan for businesses. A buying firm may decide to obtain funds from one bank or from a group of banks, which is called a syndicate.
Subordinated debt is a type of loan that a borrower pays after completely paying off all other debts and loans. It ranks below senior loans or securities with claims on earnings. In a subordinated debt, if the borrower fails to service the debt, the lender may acquire partial ownership of the property. That partial ownership is usually proportional to the balance on the loan.
When a borrower enters a bond, they receive funds from an investor for a fixed amount of time. In return, the investor earns interest on the loan until the bond expires or it reaches maturity. Reaching maturity means that the investor receives back the principal amount plus all of the interest that the loan generated for them.
Why companies may want to conduct leveraged buyouts?
The main goal for a company that wants to pursue a leveraged buyout is financial gain, market share or assets that the other company has. An acquisition of this type allows the buying business to focus on its growth, which often means multiplying resources. Common resources that the buying firm gets include human resources or equipment.
LBOs may often make sense from the seller's viewpoint. A successful LBO allows the seller to exit a business while gaining a financial reward, for example, when they're ready to retire or want to pursue a different venture. There are three main reasons why companies may want to conduct an LBO:
Taking a public company private
Taking a public company private, or privatising a company, refers to a transfer of public shares to private investors. Typically, the investors remove those shares from the market, take on majority or complete ownership of the company and assume debt liability. Although it seems like a complex transition, there are several reasons that make this strategy effective. Most commonly, it's because private entities have fewer regulatory requirements to meet. This means that taking a company private makes it easier for investors to free up resources that they can use in other ventures, including fixed assets.
Related: What are private equity funds?
Breaking up and selling a company
Although growth is usually a good thing that investors and organisational leaders want to see, growth may also impact a company's structure and make it less efficient. In a situation like this, a leveraged buyout may be a great option, as it makes it possible to break up that rapidly growing company into smaller entities, each with a narrow focus, before selling them. For example, a car manufacturer could break up into a tyre manufacturer, a wipers manufacturer and a wheel manufacturer.
Improving a company
Sometimes, the buying company may feel that they can make the acquiring company perform better and generate more revenue. For instance, this can happen when the acquiring company fails to recognise its full potential on the market and only markets its products to local consumers. In reality, that company may have higher chances of attracting international customers and generating profit that exceeds the buying company's debt.
Common leveraged buyout scenarios
Depending on the situation, leverage buyouts may have positive or negative effects for both buyers and sellers. There are different scenarios that investors and companies can consider before pursuing an LBO, as this may help them understand those scenarios' effects. Here are four common LBO scenarios:
The repackaging plan
The repackaging plan happens when a private equity company acquires another company and takes it private. They typically do this by buying all of their stock using money from a leveraged loan. The buying firm then makes efforts to repackage the company that they acquired and 'go public' with it again. Usually, going public requires them to conduct an initial public offering (IPO).
In most cases, the buying firm waits at least a few years before returning the company to the public marketplace. During this time, they make the necessary adjustments that allow them to take advantage of the company's full potential. This scenario may be beneficial to both shareholders and the company's employees, as it may save that company from failure.
The split-up, also known as 'slash and burn' or 'cut and run', is a more aggressive scenario than the repackaging plan. It involves acquiring a company with a plan to break it up because its individual parts have more value as separate entities. In this scenario, the buying firm is often an outside entity that rarely cares about the acquiring company's current employees. This means that the split-up scenario often results in terminating the majority of employees. In some instances, it may create more growth opportunities for separate business entities.
The portfolio plan
The portfolio plan, also known as the leveraged build-up, is a promising scenario for both sides of the transaction, including management and employees. In this scenario, the buying firm acquires one of its competitors. It usually happens after the buying firm makes sure that the return on this transaction can exceed the acquisition costs. A successful portfolio plan scenario then allows that firm to develop in a larger form, taking over its former competitor's market share and customers.
The saviour plan
In the saviour plan, management and employees borrow money to save a struggling company and turn it into an employee-owned company. Although this seems like a great scenario, it comes with many risks. For example, this scenario is likely to become successful if nothing within management changes because that same management caused that company to fail. If the company succeeds with this scenario, everyone benefits from it.
Example of a leveraged buyout
Here is an example of a leveraged buyout scenario:
If you decide to buy a company with a net income of £2.5 million annually, you may acquire it for £15 million. Because the transaction is a leveraged buyout, it means you'd use £10 million in loans and £5 million of your own funds. The loan interest is 10%, so you owe £1 million per year to the lender. Knowing that the company's net income is £2.5 million, your return in the first year might be around 20%. You can also predict a complete return in five years.
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