TheStreet

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What Is a Leveraged Buyout?

A leveraged buyout (LBO) occurs when someone purchases a company using almost entirely debt. The purchaser secures that debt with the assets of the company they're acquiring and it (the company being acquired) assumes that debt.

The purchaser puts up a very small amount of equity as part of their purchase. Typically, the ratio of an LBO purchase is 90% debt to 10% equity. That is, if the purchaser is buying a company for $100 million, they will borrow $90 million and pay $10 million from their own cash.

The purchaser can be any entity with access to the right banks and capital, but usually leveraged buyouts are conducted by other companies or investors.

How Is a Leveraged Buyout Different?

Almost any major corporate purchase involves significant debt. This is true even if the purchaser actually has enough cash on hand for the entire transaction. Among other benefits, using debt for a corporate acquisition has tax advantages and allows a purchaser to potentially write off bad loans if the acquired company does poorly.

However, a leveraged buyout differs from a typical corporate purchase in two primary ways.

• An LBO involves a higher debt-to-equity ratio than most ordinary corporate acquisitions.

• An LBO secures the acquisition debt with the acquired company. This is the defining feature of an LBO.

Example of A Leveraged Buyout

David owns an investment firm. He would like to purchase StoreCo, a retail chain. He intends to reform the company into a more cost-effective operation then sell it.

They agree to a purchase price of $100 million. To conduct a leveraged buyout, David first commits $10 million of his firm's money. He then finds a bank to extend a loan for the remaining $90 million.

David's firm is negotiating this loan, but it will soon own StoreCo. So the loan is structured such that StoreCo will assume this debt. The bank will secure its $90 million with StoreCo's assets. This means that StoreCo will be responsible for making all payments on the debt that David used to buy it, and that if StoreCo defaults on these obligations the bank will seize its land, inventory and other assets in lieu of payment.

Advantages of a Leveraged Buyout

Leveraged buyouts have become increasingly popular because they require very little upfront capital and can insulate a purchasing company from a financial setback. If a deal doesn't work out, the acquired company is saddled with bad debt, not the purchaser.

In our example above, let's say that David can't make StoreCo as profitable as he'd like. The $90 million loan now looks like a money loser, but it is StoreCo which must continue to make payments on that bad deal and which (in the worst case scenario) faces insolvency. David's firm won't lose any money on this loan.

This doesn't mean that a purchasing company is completely insulated from loss. In addition to the up-front capital, purchasers can face potentially significant liability in the form of shareholder lawsuits if they use an LBO to saddle an otherwise-healthy company with untenable payments. However, the purchasing company is protected against direct loss on the underlying debt.

It is not uncommon for otherwise profitable firms to face financial difficulties and even bankruptcy following a leveraged buyout, as they must subsequently pay a debt worth almost the entire value of the company.

Four Uses For a Leveraged Buyout

A leveraged buyout has three main purposes:

1. To Privatize a Public Company

Taking a publicly traded company private means consolidating its public shares in the hands of private investors who take those shares off the market. Those investors will now own either all or a majority of the target company. This requires enough capital to purchase all or most of the company's net value.

Since these investors will now own the company, they can have the company assume the debt liability for this transaction.

2. To Break Up a Large Company

Sometimes a company may grow large and inefficient, such that the whole is worth less than the sum of its parts. In this case an investor may purchase the company and split it off, selling it as a series of smaller companies. For example, a company that manufactures cars, airplanes and tanks might get split up into an automotive, an aerospace and a defense firm, each of which would get sold to larger companies in the relevant industries.

In this case the investor would buy the company through a leveraged buyout in the belief that these individual sales will more than pay off that loan.

3. To Improve an Underperforming Company

Finally, an investor might believe that a firm is significantly underperforming its potential. In this case the purchase price of the company would be worth much less than what the company could eventually be worth, making a leveraged buyout a good option.

This is the case with our example above. David believes that ShopCo could be worth substantially more than it currently is. He will have it assume $100 million in debt because he believes that in five years the company will be worth $200 million or more. Another investor might purchase ShopCo with the intention of holding and operating the company, believing that he can improve the company and generate profits worth considerably more than the debt payments.

There is a fourth, less valuable, use for the leveraged buyout.

4. To Enrich Shareholders and Owners

When a company is purchased, the purchase price flows to all owners and the stock price generally surges. For a privately held firm the individual owner(s) collect that money directly minus any partnerships or other liabilities.

For a publicly held firm the purchase capital accrues to shareholders. This typically enriches executives and members of the board of directors. The former group will often have their compensation tied to stock performance, while the latter group typically comprises some of the company's largest shareholders.

However, this means that a leveraged buyout comes with a significant conflict of interest.

The decision makers in charge of approving any acquisition stand to personally make a lot of money off the resulting deal, even if it means saddling the company with unsustainable debt obligations. In fact, in cases where an investor is purchasing the firm, often that investor will already own significant holdings in the target firm, giving them a a stake in this personal enrichment.

This is not dissimilar from the practice of leveraged buybacks, in which shareholders will have a company assume significant debt in order to buy back its own stock on the open market. In both cases the company takes on a significant financial liability in a transaction that directly enriches the individuals making that decision.

Criticisms of the Leveraged Buyout

This leads directly to the main criticism of the leveraged buyout: That it is a predatory tactic.

A leveraged buyout has potentially significant value when used properly. It can allow an investor or business leader with good ideas to reform a company even if he or she doesn't have access to substantial capital.

In our example above, David might be exactly the right person to make ShopCo a thriving 21st century concern. A leveraged buyout allows him to try without risking the utter ruin of his investment firm if the project fails.

However, leveraged buyouts can destroy otherwise healthy businesses. It is not uncommon for companies targeted by a leveraged buyout to eventually file for bankruptcy due to unsustainable debt payments imposed by this tactic. In recent years the average leveraged buyout has imposed debt almost seven times the target company's EBITDA (essentially, the company's earnings before expenses).

This is what happened, for example, when investor Sam Zell purchased the Tribune Company. In 2007 he used a leveraged buyout to take over the media company, which at the time of purchase was profitable. This imposed $13 billion in debt on the company, which severely disrupted its cash flow. The Tribune Company struggled to meet the obligations imposed by Zell's buyout, and by 2008 it had filed for bankruptcy as a direct result of the debt payments.

Financial Instability

The leveraged buyout also has received significant criticism from financial regulators and market watchers.

An LBO is a highly leveraged transaction, as noted above. This means, however, that the lending institution is far more exposed than it would be in an ordinary transaction. The threat of default is higher, because the larger debt leads to higher payments.

The consequences of default are also more severe. The bank risks losing far more money in a transaction this highly leveraged, and the underlying firm risks bankruptcy and (potentially) liquidation if it can't make its payments on time.

In this context, regulators have grown increasingly concerned over a boom in leveraged buyout loans in the past several years. As Reuters has reported, "the volume of leveraged loans in particular reached $1.3 trillion in the U.S. and Europe in 2018, versus $734 billion in 2007." This amount of debt means that even a small number of defaults could suck capital out of lending institutions and collapse firms, leading to a cascade reaction of losses.