Leveraged Buyout (LBO): Definition, Risks And Examples

What is a Leveraged Buyout?

A Leveraged Buyout is typically completed by Private equity firms to purchase an existing business along with its revenue streams, assets, debts, and obligations to expand other current businesses. It is also used as a way to buy and grow a business by improving efficiencies with current processes, procedures, or strategies a company uses.

The reason that the financing is useful to buyers and investors of a private equity LBO is that it creates leverage for the buyer. This means that a buyer may only need to show up with 15% of the price to buy the company, and investors back the remaining amount through loans that require repayment over time from the cash flow of the company. The company makes the repayments back to the investor as it pays off the debt. Then, the investor receives a profitable investment structure, while the buyer does not have to come up with all the funds at once to take over a large stake, or majority ownership in the company.

The value of this strategy is that it makes every dollar invested into buying a business stretch farther. In addition, once the loan is paid off, the cash flow returns to the company, and investors have additional profit to distribute to the new owners, reinvest, or buy additional companies that provide additional strategies and synergies. While this strategy takes place it also allows investors to improve the business through the positive efforts of all their holdings; the operational efficiency, ability to reduce cost, and grow the overall value of the business.

Key Takeaway: A leveraged buyout is when a company is purchased, and the buyer uses financing to pay for the purchase and pays off the debt from the revenue generated by the business.

What’s a Management Buyout (MBO)?

A Management Buyout, also known as an “MBO”, is a way for the current management team to take controlling ownership or full ownership of the company they work for. This is advantageous to both the former owners as a buyout strategy and the previous employees who will become the new owners.

Think of a Management Buyout as a way for employees to take control of the company in some form or fashion. They do this through purchasing the assets and operations, human capital, IP, etc. that they are already used to managing and operating for profit. This often allows new owners to streamline their cash flows and continue generating profits. This is because a management buyout is regarding the person(s) or entity(s) completing the takeover and the Leveraged Buyout is a method of financing a purchase. The Management buyout can be completed through a series of financing strategies, one of which is the Leveraged Buyout.

Key Takeaway: Don’t confuse this strategy as a separate type of transaction since a Management Buyout can use a leveraged buyout strategy alongside it.

How Leveraged Buyouts Work

Leveraged Buyouts function in a relatively straightforward manner, but are of course unique to each deal being completed. The nuances of any deal will likely be customized to the parties involved. Each leveraged buyout investors need to review the following items at a minimum during due diligence:

1. Who are the parties involved, and the structure of the proposed deal?
2. Forecasting financials, cash flow, and net income of the company
3. Cash flow and Financial Statements of current and previous years
4. Identify and review debt and interest payments of the business
5. Determine how much leverage, or loan financing, the business can comfortably handle
6. Calculate the projected free cash flow as a buyer, and for the sponsors of any new debt
7. Calculate the Internal Rate of Return (IRR) as a buyer, and for the sponsors of any new debt
8. If possible, review a sensitivity analysis to determine what variables are key influencers to the business before and after a buyout

Once investors have completed these analyses and reviews investors should have only a few items remaining to work through. Investors will need to ensure all parties are in agreement, line up any financing based on the financial forecasts, and of course, get the agreement signed.

These function as the primary analysis points for completing and implementing an LBO for most businesses; of course, this requires all parties to follow through on their portion of the investments, financing, or sale. So company performance, investor repayment, and ongoing agreements must be evaluated and managed appropriately for the full success of a leveraged buyout to be attained.

How LBOs Create Value: 6 Key Reasons

Some of the most appealing reasons to use a Leveraged Buyout strategy are financially driven. It gives the opportunity for owners to cash in on hard work and allows new buyers to acquire a business, while a third-party lending sponsor can create a new income stream by making a loan to finance the purchase.

However, these are not the only ways to create value through an LBO. Overall, a few of the best value creations may come from other areas in the business such as:

1. New Income Streams: When buying a business, investors are purchasing a revenue stream. They consider the value of a new income stream, and how that particular source of revenue would react to changes in the economy. Diversifying the types of income streams an investor has can be a valuable and positive long-term investment.
2. Operational Enhancements: A new business may be able to solve some problems the current business faces. If aligned appropriately, there may be a key technology, systems, or processes that help new owners streamline their current operations.
3. Talent Acquisition: Just like operations, it can be hard to consistently succeed at talent attraction and retention. If the potential target company can help investors expand their talent pool to work on projects investors have planned, it may be to their benefit to evaluate this reward of a potential transaction.
4. Reduce Competition: If investors buy out their competition, they are no longer a threat and they immediately capture more market share. This strategy has been around for a long time, and never goes out of style.
5. Cost Cutting: If operations can be improved easily through positive integrations from the new business to investors’ current businesses, investors can likely streamline operations. Some ways include personnel, staffing, and operational process over time to reduce cut costs, or said another way, increase profits.
6. Synergies for Future Acquisitions: A business may try to buy more companies in the future, and if they can create position enhancements in future transactions because they complete the one now, then investors should consider that in their valuation.

Key Takeaway: There are many ways of creating value in business, but this transaction type is that the purchase helps investors make money in more ways than just the business being purchased. It should help improve other holdings or endeavors being worked on and provides an income stream to investors.

Who Performs Leveraged Buyouts?

Typically, Private Equity funds are the ones behind the purchase and financing of a Leveraged Buyout. This is because they raise the funds to buy the company through various forms of debt instruments that allow them to only have to put up around 10-25% equity of the business they are buying to complete the deal. This allows them to stretch every dollar they put to work, and increase return on investment.

Leveraged Buyout & Private Equity

What is important to know is that another term for Private Equity is Leveraged Buyout Investment Firm and that the primary type of transaction the private equity firm specializes in is most often a leveraged buyout. At times, they will share equity ownership with other financiers, and at times they will also be the ones to put up debt financings to complete an LBO transaction.

Risks of an LBO

The two key types of risks associated with LBOs are interest rate risk depending on the financing arrangements, as well as a business risk with any business. Oftentimes other risks of integration have already been evaluated and mitigated to a high degree.

1. Interest Rate Risk: Interest rates are often high on this type of financing agreement and if the interest and principal payment schedules are unable to be met, then the company could end up in bankruptcy. If there is a rising rate environment with variable debt, then payments could increase unexpectedly! Finding fair credit terms and interest rates are key to a successful leveraged buyout to help prevent catastrophe.
2. Business Risk: The key here is that the risk is still tied to the financing. If a business faces an unexpected event and for some reason cannot satisfy the payments on the debt, then a company would end up insolvent, or unable to pay the creditors who could then seize the assets of the company.

Overall, these business transactions tend to provide a large benefit to shareholders and the buyers due to all of the value creation opportunities they provide. However, in exchange, investors do have to risk their capital and expose it to a few market variables out of their control.

Historical Leveraged Buyout Examples

Example 1: Hilton – Private LBO Failure to IPO Power Move

The Hilton LBO was one of the worst-timed buyouts in real estate of all time. Blackstone Group, the private equity firm, bought the Hilton brand and assets in 2007 just before the real estate crisis. After navigating this hurdle, and making many operational changes, the listed Hilton as a public company in 2013, transforming the deal into one of the most profitable LBO transactions ever.

Example 2: Harrah’s LBO “Gambler’s Fallacy”

Eventually, Harrah’s filed for chapter 11 bankruptcy, but before this downfall, they had a significant leveraged buyout transaction that was one to talk about. After the buyout of Harrah’s at a 30%+ premium to the market price on the day of the sale, the company had to navigate the housing market crash along with the lack of tourism in the company’s key target markets. Because of this, they had to withdraw an IPO capital raise and ended up filing bankruptcy in 2011.

Remember: All business transactions require the business to perform post-sale, merger, or other transaction types. If ever the business isn’t performing then investors will always end up in a lose-lose situation as an investor.

Bottom Line

A leveraged buyout is one of several transactions used for a company to transition ownership. In this instance, the buyer uses financing to reduce the equity they have to bring to the table, and often the transaction seeks to improve some efficiencies for a business and generate value for the buyer that is more than just some additional profit.