Definition of Leveraged Buyout
A leveraged buyout (LBO) is an acquisition (usually of a company, but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt, and in which the cash flows or assets of the target are used to secure and repay the debt . As the debt usually has a lower cost of capital than the equity, the returns on the equity increase with the increasing debt. The debt thus effectively serves as a lever to increase returns, which explains the origin of the term leveraged buyout (LBO).
Financing deal
An LBO is a type of financing deal.
Forms of LBOs
LBOs are a very common occurrence in today's Mergers and Aquisitions environment. The term LBO is usually employed when a financial sponsor acquires a company. However, many corporate transactions are part-funded by bank debt, and thus also effectively representing an LBO. LBOs can have many different forms, such as Management Buyout (MBO), Management Buy-in (MBI), and secondary buyout and tertiary buyout, among others. They can occur in growth situations, restructuring situations, and insolvencies just like in companies with stable performance. LBOs mostly occur in private companies, but can also be employed with public companies (in a so-called PtP transaction, Public to Private).
Common Cause of LBOs
As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition. This has, in many cases, led to situations in which companies were "overleveraged", meaning that they did not generate sufficient cash flows to service their debt. In turn, this then led to insolvency or to debt-to-equity swaps, in which the equity owners lose control over the business and the debt providers assume the equity.
Characteristics
LBOs have become attractive, as they usually represent a win-win situation for the financial sponsor and the banks: The financial sponsor can increase the returns on his equity by employing the leverage; banks can make substantially higher margins when supporting the financing of LBOs as compared to usual corporate lending. The amount of debt banks which are willing to provide and support an LBO varies greatly and depends on the quality of the asset to be acquired--stability of cash flows, history, growth prospects, and hard assets; the amount of equity supplied by the financial sponsor; and the history and experience of the financial sponsor.
Debt Ratio
For companies with very stable and secured cash flows, debt volumes of up to 100% of the purchase price have been provided. In situations of "normal" companies with normal business risks, debt of 40–60% of the purchase price are normal figures. The debt ratios that are possible also vary significantly between the regions and industries of the target. Depending on the size and purchase price of the acquisition, the debt is provided in different tranches:
- Senior debt: This debt is secured with the assets of the target company and has the lowest interest margin
- Junior debt: This debt usually has no securities and bears a higher interest margin