A leveraged buyout (LBO) refers to the acquisition of the whole or segment of a company that is funded using a significant amount of debt. The assets of the company being acquired and those of the acquiring company are used as collateral for the loan. The buyer may decide to invest a small amount of equity and fund the remainder of the purchase price with debt or other non-equity sources. The aim of the LBO model of investing is to allow investors to make large acquisitions without committing a lot of capital.
In an LBO model, the purpose of the investing company or buyer is to make high returns on their equity investments and using debt to increase the potential returns. The acquiring firm determines if an investment is worth pursuing by calculating the expected internal rate of return (IRR), where the minimum is 30% and above. The IRR rate may sometimes be as low as 20% for larger deals or when the economy is unfavorable. After the acquisition, the debt/equity ratio is usually greater than 1.0x since the debt constitutes 50-90% of the purchase price. The company’s cash flow is used to pay the outstanding debt
An LBO model is usually regarded as a predatory tactic of acquiring other companies. This is because the acquisition is not sanctioned by the target company, yet the assets of the target company are used as collateral when seeking funding to acquire it. Companies of different sizes and industries can be targets for leveraged buyout transactions.
In a leveraged buyout, the new investors (Private equity or LBO Firm) form a new company that they use to acquire the target company. After a buyout, the target becomes a subsidiary of the new company, or they merge to form one company.
There are several reasons why an LBO can occur. One of the reasons is to transfer private property to another company. This may result from a change of ownership in the business. Also, an LBO may occur when changing a public company to a private company. The transfer should be done according to the company’s policy, and such a change should benefit the shareholders. Lastly, where a company plans to sell a part of its business, a new company can be formed to buy that portion of the business.
Capital structure in a Leveraged Buyout (LBO) refers to the components of financing that are used in purchasing a target company. Although each LBO is structured differently, the capital structure is almost similar in most newly-purchased companies, with the largest percentage of LBO financing being debt. The typical capital structure is financing with the cheapest and less risky first, followed by other available options. An LBO capital structure may include the following:
Bank debt is also referred to as senior debt, and it is the cheapest form of financing instrument used to acquire a target company in a leveraged buyout, accounting for 50-80% of LBO capital structure. It has a lower interest rate than other financing instruments, making it the most preferred by investors. However, bank debts come with covenants and limitations that restrict a company from paying dividends to shareholders, raising additional bank debts and acquiring other companies while the debt is active. Bank debts have a payback time of 5 to 10 years. If the company liquidates before the debt is fully paid, bank debts get paid off first.
High yield debt is typically an unsecured debt and carries a high-interest rate that compensates the investors for risking their money. They have less restrictive limitations or covenants than there are in bank debts. In the event of a liquidation, high yield debt is paid before equity holders but after the bank debt. The debt can be raised in the public debt market or private institutional market. Its payback period is 8 to 10 years with a bullet repayment and early repayment options.
Mezzanine debt comprises small components of LBO capital structure and is junior to other financing options. It is often financed by hedge funds and private equity investors and has a higher interest rate than bank debt and high yield debt. Mezzanine debt takes the form of a high yield debt with an option to purchase stock at a specific price in future, as a way of boosting investor returns commensurate to the risk involved. They allow early repayment options and bullet payments just like high yield debt. During a liquidation, mezzanine debt is paid after other debts have been settled but before equity shareholders are paid.
Equity comprises 20-30% of the LBO financing depending on the deal. It represents the private equity fund’s capital and attracts a high-interest rate due to the risk involved. In the case of a liquidation, the equity shareholders are paid last, after the other debts have been settled. If the company defaults payments, the equity shareholders may not receive any returns on their investments.