Leveraged buyouts (LBOs) involve acquiring a company using a significant amount of borrowed money. LBOs serve various purposes, like taking a public company private or spinning off a business segment. LBO target companies are typically mature, stable companies with solid cash flows and management teams. LBOs saw a drastic decline after the 2008 financial crisis, but they have experienced a recent resurgence due partially to the COVID-19 pandemic.
Getting To Know Leveraged Buyouts (LBOs)
A leveraged buyout (LBO) is the acquisition of another company using a substantial amount of borrowed money to meet acquisition costs. Often, the assets of the company being acquired and assets from the acquiring company are used as collateral for the loans.
What does this mean in simpler terms? By taking out substantial loans secured against the company’s assets, investors of leveraged buyouts can purchase majority stakes in a firm without using all their own money. Using debt reduces the risk to investors and, if everything runs smoothly, can set up the investor (and the company) to benefit from the gains.
Understanding the Reasons Why Businesses Use Leveraged Buyouts
Debt-to-Equity Ratio in LBOs
A typical LBO setup has a ratio of 90% debt to 10% equity. Because of this high debt-to-equity ratio, the bonds issued in the buyout are usually not investment grade and are known as “junk bonds.” Junk bonds, also known as speculative-grade bonds, offer high-risk income security with a high risk of payment default. Even with these risks, the potential internal rate of return (IRR) is much too appealing to ignore.
The Goal of LBOs
The primary goal of leveraged buyouts is to allow companies to make significant acquisitions of other companies without committing a considerable amount of their capital.
This benefits each party in the following ways:
Spinning off a Portion of a Business
LBOs are used to spin off a portion of an existing business by selling it. This can help companies divest a non-core business segment and focus on its core operations.
To Make a Public Company Private
LBOs can also transfer publicly traded shares to a private investor, who will then take them off the market. This investor then owns most of the company and will assume all debt and liabilities.
To Scale a Large Business Down
LBOS can scale a business that has gotten absurdly large down to a manageable size. This process could break up the company into smaller ones. The revenue from these more minor sales typically covers the loan cost the acquiring company took out to purchase the entire company. This also gives the smaller companies a fighting chance independently rather than being swallowed by the giant corporation.
To Help a Poor Performing Company
Investors can also use leveraged buyouts to aid companies performing poorly and in danger of going under. In this scenario, the investor sees potential growth far surpassing the company’s current state. The investor assumes the debt from this acquisition and gives the company value, which eventually turns into profits.
To Position Yourself Above Your Competitor
Another way that LBOs can benefit investors is by giving them a leg up against their competition. By being acquired by a larger company, smaller businesses can expand their client base and scale more quickly.
The Pros and Cons of LBOs
When executed well, LBOs can provide the target company with many new resources, expertise, and connections that can help improve efficiency, growth, value, and profitability. LBOs have notoriously garnered a negative reputation primarily due to the potential outcomes once the acquisition is complete.
Here are some benefits and drawbacks to consider when it comes to leveraged buyouts.
- LBOs can provide the target company with new resources, expertise, and connections.
- Allows companies to make significant acquisitions without committing a considerable amount of their capital.
- Can spin off a portion of an existing business, divesting a non-core business segment and focusing on core operations.
- It can help companies scale down an absurdly large business to a manageable size by breaking it up into smaller ones.
- Provide a struggling company with potential growth opportunities.
- Sometimes help smaller businesses by being acquired by a larger company, expanding their client base, and scaling more quickly.
- Leveraged buyouts can lead to financial distress or even bankruptcy for the acquired companies.
- High debt-to-equity ratios can result in junk bond issuance.
- Drastic cost-cutting measures could lead to layoffs and downsizing.
- Predatory practices after acquisition could negatively impact companies.
- Little margin for error for buyers, and failure to repay the debt could lead to no return.
But, there are several positive reasons why LBOs can benefit companies and investors. Let’s look at two examples of successful LBO acquisitions.
Examples of leveraged buyouts
Hospital Corp. of America (HCA) Acquisition
One of the largest LBOs on record was the Hospital Corp. of America (HCA) acquisition by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch in 2006. Together, the three companies valued HCA at around $33 billion.
In 2021, a group of financiers led by Blackstone Group announced a leveraged buyout of Medline that valued the medical equipment manufacturer at $34 billion.
- A leveraged buyout (LBO) is the acquisition of a company using a significant amount of borrowed money.
- LBOs typically involve a 90% debt to 10% equity ratio, leading to junk bond issuance.
- Examples of LBOs include the acquisition of HCA and Medline.
- LBOs can negatively and positively affect the acquired company, depending on the execution and circumstances.
View Article Sources
- HCA Healthcare — HCA Completes Merger with Private Investor Group
- Tony Robbins. (n.d.). Ultimate Guide To Leveraged Buyouts
- Corporate Finance Institute(CFI) — Leveraged Buyout: The Use of Significant Leverage for Acquisitions.
- What is a Leveraged Loan? — SuperMoney
- How to Use Leverage to Build Wealth — SuperMoney