Leveraged Buyouts: What You Need To Know

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.

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.

Medline Acquisition

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.