A Guide To Leveraged Buyouts (LBO) Explained

Dave Beard

Written by Dave Beard on March 19, 2019

Updated March 19, 2019

Arranging finance with bank manager

Buying an already established company is almost always going to be an expensive transaction, and many business owners do not have the funding available to make these kinds of large purchases themselves. A large number of businesses are purchased using borrowed money, and a Leveraged Buyout is a common option for this.

Leveraged Buyouts have been a popular business transaction since the 1980s, and while they have decreased in popularity in more recent years, many companies still use it. A Leveraged Buyout is a complex transaction where a company is purchased using mainly debt, and if you are considering a Leveraged Buyout, it is vital that you properly understand all the ins and outs of this.

This guide explains what a Leveraged Buyout is, the pros and cons, and some expert tips.

What is a Leveraged Buyout?

In simple terms, a Leveraged Buyout is the acquisition of a business using almost entirely debt. This debt used for the purchase will usually come from the company’s own assets, and the Leveraged Buyout will be organised so that the company’s assets and cash flow become the primary method to pay the financing. It is known as a Leveraged Buyout as the buyer is able to take over another entity or company without having to put a large amount of their own capital at risk.

At the end of the transaction, all the assets from the acquired company will be heavily leveraged, which makes them an attractive target for a buyer that may want to sell some assets to reduce debt and make the company profitable.

For most Leveraged Buyouts, the ratio will be 90% debt and 10% equity. Due to this high debt to equity ratio, the bonds issued in the buyout are generally not of an investment grade and are sometimes referred to as junk bonds.

When you acquire a business and consider selling off individual parts of it, you should bear in mind that these parts will include real people and their jobs. While sometimes selling these off might be necessary, it is essential to consider the employees involved.

What are the advantages of a Leveraged Buyout?

Leveraged Buyouts come with a range of advantages to the businesses and the buyers involved. The main advantage for the buyer of the business is the return on equity. By utilising a capital structure with a decent amount of debt, it allows the buyer to increase their return by leveraging the seller’s various assets.

For the business owner that is selling the company, there are multiple advantages for choosing to use a Leveraged Buyout. The main advantage to the seller would be that it is one of many ways to sell a business.

A lot of sellers will happily go through with a Leveraged Buyout on the condition that they can exit the business for their asking price. For companies that are in distress or undergoing a turnaround, a Leveraged Buyout can be a viable exit for the seller while at the same time letting the business operate as normal while issues are resolved.

Leveraged Buyouts are often complex processes that take a large amount of time to complete. There are a lot of depending factors that can affect the timescale of the transaction, so it is important to be prepared for a lengthy process.

What are the disadvantages of a Leveraged Buyout?

Like with any financial product, Leveraged Buyouts have their disadvantages as well their benefits, and it is essential to be aware of these before deciding if it is right for you. As a buyer using Leveraged Buyout, there are some risks involved. The main drawback being that after the business has been purchased, it is going to be very leveraged and leaves very little room for errors to be made.

Any issues with liquidity, for example, the loss of important clients, could result in the business being put into serious distress. As a seller, the main disadvantage of Leveraged Buyouts is that buyers will often undergo an extensive and lengthy due diligence process. This can take a lot of time and resources to complete, which could get in the way of the day to day running of the business.

Some lenders may also want to undertake their own due diligence in addition to the buyers. This can add further disruption and can even lead to the deal falling through if a lender is not satisfied with their findings.

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