LBO Method

Leveraged Buy-out

Summary/Abstract

A Leveraged buy-out (LBO) is a corporate finance method under which a company is acquired by a person or entity using the value of the company's assets to finance its acquisition; this allows for the acquirer to minimize its outlay of cash in making the purchase. In other words a LBO is a company acquisition method by which a business can seek to takeover another company or at least gain a controlling interest in that company. Special about LBOs is that the corporation that is buying the other business borrows a significant amount of money to pay for (the majority of) the purchase price (usually over 70% or more of the total purchase price).

Furthermore, the debt which has been incurred is secured against the assets of the business being purchased. Interest payments on the loan will be paid from the future cash-flow of the acquired company.

LBOs became very popular in the 1980s, as public debt markets grew rapidly and opened up to borrowers that would not previously have been able to raise loans worth millions of dollars to pursue what was often an unwilling target. LBO activity accelerated, starting from a basis of four deals with an aggregate value of $1.7 billion in 1980 and reaching its peak in 1988, when 410 buyouts were completed with an aggregate value of $188 billion. The persons or company doing such a "takeover" often used very little of its own money and borrowed the rest, often by issuing extremely risky, but high interest, "junk" bonds. These bonds, since they were high-risk, paid a high interest rate, because little or nothing backed them up. No surprise some of these LBO's in the 1980s ended disastrous, with the borrowers going bankrupt.

Typical advantages of the LBO method include:

Low capital or cash requirement for the acquiring entity
Synergy gains, by expanding operations outside own industry or business,
Efficiency gains by eliminating the value-destroying effects of excessive diversification,
Improved Leadership and Management. Sometimes managers run companies in ways that improve their authority (control and compensation) at the expense of the companies’ owners, shareholders, and long-term strength. Takeovers weed out or discipline such managers. Large interest and principal payments can force management to improve performance and operating efficiency. This “discipline of debt” can force management to focus on certain initiatives such as divesting non-core businesses, downsizing, cost cutting or investing in technological upgrades that might otherwise be postponed or rejected outright. Note! In this manner, the use of debt serves not just as a financing technique, but also as a tool to force changes in managerial behavior. Indeed, the wave of LBO's in the 1980s has been a major catalyst in the rise of Value Based Management! (see: History of VBM)
Leveraging: as the debt ratio increases, the equity portion of the acquisition financing shrinks to a level at which a private equity firm can acquire a company by putting up anywhere from 20-40% of the total purchase price.

Critics of LBOs indicated that bidding firms successfully squeezed additional cash flow out of the target’s operations by expropriating the wealth from third parties, for example the federal government. Takeover targets pay less taxes because interest payments on debt are tax-deductible while dividend payments to shareholders are not. Furthermore, the obvious risk associated with a leveraged buyout is that of financial distress, and unforeseen events such as recession, litigation, or changes in the regulatory environment can lead to difficulties meeting scheduled interest payments, technical default (the violation of the terms of a debt covenant) or outright liquidation. Weak management at the target company or misalignment of incentives between management and shareholders can also pose threats to the ultimate success of an Leveraged buy-out.

👀	TIP: On this website you can find much more about acquiring companies and Leveraged Buy-outs!

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