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What is a leveraged buyout?

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A leveraged buyout (LBO) occurs when one company acquires another company by borrowing large amounts of money to cover the cost of the acquisition. These borrowings can be in the form of bonds or loans. The assets of the acquired company are often used as collateral for the loan, along with the assets of the acquiring company as security.

Key Points

• A leveraged buyout (LBO) occurs when the acquisition of a company is completed with almost complete reliance on borrowed funds.
• The popularity of leveraged buyouts declined after the 2008 financial crisis, but has begun to rise again recently.
• In a leveraged buyout, the ratio of debt to equity used for the acquisition is usually as high as possible.
• Leveraged buyouts are considered a ruthless and predatory business strategy because the target company's assets can be used as leverage against itself.

Understanding Leveraged Buyout (LBO)

In a leveraged buyout, the ratio of debt to equity used for the acquisition is usually as high as possible. Exactly how much debt is used depends on market borrowing conditions, investor demand and the cash flows the company expects to generate after the acquisition. [1] Bonds issued in acquisitions are generally not considered investment grade and are therefore called junk bonds precisely because of this high debt/equity ratio.

Important Note: The purpose of a leveraged buyout is to enable a company to make large acquisitions without requiring large amounts of its own capital.

Returns from leveraged buyouts are typically realized in three ways:

• The company pays down its debt and this deleveraging process will increase the company's equity.
• Investors improve profit margins by reducing or eliminating unnecessary expenses and increasing sales.
• The company will be sold at the end of the investment period at a multiple higher than what was paid to invest in the company, a process known as profit expansion.

Private equity groups that conduct leveraged buyouts have developed a reputation for needing to boost profit margins quickly and are often seen as ruthless and predatory. To achieve this, many investors are pursuing severe cost-cutting measures, which may include layoffs.

To realize gains, private equity investors must sell or liquidate their investments within a relatively short period of time. Typically, LBO investments have a holding period of 5 to 7 years, but may be shorter or longer than this range.

There are many ways to realize your investment:

• Taking private companies public
• sold to competitors
• Make a second round of private equity investment, completed through another round of LBO

Typically, an LBO proceeds because a private equity group has identified a company as a suitable target. A suitable target will typically return more than 20% annually, so the company must be able to generate cash to pay down debt ("deleveraging") and should have opportunities to grow profits and market capitalization.

Example of leveraged buyout

One of the largest LBOs on record was the 2006 acquisition of Hospital Corporation of America (HCA) by Kohlberg Kravis Roberts & Co. (KKR), Bain & Company, and Merrill Lynch. The three companies valued HCA at approximately $33 billion. [2]

The number of such large acquisitions declined after the 2008 financial crisis, but as the COVID-19 pandemic abated, large LBOs increased again. In 2021, a group of financiers led by Blackstone Group announced a leveraged buyout of medical device manufacturer Medline, valuing it at approximately US$34 billion. [3]4

Vista Capital Partners and Elliott Investment Management conducted the first major leveraged buyout in January 2022, acquiring software manufacturer Citrix Systems, Inc. for a transaction amount of US$13 billion. [5]

According to a report by Yahoo Finance in December 2023, leveraged loans are expected to usher in a new round of prosperity in 2024. [6]

How does a leveraged buyout work?

A leveraged buyout (LBO) occurs when one company attempts to acquire another company by borrowing large amounts of money. The acquirer will often issue bonds based on the combined assets of the two companies so that the assets of the acquired company can be used as collateral against it.

Although large-scale LBOs experienced a resurgence in the early 2020s, they are generally viewed as a predatory or hostile behavior. [7]

Why do leveraged buyouts happen?

A leveraged buyout (LBO) is often used to take a public company private or divest itself by selling part of its business. They can also be used to transfer private assets, such as a change in ownership of a small business. The main advantage of a leveraged buyout is that the acquiring company can acquire a larger company with a relatively smaller base of its own assets.

What types of companies are suitable for LBO?

Private equity firms generally prefer LBOs to companies in mature, stable industries rather than start-up or riskier industries. [8] For LBOs, the best candidate companies usually have stable and reliable operating cash flow, mature product lines, strong management teams, and feasible exit strategies so that the acquirer can realize benefits.

Conclusion

A leveraged buyout (LBO) occurs when one company acquires another company primarily by borrowing funds. Businesses often conduct LBOs to take the company private or divest part of an existing business.

Leveraged buyouts are often viewed as a predatory business strategy because the target company has little control over approving the deal and its own assets may be used as leverage against it. LBOs declined after the 2008 financial crisis, but activity has increased since then.

References

[1] Leonard N. Stern School of Business, New York University. "Corporate Restructuring." Page 34.

[2] HCA Healthcare. “HCA Completes Merger with Private Investor Group.”

[3] Blackstone. “Blackstone, Carlyle and Hellman & Friedman to Invest in Medline.”

[4] Financial Times. “[Private Equity Group Reaches Deal to Buy Medline for

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13 Billion in 2022's First Big Leveraged Buyout](https://www.latimes.com/business/story/2022-01-31/citrix-elliott-vista)."

[6] Yahoo! Finance. "2024 US Leveraged Loan Outlook: Strong Returns, Improved Issuance Likely."

[7] S&P Global Market Intelligence. "As LBOs Surged in Q4'20, US Purchase Price Multiples Hit New Heights."

[8] Business Insider. “How Private Equity Firms Screen for LBO Candidates.”

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TheQuantHackers is a cutting-edge community composed of a group of people from the world's top universities and quantitative finance practitioners, dedicated to exploring the infinite possibilities in the fields of artificial intelligence (AI) and quantification (Quant). Our team members come from world-renowned universities such as the University of Cambridge, Oxford University, Harvard University, ETH Zurich, Peking University, and the University of Science and Technology of China. Our external consultants come from first-class companies such as Microsoft, HSBC, Citadel, Man Group, Citi, Jump Trading, and top domestic private equity companies.$34bn](https://www.ft.com/content/3993dcba-4cbc-4564-a22e-8c36992589b2).”

[5] Los Angeles Times. "Citrix Sells for $13 Billion in 2022's First Big Leveraged Buyout."

[6] Yahoo! Finance. "2024 US Leveraged Loan Outlook: Strong Returns, Improved Issuance Likely."

[7] S&P Global Market Intelligence. "As LBOs Surged in Q4'20, US Purchase Price Multiples Hit New Heights."

[8] Business Insider. “How Private Equity Firms Screen for LBO Candidates.”

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