Leverage buyouts (LBOs) are a popular way for investors to achieve a high rate of investment return by acquiring businesses with strong cash flow and asset bases. In basic terms, a leverage buyout is financed using a combination of borrowed money and the equity of both the purchaser and the target company. Leverage buyouts can be initiated by the management or employees of a business, as well as by equity firms and other companies. Here’s how it works.
Three Main Purposes for Leverage Buyouts
Many LBOs are initiated as a means for taking publicly traded companies and making them privately held businesses. These types of buyouts are referred to as Public to Private or, in cases where the company is sold to another company or to the public via stock offerings, public-to-private-to-public.
Spin offs are another type of leverage buyout in which smaller elements of a business, such as divisions and subsidiaries, are sold as a way for target businesses to get cash. In these instances, LBO funds are used by investors to obtain these smaller portions of the target business.
A third type of leverage buyout is the private deal wherein an investor group purchases a privately held enterprise. This type of LBO situation usually occurs when a small business owner is ready to retire or wants out of the business but is unable to find a buyer. In this case the LBO is often organized by employees, family members or other entities connected to the current business owner.
Financing a Leverage Buyout
The two main sources of capital involved in a leverage buyout are the debt portion and the equity portion. The debt portion is acquired through loans and securities and comes in two forms: Senior debt and junior debt. Senior debt, with the lowest margin of interest, is supported by the assets of the purchaser and the target company. Junior debt, or mezzanine debt, has a higher interest margin because it is usually unsecured. In contrast, the equity portion of a leverage buyout relies not on interest bearing funding, but on sponsor raised capital.
For an LBO to be successful, the sponsor must focus on companies that are turning a profit, exhibiting growth and producing a legitimate cash flow. Why is this important? Because the company’s future cash flow will be used to pay the leveraged debt. When you understand the basics of leverage buyouts, it’s easy to see the benefits to both sponsors and target companies.
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