A leveraged buyout (LBO) is a transaction when a company or single asset (e.g., a real estate property) is purchased with a combination of equity and significant amounts of borrowed money, structured in such a way that the target’s cash flows or assets are used as the collateral (or “leverage“) to secure and repay the money borrowed to purchase the target.
Since the debt (be it senior or mezzanine) has a lower cost of capital (until bankruptcy risk reaches a level threatening to the lender[s]) than the equity, the returns on the equity increase as the amount of borrowed money does until the perfect capital structure is reached.
As a result, the debt effectively serves as a lever to increase returns on investment. LBOs are a very common occurrence in a “Mergers and Acquisitions” (M&A) environment.
The term LBO is usually employed when a financial sponsor acquires a company. However, many corporate transactions are partially funded by bank debt, thus effectively also representing an LBO.
LBOs can have many different forms such as Management Buyout (MBO), Management Buy-in (MBI), secondary buyout and tertiary buyout, among others, and can occur in growth situations, restructuring situations and insolvencies.
LBOs mostly occur in private companies, but can also be employed with public companies (in a so-called PtP transaction – Public to Private).
As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have the incentive to employ as much debt as possible to finance an acquisition.
This has in many cases led to situations, in which companies were “overlevered”, meaning that they did not generate sufficient cash flows to service their debt, which in turn led to insolvency or to debt-to-equity swaps in which the equity owners lose control over the business and the debt providers assume the equity.