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Leveraged Buy-Outs (LBO’s)

What is a leveraged buy out?

A leveraged buyout (LBO) is when a business or single asset (e.g., parcel of real property) is acquired with a combination of equity and substantial amounts of debt, organized such that the target’s assets or receivables are used as the collateral for the debt used to finance the purchase. Because, in theory, the debt has a lower cost of capital than the equity, the return on the equity increase as the amount of borrowed money does until the perfect capital structure is reached. Accordingly, the debt serves as a lever to increase returns-on-investment.

Leveraged buy outs are  standard practice in the “Mergers and Acquisitions” (M&A) environment. The term LBO is used when a buyer purchases a business. However, many M&A transactions are at least partially financed by debt, thus constituting a leveraged buy out.  There are many different types of LBOs, including Management Buyout (MBO), Management Buy-in (MBI), secondary buyout and tertiary buyout.  These types of LBOs can occur in growth environments, reorganizations and financial insolvencies.  Usually, LBOs occur in private businesses, but can also be used by public companies, e.g., PtP deals (Public to Private).

As buyers increase returns through the use of leverage (high ratio of debt to equity), buyers are incentivized to add as much debt as possible to fund purchases.  The use of such high ratios of debt to equity often results in “overlevered” businesses, as they are unable to obtain enough gross income to service their ever expanding debt.  This leads to insolvency or to debt-to-equity swaps where the lender acquires ownership of a businesses’ equity rather than exercising its lien against the businesses’ collateral.  In these types of LBO’s there is usually a debt ratio of 90%/10% debt to equity.  Due to this high debt to equity ratio, such loans usually are not invesment grade (when fiananced by bond issuance) and are referred to as junk bonds.

Although leveraged buy outs are often seen as a win-win situation for the buyer and the lenders: The buyer can increase the returns on his equity by using leverage; lenders can receive substantially higher rates when financing high-risk LBOs, many third parties, including the public at large, view LBO’s as predatory and financially irresponsible as they are perceived as often resulting in bankruptcy and a loss of any going concern value for the business.  Undoubtedly, LBO’s, or any use of a high debt to income ration, i.e. leverage, exposes business to the risks associated with economic shocks such as recessions, shortages and deflation, but LBO’s nonetheless remain a favored business strategy for both lenders and buyers, and they continue to be widely utilized.

The amount lenders are able to finance ranges greatly based on, among other things:

  • The value of the asset to be purchased (history of cash flows, potential for growth, liquidation value of collateral, etc.)
  • The amount put down by the buyer
  • The reputation of the buyer
  • The economy at large, including current interest rates

For businesses with consistent and dependable revenue, loans up to the entire amount of the purchase price have been made.  In situations of regular businesses with average lending risks, debt of 40–60% of the purchase price are standard in the industry.  Of course, debt ratios vary between regions and industries, as each respective region and industry presents unique economic and geopolitical risks.

Based on the price and value of collateral, the debt  can either be Senior, which is secured by assets of the target asset or business and has correspondingly lower interest margins, or junior, which has no secured collateral and fetches correspondingly higher interest rates.

In high value deals, it is not uncommon for all or part of the loan to be replaced by high yield bonds. Based on the value of the target business or asset, loans and equity capital can be provided by more than one party. In bigger deals, debt is sometimes “syndicated”, which is where the lender transfers all or part of its loan in pieces to other lenders in an effort to mitigate its own risk.

LBO’s and other highly leveraged transactions are an important tool in any businesses’ arsenal, and defending oneself from hostile takeovers, as well as identifying and acquiring valuable target assets, continue to be highly profitable industries.  For assistance with preparing, negotiating and formalizing a highly leveraged transaction, contact The Callan Law Firm, P.C. now to speak with an attorney.