Leveraged Buyout (LBO) is defined as an acquisition of a company using a significant amount of borrowed money to meet the cost of acquisition. LBO enables an acquisition of another company without the need to commit a significant amount of capital.
Several significant LBOs from the past can be seen in the table below.
As mentioned, LBOs are heavily financed by borrowing and the leverage ratios are therefore very high. It is important to mention that the target’s assets are used as collateral for the loan needed to purchase the target.
Often, LBOs are conducted to take a public company private. Main motives for this are the value of the tax shield, increased incentives for management through equity ownership and avoiding costs of maintaining a listing. Other reasons for LBO could be the need to spin-off a portion of an existing business by selling it or a transfer of private property to another owner.
Below, we can see a diagram of an LBO structure. On the diagram, The New Investors create the NewCo to acquire the Target. Target either becomes a subsidiary of NewCo or they merge.
Acquirer usually sells or takes their LBO target public after several years seeking large profits which can be as high as 15 to 30% annually. A good LBO candidate is usually a steady well-established company with predictable operating cashflows.
An increase in the LBO activity can usually be seen during the periods of lower interest rates which effectively decreases borrowing costs or when the economy is underperforming which can undervalue the target’s equity. On the other hand, lower borrowing costs create profit opportunities bidding up the prices, resulting in the opposing effect. Therefore, the actual LBO activity depends on the magnitude of these factors. Below we can see LBO activity during the period from 1998 to 2010 according to Standard & Poor’s.