Understanding a Leveraged Buy-Out 

     

A leveraged buy-out (LBO) is an acquisition of a public or private company in which the takeover is financed predominantly by debt with minimum equity investment. The debt is typically structured to include a combination of bank loans, loans from other financial institutions and bonds with below investment-grade credit ratings, referred to as high-yield bonds. Assets of the acquired company act as collateral for the debt and interest and principal obligations are met through cash flows of the refinanced company.

LBOs appeal to private equity firms due to the size of acquisitions that can be made with relatively small equity investments. Since the acquired company will be highly leveraged (i.e. large debt to equity ratio), a suitable LBO target should have an existing strong balance sheet, low initial debt levels and adequate stable cash flows.

LBO strategies first became widely employed in the 1980s coinciding with the growth in public debt markets, which enabled a wider group of borrowers to access large amounts of capital. The largest LBO to date is the 1998 acquisition of RJR Nabisco by Kholberg, Kravis, Roberts (KKR) for US$25 billion. During the 1980s LBOs gained a notorious reputation due to a number of high profile transactions that led to the bankruptcy of the target companies. These failures were due to the over-aggressive use of debt to finance the acquisitions, which resulted in the acquired corporate entities being unable to meet interest payments from cash flows .

LBO transactions are sometimes viewed as highly predatory in a hostile takeover situation since the target company's own financial strength and assets are used as the main source of collateral for the transaction. Whatever the initial transaction motivation, following an LBO the aim is to meet the increased debt obligations through improved corporate efficiency and / or corporate restructuring. In this respect, LBOs may be seen as a means of reducing agency costs by fully aligning the interests of managers with those of shareholders through the discipline imposed by increased financial leverage. In a corporate context, agency costs are said to arise when managers' interests (e.g. rapid business expansion) do not coincide with principals' primary interest (i.e. maximize shareholder return).

The acquiring entity in an LBO typically enters into the transaction with a planned exit strategy. A popular exit strategy to achieve a targeted return on the equity invested in the LBO is to break up and sell the acquired company or conglomerate. This technique was particularly popular in the 1980s. Other exit strategies may include an IPO or a trade sale within the company's industry. As an intermediate strategy, assuming improved financial efficiency, company shareholders may refinance the company to further increase its debt thereby releasing a portion of funds to equity holders.

In summary, an LBO is a takeover largely funded by debt, which is collateralized and serviced by the target company's assets and cash flows. Following an LBO transaction, the new shareholders aim to improve corporate efficiency and generate a targeted return on equity invested through a successful exit strategy.

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