What is a Leveraged Buyout (LBO)? How Does it Work?

A leveraged buyout, commonly referred to as an LBO, is a type of financial transaction used to acquire a company. Leveraged buyouts finance the acquisition using debt and a small equity component from the buyer. In this article, we discuss:

  1. What is a leveraged buyout?
  2. Advantages and disadvantages of an LBO
  3. The equity injection
  4. Acquisition financing
  5. Post-acquisition financing
  6. Case studies

1. What is a leveraged buyout?

A leveraged buyout allows a buyer to acquire a company using a small amount of equity. Transactions are financed using debt, secured by both the buyer’s and the target’s assets. Leveraged buyouts aim for a 90% debt and 10% equity ratio, though these figures vary.

Leveraged buyouts are also used by management teams looking to acquire a company. A transaction in which a company’s existing management acquires the business is called a management buyout. A transaction in which an external management team uses significant leverage to acquire a business they intend to operate is called a management buy-in.

2. Advantages and disadvantages of an LBO

Buyers use LBOs because their advantages make them attractive to investors. However, these transactions can also have a substantial amount of risk. The high level of debt often leaves the target company exposed to financial problems. Buyers must carefully weigh the advantages and disadvantages of using an LBO.

a) Advantages

A leveraged buyout allows the buyer to acquire a business without investing more than 10% to 15% equity. The debt-to-equity ratio allows buyers to maximize their potential returns on equity. Additionally, LBOs allow buyers to acquire larger companies than they could otherwise buy if they used lower levels of debt. This enables buyers to get the benefits of scale from the target company.

b) Disadvantages

Leveraged buyouts can be risky for buyers. The high amount of debt leaves the target business in a financially weakened position. A liquidity problem, such as losing a few key customers, could put the company in severe distress. LBOs leave operators little margin for error.

Leveraged buyouts have some disadvantages for sellers as well. The high debt levels require lenders to be very comfortable with the transaction. Consequently, there is a higher chance of the transaction falling through during due diligence. Additionally, target businesses undergo substantial scrutiny by lenders during due diligence. This process consumes the seller’s time and resources, which could be deployed elsewhere.

3. The equity injection in an LBO

Many buyers believe that a leveraged buyout allows them to acquire a company without using any equity. Effectively, they view leveraged buyouts as a “no-money-down” acquisition. This perception is incorrect. It comes from a misunderstanding of how these transactions operate and how they are portrayed in the popular media.

A leveraged buyout requires an equity injection from the buyers. The amount of equity injection varies by transaction. In larger transactions, the equity usually comes from the private equity (PE) firm or from investing partners. In smaller transactions, the equity injection comes from the individuals buying the company.

There are two situations in which a company could potentially be bought with no equity from the buyer. The first one is if the seller offers 100% financing. The second one is if the target company is sold for a price that is below the appraised value of its assets. Although both types of transactions are possible, they are uncommon.

4. How are leveraged buyouts financed?

Leveraged buyouts use different financing options based on their size and complexity. However, larger transactions have more financing alternatives than their smaller counterparts. Investment bankers and private equity firms favor larger deals due to their potential for higher fees and returns.

Smaller leveraged buyouts

Smaller leveraged buyouts, those under 5 to 10 million dollars, are financed using some or all of the following options.

a) Seller financing

Most transactions have a seller financing component. Buyers like to use seller financing because it keeps the seller involved in the business’s future success. Consequently, sellers are less likely to oversell the business’s future performance. Sellers would prefer to avoid providing financing since part of their compensation will be held for years after the sale. However, sellers often have to offer financing as an incentive to the buyer. Seller financing usually accounts for less than 20% of the transaction’s financing.

b) SBA-backed loans

An SBA-backed loan is the most effective way to finance an acquisition under 5 million dollars. These loans are offered by lenders that have SBA backing and incentives to provide financing to small companies. SBA-backed loans have attractive terms, flexible collateral provisions, and more flexible credit requirements than conventional loans. They are a common tool to finance small leveraged buyouts.

c) Conventional loans

Transactions that fall outside the qualification requirements of SBA-backed loans often use conventional bank loans. These loans don’t have the $5 million limit or industry restrictions associated with SBA-backed loans. However, they are harder to obtain. Borrowers often need to have impeccable personal credit and substantial assets among other requirements.

d) Small investors and family offices

Leveraged buyouts can also be funded through loans from individual investors and family offices. The terms of these packages are often competitive, and these lenders can offer more flexibility than conventional sources. However, finding these lenders and investors is challenging. They are usually found through personal connections, recommendations, and networking.

Mid-sized and large leveraged buyouts

Larger transactions have more financing options than smaller ones. However, all these options still fall under one or more general financing categories.

a) Senior debt

Senior debt has the priority of repayment over other types of debt. Senior debt examples include bank financing and bonds. This debt often has the strictest terms and is well secured with the company’s assets. As such, it has the lowest cost.

b) Mezzanine and subordinated debt

Mezzanine debt is subordinate to senior debt and, thus, is considered junior debt. In a liquidation or bankruptcy, this type of debt gets paid only after senior debt has been paid. Consequently, it has a much higher risk and financing cost. It may also require that warrants/options be issued.

c) Seller financing

Larger transactions can also use seller financing. With this form of funding, the existing ownership group provides financing to the buying group. Seller financing is usually a form of debt financing amortized over several years.

5. Post-acquisition financing needs

The company’s post-acquisition financing needs are important areas buyers often overlook, especially in smaller transactions. However, this type of financing can be essential to the success of the business since it is often used to help with operations. It is best to negotiate this type of financing while negotiating the buyout. Once the buyout concludes, the company will be highly leveraged and unable to get financing for some time. Common financing options include:

a) Bank financing

Buyers who foresee a financing need in the first few years of operation should get post-acquisition funding combined with their business acquisition loan. This step is usually taken by directing a portion of the loan proceeds toward operational expenses.

b) Accounts receivable financing

Companies that sell exclusively to business and government customers often face cash flow problems due to these sales’ 30- to 60-day payment cycles. Factoring receivables allows companies to improve cash flow by financing their invoices. These lines provide the funds to cover payroll and operational expenses. Smaller facilities are usually handled through conventional factoring. Larger facilities typically get funding through an asset-based loan with borrowing base certificates.

6. Case studies

The following case studies discuss some recent transactions we have been involved in:

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Editor’s note:

Given the complexity of how businesses can be purchased and the products that are used, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.