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

Summary: A leveraged buyout, commonly called an LBO, is a type of financial transaction used to acquire a company. Leveraged buyouts combine substantial debt financing with a small equity component from the buyer.

Buyers typically use LBOs because debt amplifies the results of their investment. However, this feature can be a drawback if the acquisition encounters problems. 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 the buyers' and the targets' assets. Leveraged buyouts aim for a ratio of 90% debt to10% equity, though these figures vary.

Leveraged buyouts amplify the results of the acquisition – good or bad. Acquisitions that go well can get a high Return on Equity (ROE). However, acquisitions that don't go according to plan can run into serious financial problems or failure.

a) Management buyouts and buy-ins

Management teams looking to acquire a company can also use an LBO structure. A management buyout is a transaction in which a company's existing management acquires the business. A management buy-in is a transaction in which an external management team uses significant leverage to acquire a business they intend to operate.

2. Advantages and disadvantages of an LBO

Buyers use leveraged buyouts because of the potential for great returns. However, they often underestimate the potential disadvantages of this financing strategy. Buyers should carefully weigh the advantages and disadvantages of using an LBO for an acquisition.

a) Advantages

Leverage buyouts offer two potential advantages that stem from their low equity requirements. The most important benefit is the potential for a high return on equity. This result is due to the small size of the equity relative to the company's value.

Additionally, LBOs enable buyers to acquire larger companies than they could otherwise buy if they used lower debt levels. This structure enables buyers to get the benefits of scale from the target company.

b) Disadvantages

The high amount of debt leaves the target business financially weakened. Consequently, the operator has little room for error.

A liquidity problem, such as losing a few key customers, could put the company in severe distress. Getting additional financing wouldn't be an option due to their high leverage. Consequently, the new owners could be required to contribute additional equity.

Leveraged buyouts have some disadvantages for sellers as well. The high debt levels require lenders to be very comfortable with the transaction. The target business will undergo substantial scrutiny during due diligence. This process consumes the seller's time and resources, which could be deployed elsewhere. In our experience, these transactions have a higher chance of falling through.

3. The equity injection in an LBO

A leveraged buyout requires an equity injection from the buyers. This component must come from the buyers and typically can't be financed.

In larger transactions, the equity injection usually comes from the private equity (PE) firm. In smaller transactions, the equity injection comes from the individuals buying the company.

The popular perception that LBOs are "no-money-down" transactions is mostly incorrect. It comes from a misunderstanding of how these transactions operate and how they are portrayed in the media.

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 below its assets' appraised value. 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. Investment bankers and private equity firms favor larger deals due to their potential for higher fees and returns. Consequently, larger transactions have more financing alternatives than their smaller counterparts.

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 use seller financing to pay for a portion of the acquisition. Seller financing typically accounts for less than 20% of the transaction's financing.

Buyers like to use seller financing because it offers some protection in case of post-sale issues. It gives sellers an "incentive" to perform their post-sale commitments (e.g., owner training).

Sellers would rather avoid providing financing since it ties part of their compensation for years after the sale. However, they have to offer it because most buyers and lenders make the transaction contingent on getting this type of financing.

b) SBA-backed loans

In our experience, an SBA-backed loan is the most effective way to finance an acquisition under 5 million dollars. These loans are offered by lenders with SBA backing and incentives to finance small companies.

SBA-backed loans offer attractive terms, flexible collateral provisions, and simpler qualification 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 may use a conventional bank loan. These loans don't have the 5-million-dollar limit or industry restrictions associated with SBA-backed loans. However, they have stringent qualification 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 financing packages are often competitive, and these lenders can offer more flexibility than conventional sources.

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, 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 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 business's future success.

Buyers should negotiate for post-acquisition financing while negotiating the general financing terms for the buyout. Once the buyout concludes, the company will be highly leveraged and unable to get additional financing for some time. Common financing options include:

a) Bank financing

The simplest way to get post-acquisition funding is to ask your lender to include it in their business acquisition financing package. At closing, a portion of the loan proceeds is directed toward future operational expenses.

b) Accounts receivable financing

Companies with commercial or government sales can also use accounts receivable factoring to improve cash flow. These facilities 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:

This information should not be considered legal or financial advice. Given the complexity of business acquisitions, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide you with the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.

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