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Businessmen shake hands on an LBO deal

A leveraged buyout (LBO) occurs when one company acquires another using debt as the means to complete the acquisition. LBOs allow companies to purchase other companies without tying up significant amounts of their own capital reserves. The company that’s executing a leveraged buyout may put up a certain percentage of their own equity, but the majority of the money that trades hands comes from loans or bonds. There are different stages this type of buyout goes through before it’s considered to be complete. When considering investing in companies that are party to a leveraged buyout, a financial advisor can tell you which metrics are the especially important.

Leveraged Buyout Definition

A leveraged buyout is a type of financial transaction in which one company uses debt to fund the acquisition of another company. Rather than using cash to complete the purchase, a company can take out loans or issue corporate bonds to raise the necessary funds.

In a sense, leveraged buyouts are similar to trading on leverage or margin. In that scenario, you’re using a broker’s money to invest. Likewise, companies that engage in LBOs are using someone else’s money to buy up companies. Debt can represent anywhere from 70% to 90% of LBOs.

So why would a company choose to go into debt to purchase another company? Aside from allowing companies to preserve capital, leveraged buyouts can be profitable if the company being purchased turns out to be a good investment. The company initiating a leveraged buyout may be able to realize a level of return that far exceeds the cost of the debt.

How a Leveraged Buyout Works

Abstract graphic that includes hands on a keyboardBroadly speaking, there are different stages involved in the LBO process. The first is identifying potential candidates for companies that can be acquired through a leveraged buyout. Companies that are suitable for leveraged buyouts tend to be stable, established organizations that have consistent cash flow. They may have significant assets and minimal debt, as well as a solid potential for continued growth. For example, the acquiring company may be looking to buy a company that it can use to develop a new product line.

Once a company has been selected for acquisition, the next step is finding the financing to complete the purchase. Some of the considerations for companies here include:

  • How much financing is needed
  • How much financing is available
  • What type of repayment structure and terms are required
  • Collateral and/or personal guarantee requirements

Choosing the right lender and financing option can depend largely on the state of the company’s financials and credit. Companies must also be able to satisfy the due diligence requirements that go along with leveraged buyout financing.

For example, this may include providing copies of key financial statements such as balance sheets, cash flow statements or profit and loss statements. Lenders may take a closer look at the company’s accounting practices as well as the details of the LBO itself. This due diligence is required to minimize risk to the lender.

If due diligence is completed and a company is cleared for funding, it can move on to the final stage. This is when the acquisition occurs. At this point, the buyer and the seller must come to an agreement on the final terms of the acquisition. The entire process for completing a leveraged buyout can take several months to complete.

Leveraged Buyout Financing Options

There are different types of financing that can be used in an LBO. The financing option a company chooses can ultimately depend on the size and complexity of the transaction.

For example, leveraged buyouts that are on a smaller scale may use any of the following:

  • Seller financing
  • Small Business Administration (SBA) loans
  • Conventional small business loans that are not SBA-backed
  • Loans from friends, family or other investors

These types of financing may work in situations where the total transaction is valued at less than $10 million. Once a transaction exceeds that $10 million threshold, however, other types of financing may be considered necessary to seal the deal.

For instance, a mid-sized or larger LBO may rely on these options:

Seller financing may also be considered for larger LBOs. Once an acquisition is complete, additional financing may be necessary to cover any transitional costs or ongoing operating costs associated with purchasing the company.

In this instance, companies may turn to bank loans or online business loans to get the financing they need. This can include secured and unsecured financing, such as merchant cash advances, accounts receivable financing or purchase order financing.

Some of these options can be more costly than others and/or present a more immediate strain on cash flow. Post-acquisition financing is an important consideration, as the added cost can impact the overall profitability of a leveraged buyout.

Leveraged Buyout Risks

A businessman at workWhile leveraged buyouts can be attractive for companies that are comfortable using debt for acquisitions, there is a certain amount of risk involved. The biggest is that the company won’t be able to generate sufficient cash flow after the buyout to service the debt they’ve taken on. This can happen if the company itself experiences a downturn or if the company it acquired turns out to be less profitable than expected. If a leveraged buyout causes the company that was purchased to lose customers, for example, that could affect the bottom line.

For this reason, it’s necessary for the acquiring company to spend time modeling and forecasting to determine how profitable a leveraged buyout is likely to be. This involves looking at the company’s fundamentals as well as those of the company it’s interested in acquiring. While this does not eliminate risk entirely, it can help to bring to light any issues that could be potential trouble spots later.

There’s also the risk that a leveraged buyout transaction won’t be approved at all. Again, there’s a certain amount of due diligence that has to be completed to satisfy lenders when a leveraged buyout is funded using loans. If a lender deems an LBO to be a bad investment on their end, the transaction might not go through.

The Bottom Line

Leveraged buyouts allow companies to acquire other companies without sacrificing their capital reserves. Companies may choose this option if they’re confident about their ability to repay the debt associated with an LBO, based on the returns they anticipate generating. The key for companies is balancing out potential rewards against potential risks.

Tips for Financial Planning

  • Consider talking to a financial advisor about the ins and outs of leveraged buyouts and what they could mean for your portfolio. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect with professional advisors in your local area. By answering a few simple questions, you can get personalized advisor recommendations online. If you’re ready, get started now.
  • Use a free investment calculator to get a good estimate of how your investment portfolio will do over a set period of time.

Photo credit: ©iStock.com/pixelfit, ©iStock.com/anyaberkut, ©iStock.com/SDI Productions

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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