What Is A Leveraged Buyout?

Interested in private equity funds? Then you’ve probably heard the term “leveraged buyout” before. What is a leveraged buyout, and why does it matter?

Jun 26, 2014 at 12:57PM

The majority of the private equity firms we know and love founded their businesses by focusing on leveraged buyouts. Sounds good, you might think, but what is a leveraged buyout? Read on for a brief intro to LBOs, their advantages and risks, and how the market looks today. 

What is an LBO? 
At heart, an LBO is simply the purchase of a company using debt.

Its defining characteristic, though, is that it's the acquired company that takes on the debt, while the acquirer (usually a private equity firm) puts some money down and takes a significant ownership stake. 


Flickr / liza31337.

Back when LBOs first became popular, it was common to buy a large company and split it up into pieces, which were resold individually for a higher total price than the original company was worth. The media like to make it sound like this strategy was fueled by cruelty and greed, but in fact it was a direct result of the corporate world's over-enthusiasm for empire-building in the 1960s. 

Empires are great if they can operate well; unfortunately, unlike the super-size meal, many companies don't get better as they get bigger. This created ample opportunity for the so-called corporate raiders of the 1970s and 1980s to split companies into more profitable individual parts and pocket the profits.

Nowadays, a private equity firms usually buy companies in order to make them operate better. They might invest in different lines of business, help improve operational efficiency, or restructure the company to avoid (or exit) bankruptcy.

Why Would You Choose an LBO? 
An LBO is a lot like buying a house: You put down some cash as equity (in the case of an LBO, it can range anywhere from 10% to 40%) and borrow the balance, which is backed either by hard assets or by future cash flows, or a combination of both. Just like buying a house with a mortgage, if the value of the company goes up, your returns are amplified.

In other words, you have the financial know-how to take a large company and improve it, you can make pretty handy returns in this fashion. It's even better because you as the investor are not taking on the debt liability -- it's the company that shoulders that burden. 

What are the Risks? 
Of course, the other side of the leverage coin is that if things go sour, they can go very sour. While you aren't the one holding the total debt if something terrible happens (recession, litigation, what have you), you can still lose money and valuable investor capital. Your acquired, for its part, can quickly slide into insolvency -- especially if too much leverage was taken. This can happen because of greed, excess liquidity, or both.


Flickr / flattop341.

The financial crisis provides a good example: Low interest rates and low yields on corporate debt fueled a boom in the LBO market. With so much demand for borrowers, credit standards dropped, leverage increased, and structures like "payment-in-kind" bonds, which allow the adding of interest to the principal instead of paying in cash, became very popular.

Then the crisis came, and the result was a wave of defaults that affects us to this day. Fitch, the ratings agency, estimates that LBO defaults stemming the 2004-2007 period affected $120 billion in bonds and loans as of May 2014, out of a total of nearly $500 billion in transactions.

The Current Environment 
Despite the fallout from the financial crisis, leveraged lending and buyout activity has grown again in the last few years. We have many of the same factors in play that contributed to the pre-crisis boom, including low interest rates, low yields on corporate and high-yield bonds, and a lot of liquidity. 

Banking regulators like the Fed and the Office of the Comptroller of the Currency (OCC) are getting worried: While it's private equity firms that put down equity and organize financing, it's regulated banks that typically provide the funding for these transactions. 


Flickr / laurenkerns.

So far this year, 40% of buyouts have used more debt than the six-times EBITDA level considered by the Fed and OCC to be a reasonable ceiling. The last time this threshold was surpassed was in 2007, when over 50% of loans employed so much leverage.

As a result, bank financing activities are being targeted by regulators, and more stringent rules for debt ceilings will likely be enacted this year. The implications? More lending by non-US banks and by "shadow banks," or unregulated financial institutions. Both are already on the rise: American banks have been sitting out major transactions, and so far this year 26% of leveraged buyout activity has been funded by shadow banks.

In other words, the leveraged buyout space might change shape, but it's very unlikely to go away anytime soon -- so long as there are companies to acquire and willing financiers to provide credit. 

Warren Buffett's biggest fear is about to come true
Warren Buffett just called this emerging technology a "real threat" to his biggest cash-cow. While Buffett shakes in his billionaire-boots, only a few investors are embracing this new market which experts say will be worth over $2 trillion. It won't be long before everyone on Wall Street wises up, that's why The Motley Fool is releasing this timely investor alert. Click here to learn more about what's keeping Buffett up at night and the one public company we're calling the "brains behind" the technology.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Money to your ears - A great FREE investing resource for you

The best way to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as “binge-worthy finance.”

Feb 1, 2016 at 5:03PM

Whether we're in the midst of earnings season or riding out the market's lulls, you want to know the best strategies for your money.

And you'll want to go beyond the hype of screaming TV personalities, fear-mongering ads, and "analysis" from people who might have your email address ... but no track record of success.

In short, you want a voice of reason you can count on.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich," rated The Motley Fool as the #1 place online to get smarter about investing.

And one of the easiest, most enjoyable, most valuable ways to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as "binge-worthy finance."

Whether you make it part of your daily commute or you save up and listen to a handful of episodes for your 50-mile bike rides or long soaks in a bubble bath (or both!), the podcasts make sense of your money.

And unlike so many who want to make the subjects of personal finance and investing complicated and scary, our podcasts are clear, insightful, and (yes, it's true) fun.

Our free suite of podcasts

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. The show is also heard weekly on dozens of radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable. Rule Breaker Investing and Answers are timeless, so it's worth going back to and listening from the very start; the other three are focused more on today's events, so listen to the most recent first.

All are available for free at www.fool.com/podcasts.

If you're looking for a friendly voice ... with great advice on how to make the most of your money ... from a business with a lengthy track record of success ... in clear, compelling language ... I encourage you to give a listen to our free podcasts.

Head to www.fool.com/podcasts, give them a spin, and you can subscribe there (at iTunes, Stitcher, or our other partners) if you want to receive them regularly.

It's money to your ears.


Compare Brokers