The historically low interest rates of the last couple of years have led to an increase in mergers and acquisitions. Now, the leveraged buyout is coming back in fashion after dropping off the M&A scene post-2008.
What Is a LBO?
The LBO is a type of acquisition where one company buys another using borrowed money. Percentages vary by deal, but it's common in the leveraged buyout model for the buyer to provide as little as 10% in equity and finance the rest through debt including high-yield bonds or mezzanine debt. For example, a $100 million deal enacted through a LBO may only require $10 million in equity, with the remaining $90 million financed as debt.
Due to the significant amount of borrowing that must take place in order to complete the leveraged deal, the buyer is often required to put up company assets as collateral, including assets from the company they’re purchasing.
Strategic Uses of the LBO Model
Leveraged buyouts can seem aggressive or even ruthless, particularly when the buyer plans to use the target company's assets as collateral within the deal. There were times in the past when companies that were acquired via leveraged buyout were driven into bankruptcy after the close of the deal due to the high amount of leverage committed to finance the deal. Caution should be used when considering an LBO during periods of high debt load, rising interest rates or weak cash flow.
However, there are times when this deal structure makes sense. Leveraged buyout financing may be the best option for deals that:
- Acquire a major competitor: Smaller companies can borrow money to buy much larger companies who are direct competitors
- Take over a weak company for the purposes of improving it: By combining resources, the weak company can be improved by the M&A process
- Divide a large company into smaller subsidiaries: In this scenario, a larger acquired company can be split into parts, which can then be sold off
- Take private a company that is currently operating publicly: A company can be sold to a private entity and restructured
- Rescue a failing company: New ownership may be the solution to transform a flailing company
Types of Leveraged Buyout
A leveraged buyout can take several forms, including:
- Management Buyout (MBO): A company's existing management can purchase the company, essentially seeking to transform it from the inside out through new leadership
- Management Buy-In (MBI): Management from outside the company effectively buys their way into the target company and seeks to transform operations
- Secondary Buyouts: Any time a private equity firm orchestrates an LBO for one of the businesses in its portfolio, it's called a secondary buyout
Other examples of deals that fall into the category of LBOs include Public-to-Private LBOs, Club Deals and Carve-Outs. These tend to be more complex in their nature than the types mentioned above, so it’s best to explore the options thoroughly before making a decision.
How Leveraged Buyouts Are Financed
There are a variety of financial instruments that may be employed during the course of a typical LBO process. In most cases, the capital stack consists of senior debt, subordinated debt, mezzanine financing and equity. For higher-risk deals, high-yield bonds may be employed, as well. Most of the time, private equity firms serve to secure and manage the financing. Planning for these deals depends a great deal on cash flow forecasting and debt service ratios.
Benefits/Risks of LBOs
Benefits of LBOs
When done right, the LBO can benefit the buyer and the seller. Among the many advantages of these types of deals include:
- Buyers have a high ROI potential without the need for much in the way of capital outlay
- Sellers can gain an attractive exit strategy for their floundering businesses
- LBOs allow for reorganization and operational focus for underperforming companies
- They can revitalize and re-list companies via an IPO post-transformation
That said, the critics of LBOs have valid points. Entering into an LBO can introduce a series of risks for both companies, such as:
- Rising interest rates can make the debt accrued unsustainable
- High leverage can increase financial fragility
- LBOs may attract criticism due to job cuts and other cost-cutting measures
- Poor post-acquisition integration can lead to bankruptcy or credit downgrades
Regulatory Considerations in LBOs
Finally, there’s the matter of regulatory and disclosure requirements to consider when entering the LBO process. These include SEC reporting, especially if the target company is a public entity, as well as antitrust considerations if the deal could impact market competition. This means there’s a strong need for accurate due diligence and integration planning. Here at DFIN, our compliance and reporting tools provide companies the resources they need to manage even the most complex LBO transactions without concerns about their regulatory and reporting obligations. To learn more about how our financial disclosure software and virtual data rooms can streamline your LBO procedures, reach out and speak with a member of our team today.
