Ultimate Guide to Leveraged Buyouts

Key Takeaways

• A leveraged buyout occurs when a company is acquired with a substantial amount of borrowed money, in the form of loans or bonds.

• Mature companies in established industries are often preferred by equity firms over newer or more speculative industries for leveraged buyouts.

• LBOs are frequently part of a mergers and acquisitions strategy and are sometimes used to buy the competition and to enter new industries for diversification.

While leveraged buyouts lost some popularity following the 2008 financial crisis, they are again on the rise. But what are such buyouts and why do they occur? Here is the ultimate guide to leveraged buyouts.

What is a Leveraged Buyout (LBO)?

A leveraged buyout occurs when a company is acquired with a substantial amount of borrowed money, in the form of loans or bonds.

The loans are frequently backed by the assets of both the acquiring company and the company being acquired. The latter is somewhat ironic since LBOs are widely perceived as hostile and predatory. The company being acquired usually does not sanction the acquisition.

While the frequency of large acquisitions dropped after the 2008 financial crisis, LBOs began to increase on a large scale during the COVID-19 pandemic.

Reasons Why Businesses Use LBO

The chief aim of leveraged buyouts is to permit companies to pull off large acquisitions sans the need to pledge a lot of capital. The typical ratio is 90% debt to 10% equity. The main requirement is usually that the acquired company is thriving and growing.

Leveraged buyouts typically take place because:

• The company seeks to take a public company private.
• To improve an underperforming company.
• The company wants to spin off part of an existing business by selling it.
• The company wants to transfer private property, such as a change in small-business ownership.
• A desire to acquire the competition to enter new markets and diversify holdings. 

Types of LBO

There are various types of LBOs, including:

• Management buyout. Here, the company’s current management team buys out the current owner.
• Management Buy-In. These usually take place when a company is underperforming or undervalued.
• Secondary. This is a buyout of a buyout, wherein, through an LBO, a PE sponsor takes control of a business. 

Benefits of LBO

The No. 1 advantage of an LBO is that the acquiring company can buy a significantly larger company by leveraging a comparatively small portion of its assets.

By using as little of their own capital as possible, private equity firms can potentially gain a substantial return on equity and internal rate of return, the latter typically targeted at 30% or higher.

Note that while leverage can improve equity returns, there is also increased risk. That is a main reason why LBOs usually target stable companies.

Examples of LBO

The acquisition of Hospital Corp. of America (HCA) in 2006 by Merrill Lynch, Bain & Co., and Kohlberg Kravis Roberts & Co. At the time, the companies put HCA’s value at about $33 billion.

Two years ago, Blackstone Group and other financiers conducted a leveraged buyout of the medical equipment manufacturer Medline, which was valued at $34 billion. 

What Type of Company is a Good Candidate for an LBO?

Mature companies in established industries are often preferred by equity firms over newer or more speculative industries for leveraged buyouts. The most attractive companies for buyouts usually have robust, reliable operations cash flows, high margins, comparatively low expenditures, strong managers, venerable product lines, and workable exit strategies.

What are the Steps in an LBO?

When one company attempts to acquire another, it issues bonds against the assets of both companies. In other words, the assets of the company being acquired can be used as security against it.

To start, the acquiring company produces, on average, a five-year future forecast and calculates for the final period a terminal value. The analysis will be shopped to lenders to gain as much debt as possible, creation of interest and debt schedules.

Subsequently, credit metrics will be modeled to see the amount of leverage the transaction can accommodate. Then, the free cash flow to the sponsor – usually a PE firm — is calculated, and the IRR is determined. That is followed by a sensitivity analysis.  

Such transactions usually take place when a private equity firm borrows up to 80% of the purchase and funds the rest with its own equity.

LBOs, PEs, and Diversification

LBO activity sped up in the 1980s due to the accessibility of junk bonds. The subsequent crash and ensuing regulation led to more private equity (PE) and venture capital deals. With the overcrowding of public markets in recent years, demand for private equity has heightened.

For those with risk tolerance, PE can offer high returns. Because it is an alternative asset – it has low correlation with public markets – PE holdings can mitigate portfolio volatility. One way to enter private equity is through Yieldstreet, a leading alternative investment platform that helps investors generate consistent secondary income.

The platform, on which nearly $4 billion has been invested to date, offers the broadest selection of alternative asset classes available, including opportunities in art, real estate, transportation … and private equity. Yieldstreet’s curated PE offerings have lower minimums and early liquidity options.

A chief reason to invest in private equity is to diversify one’s investment portfolio. Interspersing one’s holdings with alternative assets such as PE can help reduce risk exposure, in addition to protecting against inflation or other economic instability. In fact, diversification is crucial to long-term investment success.

Portfolio Diversification and Alternative Investments

Alternative investments can be a good way to help accomplish diversification. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

An LBO is frequently part of a mergers and acquisitions strategy and are sometimes used to buy the competition and to enter new industries for diversification. When conducted correctly, and with risks considered, LBOs can garner firms better equity returns.