A leveraged buyout (LBO) is a financial transaction in which a company is acquired by an investor group using minimal cash for equity and financing the transaction largely through debt. By maximising the portion of the acquisition financed with debt, the investors are either employing financial leverage designed to increase the returns on their equity investment or they are purchasing a company for which they only have a portion of the capital necessary and they must borrow the rest to consummate the deal.
Financial leverage is the practice of using borrowed capital to reduce the amount of cash an investor is required to commit to an investment. It can also be viewed as a way of purchasing a larger investment than could otherwise be purchased with the capital alone.
Leverage can enhance the return on equity (ROE) of an investment but also adds to the financial risk by adding the obligation to service the debt.
The objective of an LBO is to pay down the debt through cash generated from the company’s operations along with possible asset sales or business spin-offs. As that happens, the equity of the company is expected to grow over time, providing appreciation to the investors. Ultimately, the investors hope to exit by either selling the company or taking it public.
Related article: Buyout Fund: Definition & How It Works
Leverage is frequently used by investors as well as companies to enhance equity or shareholder returns.
Buying stock on margin or buying real estate with a mortgage, for example, are forms of leverage commonly employed by investors. Using leverage has to be balanced against the additional financial risks incurred through the debt obligation and the need to have a reliable cash flow to service the debt.
Private equity firms use leverage because it can enhance the equity returns for their investors. Many PE firms are well-positioned to provide the specialised expertise necessary to identify opportunistic LBO targets and then execute a strategy to acquire them, raise the necessary debt financing, restructure as necessary, and then take the target public, sell it to a strategic buyer or use other options to exit their positions.
The main steps in an LBO investment would typically include:
Since an LBO’s ability to maintain its debt burden is critical to success, companies with stable and predictable cash flows, low debt, and low capital expenditures make good prospects for LBOs. That generally means mature, non-cyclical companies with high margins.
LBOs can occur whenever PE firms spot opportunities to unlock the hidden value of a company or when companies with the above characteristics begin shopping for a way to either sell themselves or reorganise. This can occur when a major shareholder (such as in the case of Dell explained below) seeks to exit or take the company private.
In 2013, Michael Dell was facing a sagging stock price for Dell amid rising fortunes for the computer industry in general and looking for a way to reorganise or sell his company. He ended up working with PE firm Silver Lake Partners to execute a leveraged buyout involving Silver Lake, his own family office and Singaporean sovereign wealth fund GIC. Once private, the company revived its growth in the PC business and obtained a presence in cloud computing and cybersecurity through acquisitions which included a purchase of VMware.
In April, 2021, Dell Technologies announced plans to spin off its 81 percent ownership of VMware as part of efforts to expand into hybrid cloud, 5G, edge and other growth areas and simplify capital structures. At that time, Michael Dell and Silver Lake owned 52 percent and 14 percent, respectively, of Dell Technologies, which had a market capitalization of approximately $75 billion.1
There are different types of LBOs, characterised mostly by their objectives:
Important notice: This content is for informational purposes only. Moonfare does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial, or other advice. If you are unsure about anything, you should seek financial advice from an authorised advisor. Past performance is not a reliable guide to future returns. Don’t invest unless you’re prepared to lose all the money you invest. Private equity is a high-risk investment and you are unlikely to be protected if something goes wrong. Subject to eligibility. Please see https://www.moonfare.com/disclaimers.