Series 79: Leveraged Buyouts

Taken from our Series 79 Online Guide Leveraged Buyouts

One acquisition strategy you may be asked about on the exam is called a leveraged buyout (LBO). In an LBO, most or all of the target’s purchase price is financed by the use of leverage (i.e., debt). Typically, the target’s own assets and/or future cash flow is the collateral for this debt, an arrangement the acquirer makes in advance with the providers of the debt financing. LBOs are frequently used by private equity funds and other financial buyers. This is because most of the profit from an LBO comes from reselling the target, typically after 3–7 years (often referred to as the exit). By contrast, strategic buyers are much less likely to use an LBO, because a strategic buyer usually wants to hold onto the target for the long term.

Let’s begin by discussing two key concepts that underlie LBOs. First, equity in a company without much debt is worth more than equity in a company with significant debt, all other things being equal. In Chapter 3’s discussion of enterprise value versus equity value, we learned that net income is the portion of a company’s revenues associated with the company’s equity. This is because everyone else who needs to get paid out of a company’s revenues is accounted for by the various deductions that transform the revenues figure into the net income figure: the company’s workers are taken into account when operating expenses are deducted; debtholders are taken into account when interest expense is deducted; the government is taken into account when taxes are deducted; etc. Net income is the owners’ share, broadly speaking.

If a company pays down its debt without taking on significant new debt, as time goes by there should be less and less interest expense taking a bite out of earnings. This means that a greater and greater portion of the company’s revenues becomes associated with the company’s equity, making the equity more valuable.

The other key concept is that debt financing is o

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