Leveraged Buyout (LBO)

Understand

In a leveraged buyout (LBO), a company is acquired by using a substantial amount of debt to meet the acquired cost. For collateral or security of debt amount, assets of both companies are used; firstly the company being acquired and secondly the acquiring company. The debt is usually provided by private equity firms to mature or established companies, this arrangement is different from venture capitalist firms where they invest in young and emerging firms usually without control interest.

Private equity firms are formed with funding from different managing and limited partners, who favor diversification strategy and invest their money in different companies to secure investment. A company with strong cash flows, effective management, and high-profit margins are considered ideal for a leveraged buyout.

Reasons for LBO

From management perspective, leveraged buyout has following benefits

  • Tax benefits associated with debt financing,
  • Make public company as private and freedom from scrutiny for being a public company,
  • The opportunity for management to become the owner of a major portion of firm’s equity,
  • Large interest and principal payments may force management to increase operational efficiencies by investing in technological upgradations and divesting non-core businesses etc.
  • The acquisition of larger firms is possible and easy with minor commitments for equity funds.

Example

Chukar holding company is a private equity firm based in X country which invests in retail, health and technology companies, initiates a leveraged buyout (LBO) for a Target Limited which operates ten chains of retail stores across the country. It is a strong company with steady earning potential and good management, the current owners of the company want to realize their investment and agreed to sell for $5.2 billion. The acquirer company plans to finance the cost of acquisition with  $1 billion in cash and rest by issuing junk bonds. After two years of purchase, Chukar holding company sold Target Company for $9 billion, with investor’s earning of $3 billion after excluding costs.

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