Understanding Leveraged Buyouts (LBO) in M&A

A leveraged buyout (LBO) is a type of financing used frequently in mergers and acquisitions. LBOs work best with middle-market businesses that are sustaining a strong cash flow.

The LBO finances the purchase price through a combination of debt and equity, commonly at a 40/60 ratio, with a higher cost of capital found in equity. A small group of investors will then purchase the business’s assets for use of securing and repaying the debt.

However, depending on the financial stability and revenue streams of the target business, the portion of the buyout comprised of equity may become obsolete. The good-standing business may possess enough collateral to fully fund the LBO by debt.

Depending on the size of the company, the debt may be leveraged in one of two ways. If the business does not possess quality assets, then the deal will be financed by junior debt, which contains a higher interest rate due to a lack of collateral. Otherwise, with a larger company, senior debt may be implemented, and the assets may be utilized to obtain a lower interest margin. Therefore, larger companies are the best candidates for LBOs, because they have the opportunity for lower interest rates on debts and a smaller amount of equity is necessary to complete the deal. Banks tend to be enthusiastic in providing loans for an LBO, because this type of buyout tends to have a high return of capital, and the banks can earn more with LBO loans than with typical corporate lending.

One of the most popular examples of a leveraged buyout in the current news media is the case of Dell’s takeover by private equity. Large-scale LBOs have generally been less common within M&A, but due to the debt market’s availability in recent years, this deal has proven that LBOs are becoming a savvy move for businesses of all sizes. This deal with Dell has illustrated how advantageous it could be for other large companies to break into the M&A market, with the debt market wide open and the overhang of capital currently held by private equity groups working to their advantage.

If you would like to learn more about how you could use a leveraged buyout to strategically sell your business, please contact George & Company. Our expert M&A advisors would be happy to speak with you in complete confidence.