Leveraged Buyout Definition: How an LBO Works

A leveraged buyout (LBO) is a form of corporate acquisition in which one company purchases another using borrowed money. The acquired company's assets can be collateral for loans and debt financing. Private equity firms will often help fund these efforts because they see high-yield financial promise in the acquired company, which will ultimately serve their corporate finance.

LBOs require a significant amount of time, collaboration, and resources to be successful. A board of directors will help oversee this form of mergers and acquisitions, keeping finances straight and ensuring partnerships are well-maintained so the restructuring and valuation of a company lead to a profitable rate of return for all involved.

Several companies have participated in LBOs, some of which became high-profile affairs. The 1980s, for example, saw a period of hostile takeovers in which wealthy business people executed intense bidding wars, took over smaller companies, and restructured them. In 1989, the global investment company Kohlberg Kravis Roberts & Co. (KKR) closed on a $31.1 billion takeover of RJR Nabisco, which, at the time, was the largest LBO in history.

There are a few types of LBOs, including:

1. 1. Management buy-in (MBI): In an MBO, an external company acts as the purchasing party. This party will see profitability in the company, coming in and purchasing larger shares to assert dominance and direction. The target company’s assets are collateral for others to buy into it.
2. 2. Management buyout (MBO): This kind of LBO typically occurs when ownership wants to retire and sell the company to a trusted management team. Owners will create an exit strategy and name the purchase price so management can buy a large part of the company. Management will seek investment banking or equity financing to kick in the rest of the funding.
3. 3. Secondary buyout: A secondary buyout occurs when both the buyer and seller of the company are financial supporters or firms—they use an LBO to acquire an LBO. Secondary buyouts generate higher liquidation when interest rates and equity returns make it a ripe time to sell or when sales to strategic buyers and IPOs are impossible for small businesses.

A leveraged buyout occurs when a company puts itself up for sale or interested buyers approach the business. That buying company will be able to pay for a set amount—not the total purchase price—then go to an outside firm or financial sponsors to put down the rest of the money. Consider the general stages of an LBO in this hypothetical example:

• Purchase: An entrepreneur might purchase a public company going out of business, seeing the company as one in need of restructuring to be profitable. The entrepreneur approaches a prominent real estate firm to help pay for the rest of the company.
• Restructuring: The buyers can structure the debt in a few different ways. Senior debt links back to the company’s assets and will have the lowest interest margins. Junior debt, or mezzanine financing, will have higher interest rates. High-yield bonds will sometimes replace these debts, and in larger purchases, more than one company might be involved in the financing.
• Payout: Financiers become shareholders and oversee the finances of the purchased company. The financiers are the first to recoup their investment before making a cut of the company’s profits over time. The initial financing is the first step in the hopes of a more excellent payoff in the long term.

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