- A leveraged buyout (LBO) is when a company is acquired through the purchase of equity in the company through a transaction largely financed by borrowing. The term "leveraged" refers to the fact that the acquisition occurs through the use of collateral to borrow money for the purchase instead of committing capital. Ideally, the LBO pays for itself, with the revenue of the acquired company paying for most or all of the cost to service the loan used for the acquisition. Cash reserves of the acquired company can also be used to retire large portions of the debt very quickly. As the LBO market has evolved, another common way to unlock value has been to replace the equity in an acquired company with new debt, sort of like taking out a second mortgage.
- Aside from debt financing, one of the principal features of the LBO is the ability to unlock value in an undervalued company. The corporate raiders of the 1980s were famous, if not notorious, for purchasing large conglomerates and breaking them up into pieces. In a successful deal, the total value of the individual pieces would be more than the purchase price of the conglomerate. Even restructuring a company without spinning off its assets could result in higher profit margins and increased overall value, all while increasing the overall efficiency of the company.
- There are tax advantages associated with acquiring a company through debt financing rather than an outright purchase because the cost of servicing the debt is deductible. This actually allows the acquirers to pay more for the acquired company than would otherwise be possible, an obvious benefit to the sellers. The use of leverage to purchase outstanding shares of a company can allow the managers of the company to own a sizable stake, allowing them to enjoy the fruits of their labor.
- The major risk of the leveraged buyout is bankruptcy of the acquired company. If its revenues decline below the ongoing costs of the acquisition, the company could be broken up and sold off to satisfy creditors. Thus, any unforeseen events--such as economic recession, expensive litigation, adverse judicial decisions, or tighter regulation--can restrict the earnings of the acquired company. The fact that the acquired company's earnings are already committed to service the acquisition debt makes it more difficult for the company to survive other potential financial hardships.
- Even a successful LBO can have negative consequences. A buyout can hurt morale at the acquired company, or create a conflict of interest between management, employees and shareholders. A common method of cost reduction carried out by acquirers is laying off some employees. In a heated LBO environment, where many leveraged buyouts occur in a short time, the resulting rise in unemployment can be negative both within particular industries and for the overall economy.
