Pros & Cons of Leveraged Buyout

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A couple sitting on a bicycle. (Image: Steve Mason/Photodisc/Getty Images)

In a leveraged buyout, a company or an investment group buys a company largely with borrowed money. The new owners then use the cash flow the acquisition generates to retire the debt. LBOs have long been the subject of a fierce debate over whether the transactions represent an efficient way to rescue poorly run enterprises, or are simply greed-driven exercises that impose harsh consequences on employees. There are strong arguments for both positions.

LBO Mechanics

In a typical leveraged buyout, the buyer targets a company with a strong cash flow or at least the potential for it. The buyer then borrows most of the money to finance the acquisition and uses the company itself as collateral. As of 2014, debt composed about two-thirds of the acquisition cost in the average leveraged buyout, according to S&P Capital IQ data cited by LeveragedLoan.com. At the height of the LBO boom in the 1980s, however, debt commonly made up more than 90 percent of the acquisition cost.

Buyers Benefit from Leverage

For buyers, the sweet part of LBOs is the "L," as in "leveraged." These buyouts allow purchasers to acquire companies with a relatively small upfront investment. This means they can earn a handsome return on their money if the targeted company proves profitable enough. (And, as "Inc." magazine notes, a company probably won't be targeted for an LBO unless it's generating healthy profits.) This is the case even after accounting for the significant interest costs often attached to borrowing so much money.

When the Cost is Too High

In a leveraged buyout, the target company assumes the costs of its own acquisition. If the company is suitably profitable, it can retire the buyout debt with the money generated by its operations.Too much debt, however, can force the company into bankruptcy. For example, in 1988 buyers acquired the Federated Department Stores chain in an LBO they financed with about 97 percent debt. Two years later, when Federated couldn't generate enough revenue to service that debt, the owners filed for Chapter 11 bankruptcy. In other instances, acquired companies have been broken up, with various divisions, product lines or other pieces sold off to repay the debts.

Restructured Operations

Some poorly run companies make inviting targets for leveraged buyouts, since mismanagement often results in production inefficiencies, obsolete business models and cost overruns. After the buyout, the new owners can install more effective management practices and restructure the workforce for greater efficiency and production. Changes like those can immediately enhance profitability, but they may come with a cost. For instance, restructuring often means layoffs, which can devastate a company's employees and, by extension, their communities. The new owners may not share the previous management's view of the company's responsibilities and obligations. Any subsequent alteration in corporate culture could decrease employee morale. On the other hand, the introduction of innovations and improved practices can energize a workforce as employees coalesce to help the new enterprise succeed.

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