What Is a Leveraged Buyout?
A leveraged buyout is the purchase of one company by another with a significant amount of the purchasing money being funds loaned to meet the purchase cost.3 min read
Leveraged Buyout Overview
What is a leveraged buyout? A leveraged buyout, or LBO, is the purchase of one company by another with a significant amount of the purchasing money being funds loaned to meet the purchase cost. Such buyouts give companies the means to make large purchases without committing a great amount of capital, as they and their lenders are operating under the assumption that the profits generated from the acquisition will outweigh the initial cost. To that end, companies with low debt, strong cash flow, stable business trends, and a large asset base are the most attractive targets for leveraged buyouts.
The Leveraged Buyout Process
Conducting a leveraged buyout can be a long and complicated process, with many moving parts and parties involved. To successfully pull off this type of business deal, there are a number of ways to structure the procedure. Larger companies will generally use either one or a mix of the following:
- Direct purchase. In this, the buyer will purchase the assets of the target company and have them put into a new corporate entity specifically designed to hold the new assets and operate them as a business. This strategy’s main advantage is that it allows for a clean purchase of the company, thus limiting liabilities from the past activities of the old company.
- Absorption. In this method, a new business entity will not be created, but rather the assets of the old business will be folded into the business making the purchase. This method also involves receiving financing from outside sources to first acquire the target company and then run the expanded business. The amount of debt incurred from such an operation will depend on the size of the transaction, the reputation of the parties involved, and the fiscal health of the parties involved.
Smaller companies, on the other hand, will likely use the following financing processes:
- Seller financing. With this, a selling party will receive a promissory note from a buyer guaranteeing that the purchase price will be paid over time.
- Bank loans. This involves acquiring a loan from a bank and using it to help purchase the company in question. Full financing from a bank for a leveraged buyout is rare.
- Asset-based funding. This is more common when the company to be acquired holds equipment or real estate that is in good condition or paid off. The value of the assets is leveraged to secure loans to acquire the company.
Once the company has been acquired, the purchasing company will take on the operating expenses of the purchased company as well as the cost of the acquisition financing. Such expenses can be problematic if cash flow is tight, and after acquisition, alternative financing may be necessary. Such financing options may include:
- Factoring. This type of financing allows the buying party to leverage the acquired company’s accounts receivable. This improves cash flow, putting the acquiring company in a more favorable position to pay suppliers, meet payroll, and make financing payments.
- Inventory financing. This financing allows a company to finance its existing, free-and-clear inventory to up to 80 percent of the forced sale’s liquidation value or the net orderly liquidation value. It should be noted that an inventory’s liquidation value can significantly lower than the price that was paid for it.
- Asset-based lending. This allows a company to leverage its accounts receivable, inventory, equipment, and property. This method is more common with larger companies as an alternative to inventory financing or factoring.
- Bank financing. A credit line may be established with a bank to finance your operation costs, so long as you meet the lending requirements of the bank. This option can provide a good deal of flexibility at a reasonable cost, so long as the covenants that come with the credit line are kept. Such covenants may include the stipulation that certain financial ratios are kept in check, which may be difficult in some leveraged buyout scenarios.
When acquiring a company through a leveraged buyout, it is important to make sure the company being purchased has sufficient working capital to continue operating once the transaction is complete. An acquiring company may attempt to use every one of the seller’s assets available to cover the initial payment, but such a strategy can backfire, leaving one without sufficient resources to cover the operating expenses and degrading the positive cash flow. A better option then is to use inventory and accounts receivable for financing after the sale and rely on other means for funding the acquisition.
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