Leveraged buyout refers to acquisition of a different firm using equity as well as a significant amount of money that is usually borrowed to meet the acquisition cost. In most cases, assets of a company that a firm is acquiring is used as the collateral for borrowing money through loans or bonds and then that money is added to the asset of an acquiring firm. Leveraged buyout is aimed at enabling a company to invest in a large acquisition without committing hefty amount of capital.
Real estate property is the most commonly used asset in leveraged buyout. Leveraged buyouts are common occurrence in most acquisitions and mergers environments. The term leveraged buyout is employed when a company is acquired by a financial sponsor. However, bank debt is used in funding most corporate transactions partially. Thus, bank debt represents LBO effectively.
Leveraged buyout can take different forms including Management Buy-in, Management Buy-out, Tertiary buyout and secondary buyout among others. It can also occur in the situations of growth, insolvencies and restructuring situations. Leveraged buyouts are also common among private companies although they can also be used by the public companies.
Financial sponsors have the incentive of employing more debt in financing acquisition which gives them high leveraged for increasing returns. This has caused over-leveraging of companies by some institutions. This implies that the companies do not generate enough cash flows that are needed to service the debt. Eventually, this leads to debt-to-equity swaps or insolvency. In such cases, equity owners end up losing business control while debt providers take the equity.
In a leveraged buyout, there is a ration of 90 percent debt to 10 percent equity. Due to the high level of debt/equity ratio, bonds are not the usual investment grade. They are called junk bonds. The history of leveraged buyouts has been a notorious one especially during the 1980s when some acquired companies ended up being bankrupt after prominent buyouts.
This was because at that time, leveraged ratio was almost 100 percent. Interest payments offered were also large making it difficult for the cash flows of the company to meet the obligation.
Later, it came to be regarded as ironic that the success of a company in terms of its assets as presented on a balance sheet can be used as collateral in acquisition by the company that is acquiring it. As a result, some people consider leveraged buyout as a predatory and ruthless tactic.
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