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How Leveraged Buyouts (LBOs) Work

Mergers and acquisitions are common place in the business world.  Besides cash, or cash and share buyouts, there’s a common, yet controversial strategy, called the Leveraged Buyout (LBO) that private equity funds have been known to use.

What is a Leveraged Buyout?

A LBO is a way for one company or person to acquire another company for very little of their own cash, or credit.  This can work if the company to be acquired has strong cash flow, a significant value in tangible assets and very little debt on their balance sheet.

In the simplest form, the buyer acquires the selling company with debt against the assets of the selling company.  The buyer essentially uses the debt to purchase controlling interest in the company.

Why LBO?

The acquiring company has highly leveraged their purchase with very little of their own cash with the goal of improving the business and selling the company in the future (or IPO).  The acquired company has an increased debt load, but the plan is for growing earnings to cover the debt repayments.

A Practical Example

Say that company Buyer Inc. is looking to purchase private company Seller Inc.  If Buyer Inc was looking to use the LBO strategy, they would negotiate the final price based on cash flow and the amount of debt or repayments that Seller Inc cash flow can cover.  Buyer Inc. would then setup a new company NewCo Inc. and approach lenders (banks, other investors) for a loan to help cover a large portion of the purchase price with the assets of Seller Inc. used as collateral.  NewCo Inc. would need to place a down payment on that loan, this amount would depend on the terms of the deal.

Once ownership is transferred, Seller Inc moves under NewCo Inc. The new company would then attempt to improve efficiencies and improve earnings to ensure cash flow is enough to cover the new debt burden.

The most popular example in recent Canadian history is the attempted $52 billion LBO of Bell Canada (BCE) by the Ontario Teachers Pension Plan.  The buyout would have forced $32 billion in additional debt on BCE’s balance sheet.  This deal ultimately failed due to solvency clause which was amplified when the markets turned weak in 2008.

The Risk

The biggest risk with LBO’s is the financial strain that the additional debt puts on the acquired company.  This risk can be mitigated through proper due diligence, but in the case of a sudden market down turn, the acquired company can face financial trouble, sometimes insolvency.  Here are some real world examples, some good, some bad.  Like with any strategy with leverage, it may enhance the upside, but it also can increase the speed of a downward spiral.

If any readers have any experience with business acquisitions, I’d like to hear your stories in the comments.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 4 comments… add one }
  • Fit February 13, 2012, 1:26 pm

    Gordon Gekko anyone?… haha. You don’t usually see post like this very often but it shows a growing trend, cash flow is king…. solid cash flow affords a lot of oppurtunity and options

    Cash flow is the new net worth lol there are so many people with all their net worth tied up in their homes… but you can’t go to safeway with your mailbox and say “here ya go this is 1/1000 of my home” cya later…

  • Joe February 13, 2012, 10:25 pm

    Yes, leverage up everybody! The Teachers Pension was freaking out at the time, because it still had a full inflation escalator for all pensions so it was increasingly underfunded. Their run at BCE was like a compulsive gambler trying to secure their retirement at a roulette wheel. Class sizes are shrinking; there are no jobs for the thousands-upon-thousands of Whitby-esque future soccer Moms being graduated from B.Ed. programs around the province. They have no desire to sacrifice or go far north for their “calling”. They just want to win the lottery and get an 80k job reading books to kids. Teachers are brilliant investors though. I mean they all take a speculative-grade investment (defined as an investment purchased solely for capital gains) like suburban housing or Toronto condos, and buy them with 90% mortgages. Look at any teacher and that’s the biggest 2 assets in the portfolios: their bulletproof pension and ever-inflating real estate. Leverage will dig us out of this debt-bubble hole ;)

  • Fit February 14, 2012, 6:56 pm

    I was just thinking… this is just like purchasing a home for rental… isn’t it? Leverage yourself at a ratio of 4 to 1. generate cash flow. maybe you fix up some stuff inside as to make it more valuable for potential resale in the future. Funny how so many people do not rental properties as risky haha

  • Joe February 14, 2012, 11:08 pm

    lol no Fit!! Houses are 100% safe bets! They only go UP UP UP! Just ask any expert REALTOR (TM). They’ve taken a two week course and have morally hazardous perverse incentive to euchre you, so you’d best trust them! Look at all the expensive ads that CREA runs, they must have Canada’s national interests at heart.

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