Leveraged buy-out (LBO)

A leveraged buy-out (LBO) is an acquisition that is largely funded by debt. LBOs are often used by private equity firms as a way in which to make large acquisitions that they would not otherwise have the resources for.

The type of debt depends on the circumstances in which the money is raised. One method is the issue of bonds by a company set up especially to carry out the acquisition. The aim will be to repay the bonds with the cash flows of the target.

If the bid fails the acquisition vehicle may not enough money to repay the bonds. The default rate on LBO bonds is high: these are very much junk bonds.

LBOs also frequently use bank debt, borrowings form other financial institutions, and mezzanine finance. A single LBO (especially a large one) may use several types of debt.

Once an LBO is completed, the result is a highly geared business. This means that a good target for an LBO would have strong stable cashflows, low levels of existing debt and a strong balance sheet (assets to back the new debt).

A successful LBO also usually requires an exit strategy. Many LBO acquisitions have been broken up and sold, so a large part of the impact of those LBOs was creating shareholder value by breaking up a conglomerate. This was particularly true at the time LBOs first became common in the 1980s. Although LBOs occurred before then, the technique was popularised in the 70s and 80s by American private equity firms such as Kohlberg Kravis Roberts.

Other possible exit strategies include an IPO or a trade sale (a sale to another company in the industry). An intermediate step, especially if the acquirer is able to improve the operations of the acquired company, may be to further increase gearing to release cash to shareholders.

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