A leveraged buyout is where an investor group acquires a business using mainly borrowed money.
The amount of equity finance used in these deals is usually very small and 80% or more the finance for the deal takes the form of debt. Much of this debt is likely to take the form of ‘junk bonds’, which carry a high rate of interest, reflecting the risks of carrying such a high level of debt. This means there is a strong incentive for the investors to pay down the debt as quickly as possible.
Investors aim to use the cashflows of the acquired business to repay the interest on the debt. Frequently, the bidder will also raise cash to pay down the debt by selling parts of the acquired business.As the debt is paid off, the value of the investors’ equity rises. Their aim is ultimately to realise the value of their equity by selling the business or floating it on the stock market.
LBOs became common in the US in the late 1980s but were slower to take off in the UK. During the 1990s, there was a sharp rise in the number of private equity groups looking for LBO deals. But LBOs are highly risky, particularly in an economic downturn when it becomes harder to repay debt or to find a suitable ‘exit’ – ie, sell the business.
• See Tim Bennett’s video tutorial: Three ways leverage can boost your returns.