mergers and acquisitions

Leveraged buyouts are trending up across the globe, and in 2017, the U.S. saw an increase in the volume of leverage loans of 53 percent. While records for leveraged buyout volume were set in the aughts and again in this century, it's not a new financial tactic for entities that want to acquire brands without tying up existing capital. In fact, one of the largest leveraged buyouts in history occurred in 1989, when KKR leveraged assets and raised a total of $55.38 billion to purchase RJR Nabisco.

Today, both target companies and potential investors should understand leveraged buyouts because it's one of the financial options that can support a successful acquisition. It's also a tactic that some acquiring organizations use to procure companies even when the target company doesn't sanction it (aka, during a hostile takeover).

What Is a Leveraged Buyout?

A leveraged buyout occurs when one organization or group of investors acquires a company with mostly borrowed funds. Typically, the acquiring organizations use their own assets and the assets of the company they're buying as leverage (or collateral) for the loans, which is where the name leveraged buyout comes from. The better a target company looks on paper, the more likely an acquiring firm can leverage it for buyout purposes. 

Leveraged buyouts became more common in the 1970s and increased rapidly in the 1980s, due in part to economic factors at the time. While LBOs are still useful today, the method does have a checkered past due in part to the associated bankruptcies of several large corporations in the 1980s. In many of those cases, the acquisition was 100 percent covered by borrowed funds, which led to enormous interest rates and payment obligations that obliterated cash flow for the acquiring companies.

Successful LBOs today don't tend to involve 100 percent funding for this reason (though it's not unheard of if the target company is attractive enough to all involved).

What Are the Challenges and Benefits of a Leveraged Buyout?

Leveraged buyouts put the acquiring company on a debt footing from the start, which can be a risk. If the target company doesn't perform as expected or the investors don't have a robust plan for ROI, the inability to pay back the loans can result in bankruptcy or the assets used as collateral.

Even so, LBOs do offer some benefits. First, they allow investors to acquire lucrative businesses, contributing to potential growth, even when capital isn't readily available. Even if the firm does have capital, it might need to retain some for improvements on the target company if it wants to support a large-enough ROI.

The top three reasons for leveraged buyout (aside from a hostile takeover) include the following:

  • The current owner of a small business wants to sell, and the new owner likely has to borrow money to fund the purchase.
  • The target company wants to divest a specific portion of the business by selling it off.
  • A private equity firm or group of investors wants to acquire all the stock of a public company so they can take it private.

Leveraged buyouts are one tool in the M&A kit, but they do need to be handled carefully. Before either side enters into such a transaction, it's important to understand the target company, plan of action and potential ROI. Otherwise, investors put themselves at enhanced risk for major losses.

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