2.1 Leveraged Buy Outs: Business Strategy at the Top Level

Guiding Question

What is a Leveraged Buy Out (LBO) and how do high level firms use them to profit?

1) Overview

A leveraged buy out or LBO for short is a strategy in which a company acquires another firm using a significant amount of borrowed capital. The typical groups that use LBO strategies are Private Equity firms such as Blackstone, Hg, and others. Private Equity firms repay a small amount of capital finance the rest of the debt with the company’s own cash flow. Alongside the LBO, the firm purchasing the other tries to implement practices to increase efficiency and profits, with the end goal of taking the said firm public or selling it at a higher price. If the company cannot achieve the necessary cash flows to attain that higher value, the purchased firm could be in risk of bankruptcy. 

2) Learning Objectives

By the end of this section, you should be able to:

  1. Define what a LBO is and how firms use them to profit

  2. Explain the complex roles debt and equity pay in financing within the LBO structure

  3. Analyze potential risks caused by the amount of capital borrowed to finance a LBO

  4. Describe how LBOs create value through internal firm improvements

3) Key Concepts & Vocabulary

  • Leveraged Buy Out (LBO)- firm purchasing a separate firm using high amounts of debt with the end goal of profiting through either selling or taking the purchased firm public

  • Private Equity- firms specializing in buying and improving companies, often using LBO strategies

  • Cash Flows- money generated from operations, in the case of an LBO, used to pay debt

  • Leverage- use of borrowed capital to increase returns for the firm

  • Equity contribution- portion of the purchased company from that is capital from the investing firm 

  • Debt Financing- money borrowed from lenders to finance the LBO

  • Exit Strategy- plan from the Private Equity firm in how they plan to sell the purchased company or take the company public

  • Debt Service Coverage- Ability of Cash Flow to cover interest and principal payments

  • Target Company- firm being acquired by the PE company

4) History & Context

  • Early Roots (1960s/1970s)- The earliest form of the LBO emerged during this time period in the form of corporations using debt to take companies public. Much smaller scale than present day. 

  • Junk Bonds (1990s)- pioneered by Michael Milken at Drexel Burnham Lambert, fueling high stakes LBOs. This ended with the collapse of the Junk Bond market. 

  • Modern Day (2000s)- Modern LBOs undertaken by private equity firms use a far more conservative debt structuring, in order to protect the company. Today’s LBOs also emphasize improving internal efficiency before implementing the chosen exit strategy. 

5) Use in Today’s World

  • Major companies around the world are purchased by PE firms, such as Hilton Hotels, Burger King, and Petsmart. PE firms also have failures, such as ToysRUS, as there is a possibility of the target company’s bankruptcy

  • PE firms research into target companies to make sure there is a possibility for profit. 

  • Typical timeline for modern day LBO deals from PE companies are within the 5-7 year range

  • An important step in maximizing LBO returns is getting beneficial terms from lenders. If terms are beneficial, the amount of interest needed to pay off the debt decreases, allowing for increased profit. 

6) Future Outlook

  • ESG (Environmental, Social and Governance) factors are becoming more important in Private Equity LBOs

  • Despite economic cycles (inflation, tariffs, etc) LBOs are expected to grow due to opening public markets 

  • Due to risks of target companies not improving, and thus going bankrupt, PE firms are changing strategies towards more quality investments to decrease this chance. 

  • PE firms will continue to invest in tech-forward companies as artificial intelligence continues to become an economic reality. 

7) Reflection and Critical Thinking

  • What are the ethical considerations for Private Equity firms acquiring companies? Are the risks too high?

  • How might high interest rates impact the terms lenders offer to Private Equity firms? How will this affect popularity?

  • What role is the government to play in Leveraged Buy Outs? Should they have a lot or little say?

  • How do PE firms strategize in the long term when the time frame of the average LBO is so short? 

8) Key Takeaways

  • Private Equity firms use Leveraged Buy Outs to raise capital in a timeframe of 5-7 years. LBOs consist mostly of debt, with some capital from the PE firm. 

  • There is a risk of the target company going bankrupt, but if done properly, internal changes can lead to increased cash flows and debt will be paid. 

  • Exit Strategies are typically either increasing the value of the company and selling it to another firm, or taking the company public. 

  • While the roots of the LBO are centered around riskier investments, modern debt structuring is more conservative. 

9) Mnemonic for Key Points

D.E.E.R

  • D- debt financing

  • E- exit strategy in 5-7 years

  • E- enhance cash flows internally

  • R- risks of bankruptcy for target company

10) Sources for Deeper Study

  1. PitchBook and PreFin track PE deals

  2. Harvard Business School publishes LBO case studies

  3. Investopedia for easy to understand basic articles on LBOs

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