In order to understand what a Leveraged BuyOut, or "LBO," is we need to zoom out a bit and look at an investment portfolio as a whole. Say there is an institutional investor--these include pension plans, university endowments, foundations, insurance companies, high net worth individuals--who is looking to allocate money. There are several options: equities (stocks), fixed income (buying a company's debt security), real estate, and alternatives. These four types are called "asset classes". Under alternatives, the last aforementioned asset class, can be broken up into private equity, or any investment that is not public/not traded on an exchange, and hedge funds. Private equity further breaks down into venture capital (VC), growth equity, and LBO. These are investments across a company's life cycle with VC being an investment in a startup, growth equity an investment in an established but growing company/industry, and LBO an investment in a mature company with strong and lengthy track record.
This is how we get to LBO from the initial steps of deciding how to allocate funds for investment. The three key elements of an LBO are leverage, control, and going private. A leveraged buyout is the acquisition of a public or private company with a significant amount of borrowed funds, or debt usually 50% - 85% of the purchase price-- hence the name leveraged. The company becomes private after acquisition, meaning you cannot purchase shares on a stock exchange--hence the name buyout. Buyouts are change of control transactions where a private equity fund purchases more than 50% of target's shares. On the other hand, venture capital / growth capital typically involve minority investments (less than 50%) in early-stage or growing companies. Private equity firms are vehicles that make these LBO acquisitions on behalf of investors from which they have raised capital.
Borrowed funds (debt) are used because of the lower cost of capital of debt relative to cost of capital of equity. However, not all companies lend themselves to being good leveraged buyouts. This is because the company must have a strong record of revenue generation in order for the debt to be paid down. This is because during the ownership of the company, the company's cash flow is used to service and pay down the outstanding debt. There are; however, some disadvantages to using debt such as risk and cost of bankruptcy, agency cost, and loss of future financing flexibility. It's a matter of balancing the benefits and costs of debt and deciding whether this company is a good candidate for an LBO.
Some of the key characteristics of a good LBO candidate are for the industry / company to be mature, Strong competitive advantages and market position strong management team that can implement optimizing and cost-cutting measures, possibility of selling some underperforming or non-core assets, and low future capital expenditure requirements.
There are three main value creation methods after the private equity firm conducts an LBO. First, a firm can make operational improvements such as revenue growth: entering new markets, growing customer base, offering new products; and expense reduction: cutting costs & improving margins, improving monitoring & controlling to reduce managerial inefficiencies. Second, through financial engineering: debt tax shield, management discipline. Lastly, through multiple expansion: market valuation of the peer group of comparables.
Although there is much more that occurs in the time leading up the acquisition and post; however, this is a general framework for gaining a better understanding of what exactly an LBO comprises.
