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Leverage Buyout: Meaning, Purpose, Source of Funds, Risk and Stages

Nikhil Mogha

| Updated: Nov 22, 2022 | Category: Mergers and Acquisitions

Leverage Buyout

A leverage buyout or LBO is a transaction in which the buyer acquires a company from the fund borrowed from the investment banks, entity or person. It enables the business entity to acquire new companies and form new alliances in the market. This acquisition mode helps the business entity diversify its business streams, products, brands and technology while using less of its capital in the acquisition deal. The borrowing in the LBO is usually done by putting the acquired company’s property as collateral. Henceforth, in other words, it is the process of acquiring another company through using external sources such as bonds and loans. The present article will discuss in detail the meaning of leverage buyout, purpose, source of funds, risk and stages.

What is a Leverage Buyout?

A leverage buyout or LBO uses an external source of income to purchase a company. In general terms, leverage refers to borrowed capital recovered from a person, entity, or investment bank. In a leverage acquisition, the borrowings form a large part of the buyout price, approximately almost 90%. The business entity generally covers the remaining amount through its own asset or by putting the acquired assets on collateral. Therefore, the private entity firms carry on the LBO transaction to purchase an existing business along with all its revenue streams, debts, assets and obligations.

The main reason behind financing the major buyout is that it creates leverage for the buyer. It means that the buyer invests almost 10 % in the whole transaction, and the investors invest the remaining amount through loans that the company will pay over time from their cash flow. The repayment act as a payment of a debt in the whole transaction. This whole process of acquisition will benefitboth the investor and the buyer, wherein the investor will receive regular interest from the profit along with having a controllable interest in the company, and the buyer does not have to worry aboutinvesting a large amount of capital in acquiring a significant stake or ownership in the company.

What is the purpose of a Leverage Buyout?

The leverage buyout serves mainly the following purposes:

  1. Privatising a Public Company: The privatisation of a public company means consolidating and transferring public shares to private investors. Acquiring a public company through private investment puts the controlling interest in the hands of private investors. It means these investors can now either own half or majority of the acquired company by removing the shares from the market. Moreover, privatisation requires fewer regulatory requirements, which helps the buyer save more and improves the affairs of the company so that it can be reintroduced in the market as an IPO.
  2. Improving the affairs of Under performed Companies: There are occasions when the company cannot perform well for many unforeseen reasons. In that case, the buying entity presents an opportunity to the acquired company through leverage buyout to realise its full potential. The buying entity will work with full potential to improve the affairs of the acquired company to improve their profit margins which will also help in the repayment of debt.
  3. Breaking up and Selling Inefficient parts of the company: ALBO will help the company to break up and sell those parts of the business which are performing poorly and are inefficient. Generally, the buying entity splits the acquired company into smaller parts with less profit-generating margins and offers these small parts for sale. The revenue generated from the sale can be used to pay off the debt, and the remaining amount can be used as profit.

How are Leverage buyouts funded?

The leverage buyouts are funded through the following means:

1. Private Equity Firms: A LBO may be funded by private equity firms, which are an investment company that uses their own capital asset or that they acquire from investors. In this type of financing, the private equity firms generally hold controlling interests in the acquired company.

2. Subordinated Debt: A subordinated Debt is the way of financing the buyout through a loan without having any collateral. In this type of financing, if the buyer fails to pay the debt, then the lender can acquire ownership of the property proportionally to the balance amount of the loan.

3. Banks: Banks are the common way of financing the leverage buyout. The buyer and private equity firm takes a loan from the bank, and the debt is repaid at regular intervals or at the time specified by the bank.

4. Bonds: The bond is an instrument that provides financial support to the buyer. The buyer receives the bond from an investor for a specified period of time. In exchange, the investor receives interest from the buyer until the bond expires or it reaches maturity.

What are the Risks associated with Leverage Buyout?

Generally, two types of risks are generated on the leveraged buyout: interest rate risk and business risk.

1. Interest Risk: The interest rate on such financing activities are usually high, and in case the buyer is unable to make payment of interest and principal amount, then there are chances that the company may go bankrupt. Also, the rising interest rate with variable rent may also increase the overall payment of the company. Henceforth, the buyer shall find fair credit and interest rates for a successful LBO that will prevent unexpected future risks.

2. Business Risk: The business risk is the unexpected risk that the company faces. There are occasions when the company may face an unexpected event that would lead them to face losses. In that case, the company may not be able to pay off the debt, and it may go into liquidation; consequently, all the company’s assets are then acquired by the creditors.

What are the stages of a Leverage buyout?

A LBO generally includes acquiring a company using capital borrowed from a lender. The stages that are included in the transaction of leverage buyout are:

Stage 1: Searching for the Business to be Acquired

Acquiring a business is not simple and requires due diligence or pre-preparation.So, the company shall beforehand make its financial analysis and analyse the potential risk that it can withstand because if a company takes a huge risk, there are chances that it can fail in the long run. Henceforth, a balanced acquisition is one wherein the capital and equity are ample to grow from the bought assets.

Stage 2: Finding the Capital Provider

The capital requirement for a LBO can be financed in a number of ways, such as asset-based financing, integrated debt, senior cash flow debt, seller financing etc. The external capital requirement is the prerequisite in a LBO acquisition; hence the buyer shall find a financing model that is more suitable to the business service line and, at the same time, is best suited to meet the potential risks. Therefore, the capital requirement in the LBO while acquiring a company shall be met by the buyer, which is easier to pay off.

Stage 3: Due diligence by the lender

After finding the capital provider, the lender will conduct due diligence[1] on the business entity. The lender will only provide capital in the LBO if the company provides sufficient financial information, including balance sheet, cash flow statements and profit & loss statements. The lender analyses the company’s finances and determines if the company’s projections and assumptions are possible. Moreover, the lender shall also determine the accounting principles used to make financial reports.

Stage 4: Acquisition of Company

The last stage of the LBO transaction is the acquisition of the company. In the last stage, the buyer signs a purchase agreement with the seller and a loan agreement with the lender. The purchase and loan agreements are important documents as they will determine all the terms and conditions agreed upon between the seller and the lender. Therefore, the agreement shall contain all the business points, representations, warranties and other important points. Further, the lender may also review all the purchase agreements.

Conclusion

The leverage buyout is the new method of acquiring a company in the modern world. It is gaining pace in the foreign countries as the acquisition cost is decreasing. Ina LBO, the buyer acquires the other company from most of the capital bought from the lender. In this case, the profit generated by the business is used to pay off the debt. Although the LBO is a modern technique of acquisition but still this type of acquisition is not prevalent in India. Many factors still make this type of acquisition not fruitful in India, such as FDI clearance, the investor’s interest, shareholders and creditors, compliance with statutory regulations, etc. Therefore, to conclude, the LBO saves the business capital and, at the same time, acquires other business service line-ups from using the capital of lenders.

Read our Article: Financial Modeling: Top 6 Best Practices

Nikhil Mogha

An Advocate by profession, Nikhil Mogha holds experience in the field of Business and Securities law. He has done his Masters of Law in Corporate Law from Guru Gobind Singh Indraprastha University, New Delhi. He is also versed with the drafting and research work in the field of Company Law, Banking Laws and Contract Laws.

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