Leveraged buyout

A leveraged buyout (LBO) is the acquisition of a company using a large amount of borrowed money (debt) to fund most of the purchase price, with a smaller slice of equity from the buyer. The target's own cash flows and assets are used to service and repay the debt. LBOs are the signature transaction of private-equity firms (the equity sponsors).

Rationale

Leverage amplifies equity returns: with most of the price funded by debt, gains on the business accrue to a relatively small equity base. Debt interest is also tax-deductible. The trade-off is risk — high fixed debt-service obligations make the company more fragile in a downturn.

Sources of return

LBO returns come from three levers:

1. Deleveraging — using cash flow to pay down debt, so equity grows as a share of enterprise value even if that value is flat.
2. Operational improvement — growing EBITDA through revenue growth, margin expansion and efficiency.
3. Multiple expansion — exiting at a higher EV/EBITDA multiple than at entry (the least controllable lever).

Returns are measured by internal rate of return (IRR) and multiple of invested capital (MOIC / "cash-on-cash").

Capital structure

A buyout is funded from a "sources and uses" stack, typically including:

• a revolving credit facility and senior secured term loans,
• high-yield bonds or subordinated / mezzanine debt, and
• sponsor equity (and often rolled-over management equity).

The proportion of debt has varied widely over time — historically very high in the 1980s, with more equity contributed in modern deals.

A landmark deal

The 1989 buyout of RJR Nabisco by Kohlberg Kravis Roberts (KKR), at roughly US$25 billion, was for many years the largest LBO in history and was chronicled in the book Barbarians at the Gate — emblematic of the leveraged-buyout boom.

Management buyouts

A related structure is the management buyout (MBO), in which a company's existing managers acquire the business, usually with private-equity backing and substantial leverage.