Leveraged buy out: what is it and how does it works?

The practice of Leverage Buy Out (LBO) has developed since the 1980s, especially in the United States. It can be considered as an alternative to other buyout techniques, and considerably reduces the initial investment burden by using borrowing through credit institutions or investment funds.

What is the definition of an LBO?

The Leverage Buy Out is a financial arrangement that allows a company with a high level of debt to be acquired, and thus benefit from the effect of financial leverage. This type of transaction leads to a takeover of the target company based on debt leverage and makes it possible to limit the equity contribution of the buyer.

Types of LBO

We generally distinguish four types of LBOs according to the nature of the buyer:

1. The LMBO (Leveraged Management Buy-out) where the purchasers are executives of the target company;
2. The LBI (Leveraged Buy-In) where the buyers are external to the target company;
3. The BIMBO (Buy In Management Buy Out) where the buyers are both executives of the target company and outside investors;
4. The LBU (Leveraged Build-Up) where acquirers wish to optimise the capital structure in order to merge the target company with another.

The parent company created then holds shares in the target company, also called a subsidiary or daughter company, which retains its autonomy in terms of production management.

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How does an LBO work?

The Leveraged Buy Out is based on constituting a holding company which will place itself hierarchically above the target company, and take control of it. This parent company finances the acquisition of the target company by taking out a bank or bond loan, which is repaid by the acquired company with the income from its own business, thus increasing the return on equity for investors.

The debt is then repaid by a transfer of cash flows from the purchased company in the form of dividends.

In this type of financial arrangement, the overall debt can be broken down into several types and staggered so that repayments are not concentrated in a single period. Senior debt is thus repaid first, while subordinated debt is repaid later, in return for a higher yield.

What are the advantages and disadvantages of an LBO?

In addition to the financial advantages, the LBO allows the acquirer to benefit from fiscal and organisational advantages.

1. The advantages of an LBO

In the context of an LBO, the buyers benefit from a tax leverage effect. The holding company will be able to deduct the interest on borrowing from the tax of the parent company. As a consequence, the taxable share decreases, since the target company’s profit is attenuated by the holding company’s loss.

It should be noted that the parent-subsidiary regime is possible when a company holds more than 5% of the capital of another company. This allows dividends to be distributed without taxation between the target and the holding company.

At the time the LBO is issued, the merger can proceed between the holding company and the company before an IPO or a resale to other investors.

This operation often generates generous capital gains for shareholders.

1. The disadvantages of an LBO

The main disadvantage is the financial structure of this type of transaction which requires the target company to maintain a sufficient level of profitability in order to be able to repay the LBO debt.

In which situations is a Leveraged Buy Out more favourable?

The success of such an operation depends on several factors. In general the profitability of the subsidiary is the essential condition, so that the holding company can settle the debts contracted for its purchase. In fact, success depends on the market strength of the target company: In general, LBOs work when the acquired company is mature, faces relatively limited competition or has comparative advantages that can ensure the sustainability of its business.

The LBO can be a capital solution to consider in the case of a buyout by the company’s managers and employees who do not have sufficient financial means for a traditional buyout.

To conclude

In summary this strategy may be appropriate for an acquirer who is unable or unwilling to raise a significant amount of equity. Two prerequisites are essential to this type of operation: On the one hand, the fact that the future subsidiary is in good financial health and, on the other, that the investors have sufficient credibility to obtain the support of bankers who may finance the operation with debt.

If you want to learn more about merger and acqusitions, you can read our company takeover guide, or the external growth guide.
We also provided a detailed analysis on the m&a process and the business valuation process.
Finaly, we also provided a definition and explanation of several concepts, such as merger through absorption and joint ventures.