# Leveraged buyout

A leveraged buyout (LBO) is the acquisition of a company using a significant proportion of borrowed money (leverage) to fund the acquisition with the remainder of the purchase price funded with private equity. The assets of the acquired company are often used as collateral for the financing, along with any equity contributed by the acquiror.
While corporate acquisitions often employ leverage to finance the purchase of the target, the term "leveraged buyout" is typically only employed when the acquiror is a financial sponsor (a private equity investment firm).
The use of debt, which normally has a lower cost of capital than equity, serves to reduce the overall cost of financing for the acquisition and enhance returns for the private equity investor. The equity investor can increase their projected returns by employing more leverage, creating incentives to maximize the proportion of debt relative to equity (i.e., debt-to-equity ratio). While the lenders have an incentive to limit the amount of leverage they will provide, in certain cases the acquired company may be "overleveraged", meaning that the amount of leverage assumed by the target company was too high for the cash flows generated by the company to service the debt. As a result, the increased use of leverage increases the risk of default should the company perform poorly after the buyout. Since the early 2000s, the debt-to-equity ratio in leveraged buyouts has declined significantly, resulting in increased focus on operational improvements and follow-on M&A activity to generate attractive returns.
LBOs can come in various forms. The first time a company is acquired through a leveraged buyout it can be referred to as a "primary buyout" although this term is not commonly used, whereas the term "secondary buyout" is very commonly used to refer to the leveraged buyout of a company already owned by a private equity sponsor (please note the distinction between "secondary buyouts" and "private equity secondaries"). The terms "management buyout" (MBO) and "management buy-in" (MBI) involve transactions in which the current or former management of the company operate as the financial sponsor or as an active party in the transaction alongside the sponsor. Finally the leveraged buyout of a public company is often referred to as a "take-private" or a "public-to-private" (PtP).

## Characteristics

A leveraged buyout is characterized by the extensive use of debt financing to acquire a company. This financing structure enables private equity firms and financial sponsors to control businesses while investing a relatively small portion of their own equity. The acquired company’s assets and future cash flows serve as collateral for the debt, making lenders more willing to provide financing.
While different firms pursue different strategies, there are some characteristics that hold true across many types of leveraged buyouts:
* High Debt-to-Equity Ratio: LBOs rely on a significant proportion of debt, typically ranging between 50% and 90% of the total purchase price. The remaining portion is financed through equity capital from the financial sponsor.
* Stable and Predictable Cash Flows: Ideal LBO candidates generate consistent operating cash flows to meet debt obligations. Businesses with recurring revenue, high customer retention, and strong profit margins are prime targets.
* Strong Asset Base for Collateral: Companies with tangible assets, such as real estate, inventory, and equipment, provide lenders with security, reducing credit risk.
* Operational and Cost Efficiencies: Financial sponsors aim to improve profitability through cost-cutting measures, operational restructuring, and revenue growth strategies.
* Tax Efficiency: Interest payments on LBO debt are typically tax-deductible, reducing the overall tax burden and improving post-tax cash flows.
* Exit Strategy Focus: Private equity firms plan exit strategies before acquiring a company. Common exit options include an initial public offering (IPO), strategic sale, secondary buyout (SBO), or recapitalization.
Debt volumes of up to 100% of a purchase price have been provided to companies with very stable and secured cash flows, such as real estate portfolios with rental income secured by long-term rental agreements. Typically, debt of 40–60% of the purchase price may be offered. Debt ratios vary significantly among regions and target industries.
Debt for an acquisition comes in two types: senior and junior. Senior debt is secured with the target company's assets and has lower interest rates. Junior debt has no security interests and higher interest rates. In big purchases, debt and equity can come from more than one party. Banks can also syndicate debt, meaning they sell pieces of the debt to other banks. Seller notes (or vendor loans) can also happen when the seller uses part of the sale to give the purchaser a loan. In LBOs, the only collateral is the company's assets and cash flows. The financial sponsor can treat their investment as common equity, preferred equity, or other securities. Preferred equity pays dividends and has priority over common equity.
In addition to the amount of debt that can be used to fund leveraged buyouts, it is also important to understand the types of companies that private equity firms look for when considering leveraged buyouts.
Another key benefit to the equity investor in a leveraged buyout is the tax deductibility of interest payments on the acquisition financing which can offset the company's earnings and reduce the corporate income tax. Of course, the interest income on the interest payments are taxed at ordinary income rates rather than capital gains rates so while the allocation of taxes is shifted from the borrower to the lender, the total income tax generated from the company's earnings is often higher than it would be if less leverage were used.

## Management buyouts

A "management buyout" (MBO) is a form of buyout in which the incumbent management team acquires a sizeable portion of the shares of the company. Similar to an MBO is an MBI (Management Buy In) in which an external management team acquires the shares.
Management buyouts are usually an indication of a high degree of conviction by management in the future prospects of the business relative to the existing ownership. Often, management is able to secure the company outside of an auction process allowing the management team to acquire the company on favorable terms. In many cases the management may still require additional equity from a financial sponsor, which may also be actively involved in securing the financing for the acquisition. Financial sponsors often find MBOs to be attractive situations as they have the opportunity to align itself with an insider who may have unique perspectives on the company and potential areas of operational improvement.

## Secondary buyouts

A secondary buyout is the leveraged buyout of a company already owned by a private equity sponsor. A secondary buyout will often provide a realization event for the selling private equity owner(s) and its limited partner investors. Historically, given that private equity firms were extolling their unique ability to source attractive investments and drive value through a leveraged buyout, secondary buyouts were perceived as less attractive than the "primary buyout" of a private company or a "take-private" of a public company and were disdained by investors. Over time, it has been difficult to distinguish a differential investment returns based on the prior owner of the company and secondary buyouts have become a common part of the private equity ecosystem typically representing 25% to 35% of all leverage buyouts.
For sellers, secondary buyouts have led to faster realizations than an initial public offering which often takes months to prepare and requires years after the IPO to realize the remaining public shares. Similarly the sale to another private equity sponsor may be less complex than the sale to a strategic corporate acquiror which could face regulatory scrutiny or challenges financing the purchase.
Secondary buyouts differ from secondaries which typically involve the acquisition of portfolios of private equity assets including limited partnership stakes and direct investments in corporate securities. More recently GP-led Secondaries, in which a private equity sponsor creates a "continuation fund" to acquire a company from one of its own funds has brought together elements of secondary buyouts and management buyouts.

## History
### Origins

The first leveraged buyout may have been the purchase by McLean Industries, Inc. of Pan-Atlantic Steamship Company in January 1955 and Waterman Steamship Corporation in May 1955. Under the terms of that transaction, McLean borrowed $42 million and raised an additional $7 million through an issue of preferred stock. When the deal closed, $20 million of Waterman cash and assets were used to retire $20 million of the loan debt.
Lewis Cullman's acquisition of Orkin Exterminating Company in 1964 is among the first significant leveraged buyout transactions. Similar to the approach employed in the McLean transaction, the use of publicly traded holding companies as investment vehicles to acquire portfolios of investments in corporate assets was a relatively new trend in the 1960s, popularized by the likes of Warren Buffett (Berkshire Hathaway) and Victor Posner (DWG Corporation), and later adopted by Nelson Peltz (Triarc), Saul Steinberg (Reliance Insurance) and Gerry Schwartz (Onex Corporation). These investment vehicles would utilize a number of the same tactics and target the same type of companies as more traditional leveraged buyouts and in many ways could be considered a forerunner of the later private-equity firms. In fact, it is Posner who is often credited with coining the term "leveraged buyout" or "LBO."
The leveraged buyout boom of the 1980s was conceived in the 1960s by a number of corporate financiers, most notably Jerome Kohlberg, Jr. and later his protégé Henry Kravis. Working for Bear Stearns at the time, Kohlberg and Kravis, along with Kravis' cousin George Roberts, began a series of what they described as "bootstrap" investments. Many of the target companies lacked a viable or attractive exit for their founders, as they were too small to be taken public and the founders were reluctant to sell out to competitors: thus, a sale to an outside buyer might prove attractive. In the following years, the three Bear Stearns bankers would complete a series of buyouts including Stern Metals (1965), Incom (a division of Rockwood International, 1971), Cobblers Industries (1971), and Boren Clay (1973) as well as Thompson Wire, Eagle Motors and Barrows through their investment in Stern Metals. By 1976, tensions had built up between Bear Stearns and Kohlberg, Kravis and Roberts leading to their departure and the formation of Kohlberg Kravis Roberts in that year.

### 1980s

In January 1982, former U.S. Secretary of the Treasury William E. Simon and a group of investors acquired Gibson Greetings, a producer of greeting cards, for $80 million, of which only $1 million was rumored to have been contributed by the investors. By mid-1983, just sixteen months after the original deal, Gibson completed a $290 million IPO and Simon made approximately $66 million. The success of the Gibson Greetings investment attracted the attention of the wider media to the nascent boom in leveraged buyouts. Between 1980 and 1990, there were 180 leveraged buyouts involving firms with an aggregate book value of $39.2 billion.
In the summer of 1984 the LBO was a target for virulent criticism by Paul Volcker, then chairman of the Federal Reserve, by John S.R. Shad, chairman of the U.S. Securities and Exchange Commission, and other senior financiers. The gist of all the denunciations was that top-heavy reversed pyramids of debt were being created and that they would soon crash, destroying assets and jobs.
During the 1980s, constituencies within acquired companies and the media ascribed the "corporate raid" label to many private equity investments, particularly those that featured a hostile takeover of the company, perceived asset stripping, major layoffs or other significant corporate restructuring activities. Among the most notable investors to be labeled corporate raiders in the 1980s included Carl Icahn, Victor Posner, Nelson Peltz, Robert M. Bass, T. Boone Pickens, Harold Clark Simmons, Kirk Kerkorian, Sir James Goldsmith, Saul Steinberg and Asher Edelman. Carl Icahn developed a reputation as a ruthless corporate raider after his hostile takeover of TWA in 1985. Many of the corporate raiders were onetime clients of Michael Milken, whose investment banking firm, Drexel Burnham Lambert helped raise blind pools of capital with which corporate raiders could make a legitimate attempt to take over a company and provided high-yield debt financing of the buyouts.
One of the final major buyouts of the 1980s proved to be its most ambitious and marked both a high-water mark and a sign of the beginning of the end of the boom that had begun nearly a decade earlier. In 1989, KKR closed in on a $31.1 billion takeover of RJR Nabisco. It was, at that time and for over 17 years following, the largest leveraged buyout in history. The event was chronicled in the book (and later the movie) Barbarians at the Gate: The Fall of RJR Nabisco. KKR would eventually prevail in acquiring RJR Nabisco at $109 per share, marking a dramatic increase from the original announcement that Shearson Lehman Hutton would take RJR Nabisco private at $75 per share. A fierce series of negotiations and horse-trading ensued which pitted KKR against Shearson Lehman Hutton and later Forstmann Little & Co. Many of the major banking players of the day, including Morgan Stanley, Goldman Sachs, Salomon Brothers, and Merrill Lynch were actively involved in advising and financing the parties. After Shearson Lehman's original bid, KKR quickly introduced a tender offer to obtain RJR Nabisco for $90 per share – a price that enabled it to proceed without the approval of RJR Nabisco's management. RJR's management team, working with Shearson Lehman and Salomon Brothers, submitted a bid of $112, a figure they felt certain would enable them to outflank any response by Kravis's team. KKR's final bid of $109, while a lower dollar figure, was ultimately accepted by the board of directors of RJR Nabisco. At $31.1 billion of transaction value, RJR Nabisco was the largest leveraged buyout in history until the 2007 buyout of TXU Energy by KKR and Texas Pacific Group. In 2006 and 2007, a number of leveraged buyout transactions were completed that for the first time surpassed the RJR Nabisco leveraged buyout in terms of nominal purchase price. However, adjusted for inflation, none of the leveraged buyouts of the 2006–2007 period surpassed RJR Nabisco.
By the end of the 1980s the excesses of the buyout market were beginning to show, with the bankruptcy of several large buyouts including Robert Campeau's 1988 buyout of Federated Department Stores, the 1986 buyout of the Revco drug stores, Walter Industries, FEB Trucking and Eaton Leonard. Additionally, the RJR Nabisco deal was showing signs of strain, leading to a recapitalization in 1990 that involved the contribution of $1.7 billion of new equity from KKR.
Drexel Burnham Lambert was the investment bank most responsible for the boom in private equity during the 1980s due to its leadership in the issuance of high-yield debt. Drexel reached an agreement with the government in which it pleaded nolo contendere (no contest) to six felonies – three counts of stock parking and three counts of stock manipulation. It also agreed to pay a fine of $650 million – at the time, the largest fine ever levied under securities laws. Milken left the firm after his own indictment in March 1989. On February 13, 1990, after being advised by United States Secretary of the Treasury Nicholas F. Brady, the U.S. Securities and Exchange Commission (SEC), the New York Stock Exchange, and the Federal Reserve, Drexel Burnham Lambert officially filed for Chapter 11 bankruptcy protection.

### Age of the mega-buyout

The combination of decreasing interest rates, loosening lending standards, and regulatory changes for publicly traded companies (specifically the Sarbanes–Oxley Act) would set the stage for the largest boom the private equity industry had seen. Marked by the buyout of Dex Media in 2002, large multibillion-dollar U.S. buyouts could once again obtain significant high yield debt financing from various banks and larger transactions could be completed. By 2004 and 2005, major buyouts were once again becoming common, including the acquisitions of Toys "R" Us, The Hertz Corporation, Metro-Goldwyn-Mayer and SunGard in 2005.
As 2005 ended and 2006 began, new "largest buyout" records were set and surpassed several times with nine of the top ten buyouts at the end of 2007 having been announced in an 18-month window from the beginning of 2006 through the middle of 2007. In 2006, private-equity firms bought 654 U.S. companies for $375 billion, representing 18 times the level of transactions closed in 2003. Additionally, U.S.-based private-equity firms raised $215.4 billion in investor commitments to 322 funds, surpassing the previous record set in 2000 by 22% and 33% higher than the 2005 fundraising total. The following year, despite the onset of turmoil in the credit markets in the summer, saw yet another record year of fundraising with $302 billion of investor commitments to 415 funds. Among the mega-buyouts completed during the 2006 to 2007 boom were: EQ Office, HCA, Alliance Boots and TXU.
In July 2007, turmoil that had been affecting the mortgage markets spilled over into the leveraged finance and high-yield debt markets. The markets had been highly robust during the first six months of 2007, with highly issuer friendly developments including PIK and PIK Toggle (interest is "Payable In Kind") and covenant light debt widely available to finance large leveraged buyouts. July and August saw a notable slowdown in issuance levels in the high yield and leveraged loan markets with only few issuers accessing the market. Uncertain market conditions led to a significant widening of yield spreads, which coupled with the typical summer slowdown led many companies and investment banks to put their plans to issue debt on hold until the autumn. However, the expected rebound in the market after Labor Day 2007 did not materialize and the lack of market confidence prevented deals from pricing. By the end of September, the full extent of the credit situation became obvious as major lenders including Citigroup and UBS AG announced major writedowns due to credit losses. The leveraged finance markets came to a near standstill. As 2007 ended and 2008 began, it was clear that lending standards had tightened and the era of "mega-buyouts" had come to an end. Nevertheless, private equity continues to be a large and active asset class and the private-equity firms, with hundreds of billions of dollars of committed capital from investors are looking to deploy capital in new and different transactions.

### Failures

As with all companies, a proportion of companies acquired in leveraged buyouts will experience financial challenges and given the higher debt-to-equity ratio of LBO targets, these financial challenges can result in default.
Especially in the leveraged buyouts of the 1980s in which debt-to-equity ratios often exceeded 9 to 1, defaults occurred at notable levels. Robert Campeau's 1988 buyout of Federated Department Stores and the 1986 buyout of the Revco drug stores were well documented failures that resulted in bankruptcy. The failure of the Federated buyout was a result of excessive debt financing, comprising about 97% of the total consideration, which led to large interest payments that exceeded the company's operating cash flow. Many LBOs of the boom period 2005–2007 were also financed with too high a debt burden, however default rates were significantly below the expectations of market observers given the proximate onset of the 2008 global financial crisis.
The inability to repay debt in an LBO can be caused by initial overpricing of the target firm and/or its assets. Over-optimistic forecasts of the revenues of the target company may also lead to financial distress after acquisition. Some courts have found that in certain situations, LBO debt constitutes a fraudulent transfer under U.S. insolvency law if it is determined to be the cause of the acquired firm's failure. The outcome of litigation attacking a leveraged buyout as a fraudulent transfer will generally turn on the financial condition of the target at the time of the transaction – that is, whether the risk of failure was substantial and known at the time of the LBO, or whether subsequent unforeseeable events led to the failure. The analysis historically depended on "dueling" expert witnesses and was notoriously subjective and it was rare that such findings were sustained. In addition, the Bankruptcy Code includes a so-called "safe harbor" provision, preventing bankruptcy trustees from recovering settlement payments to the bought-out shareholders. In 2009, the U.S. Court of Appeals for the Sixth Circuit held that such settlement payments could not be avoided, irrespective of whether they occurred in an LBO of a public or private company. To the extent that public shareholders are protected, insiders and secured lenders become the primary targets of fraudulent transfer actions.
In certain cases, instead of declaring insolvency, the company negotiates a debt restructuring with its lenders. The financial restructuring might entail that the equity owners inject some more money in the company and the lenders waive parts of their claims. In other situations, the lenders inject new money and assume the equity of the company, with the present equity owners losing their shares and investment. The operations of the company are not affected by the financial restructuring. Nonetheless, the financial restructuring requires significant management attention and may lead to customers losing faith in the company.