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1Meaning Of Leveraged Buyout
A leveraged buyout (LBO) involves the acquisition of another company using borrowed money to match the cost of acquisition. The assets of the acquiring company, as well as the assets of the acquired company, are used as a security against the loans. The aim of leveraged buyouts is to enable companies in making large acquisitions without the need for a lot of capital.
After understanding the meaning of leveraged buyout, let us know about the how to analyze a leveraged buyout.
Leveraged Buyout Analysis
The leveraged buyout analysis helps in determining the maximum price that can be paid by a buyer for a target entity. This analysis considers the current market scenarios and the returns a target company will generate.
The leveraged buyout analysis justifies the highest price on the basis of the following:
- The target company’s current and projected free cash flows.
- The financing structure, banking covenants and interest rates required by lenders.
- The required hurdle rate for equity investors.
However, the leveraged buyout analysis only determines the floor valuation of an entity. This analysis does not take into account the premium paid by the acquiring entity for the synergies in business.
Let us now see how leveraged buyout is financed:
Leveraged Buyout Financing
Buyers often use borrowed funds to comprise the total purchase price while accomplishing a buyout.
The following are the types of financing that could be considered for a leveraged buyout:
Funds can be borrowed from an individual bank or a group of banks called a syndicate. The banks lend money to the buyer for the working capital and to pay out the existing ownership of the target company.
Bonds or Private Placements
Private notes and bonds can be utilized as a source of financing for an LBO.
Mezzanine, Junior or Subordinated Debt
This form of financing often takes place in a combination with bank financing or bonds.
In this form of financing, the acquiring entity lends money to the company being sold. The acquiring entity then takes a delayed payment thereby creating a debt-like obligation. This process, in turn, creates financing for the buyout.
After knowing the concept of a leveraged buyout, let us look at an example to gain a clearer understanding.
Example of Leveraged Buyout
Gibson Greeting Cards
Acquisition of Gibson Cards by Wesray Capital in the year 1982 proves to be the most successful example of LBO in history. The purchase price of the deal was $80 million of which $1 million was financed in cash and the remaining amount was borrowed by issuing junk bonds. This leveraged buyout benefited Wesray Capital and its investors when Gibson Cards was sold a year later for $220 million.
Leveraged buyouts are mainly executed by private equity groups to purchase and later sell an entity thereby assisting in profit maximization. Entities use LBO as a part of their mergers and acquisitions strategies to acquire competitors and to gain access to new markets.1–4