The Advantages and Risks of Leveraged Buyouts

Julien Fissette
Published on
March 20, 2024
Last edited on
min read
min read

The Advantages and Risks of Leveraged Buyouts

Julien Fissette
Published on
March 20, 2024
Last edited on
min read
min read

In finance, a leveraged buyout (LBO) involves acquiring another company using a significant amount of borrowed capital to fund the purchase.

Leveraged buyouts enable buyers to make large acquisitions without needing to commit substantial amounts of capital upfront. However, while offering opportunities to both buyers and sellers, LBOs also come with inherent risks that must be considered.

In this blog, we'll explore the key pros, cons, and mitigation strategies associated with leveraged buyouts.

What Is a Leveraged Buyout (LBO)?

A leveraged buyout occurs when a company is purchased using a significant amount of borrowed funds, like loans and bonds, rather than the buyer's own capital. The assets of both the target company and the acquiring company often serve as collateral for the borrowed funds.

To qualify as an LBO, the debt-to-equity ratio typically ranges from 70% to 90%, meaning the acquiring company invests only a fraction of the purchase price and finances the rest through debt. [1]

Despite their somewhat “predatory” reputation, LBOs serve various purposes, including taking public companies private or divesting all or part of a business.

Benefits of LBOs

Could an LBO be the right choice for your next acquisition? Let’s unpack the benefits. 

Cost Efficiency for Buyers

LBOs allow buyers to make acquisitions that would otherwise be too expensive. Raising capital is no easy feat, and LBOs make it possible for smaller investors to purchase larger companies through debt financing.

Say you were in a situation where you were buying a business for $25 million, using $20 million in debt and $5 million in equity. You may buy back half the debt over the course of five years ($10 million plus interest). After the five years have elapsed, you sell the company for $30 million and the proceeds will be split, with $10 million going to the bank and $20 million to you. In this example, you’re getting back four times your outlay, even though the value of the company itself has only increased by 1.2x.

Enhanced Return on Equity

LBOs offer investors the potential for huge returns by amplifying gains when a company's value appreciates. As with all investments though, that’s a big “if”, and it's important to recognize that this potential comes with increased risk and responsibility.

For one, under an LBO, companies face intense pressure to meet growth targets to service the debt incurred during acquisition. Management changes may also be imposed by the acquiring funds, resulting in operational challenges

Tax Benefits

Another advantage of leveraged buyouts is the potential tax benefit for both the buyer and the target company. By leveraging the target company's assets and cash flow to secure borrowed funds, interest payments on the debt become tax-deductible.

Advantages for Selling the Company

But what about the other side of the deal? Well, there are some advantages for the selling company too. 

Improving the Market Position

LBOs are often used to purchase underperforming or undervalued companies. The injection of capital can turn things around, resulting in improved growth potential and market position. This helps to protect the company from competitive pressures, which makes it more sustainable over time.

In this sense, LBOs can effectively “rescue” struggling companies, benefiting both the employees and the new shareholders (though not the existing ones, as they are typically bought out by the buyer).

Involvement of Current Management

That being said, sometimes, when a company is acquired via a leveraged buyout, the buyer will seek to retain the current management and employees. After all, they know how to run the business better than anyone. 

In cases like these, buyers often offer strong compensation packages to keep the existing team on board. This ensures continuity and motivation within the core management team, contributing to smoother post-acquisition integration.

There are no guarantees however, and the company may bring in their own management team.

Facilitating Ownership Transition

If someone wants to sell their business altogether, LBOs come in handy once again. They allow sellers to secure their desired price and exit the company with a well-defined plan, which may not be feasible through traditional sales methods.

LBOs also provide avenues for family members or employees to acquire the business, which is especially useful when it comes time for the owner to retire.

Risks of LBOs

While we've explored the advantages, investors, VC firms, and business owners must understand the risks associated with LBOs.

Financial Risks

High debt levels and susceptibility to interest rate fluctuations pose significant financial risks.

One significant risk in leveraged buyouts is the substantial debt used for acquisition financing. If the company fails to meet performance expectations, this debt burden can become unsustainable.

Moreover, variable interest rates amid economic fluctuations could exacerbate financial challenges.

Operational Risks

Integration challenges and potential disruptions to business operations present operational risks.

No acquisition is ever going to go off without a hitch. There are always going to be speed bumps, and integrating new and existing team members, as well as business processes, can be fraught with difficulties.

Expected operational efficiencies may also not materialize. Pair that with a poorly executed LBO and all sorts of operational issues could arise. 

Market and Economic Risks

Economic downturns and industry-specific shocks introduce market and economic risks.

Unexpected shocks, such as those experienced by the airline industry post-9/11 [2] or the real estate market following the 2008 financial crisis, can severely impact LBO performance.

Similarly, no amount of planning can prepare for something as seismic as COVID-19. Still, staying informed about market trends and economic forecasts can mitigate some risks.

Mitigation Strategies

Despite the risks, there are strategies investors can employ to mitigate the challenges associated with leveraged buyouts.

Financial Risk Management

Shrewd debt structuring and hedging can help mitigate financial risks associated with LBOs.

Properly structuring debt is the first and most important step in managing financial risk. Balancing debt levels with cash flow projections and revenue forecasts is the best way to go about this. 

Additionally, hedging against interest rate fluctuations can provide stability. Fixed-rate debt instruments or interest rate swaps can help safeguard against the impact of variable interest rates.

Operational Risk Mitigation

Keeping tabs on operational risks is all about strategic management planning and well-thought-out integration strategies. 

Detailed integration plans and clear communication channels are essential for managing operational risks. Identifying potential challenges early allows for proactive solutions. The more business risks that you consider as threats early on – problems with suppliers, HR issues etc – the better prepared you will be to minimize the costs these will incur

More broadly speaking, fostering a culture of adaptability and resilience within the organization will put it in a good position to overcome unforeseen operational hurdles. 

Market and Economic Risk Mitigation

Diversification strategies and scenario planning are the only ways to mitigate market and economic risks.

As we said, you can only do so much to prepare for major market fluctuations, but that doesn’t mean it’s impossible. It’s less a specific action and more a series of decisions that cultivate overall preparedness.

These include diversifying investments across different industries and performing frequent scenario planning.

Summarizing the Pros and Cons

In summary, leveraged buyouts have many attractive advantages, such as cost efficiency and potential for enhanced returns, but they come with inherent risks, including financial, operational, and market-related challenges.

To learn more about how to mitigate these risks and navigate your investments with confidence, explore Roundtable.