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Leveraged Buyout (LBO)
The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition.
In a typical LBO, up to 90 percent of the purchase price may be funded with debt.Because the assets of the target company are used as collateral, LBOs have been most successfully used to acquire companies with stable cash flows and hard assets such as real estate or inventory that can be used to secure loans. LBOs can also be financed by borrowing in the public markets through the issuance of high-yield, high-risk debt instruments, sometimes called "junk bonds."
An LBO begins with the borrower establishing a separate corporation for the express purpose of acquiring the target. The borrower then causes the acquisition corporation to borrow the funds necessary for the transaction, pledging as collateral the assets it is about to acquire. The target company is then acquired using any number of techniques, most commonly through a public tender offer followed by a cash-out merger. This last step transforms the shares of any remaining shareholder of the target corporation into a right to receive a cash payment, and merges the target corporation into the acquisition corporation. The surviving corporation ends up with the obligation to pay off the loan used to acquire its assets. This will leave the company with a high amount of debt obligations on its books, making it highly "leveraged," meaning that the ratio of debt to equity will be high. Indeed, in the average LBO during the 1980s, when they were most popular, the debt-to-assets ratio increased from about 20 percent to 90 percent.
Following an LBO, the surviving company may find that it needs to raise money to satisfy the debt payments. Companies thus frequently sell off divisions or portions of their business. Companies also have been known to "go public" again, in order to raise capital.
Many LBOs are "management buyouts," in which the acquisition is pursued by a group of investors that includes incumbent management of the target company. Typically, in management buyouts the intent is to "go private," meaning that the management group intends to continue the company as a privately held corporation, the shares of which are no longer traded publicly.
Management buyouts were particularly popular during the 1980s, when they were used in connection with the purchase of many large, prominent firms. Public tender offers by a corporation seeking to acquire a target company were frequently met with a counterproposal of a leveraged buyout by the target company management. One of the most famous takeover battles was the 1988 battle for RJR Nabisco between a management team led by F. Ross Johnson and an outside group led by the takeover firm Kohlberg Kravis Roberts & Company (KKR). Both groups proposed to take the company private using LBOs. This contest, eventually won by KKR when it purchased RJR Nabisco for $31 billion, is the subject of the book and movie Barbarians at the Gate. At the time, it was the most expensive corporate acquisition in history.
In the later years of the 1980s, LBOs became so popular that they were used in situations in which they were poorly suited, and the deals were poorly structured. Beginning in 1989, the number of defaults and bankruptcies of companies that had gone through LBOs increased sharply. As a result, the number of LBOs declined significantly.
During the 1980s, LBOs became very common and increased substantially in size, so that they normally occurred in large companies with more than $100 million in annual revenues. But many of these deals subsequently failed due to the low quality of debt used, and thus the movement in the 1990s was toward smaller deals (featuring small- to medium-sized companies, with about $20 million in annual revenues) using less leverage. Thanks to low stock prices, looser regulatory restrictions, and a rally in high-yield bonds, Barron's predicted that 2001 would be the biggest year since the 1980s for LBOs.
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