There are also arguments to be made in favor of or against each of these things I have serious reservations, for example, that market timing is a viable pathway.
But different investors have different opinions and bring different expertise to their investments, and another investor might find that pathway to be a viable strategy. Leveraged buyouts are interesting in that they can play on all of these elements, with certain transactions relying more on one or the other as the underlying rationale for the investment thesis. Strategies relying on revenue growth involve buying a company and growing its revenue at a similar expense ratio, resulting in an improvement of its earnings before interest, taxes, depreciation, and amortization—or EBITDA —and then refinancing or selling it at the same multiple but on a higher EBITDA base.
These strategies rely on the implementation of cost-cutting programs. Three examples of financial engineering strategies are:. While this strategy needs to be mentioned and, ultimately, changes in market price expectations play into all investments of any kind, in my experience, I have yet to find any investor that can reliably predict market price changes over long periods of time.
The market beta strategy is similar to market timing in that the investor implementing the strategy is relying on market forces—rather than changes at the asset level—to drive returns. The market beta investor has the perspective more of an index-fund investor, trying to diversify investments and relying on the long-term growth of assets in general to deliver earnings.
While the majority of strategies to succeed in an LBO acquisition are fairly straightforward at least conceptually, if maybe not practically , there are other aspects that are not quite as up front. One of the most important of these, in my opinion, is the inappropriately named tax shield. I would strongly prefer the term to be the more descriptively named tax transfer, or tax reallocation, either of which would more clearly underline the true dynamics of this element.
The term tax shield then is derived from the notion that if a company has more debt, and therefore uses a greater portion of its operating profits to pay for interest, those profits are in part protected from taxation.
Firstly, having a situation where the company you own has less profit and calling it a shield seems a little disingenuous. And second, while a company may not pay taxes on interest, the lender certainly will. Interest income is taxed, and often at a high rate. And one may ask how a lender might want to be compensated for such a transfer? As you may have noticed, the first word in LBO is leveraged, and that is essentially what the game is all about.
Paired with the risk-based pricing are risk-based terms. What I mean by that is that if a lender is providing a low-risk loan, they are likely to have few controls, no guarantees, limited reporting, and a great deal of flexibility for the borrower. The same lender providing a higher-risk loan may require all kinds of guarantees, covenants, and reporting.
These elements, put together, can have broad implications for the viability of an LBO, and so the devil is in the details. The business plan and debt plan have to work together, and a lot of the success of an LBO transaction is predicated on knowing what the debt market will bear and what it will accept relative to a specific opportunity with respect to pricing and terms. The purpose of an LBO is to allow a company to make a major acquisition without committing a lot of capital.
While a leveraged buyout can be complicated and take a while to complete, it can benefit both the buyer and seller when done correctly. In short, LBOs allow firms better equity returns. Why would a target company want to sell via LBO? The seller is able to get the price they want for the business and has a way to exit the company with a solid plan in place.
A leveraged buyout is an ideal exit strategy for business owners looking to cash out at the end of their careers. If you run a publicly traded company, you can use a leveraged buyout to consolidate the public shares and transfer them to a private investor who takes the shares off the market. The investors will then own a majority of or all of your company and will assume the debt liability of the transaction. For example, an LBO is useful if the business needs to be repackaged and returned to the marketplace after adjustments are made to make it more marketable.
Many business owners have used efficiency strategies to make their companies profitable and attractive to potential buyers. However, some companies grow so large and inefficient that it becomes more profitable for a buyer to use a leveraged buyout to break it up and sell it as a series of smaller companies. These individual sales are typically more than enough to pay off the loan of purchasing the company as a whole.
If you have a company with different target markets for various products, this might be a good option. An LBO of this type can then give the smaller companies a better chance to grow and stand out than they would have had as part of an inefficient conglomerate. If an investor believes your company could eventually be worth much more than it is currently, a leveraged buyout could be a good option. The investor would assume the debt with the belief that holding onto the company for a certain amount of time will increase its value and allow them to pay off the debt and make a profit.
In this type of leveraged buyout , you as the business owner would want to exit the company before it becomes profitable, but not sacrifice the profit that is likely to come in the future.
Taking the LBO money from the purchaser helps you realize part of that profit now so you can turn your sights to other ventures.
Another common leveraged buyout occurs when a smaller company wants to be acquired by a larger competitor. This allows the smaller company to grow dramatically and can help them gain new customers and scale more quickly than they would be able to without the acquisition. This can be a good way to bring other investors and knowledgeable leaders on board and take advantage of peer elevation.
With a more robust and varied team in place, you can take a previously underperforming company to new levels if you want to stay on with the company.
Many business owners sell their company via a leveraged buyout but stay on as a consultant to retain connections and help the business continue to grow. Other business owners use an LBO as a way to exit the company completely to pursue one where they have more passion as well as profitability.
Business owners often prefer MBOs if they are retiring or if a majority shareholder wants to leave the company. The buyers enjoy a greater financial incentive when the business succeeds than they would have if they remained employees.
Management buyouts have many advantages, in particular the continuity of operations. When the management team does not change, the owner can expect a smoother transition with business continuing to operate profitably. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate.
You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Terms Institutional Buyout IBO An institutional buyout is the acquisition of a controlling interest in a company by an institutional investor.
Learn About What a Buyout Is A buyout is the acquisition of a controlling interest in a company; it's often used synonymously with the term "acquisition. Club Deal A club deal is a private equity buyout or the assumption of a controlling interest in a company that involves several different private equity firms.
The shared national credit program was created in to provide an efficient and consistent review and classification of large syndicated loans. Partner Links. Related Articles. Corporate Finance How are leveraged buyouts financed? Investopedia is part of the Dotdash publishing family. Business encyclopedia Learn everything there is to know about running a business. Search Search. Leveraged Buyout LBO 2 minute read. Financial upside. Since, by definition, LBOs require acquiring companies to put up little to nothing of their own money, as long as the company being acquired can generate more than enough cash to fund its purchase, investors win.
Continued operation. When a buyer comes in, whether internal management or outsiders, the company at least has the opportunity to keep its doors open. Disadvantages of an LBO Of course, for every upside there is a downside. Here are some related to LBOs: Poor morale. Bankruptcy a big risk.
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