What is a Leveraged Buyout? The Mechanics of LBOs

A Leveraged Buyout (LBO) is the acquisition of a company using a significant amount of borrowed money to meet the cost of acquisition.

A Leveraged Buyout (LBO) is a transaction where a private equity firm acquires a company using a small amount of equity and a large amount of debt. The assets of the company being acquired are often used as collateral for the loans. The primary goal is to use the company’s future cash flows to service and pay down the debt over a 5 to 7-year period, eventually exiting the investment via an IPO or a sale to a strategic buyer.

The math behind an LBO relies on the 'Internal Rate of Return' (IRR). By using 70% to 80% debt financing, the private equity sponsor magnifies the returns on their equity contribution. For example, if a firm buys a company for $1B using $200M of equity and $800M of debt, and later sells it for $1.2B after paying down $200M of debt, the equity value has grown from $200M to $600M, a 3x return on equity despite only a 20% increase in enterprise value.

Ideal LBO targets are companies with stable, predictable cash flows, low existing debt, and significant tangible assets. In 2022, despite rising borrowing costs, several large-scale LBOs occurred in the software and healthcare sectors where recurring revenue provided the 'moat' necessary to guarantee debt servicing. If a company’s EBITDA margins contract during the holding period, the high leverage can quickly lead to insolvency, as fixed interest obligations must be met regardless of profit levels.