Leveraged buyout (LBO)

Definition

A leveraged buyout, often shortened to LBO, is the acquisition of a company using a significant amount of borrowed money, with the target company’s assets and cash flows typically used as collateral for the debt.

What it means

In a leveraged buyout, an investor, commonly a private equity firm, contributes a relatively small amount of equity and finances the rest of the purchase with debt. The aim is to improve the company’s performance, repay the debt over time using operating cash flow, and eventually exit the investment at a profit.

Because debt magnifies returns, successful LBOs can generate strong equity gains. However, high leverage also increases financial risk, especially if cash flows fall short of expectations.

How it works

• A buyer acquires a business using a mix of equity and debt
• The acquired company’s cash flows are used to service the debt
• Operational improvements or growth increase the company’s value
• The investor exits through a sale or flotation once debt levels are reduced

Example

A private equity firm acquires a business for $100,000,000, funding $70,000,000 with debt and $30,000,000 with equity. If the business grows in value and the debt is paid down, the equity value at exit can increase significantly.

Why leveraged buyouts matter

• Enable acquisitions with limited upfront equity
• Can deliver higher returns through the use of leverage
• Common strategy in private equity and corporate acquisitions

Important to note

While leveraged buyouts can enhance returns, they also raise the risk of financial distress. Strong, predictable cash flows are critical to the success of an LBO.

In short, a leveraged buyout is a high-risk, high-reward acquisition strategy that relies on careful financial structuring and operational discipline.