Leveraged Buyout (LBO) Definition: How It Works, with Example

What Is a Leveraged Buyout?

A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.

Understanding Leveraged Buyouts (LBOs)

In a leveraged buyout (LBO), there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the bonds issued in the buyout are usually not investment grade and are referred to as junk bonds.

LBOs have garnered a reputation for being an especially ruthless and predatory tactic, as the target company doesn't usually sanction the acquisition. Aside from being a hostile move, there is a bit of irony to the process in that the target company's success, in terms of assets on the balance sheet, can be used against it as collateral by the acquiring company.

LBOs are conducted for three main reasons:

1. To take a public company private
2. To spin off a portion of an existing business by selling it
3. To transfer private property, as is the case with a change in small business ownership

However, it is usually a requirement that the acquired company or entity, in each scenario, is profitable and growing.

Leveraged buyouts have had a notorious history, especially in the 1980s, when several prominent buyouts led to the eventual bankruptcy of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100% and the interest payments were so large that the company's operating cash flows were unable to meet the obligation.

Example of Leveraged Buyouts

One of the largest LBOs on record was the acquisition of Hospital Corp. of America (HCA) by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch in 2006. The three companies valued HCA at around $33 billion.

Although the number of such large acquisitions has declined following the 2008 financial crisis, large-scale LBOs began to rise during the COVID-19 pandemic. In 2021, a group of financiers led by Blackstone Group announced a leveraged buyout of Medline that valued the medical equipment manufacturer at $34 billion.

The Bottom Line

A leveraged buyout (LBO) refers to the process of one company acquiring another using mostly borrowed funds to carry out the transaction. Firms often carry out LBOs to take a company private or to spin off part of an existing business. The ratio of debt to equity is generally around 90% to 10%, which generally translates to lower credit ratings for the bonds issued in the buyout.

Leveraged buyouts are often seen as a predatory business tactic because the target company has little control over approving the deal, and its own assets can be used as leverage against it. LBOs declined following 2008 financial crisis but have seen increased activity in recent years.