Have you ever wondered how investors can acquire large companies without using much of their own money? This is the core idea behind a leveraged buyout (LBO) model. LBO is an acquisition strategy where a company is purchased using a significant amount of borrowed funds, with the acquired company's assets often serving as collateral. LBO allows buyers to minimize their capital risk while aiming for maximum returns. However, it also carries substantial risk if not handled properly. This article will explore the meaning of leveraged buyout, how it works, and the advantages and disadvantages of this acquisition strategy.

What is a Leveraged Buyout?

Leveraged buyout (LBO) model refers to an acquisition of a company using borrowed money (debt) to finance the purchase. The buyer itself only contributes a small portion of equity capital. Some reasons for using a leveraged buyout to acquire a company include privatizing a public company, improving a company's performance, and breaking up and selling a company. Leveraged buyout is different from management buyout, where the company's existing management purchases the company. The leveraged buyout acquirers are usually private equity firms or external investors.One key leveraged buyout metric is the debt-to-equity ratio, typically between 70% and 30%. This means the acquiring company invests 30% of the cost and borrows the remaining 70% to make the purchase. Private equity firms commonly use this method to buy companies with minimal equity capital while maximizing the potential return on investment (ROI). Leveraged buyout aims to acquire a company with borrowed money, improve its financial performance and operations over several years, and sell the company at a higher value to generate significant returns. 

How Does Leveraged Buyout Work?

A leveraged buyout model works by acquiring a target company by borrowing funds to minimize personal capital investment and maximize potential returns. Typically, the debt constitutes 70% to 90% of the total purchase price, while the remainder comes from the buyer's capital. The acquired company's assets and future cash flows are collateral to secure the loans used for the purchase. This means the company itself bears responsibility for repaying the debt. It allows the buyer to control the company by investing only a small amount of equity.Once the acquisition is finished, the new owners aim to improve the company's profitability by implementing operational efficiencies, reducing costs, and sometimes restructuring management. The company's steady cash flow is important to service the debt over time, gradually reducing the leverage (debt). After typically 3 to 7 years, the buyer will implement an exit strategy in their leveraged buyout strategy, meaning they will either sell the improved company at a higher price or take it public, generating substantial returns on the initial equity invested.

Advantages and Disadvantages of Leveraged Buyout

As an acquisition strategy, leveraged buyout offers various advantages and disadvantages, such as:

Advantages of Leveraged Buyout

• High Returns on Investment (ROI): LBOs allow acquiring companies to use a small equity portion combined with significant debt. If the company performs well, this will amplify returns on equity.
• Operational Improvement: LBO provides opportunities to improve efficiency and profitability by restructuring operations, cutting unnecessary costs, and replacing management to enhance company performance.
• Potential for Margin Expansion: After paying down debt and improving business operations, the company can be sold later at a higher business valuation, generating capital gains for investors.
• Acquisition with Minimal Capital: The buyer can control larger companies by leveraging debt, avoiding the need for large upfront capital when acquiring.

Disadvantages of Leveraged Buyout

• High Financial Risk: LBO increases financial risk, especially if the buyer uses the acquired company's assets as collateral. The large amount of debt also poses a significant risk. The acquired company can face bankruptcy if it fails to generate enough cash flow.
• Reduced Operational Flexibility: Debt financing usually imposes strict repayment terms and covenants, which can limit a company's ability to adapt its strategy or freely invest in growth opportunities.
• Potential for Business Failure: If operational improvements don't materialize as planned or market conditions deteriorate, the company can struggle with its debt burden, potentially reaching the brink of failure.
• Minimal Financial Cushion: The heavy debt load often leaves the company with little financial buffer to manage future downturns or unexpected problems. This can expose the company to significant vulnerability.

How to Do a Leveraged Buyout?

The process of a leveraged buyout is as follows:

Identify a Target Company

First is finding a suitable company to acquire. Investors typically look for mature and profitable companies that generate steady cash flow. This is important as the company needs enough cash flow to cover the large debt payments. The target company is usually undervalued or has the potential to improve operations and profitability in the coming years.

Structure the Financing

Next is structuring the financing for the acquisition. Most of the purchase is financed with debt; a smaller equity portion comes from the buyer. The debt can include senior, mezzanine, seller financing, bonds, or asset-based debt. The company's assets often serve as collateral for the debt. The high leverage enables the buyer to make a large acquisition without committing a large amount of cash upfront.

Conduct Financial Due Diligence

The buyer and the lenders conduct detailed due diligence to confirm the target company's financial health, cash flow, and risks. This involves reviewing financial statements, profit margins, and market position to ensure the company can support the debt load. Once finished, legal documentation is prepared to finalize the purchase agreement with the seller and the loan agreements with lenders.

Complete the Acquisition

After finalizing financing and agreements, the buyer completes the acquisition by taking control of the target company. The private equity firm or buyer sets an operational plan in motion to improve the company's profitability. This can include cutting costs, restructuring management, improving operational efficiencies, and expanding into new markets

Manage Debt and Improve Company Value

After acquisition, the main focus is to use the company's cash flow to pay down the leveraged debt over time while simultaneously improving profit margins through operational improvements. The goal is to increase the company's value by growing earnings and cash flow and optimizing the capital structure.

Plan and Execute an Exit Strategy

After a holding period typically between 5 to 7 years, the buyer aims to exit the investment profitably by selling the company either to another company, to another private equity firm, or through an initial public offering (IPO). The exit price ideally reflects a higher valuation multiple than at purchase, allowing investors to realize strong returns on equity.

Phintraco Natha Kapital: Powering Innovation Through Investment and Expertise

A leveraged buyout can be a turning point in any company's journey. With Phintraco Natha Kapital, this turning point can become a path to growth and innovation. As an investment firm, Phintraco Natha Kapital not only provides capital, but also strategic guidance and access to a huge network of industry experts. With a strong foundation in ICT and a growing portfolio in property, manufacturing, and education, we invest in promising businesses that are ready to scale.  Whether you’re an established company seeking leverage to grow or a tech-focused venture looking for a trusted partner, Phintraco Natha Kapital offers the experience and resources to elevate your business. At Phintraco Natha Kapital, we invest in ideas, in execution, and most importantly, in people.Editor: Irnadia Fardila