The majority of the private equity firms we know and love founded their businesses by focusing on leveraged buyouts. Sounds good, you might think, but what is a leveraged buyout? Read on for a brief intro to LBOs, their advantages and risks, and how the market looks today.

What is an LBO?

At heart, an LBO is simply the purchase of a company using debt.

Its defining characteristic, though, is that it’s the acquired company that takes on the debt, while the acquirer (usually a private equity firm) puts some money down and takes a significant ownership stake.

Flickr / liza31337.

Back when LBOs first became popular, it was common to buy a large company and split it up into pieces, which were resold individually for a higher total price than the original company was worth. The media like to make it sound like this strategy was fueled by cruelty and greed, but in fact it was a direct result of the corporate world’s over-enthusiasm for empire-building in the 1960s.

Empires are great if they can operate well; unfortunately, unlike the super-size meal, many companies don’t get better as they get bigger. This created ample opportunity for the so-called corporate raiders of the 1970s and 1980s to split companies into more profitable individual parts and pocket the profits.

Nowadays, a private equity firms usually buy companies in order to make them operate better. They might invest in different lines of business, help improve operational efficiency, or restructure the company to avoid (or exit) bankruptcy.

Why Would You Choose an LBO? 

An LBO is a lot like buying a house: You put down some cash as equity (in the case of an LBO, it can range anywhere from 10% to 40%) and borrow the balance, which is backed either by hard assets or by future cash flows, or a combination of both. Just like buying a house with a mortgage, if the value of the company goes up, your returns are amplified.

In other words, you have the financial know-how to take a large company and improve it, you can make pretty handy returns in this fashion. It’s even better because you as the investor are not taking on the debt liability — it’s the company that shoulders that burden.

What are the Risks? 

Of course, the other side of the leverage coin is that if things go sour, they can go very sour. While you aren’t the one holding the total debt if something terrible happens (recession, litigation, what have you), you can still lose money and valuable investor capital. Your acquired, for its part, can quickly slide into insolvency — especially if too much leverage was taken. This can happen because of greed, excess liquidity, or both.

Flickr / flattop341.

The financial crisis provides a good example: Low interest rates and low yields on corporate debt fueled a boom in the LBO market. With so much demand for borrowers, credit standards dropped, leverage increased, and structures like payment-in-kind bonds, which allow the adding of interest to the principal instead of paying in cash, became very popular.

Then the crisis came, and the result was a wave of defaults that affects us to this day. Fitch, the ratings agency, estimates that LBO defaults stemming the 2004-2007 period affected $120 billion in bonds and loans as of May 2014, out of a total of nearly $500 billion in transactions.

The Current Environment 

Despite the fallout from the financial crisis, leveraged lending and buyout activity has grown again in the last few years. We have many of the same factors in play that contributed to the pre-crisis boom, including low interest rates, low yields on corporate and high-yield bonds, and a lot of liquidity.

Banking regulators like the Fed and the Office of the Comptroller of the Currency (OCC) are getting worried: While it’s private equity firms that put down equity and organize financing, it’s regulated banks that typically provide the funding for these transactions.

Flickr / laurenkerns.

So far this year, 40% of buyouts have used more debt than the six-times EBITDA level considered by the Fed and OCC to be a reasonable ceiling. The last time this threshold was surpassed was in 2007, when over 50% of loans employed so much leverage.

As a result, bank financing activities are being targeted by regulators, and more stringent rules for debt ceilings will likely be enacted this year. The implications? More lending by non-US banks and by shadow banks, or unregulated financial institutions. Both are already on the rise: American banks have been sitting out major transactions, and so far this year 26% of leveraged buyout activity has been funded by shadow banks.

In other words, the leveraged buyout space might change shape, but it’s very unlikely to go away anytime soon — so long as there are companies to acquire and willing financiers to provide credit.

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