You hear the term in the news often enough, but knowing what a leveraged buy out (LBO) is may have been beyond you until know. Simply put, a leveraged buy out involves the purchase of a company while using a large amount of borrowed funds. It is common that the assets of the purchased firm will be used as collateral for the borrowed funds as well as the assets of the purchasing company. This allows the company making the purchase to acquire large items without committing significant amounts of capital.
By using the strategy of a leveraged buyout the purchaser may put down as little as 10% equity. Not considered investment grade purchases, LBOs have a reputation of leading to eventual bankruptcies when managed poorly. The higher the leverage ratio the more likely bankruptcy is. LBO is considered a hostile maneuver since the company’s own assets are used against it as collateral by the opposing firm. If the bonds used in the purchase are not repaid the LBO may be challenged by the creditors under the belief that the transaction was a fraudulent transfer.
The size of a company has little to do with its vulnerability to a leveraged buy out. There are certain characteristics which are common to companies which are in danger of such a maneuver:
- A stable history with recurring cash flow
- Low debt loads
- Market conditions which make the stock appear depressed
- Significant hard assets which can be used for collateral
- The potential for new management to restructure after the leveraged buy out (LBO) is complete to increase profits