Leveraged buyout

What it means

An LBO, or leveraged buyout, is an acquisition financed mainly with debt that is repaid after the purchase from the cash flows of the acquired company. The buyer puts in only a smaller part of the price from its own funds, and the rest is covered by bank loans, mezzanine finance or bonds.

Typically a special purpose vehicle borrows the money and buys the stake in the target. The SPV formally carries the debt, but repayments come from dividends or, after a merger, directly from the target's cash. Private equity funds frequently use this structure.

The logic of an LBO rests on financial leverage. If the company generates stable cash flow and its value can be increased, the return on the equity invested is far higher than if it were bought with own money alone. Losses are magnified in the same way when results deteriorate.

How it works in practice

In acquisition finance, banks look mainly at the ratio of debt to EBITDA, debt service capacity and the quality of management. Agreements include strict covenants, security over shares and the target's assets, and restrictions on dividends and further borrowing.

A good candidate is a mature company with stable revenue, low investment needs and little existing debt, for example a business going through succession when the owner steps back. Management often joins the purchase with its own contribution, which is known as a management buyout.

Thorough due diligence is essential before the deal, including cash flow modelling under different scenarios. After the purchase the SPV is often combined with the target through a merger so that debt and cash sit in one company, which has legal and tax consequences.

What to watch out for

Tax deductibility of interest is limited. For loans from related parties the thin capitalisation rules apply, and when the SPV merges with the target the tax authority examines whether the interest relates to taxable income. The structure should therefore be reviewed with a tax adviser in advance.

If the target secures or repays a loan used to acquire its own shares, the rules on financial assistance and capital maintenance apply. Overly aggressive leverage can push the company into crisis, and directors are liable if a deteriorating situation is not dealt with in time.