Leveraged buyouts - everything you need to know

Have you been thinking about your business exit strategy? If so, you’ve probably considered multiple options, from initial public offerings to liquidation.

But if you’re like many business owners, simply shutting the doors for good isn’t what you had in mind when you started your company. As Tony says, “business is for gladiators.” You put in the hard work, and you deserve a reward. If you are ready to sell and move to pursue your next passion, you may want to consider a leveraged buyout.

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What is a leveraged buyout?

A leveraged buyout, also called an LBO, is a financial transaction in which a company is purchased with a combination of equity and debt so the company’s cash flow is the collateral used to secure and repay the borrowed money. In other words, a leveraged buyout is when one company acquires another using a significant amount of financing, meaning the buyout is funded with debt. The company doing the acquiring in a leveraged buyout, typically a private equity firm, will use its assets as leverage. The assets and cash flows of the company that is being acquired (called the target company or seller) are also used as collateral and to pay for the financing cost.

The purpose of an LBO is to allow a company to make a major acquisition without committing a lot of capital. In the most typical leveraged buyout example, there is a ratio of 90% debt to 10% equity. While a leveraged buyout can be complicated and take a while to complete, it can benefit both the buyer and seller when done correctly.

Why do businesses use LBOs?

A leveraged buyout is often part of a mergers and acquisitions (M&A) strategy. They’re also sometimes used to acquire the competition and to enter new markets to help a company diversify its portfolio. Buyers like leveraged buyouts because they don’t have to put in very much of their own money, allowing them to report a higher internal rate of return (IRR). In short, LBOs allow firms better equity returns.

Why would a target company want to sell via LBO? It’s actually a relatively common method for selling a business. The seller is able to get the price they want for the business and has a way to exit the company with a solid plan in place. A leveraged buyout is an ideal exit strategy for business owners looking to cash out at the end of their careers.

Here are some additional reasons why a business owner would consider a leveraged buyout:

1. To make a public company private

If you run a publicly traded company, you can use a leveraged buyout to consolidate the public shares and transfer them to a private investor who takes the shares off the market. The investors will then own a majority of or all of your company and will assume the debt liability of the transaction. For example, an LBO is useful if the business needs to be repackaged and returned to the marketplace after adjustments are made to make it more marketable. When the company is returned to the market as an initial public offering (IPO), it can be done so with fanfare, renewing the public’s interest in the company.

what is a leveraged buyout

2. To break up a large company

what is a leveraged buyout

Many business owners have used efficiency strategies to make their companies profitable and attractive to potential buyers. However, some companies grow so large and inefficient that it becomes more profitable for a buyer to use a leveraged buyout to break it up and sell it as a series of smaller companies. These individual sales should be more than enough to pay off the loan of purchasing the company as a whole. If you have a company with different target markets for various products, this might be a good option. An LBO of this type can then give the smaller companies a better chance to grow and stand out than they would have had as part of an inefficient conglomerate.

3. To improve a company that is underperforming

If an investor believes your company could eventually be worth much more than it is currently, a leveraged buyout could be a good option. The investor would assume the debt with the belief that holding onto the company for a certain amount of time will increase its value and allow them to pay off the debt and make a profit. In this type of leveraged buyout, you as the business owner would want to exit the company before it becomes profitable, but not sacrifice the profit that is likely to come in the future. Taking the LBO money from the purchaser helps you realize part of that profit now so you can turn your sights to other ventures.

what is a leveraged buyout

4. To acquire a competitor

what is a leveraged buyout

Another common leveraged buyout occurs when a smaller company wants to be acquired by a larger competitor. This allows the smaller company to grow dramatically and can help them gain new customers and scale more quickly than they would be able to without the acquisition. Typically, the acquiring company will keep your key staff in place so you don’t have to worry that the team you carefully chose will be left without a job. This can be a good way to bring other investors and knowledgeable leaders on board and take advantage of peer elevation.

With a more robust and varied team in place, you can take a previously underperforming company to new levels if you want to stay on with the company. Many business owners sell their company via a leveraged buyout but stay on as a consultant to retain connections and help the business continue to grow. Other business owners use an LBO as a way to exit the company completely to pursue one where they have more passion as well as profitability.

Benefits of leveraged buyouts

LBOs have clear advantages for the buyer: they get to spend less of their own money, get a higher return on investment and help turn companies around. They see a bigger return on equity than with other buyout scenarios because they’re able to use the seller’s assets to pay for the financing cost rather than their own. An LBO can also lower a business’ taxable income, so that the buyer realizes tax benefits they didn’t have before.

For the seller, one of the main advantages of a leveraged buyout is the ability to sell a business that might not be at its peak performance but still has cash flow and the potential for growth. If an LBO improves a company’s market position – or even saves it from failure – the shareholders and employees stand to benefit. If the buyer is the current management, employees can also benefit from executives that are now more engaged in the business, because they own a larger stake. A leveraged buyout also allows groups such as employees or family members to acquire a company, if, for example, the current owner is retiring, which can also lead to greater engagement. Finally, if the target company is privately held, the seller could realize tax advantages from the LBO.

Criticisms of leveraged buyouts

In a LBO, the same leverage that allows greater reward also comes with greater risk. For the buyer, there is little margin for error, and if they’re not able to pay back the debt, they’ll get no return at all. Depending on how the buyer defines risk and how risk-tolerant he or she is, this could be attractive or it could be a source of anxiety. 

The risks of a leveraged buyout for the target company are also high. Interest rates on the debt they are taking on are often high, and can result in a lower credit rating. If they’re unable to service the debt, the end result is bankruptcy. LBOs are especially risky for companies in highly competitive or volatile markets.

Aside from risk, there are several criticisms of leveraged buyouts that are worth considering. Because the company will often focus on cutting costs post-buyout in order to pay back the debt more quickly, LBOs sometimes result in downsizing and layoffs. They can also mean that the company does not make investments in things like equipment and real estate, leading to decreased competitiveness in the long term.

Another criticism of LBOs is that they can be used in a predatory manner. One way that this happens is when management of a company organizes an LBO to sell it back to themselves and gain short-term personal profit. Predatory buyers can also target vulnerable companies, take them private using an LBO, break them up and sell off assets – then simply declare bankruptcy and earn a high return. This is the tactic private equity firms used in the 1980s and 1990s that led to leveraged buyouts garnering a negative reputation.

Leveraged buyouts aren’t always predatory. But as with any business decision, it’s important to consider all the pros and cons before signing on the dotted line.

Leveraged buyout examples

 To truly understand what a leveraged buyout is, you can take a look at examples of both beneficial and failed LBOs. The $9 buyout of PetSmart in 2014 is one of the largest leveraged buyout examples. The buyout was performed by BC Partners, a British buyout firm that believed they could improve the company’s market share by capitalizing on its online platforms that had been previously neglected. They purchased Chewy.com in 2017 and took it public in 2019, raising nearly $1 billion.

Another example of a leveraged buyout comes in the form of the 1986 Safeway deal, where Kohlberg Kravis Roberts (KKR) completed the friendly deal for a price of $5.5 billion. Safeway’s board of directors consented to avoid a hostile takeover from Herbert and Robert Haft of Dart Drug. The buyout was funded mostly with debt and the agreement that Safeway would divest some assets and close underperforming stores. When Safeway was taken public in 1990 after many improvements, KKR earned almost $7.3 billion on their initial investment that totaled approximately $129 million.

Leveraged buyouts can even be successful in economic downturns. Just look at the example of Blackstone’s LBO of Hilton Hotels in 2007 – right before the financial crisis. The economy plummeted and travel was especially hard-hit. Blackstone initially lost money, but it survived thanks to its focus on management and debt restructuring. In 2013, Blackstone went public to the tune of $12 billion. Today it’s one of the most successful LBOs ever.

But leveraged buyouts haven’t always been successful. Because they have high debt-to-equity ratios, there’s a high risk of failure. One of the most famous examples of an LBO gone wrong is Macy’s.

In 1985, Macy’s executives organized a leveraged buyout that at the time was the largest in the history of retail. At the time, financial analysts thought it would benefit the company – but instead, it piled on debt that the company couldn’t pay off. In 1992, with $6 billion in debt, Macy’s filed for bankruptcy. However, they did eventually bounce back, enjoying profitability for several decades before falling sales recently led to more troubles – this time not related to leveraged buyouts.

Is my company a good candidate for a leveraged buyout?

There are five typical phases in the life cycle of a business. Knowing which phase your company is in can help you decide whether a leveraged buyout is the right option or if you should postpone selling.

The first phase is the launch phase, where sales are typically low but increasing. In the second phase, called the growth phase, sales increase rapidly and you begin making a profit. This is the stage where you hone your offerings and attempt to make your business talkably different. In the third stage, the shake-out, sales peak or grow slowly and profits decrease due to new competitors entering the market and market saturation. Maturity, the fourth stage, is where many businesses begin to stagnate and profit margins get thinner. Some business owners are able to extend this stage of the cycle by using constant strategic innovation or entering new markets. The fifth and final phase is decline, which is marked by shrinking profits and sales and usually ends with the business owner getting out of the market.

Whether your business is at peak performance and you want to capitalize or your business is reaching the fifth stage of the life cycle and you’re thinking about retirement, an LBO could be a good option for you. LBOs provide a means of exit that is realistic for many companies.

Selling your company through a leveraged buyout

Thinking about selling your company through a leveraged buyout? If your business has a positive balance sheet, you’re on the right track. This means you have things like tangible assets, good working capital and positive cash flows. Having a positive balance sheet means lenders are more likely to lend to you. Firms looking to acquire companies through a leveraged buyout typically also look for proven management and a diverse, loyal customer base. They’ll want to see ways to reduce costs quickly, selling off non-core assets or finding synergies.

Your company doesn’t have to be operating at maximum performance in order to be a good candidate for a leveraged buyout. Companies that may be struggling due to a recession in their industry or poor management but still have positive cash flow are also good LBO candidates. Investors may see an opportunity to create efficiencies and improve the business and therefore be interested in acquiring it.

Making the decision to consider a leveraged buyout of your company is not something to be taken lightly. You need to decide why you started the business in the first place and if you’ve attained the goals you want to achieve. How will you feel once you sell? Do you have a plan in place for your next endeavor or, if you’re at retirement age, do you have enough in the bank or investments to unlock the extraordinary life you desire for your golden years?

Ultimately, if you’re asking yourself, “What is a leveraged buyout and would it work for my company?,” you could benefit from working with a business coach who can help you consider all angles and make the best decision for you and your company. A business coach can look at the prospect objectively and without the emotion that you as the business owner will bring to the decision. With their help, you can make a solid decision that is best for your future.

Despite some bad press in recent years, a leveraged buyout is a viable exit strategy in many situations. As with any business decision, weigh the pros and cons before making your decision. With a little intuition, a lot of research and the help of a business coach, you’ll make the right choice and see significant personal and financial rewards.

Ready to sell your business successfully?

Learn about the advantages and disadvantages of a leveraged buyout, along with other exit strategies, by utilizing Tony Robbins’ Business Owner Evaluation Assessment.