Leveraged buyouts
A leveraged buyout (LBO) is the acquisition of a company using a large amount of borrowed money, typically by a private equity firm. The debt sits on the acquired company, and its cash flow is used to pay it down.
How it works
A private equity fund puts in equity (often 30-50% of the price) and borrows the rest from banks and credit funds. It owns the company for, typically, three to seven years, then sells it to another buyer, floats it or sells to another fund.
A simple example
| Entry | Exit (5 years) | |
|---|---|---|
| EBITDA | £100m | £150m |
| Multiple | 10x | 10x |
| Enterprise value | £1,000m | £1,500m |
| Debt | £600m | £300m (paid down from cash flow) |
| Equity | £400m | £1,200m |
| Return on equity | 3x, about 25% a year |
The company was bought for £1bn with £400m of equity. Five years later it is worth £1.5bn, and debt has been paid down to £300m, so equity is worth £1.2bn: three times the money. Without debt, the same improvement would have returned only 1.5x.
Where the returns come from
- Earnings growth: growing revenue and improving margins.
- Debt paydown: cash flow reduces debt, transferring value to equity.
- Multiple expansion: selling at a higher multiple than you bought at. Helpful, but not something to rely on.
What makes a good LBO target
Stable, predictable cash flows, low capital needs, a strong market position, room for operational improvement, and a price that isn't too high. Businesses with volatile cash flows can't safely carry the debt.
The risks
Leverage works both ways (lesson 1.7). If earnings fall or rates rise, interest can swallow the cash flow and the company can default. Critics argue that some buyouts load companies with debt, pay large dividends to owners and leave the business fragile. The famous 1989 buyout of RJR Nabisco by KKR, at around $25 billion, became a symbol of the excesses of the era. Higher interest rates since 2022 have made LBOs harder, because debt costs much more.
Key takeaway
An LBO is a bet that a company can carry more debt than the public market thinks, and use its cash to repay it while improving the business. When it works, returns are large. When it doesn't, the debt is unforgiving.
Educational content only, not financial advice. Investing involves risk and you can lose money.