Leveraged buyout

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A leveraged buyout (LBO) is the acquisition of a company using a significant proportion of borrowed money (leverage) to fund the acquisition with the remainder of the purchase price funded with private equity. The assets of the acquired company are often used as collateral for the financing, along with any equity contributed by the acquiror.^[1]

While corporate acquisitions often employ leverage to finance the purchase of the target, the term "leveraged buyout" is typically only employed when the acquiror is a financial sponsor (a private equity investment firm).

The use of debt, which normally has a lower cost of capital than equity, serves to reduce the overall cost of financing for the acquisition and enhance returns for the private equity investor. The equity investor can increase their projected returns by employing more leverage, creating incentives to maximize the proportion of debt relative to equity (i.e., debt-to-equity ratio). While the lenders have an incentive to limit the amount of leverage they will provide, in certain cases the acquired company may be "overleveraged", meaning that the amount of leverage assumed by the target company was too high for the cash flows generated by the company to service the debt.^[2] As a result, the increased use of leverage increases the risk of default should the company perform poorly after the buyout.^[3] Since the early 2000s, the debt-to-equity ratio in leveraged buyouts has declined significantly, resulting in increased focus on operational improvements and follow-on M&A activity to generate attractive returns.^[4]