Leveraged buyout (LBO)
During the 1980s, leveraged buyouts were considered the newest and greatest method of investing. Huge corporations were turned over by private equity investors, resulting in big headlines and massive financial scandals. The heydays of leveraged buyouts may be over, but they are still a viable form of investing in the private equity market, and are worth consideration.
A leveraged buyout (LBO) is defined when private investors acquire a company with limited equity but large amounts of debt. The assets of the company are utilized as the collateral in order to secure the borrowed debt to purchase the company. This can easily be seen in the purchase of a rental property, where the expected monthly rent payments are used as the collateral for the purchase loan, as well as the means to repay the loan.
The risks of these types of buyouts are large, e.g.:
- One potential risk is that, there is a high element of default on the initial debts, creating a vicious cycle. Investors are often apprehensive about investing in companies that have large amounts of existing debts.
- Another potential risk in leveraged buyouts is the initial investment required to “buy in” to a buyout is often large. There is generally a $5 million dollar fee associated with joining a buyout fund – so it is not the investment plan for everyone.
Many times the buyout is financed through a bank, which must consider the amount of debt the company already has, the amount of equity the investor has, the experience of the investor and the environment in the company’s field. When a bank participates in a LBO, it may parcel out portions of its debt to other investors, reducing the risk for the bank.
Leveraged buyouts are not for everyone. They require careful analysis and financial experience that not everyone is comfortable with. While recent guidelines have changed the availability of individual users to invest in LBO’s, people are still apprehensive about such large investments in a shaky market.
For every successful LBO, there are just as many unsuccessful ones, a warning to investors that just because it looks great doesn’t necessarily mean that it is a sure win.