Corporate Finance, 4th Edition

Chapter 46Leveraged buyouts (LBOs)

Leverage on management!

A leveraged buyout (LBO) is the acquisition of a company by one or several private equity funds who finance their purchase mainly by debt. Most of the time, LBOs bring improvements in operating performance as the management is highly motivated (high potential for capital gains) and under pressure to rapidly pay down the debt incurred.

Why are financial investors willing to pay more for a company than a trade buyer? Are they miracle workers? Watch out for smoke and mirrors. Value is not always created where you think it will be. Agency theory will be very useful, as the main innovation of LBOs is new corporate governance, which, in certain cases, is more efficient than that of listed or family companies.

Section 46.1 LBO structures

1/ Principle

The basic principle is to create a holding company, the sole purpose of which is to hold financial securities. The holding company borrows money to buy another company, often called the “target”. The holding company will pay interest on its debt and pay back the principal from the cash flows generated by the target. In LBO jargon, the holding company is often called NewCo or HoldCo.

Operating assets are the same after the transaction as they were before it. Only the financial structure of the group changes. Equity capital is sharply reduced and the previous shareholders sell part or all of their holding.

From a strictly accounting point of view, this setup makes it possible ...