Leveraged Buyout Theory

Aleveraged buyout is an acquisition of a company using a significant amount of debt to meet the cost of the acquisition. This allows for the acquisition of a business with less equity (out-of-pocket) capital. Think of a mortgage on a house. If you take out a mortgage to fund the purchase of a house, you can buy a larger house with less out-of-pocket cash (your down payment). Over time, your income will be used to make the required principal (and interest) mortgage payments; as you pay down those principal payments, and as the debt balance reduces, your equity in the house increases. Effectively, the debt is being converted to equity. And maybe you can sell the house for a profit and receive a return. This concept, on the surface, is similar to a leverage buyout. Although we use a significant amount of borrowed money to buy a business in an LBO, the cash flows produced by the business will hopefully, over time, pay down the debt. Debt will convert to equity, and we can hope to sell the business for a profit.

There are three core components that contribute to the success of a leveraged buyout:

1. Cash availability, interest, and debt pay-down.
2. Operation improvements.
3. Multiple expansion.


This is the concept illustrated in the chapter’s first paragraph. The cash being produced by the business will be used to pay down debt and interest. It is the reduction of debt that will be converted into the ...

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