The Only Guide to Alternative Investments You'll Ever Need: The Good, the Flawed, the Bad, and the Ugly

Chapter 16. Leveraged Buyouts

Leveraged Buyouts (LBOS) involve a private equity firm purchasing a public company, after which it generally takes it private. When making its acquisitions, the private equity fund typically employs minimal amounts of its own equity, while using unusually large levels of debt. Hence, the term leveraged buyout. The high leverage creates the opportunity for incremental returns (when the acquired company is sold again) on the limited amount of equity.

Investment consultants Cambridge Associates studied the performance of more than 300 buyout funds, for the twenty-year period ending June 2003, and found that the average fund produced a mean return of 11.5 percent per year, while S&p 500 Index returned 12.2 percent per year. However, although investors in LBOs were, on average, receiving below-market returns, they were also taking far greater risk. This greater balance-sheet risk was created by a combination of the leverage and the loss of liquidity (the lack of daily access to their assets that investors enjoy in mutual funds).^[154]

A study by the Yale University Investments Office provides additional insight into how the use of a similar amount of leverage outside of an LBO would have boosted the 12.2 percent return of the S&p 500. The study examined 542 buyout deals concluded between 1987 and 1998 and found that the net returns were 36 percent per year—well above the 17 percent return produced by a comparably timed and sized investment in the S&p 500. However, ...