What is a Leveraged Buy Out?
A leveraged buyout (LBO) is simply when one company acquires another company using a significant amount of borrowed money to meet the cost of acquisition.
Do they always use cash to acquire?
Sometimes the acquiring company uses the assets of the target company along with their own assets as collateral for the loans.
The overall burden of financing the acquisition is reduced because normally equity has a lower cost than capital [the money needed to buy an asset],
The cost of debt is also lower because interest payments often reduce corporate income tax liability, whereas dividend payments normally do not. This reduced cost of financing allows greater gains to accrue to the equity, and, as a result, the debt serves as a lever to increase the returns to the equity.
The term LBO is usually employed when a financial sponsor acquires a company. However, many corporate transactions are partially funded by bank debt, thus effectively also representing an LBO. LBOs can have many different forms such as management buyout (MBO), management buy-in (MBI), secondary buyout and tertiary buyout, among others, and can occur in growth situations, restructuring situations, and insolvencies.
LBOs mostly occur in private companies but can also be employed with public companies (in a so-called PtP transaction – Public to Private).
As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition.
This has, in many cases, led to situations in which companies were “over-leveraged”, meaning that they did not generate sufficient cash flows to service their debt, which in turn can lead to insolvency or to debt-to-equity swaps in which the equity owners lose control over the business to the lenders.
What is Capital?
Capital in the usual context of accounting and finance means the amount of funds that is contributed by the owners or investors of the business, to purchase assets or capital equipment required for the running of the business.
What is Equity?
Equity represents the claim that shareholders have, once the liabilities have been reduced from business assets. When assets exceed liabilities, positive equity exists and in the case that liabilities are higher than assets, the company will have a negative equity.
So, if the value of assets is higher than the debt owed on the asset there is positive equity.
Here is an example
A house for which no debt remains [no mortgage] The current sales value of the house is the owner’s equity.