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A leveraged buyout (LBO) is a purchasing arrangement in which the acquirer takes out a loan that is structured so that the buyout target's assets are used as collateral to obtain the loan.
In finance, to leverage is to be willing to assume debt in order to create a larger return on an investment (ROI). In a leveraged buyout, the ratio of debt to equity varies, but the debt can range from 100% of the purchase price to, more typically, 40% to 60% of the purchase price.
Borrowing against the buyout target's assets allows an acquirer to make a large purchase without having to put a lot of money up front. Because leveraged buyouts have been used in hostile takeovers, this type of deal structure has become associated with corporate raiding and has picked up a negative connotation.
Banks like LBO deals because the interest rates are much higher than in traditional corporate lending. But the deals also carry significant risk when, for example, the acquired company's assets have been over leveraged due to poor planning or economic conditions decline and the acquired company's assets can no longer cover the loan.
The amount of debt banks will provide in such deals depends upon a number of factors, including:
- the financial soundness of the acquired company; in particular, the stability of its cash flow and its capacity for growth
- the amount of equity backing from the acquiring entity and its financial reputation
- economic conditions
The type of debt used in these deals varies by industry and depends on where a deals is finalized. The financial structure of these deals, according to business historians, dates to the 1950s when McLean Industries borrowed millions to buy out two steamship companies. Financier Victor Posner of DWG Corp. is said to have coined the term LBO in the 1960s.
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