A leveraged buyout (LBO) is a financial transaction in which a company is purchased with a

combination of equity and debt, such that the company's cash flow is the collateral used to secure
and repay the borrowed money. The use of debt, which has a lower cost of capital than equity,
serves to reduce the overall cost of financing the acquisition. The cost of debt is lower because
interest payments reduce corporate income tax liability, whereas dividend payments do not.[1] 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.[2]
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 led to insolvency or
to debt-to-equity swaps in which the equity owners lose control over the business to the lenders.[1]

Contents
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 1Characteristics
 2History
o 2.1Origins
o 2.21980s
o 2.3Age of the mega-buyout
 3Management buyouts
 4Secondary and tertiary buyouts
 5Failures
 6Popular references
 7See also
 8Notes
 9External links

Characteristics[edit]
LBOs have become attractive as they usually represent a win-win situation for the financial sponsor
and the banks: the financial sponsor can increase the rate of returns on his equity by employing the
leverage; banks can make substantially higher margins when supporting the financing of LBOs as
compared to usual corporate lending, because the interest chargeable is that much higher. Banks
can increase their likelihood of being repaid by obtaining collateral or security.[1]
The amount of debt that banks are willing to provide to support an LBO varies greatly and depends,
among other things, on:

 The quality of the asset to be acquired (stability of cash flows, history, growth prospects, hard
assets, etc.)
 The amount of equity supplied by the financial sponsor
 The history and experience of the financial sponsor
 The overall economic environment
For companies with very stable and secured cash flows (e.g., real estate portfolios with rental
income secured with long-term rental agreements), debt volumes of up to 100% of the purchase
price have been provided. In situations of "normal" companies with normal business risks, debt of
40–60% of the purchase price are usual figures. The possible debt ratios vary significantly among
the regions and the target industries.
Depending on the size and purchase price of the acquisition, the debt is provided in different
tranches.

 Senior debt: This debt is secured with the assets of the target company and has the lowest
interest margins
 Junior debt (usually mezzanine): this debt usually has no securities and thus bears higher
interest margins
In larger transactions, sometimes all or part of these two debt types is replaced by high yield bonds.
Depending on the size of the acquisition, debt as well as equity can be provided by more than one
party. In larger transactions, debt is often syndicated, meaning that the bank who arranges the credit
sells all or part of the debt in pieces to other banks in an attempt to diversify and hence reduce its
risk. Another form of debt that is used in LBOs are seller notes (or vendor loans) in which the seller
effectively uses parts of the proceeds of the sale to grant a loan to the purchaser. Such seller notes
are often employed in management buyouts or in situations with very restrictive bank financing
environments. Note that in close to all cases of LBOs, the only collateralization available for the debt
are the assets and cash flows of the company. The financial sponsor can treat their investment as
common equity or preferred equity among other types of securities. Preferred equity can pay a
dividend and has payment preferences to common equity.
As a rule of thumb, senior debt usually has interest margins of 3–5% (on top of Libor or Euribor) and
needs to be paid back over a period of 5 to 7 years; junior debt has margins of 7–16%, and needs to
be paid back in one payment (as bullet) after 7 to 10 years. Junior debt often additionally
has warrants and its interest is often all or partly of PIK nature.
In addition to the amount of debt that can be used to fund leveraged buyouts, it is also important to
understand the types of companies that private equity firms look for when considering leveraged
buyouts.
While different firms pursue different strategies, there are some characteristics that hold true across
many types of leveraged buyouts:

 Stable cash flows - The company being acquired in a leveraged buyout must have sufficiently
stable cash flows to pay its interest expense and repay debt principal over time. So mature
companies with long-term customer contracts and/or relatively predictable cost structures are
commonly acquired in LBOs.
 Relatively low fixed costs - Fixed costs create substantial risk for Private Equity firms because
companies still have to pay them even if their revenues decline.
 Relatively little existing debt - The "math" in an LBO works because the private equity firm adds
more debt to a company's capital structure, and then the company repays it over time, resulting
in a lower effective purchase price; it's tougher to make a deal work when a company already
has a high debt balance.
 Valuation - Private equity firms prefer companies that are moderately undervalued to
appropriately valued; they prefer not to acquire companies trading at extremely high valuation
multiples (relative to the sector) because of the risk that valuations could decline.
 Strong management team - Ideally, the C-level executives will have worked together for a long
time and will also have some vested interest in the LBO by rolling over their shares when the
deal takes place.

History[edit]
History of private equity
and venture capital

Early history

(origins of modern private equity)

The 1980s

(leveraged buyout boom)

The 1990s

(leveraged buyout and the venture capital bubble)

The 2000s

(dot-com bubble to the credit crunch)

 v
 t
 e
Main article: History of private equity and venture capital

Origins[edit]
Main article: Early history of private equity

The first leveraged buyout may have been the purchase by McLean Industries, Inc. of Pan-Atlantic
Steamship Company in January 1955 and Waterman Steamship Corporation in May 1955.[3] Under
the terms of that transaction, McLean borrowed $42 million and raised an additional $7 million
through an issue of preferred stock. When the deal closed, $20 million of Waterman cash and assets
were used to retire $20 million of the loan debt.[4]
Similar to the approach employed in the McLean transaction, the use of publicly traded holding
companies as investment vehicles to acquire portfolios of investments in corporate assets was a
relatively new trend in the 1960s, popularized by the likes of Warren Buffett(Berkshire Hathaway)
and Victor Posner (DWG Corporation), and later adopted by Nelson Peltz (Triarc), Saul
Steinberg (Reliance Insurance) and Gerry Schwartz (Onex Corporation). These investment vehicles
would utilize a number of the same tactics and target the same type of companies as more
traditional leveraged buyouts and in many ways could be considered a forerunner of the later private
equity firms. In fact, it is Posner who is often credited with coining the term "leveraged buyout" or
"LBO."[5]
The leveraged buyout boom of the 1980s was conceived in the 1960s by a number of corporate
financiers, most notably Jerome Kohlberg, Jr. and later his protégé Henry Kravis. Working for Bear
Stearns at the time, Kohlberg and Kravis, along with Kravis' cousin George Roberts, began a series
of what they described as "bootstrap" investments. Many of the target companies lacked a viable or
attractive exit for their founders, as they were too small to be taken public and the founders were
reluctant to sell out to competitors. Thus a sale to a buyer might prove attractive. Their acquisition
of Orkin Exterminating Company in 1964 is among the first significant leveraged buyout transactions.
In the following years the three Bear Stearns bankers would complete a series of buyouts including
Stern Metals (1965), Incom (a division of Rockwood International, 1971), Cobblers Industries (1971),
and Boren Clay (1973) as well as Thompson Wire, Eagle Motors and Barrows through their
investment in Stern Metals.[6] By 1976, tensions had built up between Bear Stearns and Kohlberg,
Kravis and Roberts leading to their departure and the formation of Kohlberg Kravis Roberts in that
year.

1980s[edit]
Main article: Private equity in the 1980s

In January 1982, former U.S. Secretary of the Treasury William E. Simon and a group of investors
acquired Gibson Greetings, a producer of greeting cards, for $80 million, of which only $1 million
was rumored to have been contributed by the investors. By mid-1983, just sixteen months after the
original deal, Gibson completed a $290 million IPO and Simon made approximately $66
million.[7] The success of the Gibson Greetings investment attracted the attention of the wider media
to the nascent boom in leveraged buyouts.[8] Between 1979 and 1989, it was estimated that there
were over 2,000 leveraged buyouts valued in excess of $250 billion[9]
In the summer of 1984 the LBO was a target for virulent criticism by Paul Volcker, then chairman of
the Federal Reserve, by John S.R. Shad, chairman of the U.S. Securities and Exchange
Commission, and other senior financiers. The gist of all the denunciations was that top-heavy
reversed pyramids of debt were being created and that they would soon crash, destroying assets
and jobs. [10]
During the 1980s, constituencies within acquired companies and the media ascribed the "corporate
raid" label to many private equity investments, particularly those that featured a hostile takeover of
the company, perceived asset stripping, major layoffs or other significant corporate restructuring
activities. Among the most notable investors to be labeled corporate raiders in the 1980s
included Carl Icahn, Victor Posner, Nelson Peltz, Robert M. Bass, T. Boone Pickens, Harold Clark
Simmons, Kirk Kerkorian, Sir James Goldsmith, Saul Steinberg and Asher Edelman. Carl
Icahn developed a reputation as a ruthless corporate raider after his hostile takeover of TWA in
1985.[11][12] Many of the corporate raiders were onetime clients of Michael Milken, whose investment
banking firm, Drexel Burnham Lambert helped raise blind pools of capital with which corporate
raiders could make a legitimate attempt to take over a company and provided high-yield
debt financing of the buyouts.[13]
One of the final major buyouts of the 1980s proved to be its most ambitious and marked both a high-
water mark and a sign of the beginning of the end of the boom that had begun nearly a decade
earlier. In 1989, KKR closed in on a $31.1 billion takeover of RJR Nabisco. It was, at that time and
for over 17 years following, the largest leverage buyout in history. The event was chronicled in the
book (and later the movie), Barbarians at the Gate: The Fall of RJR Nabisco. KKR would eventually
prevail in acquiring RJR Nabisco at $109 per share marking a dramatic increase from the original
announcement that Shearson Lehman Hutton would take RJR Nabisco private at $75 per share. A
fierce series of negotiations and horse-trading ensued which pitted KKR against Shearson Lehman
Hutton and later Forstmann Little & Co. Many of the major banking players of the day,
including Morgan Stanley, Goldman Sachs, Salomon Brothers, and Merrill Lynch were actively
involved in advising and financing the parties. After Shearson Lehman's original bid, KKR quickly
introduced a tender offer to obtain RJR Nabisco for $90 per share – a price that enabled it to
proceed without the approval of RJR Nabisco's management. RJR's management team, working
with Shearson Lehman and Salomon Brothers, submitted a bid of $112, a figure they felt certain
would enable them to outflank any response by Kravis's team. KKR's final bid of $109, while a lower
dollar figure, was ultimately accepted by the board of directors of RJR Nabisco.[14] At $31.1 billion of
transaction value, RJR Nabisco was by far the largest leveraged buyout in history. In 2006 and
2007, a number of leveraged buyout transactions were completed that for the first time surpassed
the RJR Nabisco leveraged buyout in terms of nominal purchase price. However, adjusted for
inflation, none of the leveraged buyouts of the 2006–2007 period would surpass RJR Nabisco.
By the end of the 1980s the excesses of the buyout market were beginning to show, with
the bankruptcy of several large buyouts including Robert Campeau's 1988 buyout of Federated
Department Stores, the 1986 buyout of the Revco drug stores, Walter Industries, FEB Trucking and
Eaton Leonard. Additionally, the RJR Nabisco deal was showing signs of strain, leading to a
recapitalization in 1990 that involved the contribution of $1.7 billion of new equity from KKR.[15]
Drexel Burnham Lambert was the investment bank most responsible for the boom in private equity
during the 1980s due to its leadership in the issuance of high-yield debt. Drexel reached an
agreement with the government in which it pleaded nolo contendere (no contest) to six felonies –
three counts of stock parking and three counts of stock manipulation.[16]It also agreed to pay a fine of
$650 million – at the time, the largest fine ever levied under securities laws. Milken left the firm after
his own indictment in March 1989.[17] On February 13, 1990, after being advised by United States
Secretary of the Treasury Nicholas F. Brady, the U.S. Securities and Exchange Commission (SEC),
the New York Stock Exchange, and the Federal Reserve, Drexel Burnham Lambert officially filed
for Chapter 11 bankruptcy protection.[17]