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Leveraged Buyout

Leveraged Buyout (LBO) is the acquisition of a company where the acquisition is substantially financed by loans and debt. When the management of a company buys their company from their owners, it is called Management Buyout (MBO).
The purchase price has 70-90% of debt proportion and generally has a low credit rating. LBOs are popular in countries like the USA, UK. The sellers obtain debt on the basis of the company's future growth potentiate.
The key objective of LBS is to enhance wealth swiftly in a very short period of time. The acquirer will go public after few years and earn capital gains.

Targets for LBO:

The companies decide on characteristics that must be possessed by the acquired firms. Following are general targets for LBOs
Low operating risk: Companies that have a low business or operating risk are attractive for LBOs.
High Debt Capacity: Firms that have high debt capacity and high liquidity are preferred as there is less chance of insolvency.
High Profits: A firm that has high growth and profit earning potentials is also favored for LBO.

Risk and Rewards in LBO:

  • The leader in LBO assumes a high degree of risk because he has full confidence that buying company has strong management which will fully utilize the earning potential of the firm and transform it into a huge value. This is a reward for him.
  • The risk is assumed to be low. The risk for the lender is that the merged firm will collapse.
  • The lender safeguards himself against the risk by purchasing ownership position in the company in the future and retaining the right to change the ownership of buyers if the acquiring company does not manage the company well.
  • As there is a high risk, the lender demands high rewards in return. He also assumes that the merged firm will go for public offerings which will give him high capital gains.
  • There can be conflicts between the shareholders of the firm and the management of the acquiring firm. If the deal is very attractive then the shareholders will lose value. This is known as agency cost, which is a risk of LBO.
  • Another risk is that the debt instruments such as debentures and bonds may lose their value in the case of the target company. Because the value of debt instruments gets diluted, they demand protection in LBO/MBO such protection may include redemption at apr.
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