What is a leveraged buyout, really?Medium

A company is bought largely with money borrowed against the company itself — so the thing being purchased pays for most of its own purchase.

2 min read · 434 words

A fund buys a company. It puts in some of its own money and borrows the rest — and the borrowing is secured on the company being bought, not on the fund. That is the whole idea, and everything else follows from it.

Where the debt sits, and why it matters

After completion the loans are obligations of the acquired company. It pays the interest out of its own cash flow. If it cannot, the lenders' claim is against it, not against the fund that bought it.

So the fund's downside is the money it put in, and its upside is geared. That asymmetry is the business model, and it is legal, ordinary, and disclosed to the lenders who chose to lend.

Where the return actually comes from

Three places, and they can be separated — the calculator on the leveraged finance desk does exactly that:

• The earnings grew. The business is bigger or more profitable than it was.
• The multiple moved. It was bought at one valuation multiple and sold at a higher one. This is the market's doing, not the owner's.
• The debt was repaid. Cash generated by the company paid down the loan, so the equity is worth more even if nothing else changed.

Which of the three is largest is the entire argument about whether buyouts create value, and it differs deal by deal.

Why the price is set by the lenders

A buyer can only bid what the debt will support plus what it is willing to put in. So the ceiling on the price is a lending decision, and when interest rates move, every bid in the market reprices at once — which is why auctions stall in the same weeks across unrelated industries.

What changes for the company

• Cash goes to interest first. Investment that would have been made is the discretionary line, and it is what gets cut when things tighten.
• Reporting becomes lender-facing. Covenants are tested on defined measures, and the definitions are in the credit agreement.
• There is a clock. The debt matures on a date, and refinancing it depends on a market being open then — which is a risk nobody underwrites. A levered retailer is the case on that.

What it is not

It is not asset stripping by definition, and it is not a guarantee of failure. It is a funding structure that raises the return on a good outcome and removes the margin for a bad one. What it removes is time: a company with no debt can be wrong for three years, and a levered one frequently cannot.