FINANCIAL MANAGEMENT : Leveraged buyouts (LBOs)
A leveraged buyout is a transaction whereby the purchase of a company is financed primarily with borrowed funds. A holding company contracts the debt and purchases the target company. The company's cash flow is regularly funnelled upstream to the holding company via dividends to enable the latter to pay interest and reimburse the loans.
An LBO is often a solution in a family succession situation or when a large group wants to sell off a division. It can also be a way for a company to delist itself when it is undervalued in the market.
The target company in an LBO may keep the current management in place or hire a new management team. Equity capital is provided by specialised funds, the LBO funds. The structure depends on several layers of debt – senior, junior, mezzanine – with different repayment priorities. As priority declines, risk and expected returns increase.
Increased gearing and the deductibility of interest expense do not satisfactorily explain why value is created in an LBO. Instead, it appears that the heavier debt burden motivates management to do a better job managing the company, of which they are often destined to become shareholders themselves. This is agency theory in action. LBO funds bring different and, most of the time, more efficient corporate governance policies than those of family companies or listed groups: they focus management teams on cash flow generation and value creation. This is why a company can remain under a LBO for years, with one LBO fund selling it to another.