How are leveraged buyouts financed?

A leveraged buyout (LBO) is a type of acquisition in the business world whereby the vast majority of the cost of buying a company is financed by borrowed funds. LBOs are often executed by private equity firms who attempt to raise as much funding as possible using various types of debt to get the transaction completed. Although the borrowed funds can come from banks, the capital can come from other sources as well.

Understanding How Leveraged Buyouts Are Financed

Leveraged buyouts allow companies to make large acquisitions without having to commit significant amounts of their own capital or money. Instead, the assets of the company being acquired help to make an LBO possible since the acquired company’s assets are used as collateral for the debt. However, the assets of the acquiring company can also be used as collateral.

LBOs carry a higher level of risk than other financial transactions considering the significant amounts of debt involved. If the combined companies can’t meet their debt obligations using the combined cash flow of the two companies, the company being acquired could go bankrupt. In some cases, both the acquiring company and the company being purchased can go bankrupt.

Private Equity Sponsor

The private equity firm is typically the private equity sponsor, meaning the firm earns a rate of return on their investment. A private equity firm represents funds from investors that directly invest in buyouts of publicly-traded companies as well as private companies.

A key feature of an LBO is that the borrowing takes place at the company level, not with the equity sponsor. The company that is being bought out by a private equity sponsor essentially borrows money to pay out the former owner.

However, being the private equity sponsor also provides cash upfront for the transaction. The amount of capital committed by the sponsor could be 10% of the LBO price while in some transactions, the upfront funds can be as high as 50% of the LBO price. The amount of money paid upfront by the sponsor can vary depending on the ability to obtain financing to cover the cost of the acquisition.

Bank Financing

A private equity sponsor often uses borrowed funds from a bank or from a group of banks called a syndicate. The bank structures the debt using a revolving credit line or revolving loan, which can be paid back and drawn on again when funds are needed. Banks more commonly use term debt, which is a fixed-rate business loan.

The bank can establish several funding tranches when lending the money to the company for the LBO as well as working capital needs afterwards. Working capital is the cash needed for day-to-day operations. Banks can also use a combination of financing solutions whereby a term loan is used to fund the LBO cost, and a working capital credit line is established to help fund operations.

Bonds or Private Placements

Bonds and private notes can be a source of financing for an LBO. A bond is a debt instrument that a company can issue and sell to investors. Investors pay cash upfront for the face value of the bond and in return, get paid, an interest rate until the maturity date or expiration of the bond.

Bonds are offered through a private placementwhich is an offering or sale of the debt instruments to pre-selected investors. A bank or bond dealer acts as an arranger in the bond market on behalf of the company being sold, assisting the company in raising the debt on the public bond market.

Mezzanine, Junior, or Subordinated Debt

Subordinated debt (also called mezzanine debt or junior debt) is a common method for borrowing during an LBO. Mezzanine financing is a method of obtaining funding without offering collateral. However, mezzanine financing often requires a higher interest rate and warrants or options to be issued. The warrants or options provides the buyer with additional benefits in the case of default.

Mezzanine debt carries a lower priority, meaning it’s subordinate to bank loans when it comes to being repaid in the event of bankruptcy or liquidation. Mezzanine financing often takes place in conjunction with senior debt, such as the bank financing or bonds described above, and has features that are both equity-like and debt-like.

Seller Financing

Seller financing is another means of financing an LBO. The exiting ownership essentially lends money to the company being sold. The seller takes a delayed payment (or series of payments), creating a debt-like obligation for the company, which, in turn, provides financing for the buyout.