The term LBO comes from the English phrase Leveraged Buy-Out, which is often translated into French as acquisition par effet de levier (leveraged acquisition).
Although this mechanism was initially used to acquire publicly traded companies, it gradually became popular for acquiring SMEs, allowing buyers to achieve excellent returns on investment.
A look back in time
In 1987, the stock market experienced a dramatic crash—Black Monday. Having lost significant amounts of money, banks sought ways to replenish their funds and decided to invest heavily in their M&A (mergers and acquisitions) departments, which began structuring LBO deals to offer to clients.
At the same time, publicly traded companies had become relatively cheap due to the market decline. Some investors saw an opportunity to buy these businesses and take them private at attractive prices. Of course, few investors had enough capital to acquire all the shares of companies such as RJR Nabisco (known for brands like Snickers, Camel, Oreo, etc.) or Heinz (the famous ketchup brand). As a result, they had to rely heavily on debt—hence, the leverage effect.
How leverage works in practice
But what exactly is the leverage effect? Let’s take a concrete example.
Imagine Company A wants to purchase an asset. This asset could be a building, a production line, software, etc. In the specific case of an LBO, the acquired asset is a company. For our example, let’s say Company A wants to buy a building and rent it out.
The building is offered for €1,000,000 (for simplicity, we will omit registration fees). It generates an average annual net income (rent received minus expenses and taxes) of €40,000. Company A is debt-averse and decides to use its entire cash reserve to acquire the building. What is its return? It is calculated using the formula net income / invested equity (Return on Equity, ROE):
€40,000 / €1,000,000 = 4%.
Company B is also interested in the same building. Unlike Company A, it is comfortable with debt. Its bank agrees to lend it €600,000 at an annual interest rate of 2%, meaning Company B needs to invest only €400,000 of its own money. In the first year, it will pay €12,000 in interest (2% × €600,000). Since interest payments are tax-deductible, Company B will also reduce its taxable base by the same amount, saving €3,000 in taxes (assuming a 25% tax rate). The after-tax cost of the debt is thus:
€12,000 – €3,000 = €9,000.
The company’s net income is reduced by this amount, resulting in:
€40,000 – €9,000 = €31,000.
Now, let’s calculate the ROE:
ROE = €31,000 / €400,000 = 7.75%.
The risks of leverage
Great! So why not maximize debt and ask the bank to finance the entire investment?
Because higher debt means higher investment risk. In our example, let’s assume the net rental income is just enough to cover the loan payments with a small surplus. What happens if the building’s only tenant decides to leave and it takes six months to find a new one? The company would be unable to meet its loan payments, and the bank could demand that Company B be declared bankrupt.
Using leverage increases investment risk. This is a fundamental principle of finance: higher returns come with greater risk.
The art of structuring a good LBO
This is where structuring a good LBO becomes an art—optimizing debt to achieve the best balance between return and risk, depending on investors’ risk tolerance.
Of course, most business acquisitions involve debt and therefore some degree of leverage. However, an acquisition is not necessarily an LBO if the goal is not to optimize debt to enhance investment returns.
Three key questions about LBOs
Is structuring a good LBO easy? Just balance debt and equity, call the bank, and request a loan?
Unfortunately, no… There are numerous financial instruments available to optimize debt.
In our example, Company B could not increase its “traditional” debt because the net rental income wouldn’t support significantly higher loan repayments… unless the new debt was only repayable at maturity! If the company plans to buy the building, operate it for ten years, and then sell it, this could be a viable strategy. During this period, it would only pay interest, and when it sells the building, it would repay the principal.
Can any company be acquired through an LBO?
No. An LBO must be based on a solid cash flow plan. To execute a successful LBO, the target company must have stable and predictable cash flows.
How long does an LBO last?
That depends on the buyer. In the early years, the structure generates little to no excess cash flow. The buyer cannot distribute dividends because every euro earned is used to repay debt and interest. Once all debts are repaid, there are several options:
- Sell the company
- Take on new debt to distribute dividends to shareholders
- Enjoy the company’s high cash flows to pay shareholders over the following years
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