How Are Leveraged Buyouts Financed?

A leveraged buyout (LBO) is an 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 that 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.

Key Takeaways

• A leveraged buyout is a type of acquisition whereby the cost of buying a company is financed primarily with borrowed funds. 
• LBOs are often executed by private equity firms who raise the funds using various types of debt to get the deal completed.
• Capital for an LBO can come from banks, mezzanine financing, and bond issues.

Financing Leveraged Buyouts

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

LBOs carry a higher level of risk than other financial transactions. That’s because of the significant amount of debt used to complete the transaction. If the combined companies can’t meet their debt obligations using the combined cash flow of the two companies, the acquired company could go bankrupt. In some extreme cases, both the acquiring company and the target firm can go bankrupt. 

Note

The assets of the acquiring company can be used as collateral in addition to those of the acquired company.

Private Equity Sponsor

The private equity firm is typically the private equity sponsor, meaning the firm earns a rate of return on its investment. A private equity firm represents funds from investors that directly invest in buyouts of private and public companies.

A key feature of an LBO is that borrowing takes place at the company level—not with the equity sponsor. The company 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 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 to the company for the LBO. It can also provide any working capital it needs once the transaction is completed. 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 placement, which is an offering or sale of 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, which is also called mezzanine or junior debt, is a common method for borrowing during an LBO. Mezzanine financing is a method of obtaining funding without offering collateral. However, it often requires a higher interest rate and warrants or options to be issued. The warrants or options provide 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 way to finance 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.

What Are Some Examples of Leveraged Buyouts?

Leveraged buyouts involve using debt to finance most, if not all of, the purchase of a company. Borrowing money to make an acquisition frees up the acquiring company’s capital for other purposes.

Some of the most famous real-world examples of leveraged buyouts include:

• Hilton Hotel, which was purchased by Blackstone in 2007 for $26 billion
• Nabisco, which was purchased by Kohlberg, Kravis, Roberts & Co. for $31 billion in 1989
• PetSmart, which was purchased by British private equity firm BC Partners for $9 billion in 2014

What Impact Do LBOs Have on Investors?

Leveraged buyouts can have a major impact on investors. If all goes well, an LBO can provide high returns for investors. Equity returns increase if the venture ends up performing as or better than expected. It also gives investors more control because the acquiring company uses debt rather than equity to fund the acquisition. But, there are drawbacks. Investors may not see the returns the expect if things go sour. There is also a financial risk if the company can’t repay the debt or if rates increase, making the borrowing costs higher.

What Was the Value of Leveraged Loan Activity in 2024?

Leveraged loan activity remained strong during the third quarter of 2024, amounting to $206.1 billion, but well below the $389.7 billion recorded in the second quarter of the year, according to Fitch Ratings.

The Bottom Line

Companies using borrowed capital to acquire other businesses do so through leveraged buyouts. Because they free up the acquiring company’s capital, companies can use their money for other purposes. If a venture works, it can boost returns for investors. But, they are considered predatory because the acquiring company may use the target’s assets as collateral. If things don’t work out, the target could lose its assets and go under.