What is a Leverage Buyout (LBO)?

Welcome to the Investors Trading Academy talking
glossary of financial terms and events. Our word of the day is “Leverage Buyout”
The use of a target company’s asset value to finance most or all of the debt incurred
in acquiring the company. This strategy enables a takeover using little capital; however,
it can result in considerably more risk to owners and creditors. See also hostile leveraged
buyout, reverse leveraged buyout. Case Study Leveraged buyouts known as an LBO
became popular in the 1980s when firms such as Beatrice Companies, Swift, ARA Services,
Levi Strauss, Jack Eckerd, and Denny’s were acquired and then were taken private.
With an LBO, a firm’s management often borrows funds using the firm’s assets as collateral.
The borrowed money is used to purchase the entire firm’s outstanding stock. As a result,
a small group of individuals is able to take control of the firm without using any or much
of the group members’ own money. Following the buyout the new owners frequently
attempt to cut costs and sell assets in order to make the increased debt more manageable.
Because the group initiating the LBO must pay a premium for the stock over the market
price, an LBO nearly always benefits the stockholders of the firm to be acquired. However, investors
holding bonds of the acquired company are likely to see their relative position deteriorate
because of the increased debt taken on by the company. For example, the leveraged buyout
of R. H. Macy & Co. produced a $16 jump in the price of its common stock at the same
time the price of its debt securities fell. Most bondholders have no recourse to the increased
risks they face because of the greater resultant debt.

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