Leveraged Buyout (LBO) Mechanics

LBOs: The Leveraged Playbook

How private equity uses debt to make big returns.

1. The Goal:

• Buy an undervalued or underperforming company.
• Improve it.
• Sell it for a huge profit (3-7 years).

2. The Money Stack:

• Equity (Small): The private equity firm’s own money (e.g., 20-40%). This is their skin in the game.
• Debt (Big!): A large amount of borrowed money (e.g., 60-80%). This is the “leverage.”
  • Senior Debt: Bank loans (lowest risk, lowest interest).
  • Mezzanine Debt: Hybrid debt/equity (higher risk, higher interest).

3. The Magic (Value Creation):

• Debt Paydown: Use the target company’s cash flow to pay down the debt. As debt shrinks, the equity piece becomes a larger slice of the pie.
• Operational Improvements: The PE firm streamlines operations, cuts costs, and boosts revenues to make the company more profitable.
• Multiple Expansion: Sell the improved company at a higher valuation multiple.

4. What Makes a Good LBO Target?

• Stable, predictable cash flows.
• Strong management team (or potential for improvement).
• Undervalued assets.
• Limited need for heavy R&D or CapEx.

Golden Rule: The high debt involved amplifies both the potential returns AND the risk. If the company’s cash flow struggles, the whole deal can fall apart.