A leveraged buyout is a highly financed buyout when the bidder uses financing to purchase the majority stake in a company. A company will secure the loan by using the collateral from the company they are looking to purchase. Leveraged buyouts end the bidder having to pay interest much like a conventional loan. This is why leveraged buyouts are viewed as more risky, because the acquired company will have to make enough money to cover the risks associated with taking the loan. There are no hard numbers on the debt ratio for securing financing, but on average a bidder must have between 15% – 50% cash on hand to receive financing.
The first leverage buyout occurred in January 1955, where McLean Industries, Inc. purchased Pan-Atlantic Steamship Company. In this arrangement, McLean borrowed $42 million and used $7 million in preferred stock to close the deal. The company then turned right around and used $20 million of cash and assets received from the deal to pay down debt.
A leverage buyout is a good choice for the following reasons:
Leverage buyouts appear to be simple enough, secure financing, purchase the company, and make boat loads of cash. The reality is that these deals are extremely complicated and carry extreme risks. Recently with lower interest rates, companies have been able to secure financing with as little as 5% cash on hand to secure the deal. This sort of over leverage leads to a situation where the bidder ends up carrying to much debt and any cyclical downturn could result in missed payments on the deal.