What is a leveraged buyout (LBO)?

What is a leveraged buyout (LBO)?

In a leveraged buyout, a buyer - commonly a private equity firm - acquires a target company by placing a substantial portion of the purchase consideration onto the target’s balance sheet as debt. The buyer then uses the target’s future cash flows or assets as collateral to service and eventually repay this debt.

LBOs became particularly popular in the 1980s with groundbreaking deals like the acquisition of RJR Nabisco by private equity firm, KKR. In today’s market, they remain a staple in private equity strategies, ranging from small, niche acquisitions to multi-billion-dollar transactions.

Why are LBOs used?

LBOs are attractive financing structures for private equity firms because the use of debt to purchase a company can significantly amplify investors’ return on equity (ROE) -typically measured by the internal rate of return (IRR). 

This structure also enables private equity firms to invest less of their own - and their investor’s capital - into a deal, allowing firms to fund and operate a larger set of companies than they would have been able to by financing each acquisition with only equity. Spreading out their capital leads to diversification for the firm and its investors, allowing them to gain exposure to more companies and industries.

How LBOs work

Executing an LBO requires robust due diligence and financial modeling to account for the risk profile of using significant debt for an acquisition. A private equity firm will typically follow the below steps in order to successfully close on an LBO transaction and operate the business to a successful exit. 

1. Target identification: The buyer looks for a business with strong, predictable cash flows and a leading market position, with growth potential and an experienced management team in place. Target companies will typically need to have a solid asset base for the buyer to use as collateral for debt financing. Industries that are common for LBO targets are manufacturing, real estate, healthcare, and certain consumer goods companies. 
2. Due diligence and financial modeling: The buyer rigorously evaluates the target’s financial performance, market position, and growth potential. The buyer also builds detailed financial models - most commonly an LBO model - and conducts a sensitivity analysis to forecast different outcomes based on changing assumptions and scenarios.
3. Financing structure: The buyer arranges debt financing (bank loans, high-yield bonds, or mezzanine financing) secured by the target’s assets and future earnings. In addition to securing debt capital for the acquisition, the buyer invests a portion of equity, creating the full “capital stack.” The target financing structure is specific to the buyer's LBO model and sensitivity analysis and is a key driver of financial returns and assumed risk in the acquisition. 
4. Deal execution: Once financing is secured, the buyer moves to finalize legal documentation, negotiate closing terms, and complete all necessary approvals before officially acquiring the target company. This phase involves close coordination between investment teams, legal counsel, lenders, and regulatory bodies to ensure a smooth transfer of ownership. 
5. Post-acquisition management: The buyer seeks to improve the company’s profitability. Over time, the focus is on strategic initiatives that enhance the business’s value—ultimately aiming to pay down the debt and achieve a higher valuation on exit. These initiatives may include restructuring the company, selling off certain assets, merging business units, or other changes. A buyer will typically operate the company for 5-7 years before seeking an exit opportunity to capitalize on their performance.

The financing structure of an LBO

While we know that LBOs use a high level of debt as part of the capital stack of a deal, not all debt has the same characteristics. Firms combine a variety of debt and equity sources to fund an LBO which can generally be broken down into the following categories:

• Senior debt: Typically the largest portion of the debt and the first to be repaid. It carries the lowest risk for lenders but may have stricter repayment terms and covenants. Senior debt typically comprises between 50-80% of the total capital stack of an LBO. 
• Junior or subordinated debt: Higher risk and lower priority of repayment if the target can’t meet its obligations, but it also carries a higher interest rate. Subordinated debt can comprise up to 20-30% of the total capital stack depending on the LBO model the buyer build in due diligence. 
• Mezzanine financing: A hybrid of debt and equity features. Often carries warrants or convertible securities.
• Equity contribution: The buyer injects a certain amount of equity, aligning their interest with the success of the business. This equity portion can be between 20-30% of the capital stack depending on the deal.  

Advantages and disadvantages of LBOs

Advantages

1. Higher potential returns: The strategic use of debt can magnify returns if the target’s value appreciates.
2. Minimal equity contribution: By injecting just 20-30% of the deal with the buyer and investor capital, the sponsor can increase its buying power and spread their financial exposure across more companies, supporting diversification while acquiring larger companies than it would’ve been able to in all-cash deals. 
3. Tax benefits: Interest payments on debt can be tax-deductible, reducing overall tax liability.

Disadvantages

1. Increased financial risk: High levels of debt can strain the target company’s cash flows, especially if revenue projections fall short.
2. Operational pressure: The company must consistently generate enough cash to meet interest payments and principal repayments.
3. Potential for conflict: Stricter lender covenants can limit strategic decisions, leading to tension between management teams and debt providers.

Key considerations for investors

Investors who may be considering participating in a firm’s leveraged buyout transaction should carefully consider specific company, market, and operator factors that could positively or negatively influence the outcome of the deal. Here are some to keep in mind:

1. Market outlook: In a rising interest rate environment, debt payments can become more expensive, reducing the overall returns of an LBO.
2. Cash flow stability: Companies with steady, predictable earnings are better suited for debt repayment. Investors should review historical financial statements and stress-test forecasts.
3. Operational expertise: A well-managed LBO relies on capable operators who can execute growth plans and optimize performance post-acquisition.
4. Exit strategy: Typically, LBO investors look to exit in 5–7 years through a strategic sale, secondary buyout, or IPO. Planning the exit early can help inform operational decisions.

How Zest can help

Zest is digitizing private market transactions, building tools to streamline how entrepreneurs, funds, and investors transact. Our platform is designed to save you time, reduce administrative costs, and bring transparency to your deal process. Whether you’re exploring your first LBO or looking to expand your portfolio with another, our technology can simplify documentation, execution, and post-acquisition reporting.

Get started with Zest today.