Leveraged Buyouts (LBO) - Introduction
In a leveraged buyout, a group of investors uses a large amount of debt and some equity to buy a firm. The firm's cash flow is then used to pay down the debt. The investors usually sell the firm four to seven years from when they purchase it.
The target firm can vary in size, from a few million dollars to billions of dollars, such as the leveraged buyout of RJR Nabisco for $25 billion by Kohlberg Kravis Roberts & Co. (KKR) in 1988. Acquiring firms (the investors) usually have a price range for which they look.
The financing structure consists of three or four layers:
- 5% to 15% Revolving Credit - The first layer of debt, revolving credit, carries an interest rate of 2% to 2.5% prime plus, which is fairly low. It is provided by commercial banks or commercial paper and is secured by liquid assets such as cash and inventory. It is the first debt to be payed back.
- 25% to 50% Senior Term Debt - The second layer of debt, senior term debt, typically carries an interest rate of 2% to 3% prime plus, which is also low. It is lended by commercial banks, investment banks, mutual funds, and other similar institutions. Senior term debt is secured by long term assets such as buildings, equipment, and real estate.
- 20% to 40% Subordinated Debt - Subordinated debt usually comes in the form of high yeild bonds (junk bonds). Since it is "subordinated", it is the last debt to be payed back in a leveraged buyout. Therefore, it carries a high interest rate of 4% to 7% prime plus. It is provided by hedge funds, investment banks, and institutional and private investors.
- 20% to 40% Equity - The acquiring firm fronts 20% to 40% of the purchase price. About a third of the equity is provided by partners and the rest is provided by limited partners, who are not guaranteed a good return.