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Leveraged buyouts

Leveraged buyout is a finance term you need to understand. Bankrate explains.

What are leveraged buyouts?

A leveraged buyout is the acquisition of a company by a group of investors using borrowed money, or leverage, to finance the deal. The assets of the company being purchased are used as collateral for the buyout. There is an element of risk associated with leveraged buyouts because of the high level of debt, which could reach as much as 90 percent of the company’s value.

Deeper definition

Leveraged buyouts are a popular way of purchasing companies. The investors backing an acquisition do not need to hold significant amounts of capital, given that the buyout is funded with borrowed funds that are secured by the company being purchased.

For a leveraged buyout to succeed, the business being purchased should offer adequate returns that allow for payment of the interest on the debt used to finance the deal while also retaining sufficient cash to be able to operate profitably and expand. To limit risk, the Federal Reserve guidelines specify that the debt assumed through a leveraged buyout should not be more than six times the annual earnings of the company.

Facilitating a leveraged buyout is one way that an owner of a business can sell a company, and when this option is chosen, it is often sold to the existing management team, who have a vested interest in the company’s survival. Frequently, there is a need for additional financing from a private equity partner who would focus on making the company profitable and then, after a reasonable period, sell its share in the business.

Another common reason for a leveraged buyout is to take a public company private, often at the instigation of the company’s management team. In addition, it is used as a way to spin off parts of a corporation into separate companies.

Leveraged buyout example

Mason is a senior manager at XYZ tools. He and his colleagues have heard that the company’s owners want out because they need money to fund the rest of their business portfolio. Mason and his colleagues get together with a venture capital fund and make an offer to purchase the company, using money borrowed from the venture fund. Each manager has to put in some equity, so Mason remortgages his home to raise his share.

Have you been invited to participate in a leveraged buyout? Use Bankrate’s remortgage calculator to see how much equity you can raise.

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