Understanding Leveraged Buy-Outs in Private Equity

Leveraged buy-out

You may have come across the term leveraged buy-out in the context of private equity and wondered what it means. The term is divided into two parts: leveraged and buy-out. Starting with the latter, private equity was originally intended as an alternative form of business succession, where an entrepreneur was bought out—hence the name buy-out. These buy-outs still exist and continue to form the core of private equity. The term leveraged means that the buy-out is conducted with a lever (leverage in English) of debt. When a buy-out fund makes a purchase, part of the purchase price is borrowed from one or more banks, with the company as collateral. The leverage effect is that as a fund, you can enter larger companies with less of your own money.

Leverage ratio

A simple example: if a fund acquires a company worth €150 million and invests €50 million from the fund itself and borrows €100 million from the bank, then a leverage of €100 million is applied. Important here is the leverage ratio, or the ratio between cash from the fund and debt at the bank. The greater the ratio of debt to equity, the higher the risk.

Alternatives to leverage

Leveraged buy-outs have not had the best reputation due to a few notorious cases, especially in the 1980s when the category was still new and large risks were taken with the amount of debt placed in a company. As private equity further developed as a sector and the wild 1980s receded into the rearview mirror, the percentage of leverage in deals has steadily declined. Nowadays, besides bank loans, there are many more instruments for buy-out funds to finance their purchases. For example, co-investments, private debt solutions, and other forms of capital are now used. As the sector relies less on bank debt, the term leveraged buy-out has gradually faded from view.