How Does a Buyout Work?

by Tiesha Whatley; Updated September 26, 2017

Introduction

A leverage buyout, or LBO, is what happens when the controlling interest in a company is acquired by a financial sponsor. A management buyout, or MBO, is when existing managers acquire a large part or all of the company's assets. No company is safe from being a target of buyout, but some companies are more desired than others.

Targeted Companies

Several characteristics make some companies more targeted for a buyout: No or very low existing debt The value or price of the stock is decreased to present market conditions Stable and recurring cash flow for multiple years Low-cost secured debt collateral in the form of hard assets *A potential boost in cash flow brought on by operational improvements made by new management When companies have met one or more of the previous conditions, investors or management may start thinking of a buyout. In the past, companies of all sizes and industries have found themselves targeted. Great concern is placed on debt and whether acquiring the firm will be beneficial in making loan payments successfully.

How Does a Leveraged Buyout Work?

In a leveraged buyout, financial sponsors or private equity firms try to make a large acquisition of a company. They do this without committing the entire amount of required capital for the acquisition.

The financial sponsors stand to gain a significant return on their investment in a leverage buyout, which is why they are so desired. All debt is paid down from the company's cash flow, so the financial sponsors don't have to bear this cost. Then the company is acquired at only a fraction of the original purchase price. Later on, if the financial sponsors decide to sell the business, they will gain a significant return on their initial investment.

Many times, during a leverage buyout, many financial sponsors get together to co-invest in the targeted company. Together, they come up with the money required to fund the transaction. The amount of funds that are needed depends on market conditions, history and financial conditions of the targeted company, and the agreement from lenders to extend credit. The debt that is involved is usually 50 to 85 percent of the final purchase price.

How Does a Management Buyout Work?

There are many benefits to a management buyout over other types of buyouts. For one, the due diligence process doesn't require much time since the potential buyers already know the ins and outs of the company. In many companies, the managers know more about the operational practices of the company more than the sellers. This gives the sellers the opportunity to only provide the most basic warranties, since the state of the company doesn’t need a warranty.

Managers' knowledge of the company is also a source of concern for current owners because it raises the threat of them having an unfair advantage. There are also the risks of principal-agent problems and moral hazards. MBOs are also at the risk of subtly lowering the stock price of the company’s shares.

Mostly private companies are targeted for management buyouts. If a public company is acquired, then the managers will most likely make it private after the sale. The main reason for a management buyout is that managers are concerned about the fate of their jobs if the company is acquired by an outside source. During an MBO, the managers gain the benefit of increased financial profits if the company is a success.

To raise all the funds needed, the managers may go to many sources. The first stop is to try to get financing from a bank or other type of financial institution. Banks are leery of financing management buyouts because of the risks involved. If a bank refuses to accept the risk, private equity financing is usually the next step. Private equity investors are the most common source of financing in MBOs. Investors gain a portion of shares in the company in exchange for the funds needed for the buyout.

About the Author

Tiesha Whatley has been writing for over 10 years. She has been published in "Marie Claire," "Ebony" and "Modern Bride" magazines. She holds a Bachelor of Science in English from the University of Alabama at Birmingham and has been working in the wedding planning industry for over 13 years.