The first leveraged buyouts started in early 1980s with high yield bonds invented by Michael Milken (commonly called ‘junk bonds’) being an essential source of financing. A leveraged buyout (LBO) is simply the purchase of a company using debt. It’s an efficient method of acquisition without investing much capital and deriving good returns on equity and tax benefits.

A buyer, usually a private equity firm, invests a small amount of equity relative to the total purchase price, and uses leverage (debt) to fund the remainder of the consideration paid to the seller. The debt is backed either by hard assets or by future cash flows, or a combination of both.

The LBO analysis generally provides a "floor" valuation for the company, and useful in determining what to pay for the target company and still realize an adequate return on its investment.

The buyer evaluates investment opportunities by analyzing expected internal rates of return (IRRs), which measure returns on invested equity. IRRs represent the discount rate at which the net present value of cash flows equals zero.

The acquired company that takes on the debt, while the acquirer takes a significant ownership stake. If the value of the company goes up, your returns are amplified.

In a leveraged buyout, a publicly traded company is first taken private for a period of time, with the intent of going public again at the end of that period. During the "private period", the investors hope to make changes that may have been difficult to execute in a publicly traded firm.

Firms with significant operating problems that require major restructuring are most likely to be targeted in buyouts. If, operating changes have not been made already because of management, a buyout will be hostile, and directed at removing existing managers.

Since these buyouts are funded with debt, they are more likely to occur in firms that generate substantial cash flows from existing assets.

Characteristics of a good LBO include:

• Strong, predictable operating cash flows with which the leveraged company can service and pay down acquisition debt.
• It’s important that cash flows are predictable, with high margins and relatively low capital expenditures
• Well-established business and products and leading industry position, with limited working capital requirements, strong tangible asset coverage, that is undervalued or out-of-favor.

For investors, the potential for buyouts could increase the stock prices of poorly managed firms, and the threat of being acquired will put managers on notice.

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