The purchase of a company funded largely through borrowed money. When one company or private equity firm decides to buy another company through a leveraged buyout, the purchaser puts down between 10 percent and 40 percent equity in the business and then borrows money to pay the rest of the costs. This is similar to making a down payment on a house and then taking out a mortgage.
An interesting feature of a leveraged buyout, however, is who becomes responsible for the debt. The purchaser uses the assets of the purchased company as collateral on the loans. As such, the purchased company takes on the debt rather than the purchaser.
Leveraged buyouts can be a legitimate strategy that is beneficial to both the purchaser and purchased company. But they have earned a bad reputation dating back to the 1970s and 80s, during the “hostile takeover” era. In many cases, the companies being purchased were not on board with the sale, and purchasers would often split up the purchased companies and resell the pieces individually. Together, the pieces often sold for more than the original value of the company, which was beneficial to purchasers but not necessarily to the company being purchased. Many still view leveraged buyouts to be a predatory and harmful practice.
Johnny: “I don’t like competing with your lemonade stand, Billy, so I’ve decided to initiate a leveraged buyout you out.”
Billy: “You don’t have the money to do that.”
Johnny: “Hence, the “leveraged” aspect of the buyout. I borrowed money from my dad.”
Billy: “But what happens if business dries up and you can’t afford to pay your dad back?”
Johnny: “I’ll just give him the assets of your lemonade stand to settle the debt.”
Billy: “So you get to buy me out using someone else’s money, and you face virtually no consequences if the business fails?”
Johnny: “Yeah. Isn’t capitalism great?”