Leveraged buyout (LBO) | In Principle

A leveraged buyout is a transaction in which an outside investor acquires a controlling stake of the shares of the target, using chiefly borrowed funds, with an equity investment of perhaps 15–25%. A key feature of this type of transaction is that the shares in the target serve as security for the borrowed capital. An LBO is very similar to a management buyout. Unlike an MBO, however, the acquirers behind an LBO are outside investors, who, unlike the managers of the target, do not have specific inside knowledge about the condition of the company.

A management buy-in (MBI) is a combination of the LBO and the MBO, in other words, a secondary management buyout. An MBI is instigated by managers who are not connected with the target, but have special knowledge about the condition of the target or, at least, the sector in which the target operates.

Subject of LBO

An LBO involves shares of capital companies of any size, operating in any sector of the economy. Investors are interested in LBOs particularly in the case of companies with hidden potential, where the shares may be resold at a profit after restructuring the target. In an LBO, the features of the target that are most important for the investors and the partners providing financing include:

• Stable financial condition (proven steady cash flow) and a low level of debt
• Holding assets (such as real estate and production equipment and machinery) that may be used as additional security for credit
• Capacity for reduction of operating costs after restructuring
• Individual characteristics of the new management team who are capable of exploiting the potential of the target
• Undervaluation by the market.

Financing

LBO transactions are mainly financed by an investment partner (such as a bank or private-equity fund), whose contribution represents about 75–85% of the transaction value, with the strategic investor putting up 15–25%. Financing by the investment partner requires a positive assessment of the proposal.

Because the shares of the target are the main security for repayment of the loan, and the obligation to repay the loan is shifted to the company itself, assessment of an LBO proposal is based on an analysis of:

• The market sector of the target
• The target itself, including its current and projected cash flows
• The quality of the new management team
• The plan for restructuring the target

Legal aspects

As with MBOs, LBOs are connected with the issue of financial assistance granted to the investors by the target company for acquisition of its own shares.

If the target is a joint-stock company, the issue of financial assistance is governed by Commercial Companies Code Art. 345. This provision generally allows the company to finance the acquisition of its own shares, if certain conditions are met:

• The financing of acquisition of the shares is made on market terms, after review of the solvency of the debtor.
• The shares are acquired at a fair value.
• The financing of acquisition of the shares is made from the company’s capital reserves.
• The financing is conducted on the basis of prior consent of the shareholders, in the form of a resolution.

If the target of an LBO is a limited-liability company, there are only modest limitations on financial assistance by the company, mainly under Commercial Companies Code Art. 189 §2, which prohibits the company from making payments to shareholders out of the assets of the company that would reduce the assets needed to fully cover the share capital.