Question

Cash flows of firms improve following leveraged buyouts (LBOs). What are the explanations for these improvements? Corporate Finance Question

Answer 1

Meaning of Leveraged Buyout

A leveraged buyout is the acquisition of a company, either privately held or publicly held, as an independent business or from part of a larger company (a subsidiary), using a significant amount of borrowed funds to pay for the purchase price of the company. The leveraged buyout transaction is orchestrated by a private equity firm (also called a financial sponsor) or group of private equity firms (also called a private equity group or a consortium), which will take ownership (own the equity of) the business after the acquisition has been completed.

Cash flows of firms improve following leveraged buyouts

In an LBO, the cash flow generated by the acquired company is used to service (pay interest on) and pay down (pay principal on) the outstanding debt. For this reason, while companies of all sizes and industries can be targets of LBO transactions, companies that generate a high amount of cash flow are the most attractive.

Stable, recurring cash flows are necessary, as that cash flow is needed every year to service the large debt burden for the LBO (especially in the first several years post-acquisition). Cyclical or highly seasonal companies, therefore, can run into trouble quickly if a downturn occurs. Debt pay-down is also important in that it increases the equity/total assets ratio of the company, boosting investor returns.