What is a Leveraged Buyout?

        In mid-January, private equity firm Apollo Global Management executed a $1.3 billion acquisition of CEC Entertainment, the parent company of Chuck E. Cheese.  The deal was done through a leveraged buyout, which is a popular method particularly for equity firms.  In the world of mergers and acquisitions, companies, investors and private equity firms acquire other entities or at least a controlling stake in those entities through this strategy.  Acquisitions can occur between private entities, or may even be used to convert a public company back to private ownership.

How Is It Structured?

        In a leveraged buyout, the acquiring entity does not pay cash outright to obtain that ownership.  Rather, the acquiring entity will borrow money through loans or bonds to help finance the acquisition.  In financing through loans or bonds, the buyer will use the assets of the target company or entity as collateral for those loans.  While sometimes the acquiring entity or investor will put up some of its own assets as collateral, it is typically the target company’s assets that will be the most significant collateral.  This largely comprises the most significant component of the transaction: debt.  Typically, the loans or bond sales will predominantly help finance the deal, while the remaining financing will come from the acquiring company’s own capital.  In these deals, debt can comprise up to 90% of the deal, while the buying company’s input of capital can be as low as 10%, representing the acquiring entity’s equity interest in the target.

Advantages versus Risks

Leveraged buyouts allows investors, firms or companies to acquire whole or at least controlling stakes in other entities without having to front too much of their own capital.  In a leveraged buyout where a large proportion of debt finances the deal, risk is minimized for the buyer because the acquired company’s assets serve as collateral for the loan or bond.  Such a structure is advantageous in that the transaction is accomplished because the acquiring firm can mitigate its risk through this levering.  If the target entity is properly managed, and debts can be repaid overtime while still generating revenue, everyone benefits.

While this makes such a deal attractive and has its advantages, there is also certain risk involved.  Because the debt is secured by the target entity’s assets and the debt is usually paid in large part by the target’s cash flow, there is tremendous risk for the company being acquired.  If its revenue stalls it may not be able to adequately pay off that debt, and its assets will be forfeited should there be a default on the loan and bankruptcy will occur.  Additionally, because the target entity’s assets and cash flow are necessary to these transactions, it is somewhat limited in the amount of additional debt it can take on due to the debt already incurred.  Thus the company must operate carefully, and in a lean fashion so as to have enough money to pay off the loans and/or bonds.  Because of the overall risk involved, companies that have stable cash flows and do not require additional financing for growth are usually viable takeover targets with leveraged buyouts.  Ideally, if all goes well, the target company will pay off that debt and become profitable so that the acquiring entity can then sell it for a greater profit down the road.