Definition: Leveraged Buyout or LBO is the transaction wherein the acquisition of another company or a single asset is financed through the combination of equity and the significant amount of debt or borrowed funds.
In other words, Leveraged buyout is the acquisition of another company by using the debt as the major or primary source of financing. Usually, the ratio used in LBO is 90% debt and 10% equity. Since the cost of debt is cheaper than the cost of equity, so the returns on equity increases with the increased debts. Therefore, the debt act as a lever that facilitates the increased returns on investments.
Often the assets of the companies being acquired are used as collaterals for the loans along with acquiring company’s own asset to secure and repay the debt. The purpose of Leveraged buyout is to enable the companies to perform big acquisitions without having a larger capital base.
In a leveraged buyout, the bonds are not the investment grade, a rating given to the bonds which are relatively less risky, such as corporate or municipal bonds and therefore, are often called as junk bonds. The bonds, which are riskier and whose returns are speculative in nature, but however, offers a higher yield than the safer bonds.