Leverage Buyouts

Note on Leveraged Buyouts

Case #5-0004

Updated September 30, 2003

Note on Leveraged Buyouts
A leveraged buyout, or LBO, is the acquisition of a company or division of a company with a substantial portion of borrowed funds. In the 1980s, LBO firms and their professionals were the focus of considerable attention, not all of it favorable. LBO activity accelerated throughout the 1980s,starting from a basis of four deals with an aggregate value of $1.7 billion in 1980 and reaching its peak in 1988, when 410 buyouts were completed with an aggregate value of $188 billion1. In the years since 1988, downturns in the business cycle, the near-collapse of the junk bond market, and diminished structural advantages all contributed to dramatic changes in the LBO market. In addition, LBO fundraising has accelerated dramatically. From 1980 to 1988 LBO funds raised approximately $46 billion; from 1988 to 2000, LBO funds raised over $385 billion2. As increasing amounts of capital competed for the same number of deals, it became increasingly difficult for LBO firms to acquire businesses at attractive prices. In addition, senior lenders have become increasingly wary of highly leveredtransactions, forcing LBO firms to contribute higher levels of equity. In 1988 the average equity contribution to leveraged buyouts was 9.7%. In 2000 the average equity contribution to leveraged buyouts was almost 38%, and for the first three quarters of 2001 average equity
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Securities Data Corporation Venture Economics

This case was prepared by John Olsen T’03 and updated by SalvatoreGagliano T’04 under the supervision of Adjunct Assistant Professor Fred Wainwright and Professor Colin Blaydon of the Tuck School of Business at Dartmouth College. It was written as a basis for class discussion and not to illustrate effective or ineffective management practices. Copyright © 2003 Trustees of Dartmouth College. All rights reserved. To order additional copies, please call (603) 646-0522.No part of this document may be reproduced, stored in any retrieval system, or transmitted in any form or by any means without the express written consent of the Tuck School of Business at Dartmouth College.

Note on Leveraged Buyouts

Case #5-0004

contributions were above 40%3. Contributing to this trend was the near halt in enterprise lending, in stark comparison to the 1990s, when bankswere lending at up to 5.0x EBITDA. Because of lenders’ over-exposure to enterprise lending, senior lenders over the past two years are lending strictly against company asset bases, increasing the amount of equity financial sponsors must invest to complete a transaction.4 These developments have made generating target returns (typically 25 to 30%) much more difficult for LBO firms. Where once theycould rely on leverage to generate returns, LBO firms today are seeking to build value in acquired companies by improving profitability, pursuing growth including roll-up strategies (in which an acquired company serves as a “platform” for additional acquisitions of related businesses to achieve critical mass and generate economies of scale), and improving corporate governance to better alignmanagement incentives with those of shareholders.

History of the LBO While it is unclear when the first leveraged buyout was carried out, it is generally agreed that the first early leveraged buyouts were carried out in the years following World War II. Prior to the 1980s, the leveraged buyout (previously known as a “bootstrap” acquisition) was for years little more than an obscure financingtechnique. In the years following the end of World War II the Great Depression was still relatively fresh in the minds of America’s corporate leaders, who considered it wise to keep corporate debt ratios low. As a result, for the first three decades following World War II, very few American companies relied on debt as a significant source of funding. At the same time, American business became caught up...