Clarification on Leverage in LBO

Might be silly question but I am little confused in the word leverage in “Leveraged Buyout a.k.a LBO”.

As per the concept, the PE firm interest is in buying controlling stake in the equity of target firm. For this they can engage in LBO which means leverge is involved (i.e simply mean debt/loan is taken in transaction.)

What is confusing is that whose debt/loan is considered in transaction as leveraged.

A) I mean if PE firm doesn’t have sufficient funds at their end and they took debt/loan from market and buy equity in target OR

B) PE firm has sufficient funds at their end but they give part of money as debt/loan to firm and use remaining to buy equity in firm.

In A) the PE firm has taken loan/debt and target has just sold equity and in B) PE hasn’t taken any loan/debt but target has taken some loan/debt from PE.

Can someone please clarify if A) and B) both are LBO transaction or just B) is LBO or just A) is LBO.

Imagine this:

Company QWERTY has 1000 in assets and 400 in debt (hence equity 600). A Private Equity firm believes this is a good investment and decides to make a LBO on QWERTY, so the PE firm engages in a big loan with a value of 700. The PE firm owns QWERTY and its balance sheet looks like 1000 assets and 700 debt (300 equity).

LBO transactions commonly buy the whole assets of the target, not just the equity portion because the value of the target (strategically looking) is in their assets composition. If you just buy equity, you will need to liquidate assets and lose that precious combination of them. This means that the PE firm will buy both the equity portion of the target and its debts. To accomplish this, PE firm will ask for a big loan and also commit some money as equity.

Hope this helps.

Thanks Harrogath. So in terms of what I asked i.e. which is LBO i.e. A) or B). Are you saying that both A) and B) are LBO because in both cases the PE firm has bought equity and debt. It also means it is immaterial if PE finance its purchase via all its own money or they also took loan?

I don’t get exactly your A and B statements but:

A) LBO = leveraged buy-out, so debt is the main driver to acquire the target company, which means buying all assets, not just equity. Buy just equity by the PE firm would mean that the target would need to liquidate part of its assets and repay its debt. Also would mean that if target don’t liquidate its assets, the PE firm would accept the current target debt, which presumably is not much good as the PE firm could get after.

B) Commonly PE firms buy all assets and replace the current target debt with better-conditions debt to create effciencies. So PE firms buy both equity and debt = total assets.

If you want to make a LBO, you will want to use leverage to complete the transaction. We all already know the benefits of a good debt in projects.

Hope this helps.