A leveraged buyout (or LBO) occurs when a financial sponsor gains control of a majority of a target company's equity through the use of borrowed money or debt. Typically this money is borrowed through a combination of prepayable bank facilities and/or public or privately-placed bonds, which may be classified as high-yield or junk bonds. Often, the financial sponsor will use the target company's free cash flow to repay the borrowed debt. Finally, the financial sponsor will sell the target company to another company, sell shares in an IPO or pay itself a dividend payment in a refinancing. Most leveraged buyout firms look to earn a return on investment in excess of 20%.
Proponents of LBOs claimed that they caused companies to make more efficient use of their resources. Opponents claimed that they tended to destroy value and cause great economic hardship through the economic disruptions they caused.
This strategy was widely used in the 1980s, with both success and dramatic failure. A very well-known LBO was the purchase of RJR Nabisco in 1989 by Kohlberg Kravis Roberts & Co. (KKR) as chronicled in the book Barbarians at the Gate. KKR is often credited with pioneering the idea of large LBOs.
Some LBOs in the 1980s and 1990s resulted in corporate bankruptcy, such as Robert Campeau's 1988 buyout of Federated Department Stores. The failed buyout was a result of excessive debt financing, which comprised about 97% of the total consideration, and led to significant interest payments in excess of Federated's operating cash flow. In response to the threat of LBOs, certain companies adopted a number of techniques, such as the poison pill which protected them against hostile takeovers.
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