LBO is acquiring a company with a lot of debt. The debt raised is paid back with cash flows of the acquired business.
Imagine you want to buy a company worth $100 million, but you only have $10 million of your own money. The rest? You borrow $90 million from a bank.
Now, let’s say that after a few years, the company grows in value to $150 million. If you sell it, you repay the $90 million loan and keep the remaining $60 million.
Your initial investment was just $10 million, but now you walk away with $60 million—that’s a 6x return on your money! 🚀
To understand LBO, you need to understand the concept of Financial Leverage.
Financial Leverage concept
Warren Buffet’s Berskhire Hathaway had $ 47 billion of cash at the end of 2024. At the end of Q3 2024, Apple had $ 65 billion of cash. But both companies have debt in their books. Why they borrow money if they have so much cash?
It’s Financial Leverage.
The magic of Financial Leverage is that you use debt to boost return.
Let’s return to previous example of acquiring a company, but you have $ 100 million on your bank account. You have 2 options:
✅100% Equity – take all the money and acquire a company worth $ 100 million
✅10% Equity – take a $ 90 million loan and use it for acquisition. You pay $ 10 million of your own money
In both scenarios, the company grows in value to $150 million:
✅100% Equity – you invested $ 100 million; you walk away with $ 150 million – that’s a 1.5x return on your money
✅10% Equity – you repay the $90 million loan and keep the remaining $60 million. That’s a 6x return on your money.
This is the magic of Financial Leverage. You quadrupled your return by using leverage. In addition, you still got $ 90 million you could use for acquisitions of more companies, while in 100% Equity, you could have acquired only one company.
If used intelligently and with a little bit of luck, you can use Financial Leverage to maximize your Return on Equity (ROE).
But Financial Leverage is a dangerous thing. Take a look at the following quotes:
- ✅”Smart men go broke three ways – liquor, ladies and leverage.” – Charlie Munger
- ✅“Leverage is a double – edged sword that enhances returns in good times while sinking them in down markets.” – Seth Klarman
- ✅”The lesson of leverage is this: Assume that the worst imaginable outcome will occur and ask whether you can tolerate it. If the answer is no, then reduce your borrowing.” – Ed Thorp
These 3 quotes capture the very essence of leverage.
If things go south, you still have a loan to repay. Plus, you pay interest each year (which was not covered in our simple example).
Let’s return to our example. You acquired a company for $ 100 million, using $ 10 million of equity and $ 90 million debt. But, the company struggles and its value drops to $80 million, you still owe the bank $90 million. In that case, you’d lose everything—and even owe more!