Business always have its twists and turns and in every miscalculated decision of the company can result to financial losses and obtaining debts are oftentimes being resorted to in order to improve the financial status of the company with the hopes that it will be able to get back to the business world.
If a company will not resort to debt incurring activity, it will resort to merger and acquisition.
Usually, in merger and acquisition, a company can have a Leverage Buy Out a process of acquisition of a company of certain asset of which the purchase price is a combination of debt and equity. The cash flow of the target is being used to secure for the repayment.
Debt is considered to have a lower cost of capital than equity, thus, equity increases as debt increases. In this process, debt becomes a toll to lever to increase the returns of equity. This could explain the term Leverage Buy Out.
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There are several forms for Leverage Buy Out, this could be Management Buy Out, Management Buy In, Secondary Buy Out and Tertiary Buy Out. Usually Leverage Buy Out is a natural occurrence in merger and acquisition.
The term Leverage Buy Out is being referred to when a financial sponsor acquire a company. These financial sponsors can increase their returns by setting a high leverage. Remember is considered as a lever for the return of equity. This can be done through a high ratio of debt to equity.
Financial sponsor can employ as much debt as possible to acquire a property. This scenario will eventually lead a company to be over levered, then leading to the state of bankruptcy.
Once the company is overleveraged it means that company was not able to generate sufficient cash flow to pay off for their debt. Eventually the equity owners will lose control of their business and the equity will be owned by financial sponsor.
Leverage Buy Out is considered to be good financial investment for financial sponsor and for the banks. The banks can get high interest rates in Leverage Buy Out than in corporate lending.
The amount of debt that can be provided by the bank in Leverage Buy Out will also depend on the company. If the company has earned the reputation of being stable when it comes to its cash flows, then, the bank can give a debt up to 100% of the purchase price.
If the company is not considered an s financially viable, it can provide up to 60% of the purchase price. Of course, the amount that can be provided by the bank will depend on the status of the company and as well as of its location. The bank will also look into the amount of equity that is being supplied by financial sponsor.
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Aside from the status of the company and equity provided by financial sponsor, the bank can also check the financier’s experience and history.The economic environment is also being considered by the bank in order for it to come out for a decision of how much it can provide for the Leverage Buy Out.