Finance For HR Nerds: How an LBO (Leveraged Buyout) Firm Works

There's been lots of talk in this election cycle about whether LBO firms are net positive or net negative to the economy, and to a larger degree, America in general.  So it stands to reason we should talk about it, right?

LBO firms are another name for private equity firms that practice leveraged buyouts - meaning they borrow money (leverage) to buy controlling positions in companies. Gekko  

What they do after they gain control is something you'll hear a lot about in the election from now until November.  Still, it's hard to get your head around how an LBO firm operates.  Here's the best explanation/example of classic LBO firm activity I've seen from Allan Sloan's column in Fortune Magazine:

"Let's say an LBO firm spends $300 million to buy a company and borrows $200 million - two thirds of the price - to finance the purchase.  The buyout firm's investors thus have only $100 million invested.  The company's value doubles to $600 million because of luck, skill or both.  

The company then borrows another $200 million - two thirds of the increased value - and uses the cash for a payout to investors, who have now recovered more than they put in and still own the upside potential (Managers  get a piece of the profit, I'm ignoring that to keep the math simple).

Employees of the now more heavily indebted company are at greater risk because the company is more vulnerable to failing if anything goes wrong.  But the buyout firm's investors have already made out well.  Then the company runs into trouble.  Workers lose thier jobs, but investors and the LBO firm nevertheless come out ahead."

Sloan goes on to say there's no evidence on whether LBO firms add more jobs than they destroy, or vice-versa.

That's all you need to know about how an LBO performed by a private equity firm works to look smart.

Of course, after reading that and soaking on it, you may wish you didn't know.

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