[Music] hey guys kieran king here today we are talking about leveraged buyouts or lbos a mechanism for essentially buying a company used by mainly private equity firms now you may have heard of leveraged buyouts or lbos before in the press and probably not in the most positive light and i'm going to talk to you about why a bit later on but first let's dive into the concept and learn a little bit about it in short an lbo leverages the acquisition company's assets to obtain debt finance to buy the company as opposed to buying it with full equity now if that means gibberish to you then let's look at an example john has a company xyz company that he has run successfully for 30 years the company is quite stable and does about 15 million in pre-tax revenue every year after tax which is say a third of his revenue so minus 5 million of tax his net revenue is 10 million a year now this company has other assets like factories and machineries too crucial things needed to make the business tick john takes his salary every month and pays himself a nice dividend when he can however he is now reaching retirement he's worked hard all his life and he wants to sell his business and effectively cash out for a lump sum so he can enjoy the fruits of his hard work a private equity firm approaches john and makes an offer to buy the company for 100 million pounds now john is quite happy with this deal as is basically 10 times his annual net revenue and these guys john and the p firm they sit down to talk now the pe firm could just give john 100 million pounds worth of cash for the company and if the business is making 10 million pounds a year that's essentially a 10 yield for the pe firm however that is a big chunk of cash for the pe firm to give out in one go so instead they go down the route of an lbo the pe firm puts down 10 million pounds of its own money in exchange for equity in the company which is 10 it then goes to a bank to borrow the rest which is 90 million pounds now the bank is not just going to give the pe firm 90 million pounds unless that money is secured against something and that something is the assets of x y z company this means that if the pe firm defaults on its payments to the bank the bank can come in and acquire the assets the bank will also of course charge an interest rate of say 10 a year this means that repayments of the bank each year are 10 of 90 million which is 9 million so hang on you might be thinking now the pe firm has to pay 9 million pounds a year of interest on the borrowed money why would they do that and that's a really good question but this is where the whole magic happens now remember the pe firm has only put down 10 million pounds of its own money and company xyz does around 15 million in turnover a year now remember nine million pounds a year goes back to paying the bank um plus interest leaving us with six million pounds of that let's say one third again goes to the tax man leaving us with a post-tax revenue of the business of four million pounds now four million pounds a year based off a 10 million pound investment because that's how much they put down originally they didn't put down all of it is now giving a yield of 40 a year which is much better than the 10 scenario where the pe firm had put down 100 cash and over time as the debt position of the company decreases due to the repayments back to the bank the pe firm's equity position of the business increases and before long it owns 100 of xyz company anyways so do you see how this is so much more beneficial to the pe firm they've put less money down but they're getting a better rate of return okay so why do these sort of deals get bad press simply put it's because the debt is secured against the assets of the acquired company if the pe firm can't keep up its high interest repayments the knock-on effect on the acquired company could result in layoffs shutting down of departments unemployment and so on in many cases healthy companies that would have worked absolutely fine in the past and have worked for many years have suffered due to being on this end of the transaction so looking at the same example the business one year may only do 10 million in top line turnover as opposed to 50 million pounds remember 9 million is repaid to the bank the lender and is only left then with one million pounds of which tax needs to be paid and suddenly the net income of the business could be around seven hundred thousand pounds as opposed to the pre-leveraged buyout income of what would be around 6 million in this in this scenario and with 700 000 the business might not be able to reinvest that money it might not be able to do the things it wants to do with the business to help it grow and it's sort of like a downward spiral which eventually leads to the stuff we spoke about before like unemployment shutting down of factories assets being sold off etc just to make ends meet basically a less than ideal situation so there you have it a very simplified explanation of leveraged buyouts there is a lot more detail we can go into and i'll be looking at doing some more videos on this in the future maybe using some real life examples as well if you enjoyed this video please smash that subscribe and like button and do check out my others take care everyone and i'll see you all soon