Basic Mechanics of a Leveraged Buyout

Let's detail how a leveraged buyout transaction is completed.  We will not discuss how investment ideas are found or performance of private equity fund managers or risk management.  The simplest way to describe a leverage buyout is through an analogy.  A common transaction that everyone is familiar with is a traditional home mortgage.  For example, the home buyer will want to purchase $1 million house.  $200,000 will be paid as a down payment and $800,000 will be financed by the bank.  The lending institution will approve or deny the loan based on the buyer's credit score, salary history, payment history, current debts and assets.  To a certain extent, the information may determine the interest rate of the loan.  The buyer's annual salary will be used to pay back the debt.  The house will be used as collateral for the loan.

For the leveraged buyout, the down payment is the investor's equity in the deal and a consortium of lenders will finance the loan.  In turn, the lenders will package the loan to banks or investors as a leveraged loan or bonds - high yield (junk) or mezzanine debt.  The banks that financed the LBO will earn fees for either transaction.  Both of these vehicles will be considered more risky/have a higher change of defaulting because the company will be saddled with a large amount of debt.  Interest rates will be higher to compensate investors for the increased risk.  The company will use its future earnings to re-pay the loan.  In the example above, this is equivalent to the home buyer's salary.  As in a mortgage, the company's assets will be used as collateral for the leveraged loan.  Leverage gives the buyer the possibility of increased returns or losses.

This is a bare bones, simplistic version of the deal.