Chapter 4 Part 2: Leveraged Buyouts and Special Situations - When PE Gets Serious
If venture capital is the glamorous part of private equity, LBOs are where the real money lives. According to Demaria, leveraged buyouts represent roughly 69% of all PE fund investments. This is the heavy machinery of finance, and Chapter 4 spends serious time explaining how it works.
The Basic LBO Trick
An LBO is surprisingly simple in concept. You want to buy a company but you do not have enough cash. So you borrow 60-80% of the purchase price, and the company you are buying pays back the loan from its own profits. The company literally pays for its own acquisition.
Here is the structure. You set up a holding company. The bank lends money to that holding company. The holding company buys the target. The target pays dividends up to the holding, which uses that cash to repay the debt. If things go well, the debt shrinks over time, the company grows in value, and eventually you sell at a profit. If things go badly, the bank ends up owning the company.
There is also a mezzanine layer sometimes. Mezzanine funds sit between the bank and the PE fund. They invest through convertible debt, meaning they collect interest first, and if the deal works out, they also get a slice of the profits. It is like being both a lender and a partial owner.
Not All LBOs Are the Same
Demaria lists several flavors, ranked roughly by risk:
Owner buy-out (OBO) is the safest. One co-owner wants out, the remaining owners borrow to buy that stake. Think three brothers owning a paint company, one wants to leave. The other two structure the deal and slowly repay from company earnings. Or two divorced people splitting a business.
Management buy-out (MBO) is when the company’s own managers buy it, usually when the owner retires. The managers know the business inside out, which reduces some risk. But they can struggle to separate being operators and being owners.
Institutional buy-out is the standard LBO template. A PE fund identifies a company, buys it, runs it for a few years, then sells. Risk goes up because the historical owners leave and some corporate memory disappears.
Leveraged buy-in (LBI) and management buy-in (MBI) are riskier still. New people come in to run a company they do not know well. And the riskiest of all is the leveraged build-up (LBU), where you buy a “platform” company and then bolt on acquisitions to build an industry leader. Mergers fail often enough on their own. Doing them while carrying heavy debt is playing on hard mode.
Three Ways LBOs Make Money
Demaria breaks down value creation into three “levers”:
Tax lever. When the holding company owns enough of the target (90% in the UK, 95% in France, 98% in Switzerland), it can consolidate financial statements. The holding is basically a money-losing shell that only exists to hold shares and pay interest. Those losses offset the target’s profits, reducing the tax bill. The LBO is effectively subsidized by lower taxes.
Financial lever. Two things happen. First, the debt shrinks over time as the target’s profits pay it down, so the equity portion grows. Second, if the target’s dividend yield is higher than the cost of debt, the holding pockets the difference. The riskiest moment is day one, when the debt is highest. That is why PE firms obsess over a “first 100 days plan.”
Legal lever. Owning the holding means total control of the board and governance. The fund can replace management if needed. Full control means the strategy actually gets executed.
Where the Returns Actually Come From
This is one of the most interesting parts. Studies cited by Demaria (via Quiry and Le Fur) show that the average LBO multiplied equity by 2.72 over 3.5 years, which is a 48% IRR. Break that down: about a third came from debt, 17% from selling at a higher multiple, and the rest from actually improving operations like growing revenue and cutting fat.
Here is the uncomfortable bit though. After fees and carried interest, the net IRR for investors was about 25%, roughly the same as investing in public stocks over the same period. Some academics use this to argue that LBOs create no net value for the end investor. The fund managers make out well. The investors, maybe not so much.
The best returns came from investments made during bad times, 1991-1993 and 2001-2003. Buying cheap works in PE just like it works everywhere else.
The Problem With Too Much Money
LBO techniques have become a commodity. The “easy target” companies have already been bought, flipped, and bought again. Purchase price multiples in the US went from 7.3x EBITDA in 2004 to nearly 11x by 2017-2018. And the price increase was largely financed by more debt, not more equity. When regulators tried to cap debt at 6x EBITDA, fund managers just started adding back “expected synergies” to their EBITDA calculations to stay within guidelines. Creative accounting at its finest.
As of writing, about $2 trillion in “dry powder” (committed but uninvested capital) was sitting in PE funds, with 35% earmarked for LBOs. All that money chasing deals pushes prices up even further.
Dividend Recaps: The Controversial Move
When a PE fund cannot sell a company at the right time, there is a backdoor: re-borrow against the company and distribute the cash as early profits. This is called a dividend recapitalization. In 2010, $234 billion in loans were granted, and 84% of those went to distributing dividends to PE funds.
Demaria shows a clever example of why this is sketchy. Without a recap, you invest 100 and get 300 after six years - a 3x multiple at 20% IRR. With a recap, you get 150 back in year three and 100 at year six - only 2.5x total, but a higher IRR of 26%. You made less money but the return metric looks better. The IRR “thermometer” is broken.
Special Situations: Buying the Broken Stuff
Turnaround capital is a niche. Only about 47 fund managers were active in this strategy as of 2016. The idea is to buy companies that are failing but not yet bankrupt, usually for almost nothing. Sometimes the sellers actually pay the buyers to take the company off their hands, to avoid the cost and embarrassment of bankruptcy.
There is a hidden tax benefit too. Failing companies accumulate losses. After restructuring, those losses become a tax shield for future profits. Similar to the LBO tax trick.
Turnaround investments perform best when bought during or right after a recession. They underperform when bought during boom times. They are basically a contrarian bet on the economic cycle.
Europe has a harder time with this than the US. No equivalent of Chapter 11 bankruptcy protection means companies often wait too long before seeking help. And there is a cultural stigma around bankruptcy in continental Europe that does not exist the same way in America.
When PE Meets the Stock Market
Private equity does not stay in its lane. Two ways it crosses into public markets:
PIPEs (Private Investments in Public Equities) happen when a listed company cannot raise capital on the exchange. A PE fund steps in, gets shares at a discount, gets board seats, and agrees to hold for a set period. After changes are made and the lock-up expires, the fund sells on the open market.
Public-to-private deals are when PE funds buy a listed company and take it off the stock exchange. This gives them flexibility to restructure without quarterly earnings pressure. Big examples include HCA, Kinder Morgan, and the attempted Kraft Heinz takeover of Unilever at $143 billion in 2017. At that scale, almost no company is safe from a PE takeover.
Hedge funds sometimes get involved too. They spot the same undervalued companies that PE firms target, take positions, and try to profit from the action. Eddie Lampert’s hedge fund bought Kmart and merged it with Sears for $11.5 billion. He was voted worst CEO of 2007. Turns out being good at spotting undervalued stocks and actually running a business are very different skills.
The Takeaway
LBOs are the engine room of private equity. The mechanics are clever: use debt to buy, use the company’s own cash to repay, improve operations, sell at a higher price. But the space is crowded, prices are inflated, and some of the practices like dividend recaps are questionable at best. The best returns come from buying during downturns and from genuine operational improvement, not from financial engineering alone.