Leveraged buyout transactions, or LBOs, involve one or more private equity sponsors acquiring a company using a significant amount of debt financing. There can be huge potential returns if the acquisition is successful. However, the high debt load can create risks if the acquired company cannot generate sufficient cash flows to cover interest payments on the debt.

While there are numerous examples of successful LBOs that have helped struggling companies become profitable again, there are also cautionary examples of poorly executed LBOs that have caused companies to collapse under the weight of too much debt.

One classic example of a failed LBO was the 2005 acquisition of Toys “R” Us by KKR, Bain Capital, and Vornado Realty Trust. There were initially high hopes that the $6.6 billion acquisition could turnaround the toy company’s performance and make it more competitive. However, the burden of high interest payments on outstanding debt prevented the company from making investments in new stores and e-commerce improvements. In 2017, Toys “R” Us filed for Chapter 11 bankruptcy protection and subsequently Toys “R” Us closed all of its remaining store locations.

Another failed LBO example was the 2012 acquisition of Party City by Thomas H. Lee Partners. Although Party City was a popular destination for party decorations and Halloween costumes in the United States, its business had low profit margins. The large amount of debt used to finance the LBO added to Party City’s financial burdens. Following the LBO transaction, Party City had an extremely high debt-to-equity ratio relative to its retail company peers. On the other hand, the company’s interest coverage ratio became extremely low. The interest coverage ratio is a measure of a company’s ability to pay interest on outstanding debt obligations. As a result of its ongoing financial struggles, in 2023 Party City filed for Chapter 11 bankruptcy protection. In 2024, Party City announced that it is winding down its operations and permanently closing all of its stores.

Companies that are desirable targets for an LBO are companies that are able to generate steady operating cash flows and have the potential for improved financial performance. A common rule of thumb is that the company should be able to generate an annualized return of at least 20%. This internal rate of return (IRR) is calculated using a formula that makes the net present value (NPV) of all cash flows equal to zero.

In determining whether a company is an optimal target for an LBO transaction, the private equity buyer will create a financial model of the company’s projected cash flows and debt. The model will display credit metrics such as debt/EBITDA ratio, interest coverage ratio, and the fixed charge coverage ratio in order to forecast how much leverage the transaction can withstand. The financial model will take into account how market conditions and changes in interest rates could impact the investment. This is known as a sensitivity analysis.

LBOs continue to be a popular business acquisition strategy used by private equity sponsors and other financial buyers. However, the private equity sponsor should factor in a number of different potential risk scenarios in its LBO financial model before proceeding with a leveraged buyout transaction strategy.