A leveraged buyout (LBO) is the acquisition of a company financed primarily with debt, with the acquired company's assets and cash flows serving as collateral and repayment source for that debt. LBOs are executed by private equity sponsors who contribute equity capital — typically 30–50% of the purchase price — with the remainder financed by bank and capital markets debt. The resulting capital structure is highly levered, creating significant financial risk that is the primary analytical challenge for LBO credit analysis.
A typical LBO capital structure layers multiple debt tranches with different seniority, security, and pricing. First-lien term loans (Term Loan A/B) sit at the top of the debt waterfall, secured by substantially all assets and entitled to first priority in recovery. Second-lien term loans or notes occupy the next position, with a junior lien on the same collateral. Mezzanine debt — unsecured or structurally subordinated — provides additional leverage capacity at higher cost. Each layer carries distinct pricing, covenants, and recovery expectations in default.
LBO credit analysis focuses on: (1) purchase price multiple and implied leverage (enterprise value / EBITDA at close), (2) interest coverage ratio (EBITDA / total interest expense, assessed against base case and stress scenarios), (3) free cash flow generation relative to debt amortization and maturity schedule, (4) business quality (recurring revenue, margin stability, pricing power), and (5) exit optionality for the sponsor through sale or IPO.
The interagency Leveraged Lending Guidance (Federal Reserve SR 13-3) defines leveraged transactions and establishes supervisory expectations for bank underwriting of LBO debt, including total leverage thresholds (generally >6× EBITDA flags regulatory concern), EBITDA definition discipline, and repayment capacity analysis requirements.
Sources: Federal Reserve SR 13-3 Leveraged Lending Guidance; OCC Comptroller's Handbook — Leveraged Lending; SEC EDGAR — LBO merger filings and credit agreements; SIFMA Leveraged Finance Statistics.