Quora Answer: Why are Leveraged Buyouts Legal?

The following is my answer to a Quora question: “Why are leveraged buyouts legal?”

Before we address why they are legal, we have to understand what they really are, and how they work.  Essentially, a leveraged buyout is simply a financial transaction in which a company is purchased through some combination of equity and debt.  The company’s cash flow is the collateral for the debt.  They are borrowing against the company to pay for it.  This is not as strange as it sounds.  When you buy a car or house, you take out a loan to buy it.  You are also borrowing against the asset to buy it.  In this case, since a company itself has no intrinsic value, they borrow against the cashflow, future projected earnings.

In the case of companies, this makes a lot of sense since the use of debt is cheaper than equity against the capital, making the acquisition cost less.  The interest payments are used to offset some of the corporate tax liability.  If they used equity and issued dividends after the acquisition, that dividend is taxable as income.

As can be seen, this makes perfect financial sense, and reduces costs all around.  Few people have that much liquidity available for outright purchases, and the use of debt instruments increases economic activity, contributing to GDP.  There are instances, of course where the buyout fails due to the acquired company being overleveraged on debt, and their earnings cannot fund debt payments.  This is a case of overly optimistic projections of earnings, overvalued asset, or too high a debt ratio.  This is bad analysis.  It does not make the majority of leveraged buyouts illegal.