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Risks of Leverage

There are numerous risks that come along with completing any deal in the business world. One right move and the margins can increase exponentially, while one wrong move and everything can come crashing down. It is important to be aware of the potential risks of a leverage buyout before deciding to pursue one. When a business completes a leverage buyout, it is acquiring another company using capital from an outside lender to successfully “leverage” the purchase the business. The goal of a leverage buy out to efficiently transfer ownership from one party to another, using a combination of equity and debt to fund the purchase price.

First, the business must ask itself whether it can handle the new debt that will be put on the balance sheet. Does the company have the necessary cash flows to fund the multi-year carry cost of principal and interest? The interest costs resulting from the deal are fixed costs that can be detrimental to a company if not paid on time and can cause the company to default. The purchaser must also be confident in its valuation and the cash flow generation of the business that it is acquiring. If the company is overvalued and does not provide the level of cash flow expected, it can lead to illiquidity, putting the entire company at risk. Often with an acquisition, purchasers are too aggressive with using leverage to finance their purchase. The interest cost of the loan may be attractively low, but if the loan consumes most of the company’s working capital availability, there will be a little in the way of margin of error for financial under performance. Throughout the decades, failed deals are often by characterized by an illiquidity squeeze, where companies run out of money because they did not have sufficient capital cushion going into the deal. Be sure to mitigate this risk in your next deal by prudently structuring your leverage buy out.

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