Investing Assets & Markets Stocks LBOs and Their Threat to the U.S. Economy This Financial Trick Could Trigger the Next Financial Crisis By Kimberly Amadeo Updated on May 24, 2021 Reviewed by Charles Potters Fact checked by Vikki Velasquez LBOs are like too much credit card debt for companies. Photo: Photo: Daryl Solomon/Getty Images A leveraged buyout is when one company borrows a lot of money to buy out another one. A typical buyer borrows the money by issuing bonds to investors, hedge funds, and banks. Like any other bond, the buyer will put up its own assets as collateral. But an LBO allows it to put up the assets of the company it wishes to buy as collateral as well. That leverage allows a small company to borrow funds to buy a much bigger company without much risk to itself. All the risk is carried by the bigger target company. That's because the debt is put on its books. If there's trouble paying the debt, its assets will be sold off first and it will go bankrupt. The smaller, acquiring company goes scot-free. These deals are usually done by private equity companies that purchase a public company to take it private. That gives the purchaser time to make the changes needed to make the target company more profitable. It will then sell the acquired company later on at a profit, often by taking it public again in an IPO. It's like a flipper for companies instead of houses. The debt must offer high yields to offset the risk. The high-interest payments alone can often be enough to cause the bankruptcy of the purchased company. That's why, despite their attractive yield, leveraged buyouts issue what's known as junk bonds. They're called junk because often the assets alone aren't enough to pay off the debt, and so the lenders get hurt as well. Is There Any Protection From LBOs? The Federal Reserve and other banking regulators issued guidance in 2013 to their banks to control LBO risk. They urged banks to avoid financing LBOs that allowed the debt to be more than six times annual earnings of the targeted company. The regulators told banks to avoid LBOs that stretched out payment timelines or didn't contain lender protection covenants. But enforcement of the guidelines isn't straightforward. Many bankers complain that the guidelines aren't clear enough. There are different ways to calculate earnings. Some deals may follow most, but not all, guidelines. Banks want to make sure they are all judged the same. Banks have reason to be concerned. The Fed has allowed some banks to exceed the recommended level in certain cases. The Fed has a far reach, overseeing bank holding companies, state member banks, nonbank financial companies, and foreign banks operating in the U.S., to name a few. The Office of the Comptroller of the Currency oversees banks chartered under the National Bank Act and federal savings associations under the Home Owners' Loan Act. The Looming LBO Threat Too many banks have ignored the regulations. As a result, an alarming 40% of U.S. private equity deals exceeded the recommended debt levels. That's the highest since the 2008 financial crisis. In 2007, 52% of loans were above the recommended levels. Regulators are concerned that, if there is any kind of a downturn, banks will once again be stuck with too much bad debt on their books. Only this time it will be junk bonds instead of subprime mortgages. Warning signs first appeared in 2014. In April 2014, the largest LBO in history became the eighth largest bankruptcy ever. Energy Future Holdings was destroyed by the $45 billion debt it was saddled to pay for its buyout. The three who brokered the deal, KKR, TPG and Goldman Sachs bought the company for $32 billion in 2007 and took on $13 billion in debt the company already had. The company they bought, TXU Corp, was a Texas utility with strong cash flow. The dealmakers didn't realize that energy prices were about to drop thanks to discoveries of shale oil and gas. They paid top dollar to shareholders to take the company private, thinking that gas prices would rise instead. The company lost customers, since Texas utilities were deregulated. During the first nine months of 2018, almost 13% of LBOs had too much leverage. The average debt load was seven times the target company’s earnings before interest, taxes, depreciation and amortization. It's more than double the 2017 level, according to S&P's Global Market Intelligence’s LCD. It will be the highest since 2014, when 13.5% of deals crossed that threshold. LBOs Hurt Job Growth and Economic Growth The next four largest LBOs were also flailing: First Data ($26 billion) hired a new CEO, Frank Bisignano, in April 2013, to turn it around.Alltel ($28.1 billion) was sold to Verizon in June 2008 for $5.9 billion, plus $22.2 billion in remaining debt. Often after a merger like this, jobs are lost as the companies try to find more efficient operations.In 2015, H.J. Heinz ($23.6 billion) closed plants to generate more cash flow.In 2007, Equity Office Properties ($39 billion) sold off more than half of its 543 commercial buildings. These are great examples of how LBOs hurt the economy. The new owners must find ways to increase profits to pay off the debt. The best way to do this is to sell buildings, consolidate operations and reduce headcount. All these steps reduce jobs, or at least stop job growth. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. U.S. Office of the Comptroller of the Currency. "Leveraged Lending, Comptroller’s Handbook, February 2008." Federal Reserve Bank. "Frequently Asked Questions (FAQ) for Implementing March 2013 Interagency Guidance on Leveraged Lending." Federal Reserve Bank. "SR 13-3: Interagency Guidance on Leveraged Lending." Federal Reserve Bank. "Function Supervising and Regulating Financial Institutions and Activities," Pages 74-80. U.S. Office of the Comptroller of the Currency. "What We Do." Wall Street Journal. "Debt Rises in Leveraged Buyouts Despite Warnings." Wall Street Journal. "How Shale-Gas Boom Led to Demise of Energy Future Holdings." Wall Street Journal. "Risky Deals Return to Leveraged-Buyout Market." New York Times. "K.K.R. Offer of $26 Billion Is Accepted by First Data." First Data. "Frank Bisignano: Chairman and Chief Executive Officer." New York Times. "Verizon Agrees to Buy Alltel for $28.1 Billion." Verizon. "Verizon Wireless Completes Purchase of Alltel; Creates Nation's Largest Wireless Carrier." Wall Street Journal. "Kraft to Slash 2,600 More Jobs, Close Seven Plants." New York Times. "Brazilian Investor 3G Capital’s Big Food Deals." New York Times. "Vornado Under Pressure to Sweeten Its Bid for Office Landlord." New York Times. "After Acquiring Equity Office, Blackstone Begins Selling It."