I’m finally reading the Supreme Court opinion in Czyzewski v. Jevic Holding Corp, 137 S. Ct. 973 (2017). Justice Breyer very nicely explains how an LBO works.
In 2006, Sun Capital Partners, a private equity firm, acquired Jevic Transportation Corporation with money borrowed from CIT Group in a “leveraged buyout.” In a leveraged buyout, the buyer (B) typically borrows from a third party (T) a large share of the funds needed to purchase a company (C). B then pays the money to C’s shareholders. Having bought the stock, B owns C. B then pledges C’s assets to T so that T will have security for its loan. Thus, if the selling price for C is $50 million, B might use $10 million of its own money, borrow $40 million from T, pay $50 million to C’s shareholders, and then pledge C assets worth $40 million (or more) to T as security for T’s $40 million loan. If B manages C well, it might make enough money to pay T back the $40 million and earn a handsome profit on its own $10 million investment. But, if the deal sours and C descends into bankruptcy, beware of what might happen: Instead of C’s $40 million in assets being distributed to its existing creditors, the money will go to T to pay back T’s loan—the loan that allowed B to buy C. (T will receive what remains of C’s assets because T is now a secured creditor, putting it at the top of the priority list). Since C’s shareholders receive money while C’s creditors lose their claim to C’s remaining assets, unsuccessful leveraged buyouts often lead to fraudulent conveyance suits alleging that the purchaser (B) transferred the company’s assets without receiving fair value in return. See Lipson & Vandermeuse, Stern, Seriously: The Article I Judicial Power, Fraudulent Transfers, and Leveraged Buyouts, 2013 Wis. L. Rev. 1161, 1220–1221.