What defines a leveraged buyout (LBO)?

A leveraged buyout (LBO) is defined as a transaction in which a company is purchased using a significant amount of borrowed funds, with the expectation that the cash flows generated by the acquired company will be sufficient to meet the debt payments. This strategy allows investors to make a larger investment in a company than they could using only their own capital.

In an LBO, the debt raised to finance the acquisition is typically secured against the assets of the target company, which means that the future cash flows of the company are used to pay off the debt over time. This can create a situation where the equity investment of the buying party is relatively small compared to the total value of the purchased company, thereby leveraging their investment.

The other choices do not align with the fundamentals of an LBO. For example, using cash reserves or shareholder equity does not involve leverage, as these options do not employ debt. Additionally, an acquisition with no debt involved clearly contradicts the defining characteristic of a leveraged buyout, as debt is a core component of such transactions. Thus, the principle of using borrowed funds to enhance investment returns is what distinctly characterizes an LBO.