What Is a Leveraged Buyback?

A leveraged buyback, also known as a leveraged share repurchase, is a corporate finance transaction that enables a company to repurchase some of its shares using debt. By reducing the number of shares outstanding, it increases the remaining owners' respective shares.

Leveraged buybacks have similar impacts to leveraged recapitalizations and dividend recapitalizations, in which companies employ leverage to pay a one-time dividend. The difference is that dividend recapitalizations do not change the ownership structure.

Key Takeaways

  • A leveraged buyback is a financial transaction that lets a company repurchase some of its stock by using debt. 
  • The process boosts the remaining owners' shares by limiting the number of shares that are outstanding.
  • Companies sometimes use leveraged buybacks to protect themselves from hostile takeovers by having extra debt on their balance sheets.
  • More often the purpose of these kinds of buybacks is to increase earnings per share (EPS) and improve other financial metrics.

How a Leveraged Buyback Works

Leveraged buybacks should, theoretically, have no immediate impact on a company's share price, net of any tax benefits from the new capital structure, and higher interest payments. But the extra debt provides an incentive for management to be more disciplined and improve operational efficiency through cost-cutting and downsizing, in order to meet larger interest and principal payments; a justification for the extreme levels of debt in leveraged buyouts.

Leveraged buybacks are sometimes used by companies with excess cash to decapitalize their balance sheets to avoid overcapitalization. Increasing the debt on the balance sheet can provide shark repellant protection from hostile takeovers.

The use of leveraged buybacks, particularly to improve EPS and other financial metrics, increased significantly in the aftermath of the 2008 financial crisis.

But more often than not, leveraged buybacks, like other share repurchases, are simply used to increase earnings per share (EPS), return on equity, and price-to-book ratio.

Leveraged Buybacks and EPS

Boosting EPS through leveraged buybacks can be an effective tool for companies to use, but it does not signify an improvement in underlying performance or value. It can even do damage to the business if financial engineering comes at the expense of not investing capital productively for the long term. Executives say there are not enough investment opportunities. But there is clearly a big conflict of interest, given that executive compensation is linked to EPS in most American companies.

Financial markets have rewarded companies using buybacks as a substitute for improving operational performance. So it is no wonder that buybacks have become one of Wall Streets' favorite tools since the global financial crisis.

Buybacks are a mixed bag, they can increase earnings-per-share and improve other financial metrics but also put a firm's credit ratings at risk.

Between 2008 and 2018, companies in the United States spent over $5 trillion buying back their own stock, or over half their profits. And for such large companies, such as Procter & Gamble, Mondelez, and Eli Lilly, approximately 40% of EPS growth has been a result of buybacks.

Leveraged Buyback Returns

Leveraged buybacks have made a big comeback in the U.S., where share repurchases have exceeded free cash flow since 2014. They can also be used to avoid having to repatriate cash and pay U.S. taxes.

The buyback boom has increased the risk for both bondholders and shareholders. Even investment-grade companies have been willing to sacrifice their credit ratings in order to reduce the number of shares. For example, McDonald’s, whose executives depend on EPS metrics as a component of their performance incentive payout, had borrowed so heavily to fund buybacks that its credit rating fell from A to BBB between 2016 and 2018. 

Rising interest rates could choke off this boom in leveraged buybacks. But so could politicians. Senate Democrats have strongly criticized the buyback boom, arguing that Trump's tax reform isn't trickling down to workers. They want to regulate buybacks, which were seen as a form of market manipulation before the Securities and Exchange Commission (SEC) gave them the green light in 1982 when it adopted Rule 10b-18. This protects corporations from charges of stock market manipulation if buybacks on any given day are no more than 25% of the previous four weeks’ average daily trading volume.