A signalling hypothesis of leveraged buyout (LBO) capital structure is examined, wherein the promoters of an LBO unambiguously convey their commitment to generate and distribute free cash flow to investors by assuming debt service obligations high enough to exhaust free cash flow during the initial phase of the LBO operation. The signalling equilibrium results in an equity value consistent with the promoters' expectations concerning free cash flow and permits them to keep the value released by the LBO. The model admits positive probability of default in equilibrium, but equity values are shielded from the costs of financial distress by the adoption of a strip financing arrangement. The promoters have an incentive to adopt strip financing, and investors find it not optimal to unbundle the securities making up the strip. Properties similar to those of strip financing are identified in a number of common financial structures and instruments.
Arzac, Enrique. "On the Capital Structure of Leveraged Buyouts." Financial Management 21, no. 1 (Spring 1992): 16-26.
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