What Is a Leveraged Buyout?
A leveraged buyout (LBO) is the acquisition of a company using a significant amount of borrowed money to fund the purchase. Assets are used as collateral for the additional debt. This includes assets of the company being acquired as well as assets of the acquiring company. In a leveraged buyout (LBO), there is usually a ratio of 90% debt to 10% equity. The purpose of a leveraged buyout is to allow a company to make a large acquisition without having to commit as much capital.
In the world of corporate finance, a leveraged buyout (LBO) is a transaction where a company is acquired using debt as the primary source of funding. LBO transactions typically occur when a private equity (PE) firm borrows as much as it can using a variety of lenders. Up to 70 – 90 percent of the purchase price is funded with borrowed money. The remaining balance is funded with their own equity.
Understanding a Leveraged Buyout (LBO)
In a leveraged buyout (LBO), there can be a ratio of 90% debt to 10% equity. Because of this high debt-to-equity ratio, the bonds issued in the buyout are not always investment grade. They are sometimes referred to as junk bonds. Further, many people regard LBOs as an especially ruthless, predatory tactic. This is because it isn’t usually sanctioned by the target company. Ironically, a profitable company’s success can be used against it. Assets on the balance sheet are targeted as collateral by the hostile company.
LBOs are conducted for a number of reasons. One reason is to take a public company private. A second reason is to spin-off a portion of an existing business by selling it. A third reason is to transfer private property, as is the case with a change in small business ownership. It is usually necessary that the acquired company, in each of these scenarios, is profitable and growing.
Why Use a Leveraged Buyout?
A leveraged buyout can be part of a mergers and acquisitions (M&A) strategy. They can sometimes be used to acquire the competition, to enter new markets, or to help a company diversify. Buyers like leveraged buyouts because they don’t have to put in very much of their own money. Additionally, this allows them to report a higher internal rate of return (IRR). Leveraged buyouts earned a bad reputation in the 1980s after a series of well-publicized hostile takeovers. Today, it is a relatively common method for selling a business. The seller is able to get the price they want for the sale of their business. It paves the way to exit the company with a solid plan in place for continued business. A leveraged buyout is a common strategy for business owners to retire. It lets professionals, like doctors and dentists successfully cash out at the end of their careers.
To take a public company private
Taking a publicly-traded company private means consolidating its public shares. It requires buying those shares and putting them into the hands of private investors. These private investors then take those shares off the market. The private investors will now own either all or a majority of the target company. To achieve this, it requires enough capital to purchase all or most of the company’s net value. You can use a leveraged buyout to consolidate the public shares and transfer them to a private investor. The investor will then own a majority of the company and will assume the debt liability created by the transaction.
To break up a large company
Sometimes a company may grow large and inefficient, such that the whole is worth less than the sum of its parts. In this case, an investor may purchase the company and split it up. It may be more valuable to sell it as a series of smaller companies. For example, Motorola is splitting its consumer-oriented side, which makes cell phone and cable set-top boxes. Consumer products will be separate from the professional business of selling police radios and barcode scanners to government agencies and large companies. The new companies will be called Motorola Mobility and Motorola Solutions. An LBO using this strategy can give smaller companies a better chance to grow and stand out. They can be more manageable and focused than they would have been as part of an inefficient conglomerate.
To enrich shareholders and owners
When a company is purchased, one way or another the purchase price flows to the owners.
- Privately Held Firms – For a privately held firm, the individual owners collect that money directly minus any other liabilities.
- Publicly Held Companies – For a publicly held firm the purchase capital accrues to shareholders. This typically enriches executives and members of the board of directors. Executives will often have their compensation tied to stock performance. Directors typically comprise some of the company’s largest shareholders.
This means that a leveraged buyout comes with a significant conflict of interest. The decision-makers in charge of approving any acquisition stand to personally make a lot of money. This will occur even if it results in saddling the company with unsustainable debt obligations. In cases where an investor is purchasing the firm, often that investor will already own significant holdings in the target firm. As a result, it gives them an additional stake in this personal enrichment.
An LBO is similar to the practice of leveraged buybacks. This is where shareholders have a company assume significant debt in order to buy back its own stock on the open market. In both cases, the company takes on a significant financial liability. The conflict of interest occurs with a transaction that directly enriches the individuals making that decision.
Why do Private Equity Takeovers Use so Much Leverage?
The use of leverage (debt) enhances expected returns to the private equity firm executing the deal. By putting in as little of their own money as possible, PE firms can achieve a large return on equity (ROE). Private Equity firms are typically compensated based on their financial returns. The use of debt in an LBO is an essential ingredient in achieving their targeted rates of return.
While leverage increases equity returns, the drawback is that it also increases risk. By strapping multiple tranches of debt onto an operating company the PE firm is significantly increasing the risk of the transaction (which is why LBOs typically pick stable companies). If cash flow is tight and the economy of the company experiences a downturn they may not be able to service the debt and will have to restructure, most likely wiping out all returns to the equity sponsor. (Source:cfi.com)
What type of Company is a Good Candidate for an LBO?
Generally speaking, companies that are mature and stable are potential candidates for a leveraged buyout. Given the amount of debt that will be added to the business, it’s important that cash flows are predictable. High margins and relatively low capital expenditures are also an advantage. Steady cash flow is what enables the company to service the additional debt.
An ideal candidate for a leveraged buyout is a company that has a stable cash flow, has low outstanding debt, and is undervalued. Companies with these characteristics are most likely to avoid bankruptcy and maximize profitability for their buyers. Stable cash flow is perhaps the most important characteristic that an LBO target company needs to possess. Stable cash flows will help the business to survive while it pays off the significant debt it incurred during the acquisition. If the company can’t handle the new debt, it will be forced into bankruptcy. In that event, the PE firm will lose its entire investment and the bank will seize the company’s assets as collateral.
Leveraged Buyout Targets
Another key feature of LBO target companies is that they have low outstanding debt at the time of acquisition. If a large amount of debt already exists when the buyout occurs, the company almost certainly will not be able to handle the payments associated with its pre-existing debts in addition to those associated with the leveraged loan. The leveraged loan would demand even higher rates in this situation, creating a nightmare scenario for the business. Because the money to be made in an LBO is in the margins, an undervalued company can save buyers money by reducing the total cost of the acquisition, which therefore reduces the total size and cost of the loan. When the target company is resold, its newly restructured management and greater efficiency make for a higher valuation, increasing profits considerably. (Source:medium.com)
An Example of A Leveraged Buyout (LBO)
Leveraged buyouts have had a spotted and checkered history. In the 1980s, several prominent buyouts led to the eventual bankruptcy of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100%. The interest payments were so large that the company’s operating cash flows were unable to meet the obligation.
One of the largest LBOs on record was the acquisition of Hospital Corporation of America (HCA) by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch in 2006. The three companies paid around $33 billion for the acquisition of HCA. LBOs are often complicated and take a while to complete. For example, JAB Holding Company, a private firm that invests in luxury goods, coffee, and healthcare companies, initiated an LBO of Krispy Kreme Doughnuts, Inc. in May 2016. JAB was slated to purchase the company for $1.35 billion, which included a $350 million leveraged loan and a $150 million revolving credit facility provided by the Barclays investment bank. However, Krispy Kreme had debt on its balance sheet that needed to be sold, and Barclays was required to add an additional 0.5% interest rate in order to make it more attractive. This made the LBO more complicated. (Source:investopedia)
Benefits of a Leveraged Buyout
LBOs have clear advantages for the buyer:
- Preserves Capital – They get to spend less of their own money,
- Higher Return on Investment – Buyers get a higher return on investment which can help turn companies around.
- Higher Return on Equity – They see a bigger return on equity than with other buyout scenarios. This is because they’re able to use the seller’s assets to pay for the financing cost rather than their own.
- Tax Implications – An LBO can also lower a business’ taxable income. The added debt can yield tax benefits the buyer didn’t have before.
Advantages for the seller:
- Turnaround Potential – One of the main advantages of a leveraged buyout is the ability to sell a business that might not be at its peak performance but still has cash flow and the potential for growth.
- Improved Market Position – If an LBO improves a company’s market position – or even saves it from failure – the shareholders and employees stand to benefit.
- Engaged Owners – Employees can also benefit from executives that are now more engaged in the business because they own a larger stake.
- Non-hostile Takeover Opportunity – A leveraged buyout allows groups such as employees or family members to acquire a company. For example, if the current owner is retiring. This can also lead to greater engagement.
- Tax Advantages – If the target company is privately held, the seller could realize tax advantages from the LBO.
Criticism of Leveraged Buyout
- Greater Risk – The same leverage that allows greater reward also comes with greater risk. For the buyer, there is little margin for error, and if they’re not able to pay back the debt, they’ll get no return at all. Depending on how the buyer defines risk and how risk-tolerant he or she is, this could be attractive or it could be a source of anxiety. The risks of a leveraged buyout for the target company are also high. Interest rates on the debt they are taking on are often high and can result in a lower credit rating. If they’re unable to service the debt, the end result is bankruptcy. LBOs are especially risky for companies in highly competitive or volatile markets.
- Decreased Competitiveness – Aside from risk, there are several criticisms of leveraged buyouts that are worth considering. Because the company will often focus on cutting costs post-buyout in order to pay back the debt more quickly, LBOs sometimes result in downsizing and layoffs. They can also mean that the company does not make investments in things like equipment and real estate, leading to decreased competitiveness in the long term.
- Hostile and Predatory – Another criticism of LBOs is that they can be used in a predatory manner. This can occur when the management of a company organizes an LBO to sell it back to themselves and gain short-term personal profit. Predatory buyers can also target vulnerable companies, take them privately using an LBO, break them up and sell off assets – then simply declare bankruptcy and earn a high return. This is the tactic private equity firms used in the 1980s and 1990s that led to leveraged buyouts garnering a negative reputation. However, leveraged buyouts aren’t always predatory. (Source:tonyrobins)
Sandbagging is a strategy of lowering the expectations of a company in order to appear to produce greater-than-anticipated results. In a business context, sandbagging is most often seen when a company’s top executives manage the expectations of shareholders. They do this by providing guidance that is well below what they know will be realistically achievable. In other words, management will purposely low-ball projected earnings and other performance indicators. As a result, the company achieves better-than-expected results and investors are significantly more impressed. Psychologically, it is better to over-deliver on mediocre guidance than to just meet average expectations.
Sandbagging occurs when a company intentionally lowers its estimation for success with the goal of producing greater than expected results. When the expected results are surpassed, the company will be seen as financially savvy. The top employees may even receive a bonus in appreciation of their good performance.
