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.
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.