A leveraged buyout – or LBO for short – is the acquisition of a company or division of a company financed largely by borrowed funds (hence the term ‘leveraged’). Leveraged buyouts allow a private equity firm to finance a large acquisition without having to commit a lot of capital. The acquisition is still funded with both debt and equity, like other leveraged transactions. Take a mortgage, for example. Just as your mortgage is secured by the value of the house you’re purchasing, so too is the debt required for an LBO secured by the assets of the business being bought. In other words, those assets are the loan’s collateral.
LBOs are large, high-profile, and complex operations, and will often require the input of third parties – such as investment banks, law firms, and consultants – to structure the transaction. An intermediary is also sometimes required to negotiate emotional matters which will affect the people currently involved with the business. These might include severance deals, union contracts, restructuring plans, and the like.
How Does A Leveraged Buyout Work?
The first – and most important – step is to discern whether the LBO will be a profitable venture. To do this, an acquirer must study the financial forecasts and reports of the target business to ensure that enough cash is being generated to fund the principal and interest payments of the loan required to make the purchase. If these forecasts are correct, the idea is that the business will then pay for itself, and make further profits thereafter – this is why you might also hear an LBO called a ‘bootstrap’ acquisition.
Once the target company’s financial health has been verified, the next step is to discern how much debt will be used, and how it will be sourced. One common method is to issue bonds in the open market. Because the debt-equity profile of a leveraged venture is so high, these are often very low-grade, or ‘junk bonds’. When this is done, a bid may be made, which it is hoped shareholders will have no choice but to accept. It’s also hoped that no other bidders will emerge, which can start a takeover war!
Advantages Of A Leveraged Buyout
Leverage brings a lot of advantages when used to acquire (buyout) a company. As the debt ratio in a deal increases, the equity portion of the acquisition financing will obviously shrink. This means a private equity firm may be able to acquire a firm by putting up only, say, 20-30% of its total price, allowing the acquirer to access opportunities for wealth generation that would otherwise have been out of their financial reach. Plus, leveraged buyout deals are typically struck alongside members of a company’s existing management, which means top executives will often have significant portions of their personal net wealth at stake in the company. This means they have ample motivation to bring their A-game to the new venture, and align their own incentives with that of the wider enterprise. Finally, the large interest and principal requirements of the owners can also force management to improve performance and operating efficiency out of necessity, for example by trimming down its corporate structure and securing better deals from suppliers. This extra discipline forced by being indebted will therefore, in the long run, result in a more effective business, and once the initial debts are paid off, profits can continue for many years to come.
Disadvantages Of A Leveraged Buyout
Of course, there are major downsides. The most obvious risk is that of financial distress – failure to meet interest payments, technical default, or even the dreaded outcome, liquidation. So many factors in the financial world can cause a previously rosy venture to quickly turn sour. Recession, litigation, and new restrictive changes in the regulatory environment can all lead to difficulties, and the ability of a business to remain competitive is never an absolute certainty, as technological and social developments abound. It is, therefore, crucial that the firm being bought will be managed properly. Weak management is anathema to the success of an enterprise of this type, and will almost certainly result in everybody losing money.
The Rise Of Leveraged Buyouts
While leveraged buyouts have been around in finance since roughly after World War II, they were, for decades, an obscure and rarely seen finance technique. Since the Great Depression, firms were keen to avoid risk, thus the use of leverage was at an all-time low. But attitudes towards debt have rapidly changed in the financial world since then, as new generations of bankers have emerged. In the 1980s, leveraged buyouts were en mode, as activity peaked in 1988 with 410 buyouts completed at an aggregate value of $188 billion. They were the focus of particular media attention, though not all of it favourable. In hostile takeover situations, the target’s assets are used to secure credit for the acquirer, which has helped LBOs accumulate a predatory reputation, whose proponents are often characterised as greedy and irresponsible. One of the most famous – if ill-fated – leverage buyout decisions in the finance world was the attempted buyout of RJR Nabisco by Ross Johnson, as documented in the brilliant book and HBO tele-film, ‘Barbarians At The Gate’. If you get the time, and you’re interested about learning more on how an LBO works, we fully recommend you check it out.
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