Private equity transactions, which used to be more commonly referred to as venture capital transactions, cover a range of arrangements which have one common feature: the source of the money that finances the transaction. This source is typically a fund set up expressly for investing in unquoted securities (private equity) rather than publicly quoted securities or government bonds. Funds formed to invest in private equity transactions are financed by a range of sources, including pension funds, banks and insurance firms, companies, individuals and public agencies. Among themselves, private equity transactions fall into three broad categories:
- Start-ups. This is the financing of companies from scratch.
- Development Capital. This money is used to promote the growth of existing businesses.
- Buy-Outs- It is the investment teams financing the acquisitions of companies. When talking about private equity and venture capital, it is this area of private equity funding that many people consider.
A buyout is a process whereby a management team, which could be the original team or one explicitly formed for the acquisition purpose, acquires a company (Target) from Target’s current owners using equity funding from a private equity provider and debt financing from financial institutions. To achieve this, a group of new enterprises (Newco group) will be established. A simple arrangement would consist of a top corporation (Newco), serving as the investor’s investment vehicle, and a wholly-owned Newco subsidiary (Newco 2), and serving as the acquisition and debt vehicle.
Buyouts fall into one of these categories:
- Management buyouts (MBOs) – where the existing management team purchases the business they are managing.
- Management buy-ins (MBIs)-where, a management team is formed for acquisition purposes.
- Buy-in/management buyouts (BIMBOs) – a combination that incorporates an internal team of management with an external team.
- Institutional buyouts (IBOs) – where a private equity fund establishes a firm to acquire a business and gives management a small stake either at the time of purchase or after completion of the purchase.
Advantages of Buyouts
A buyout of businesses may get rid of any service areas or duplication of services. It can reduce operating expenses, which can, in turn, result in increased profits. The company that participates in the buyout can compare individual processes and choose the better one. The corporation that is created will be in a better position at better rates to purchase insurance, merchandise and other things.
By buying out one‘s competition, a business can increase its profits. The buyout can offer increased economies of scale to the newly formed company, as well as eliminate the need to engage in a price war with a competitor. That can result in lower prices for the company’s products or services, which will benefit its customers.
A big and well-established company may decide to buy a smaller business with a new technology or a promising product, a change that will help both businesses. The smaller business being acquired will benefit from having access to more and more resources, as well as the ability to sell the technology or goods to a broader customer base. The more extensive company will benefit from integrating the smaller company’s latest technology or goods into its existing product line, without charging for licensing the technology.
Disadvantages of a Company Buyout
The acquiring firm might need to borrow money to finance the new company’s purchase. This move will affect the acquirer’s debt structure and increase loan payments on the books of the firm. It may force the company to cut spending elsewhere. They may be required, for example, to lay off some employees or even end up selling a portion of their business to ensure they remain profitable. Besides, the company’s funds used for the business buyout are taking resources away from internal growth programs.
Sometimes buyouts from companies can be seen as a time for some of the key personnel to quit and retire or find a new challenge. It can be a tough challenge to find another person with similar experience and knowledge.
Integration of the two companies’ personnel and procedures will take time. Although the two companies may do comparable things, they may have significantly different corporate cultures and methods of operation. This can lead to resistance to change within the organization, which can cause severe and costly problems. The effect may be a loss in profitability for the client.
Effect of Private equity buyouts in Economy
A study conducted by the researchers at Harvard University and the University of Chicago, “Economic effects of private equity buyouts and covered the real side of effects of private equity buyouts” by examining more than 9000 private equity buyouts power period of 30 years.
When credit was cheap, PE companies preferred to produce returns through financial engineering rather than operational improvements, for example by issuing new debt to finance increased dividend returns on equity, but when it was expensive private equity firms had less financial engineering and concentrated on operational improvements as economic booms and credit expanded narrow private equity deals
Labour productivity has a striking effect in public-private buyouts, with goals appearing to be large companies in major industries, the study said productivity often rises by 8 per cent in private-private buyouts.
The study did not explain how buyouts in the acquired companies produce efficiency gains. One of the levers, however, was the reallocation of resources from less productive manufacturing plants to more productive ones, including human resources, to more productive parts of the company.
While employment expands the buyout of private firms and secondary buyouts by 13% and 10% respectively of public firms and carves outs See employment drop by 13% and 15% respectively. Many public-private deals involve companies suffering from poor corporate governance and the need to cut costs, including closing down some of the facilities noted in the parent company’s carve-outs, many recognize the need for downsizing but resist to shield its public image and preserve the morale of employees in the rest of the phone.
Average earnings per worker drop by 1.7 per cent and buyout erase 70 per cent of the small pre-buy wage premium over the pre-post transaction of two years. The combination of buyouts leading to significant productivity gains on the one hand and job and wage losses on the other, pose severe challenges for policy design particularly in the era of slow productivity growth that ultimately drives living standards and economic inequality concerns. However, buyouts of private equity are a potentially powerful tool to increase productivity and make the pie bigger. Hence further exploration would address harnessing private equity’s power to drive productivity growth in a socially beneficial way.
The results of buyouts on growth in jobs indicate a multiplier impact of private equity that resonates with fears that private equity magnifies the impact of the economic shock. Public to private deals, in particular, proliferate before credit market tightening. Those buyouts later show significant job losses and poor results during aggregate downturns.
Conclusion
A buyout includes the process of acquiring a controlling interest in another company, either by buying it outright or by receiving a controlling interest in equity. Typically buyouts occur because the acquirer is confident that a company’s assets are undervalued.
Others may occur because the buyer has a vision of gaining strategic and financial benefits like new market entry, better operating efficiency, higher revenues or less competition. In the end, most buyouts occur as a result of the buyer’s belief that the transaction will create more value for a company’s shareholders than is possible under the current management of the target company.
Both sides can see both benefits and inconveniences during a buyout. Many things need to be addressed if the transaction is to be successful. The agreement should ensure that both parties are satisfied with their needs. However, it is unrealistic for both sides to achieve all they desired. Both sides need to consider the pros and cons of the buyout carefully.
(Anand S, Student of Second Semester at National University of Advanced Legal Studies, Kochi)
References
- What is private equity & and how does a buyout work? – DFA …. https://www.dfalaw.co.uk/faq_type/what-is-private-equity-and-how-does-a-buyout-work/
- Buyout – Overview, Types, Advantages and Disadvantages. https://corporatefinanceinstitute.com/resources/knowledge/deals/buyout/
- “Economic effects of private equity buyouts and covered the real side of effects of private equity buyouts” https://www.hbs.edu/faculty/Publication%20Files/20-046_ceb00b98-e62a-45db-8d5f-9793ffd0226e.pdf
- What Happens After a Private Equity Buyout? https://budgeting.thenest.com/happens-after-private-equity-buyout-28601.html
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