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Leveraged Buyout (LBO) has been in the news recently which said that,  Corus –    an Anglo-Dutch company would be taken over by TATA – an Indian company.

Being a relatively new business concept for us, this Article aims to highlight what ‘LBO’ is all about, its advantages and disadvantages. It cannot be ruled out that, India Inc. may have to see take-overs in the form of LBOs, amidst Globalisation. 

What does LBO actually mean technically?

Simply put – it is the purchase of a company by using a small investment and a large loan. The new owner would gain control with a small amount of invested capital because he or she is able to secure a large loan for the balance of the amount needed. A leveraged balance sheet has a small portion of equity capital and therefore a large portion of loan capital.

Leveraged Buyout – also called as ‘Highly-Leveraged Transaction (HLT)’ – occurs when a financial sponsor gains control of a majority of a target company’s equity through the use of borrowed money or debt.

Typically, the loan capital is borrowed through a combination of prepayable bank facilities and/or public or privately placed bonds, which may be classified as high-yield debt, also called junk bonds. Often, the debt will appear on the acquired company’s balance sheet and the acquired company’s free cash flow will be used to repay the debt.

A leveraged buyout is essentially a strategy involving the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. In an LBO, there is usually a ratio of 70% debt to 30% equity. LBOs today  focus more on growth and complicated financial engineering to achieve their returns.

Brief History:

What is believed to be the first leveraged buyout in business history is through the acquisition of Orkin Exterminating Company in 1964. However, the first LBO may have been the purchase by McLean Industries, Inc. of Waterman Steamship Corporation in May 1955.

The Theory of the Leveraged Buyout:

While every leveraged buyout is unique with respect to its specific capital structure, the one common element of a leveraged buyout is the use of financial leverage to complete the acquisition of a target company. In an LBO, the private equity firm acquiring the target company will finance the acquisition with a combination of debt and equity, much like an individual buying a rental house with a mortgage .Just as a mortgage is secured by the value of the house being purchased, some portion of the debt incurred in an LBO is secured by the assets of the acquired business. The bought-out business generates cash flows that are used to service the debt incurred in its buyout, just as the rental income from the house is used to pay down the mortgage. In essence, an asset acquired using leverage helps pay for itself.

In a successful LBO, equity holders often receive very high returns because the debt holders are predominantly locked into a fixed return, while the equity holders receive all the benefits from any capital gains. Thus, financial buyers invest in highly leveraged companies seeking to generate large equity returns. An LBO fund will typically try to realize a return on an LBO within three to five years. Typical exit strategies include an outright sale of the company, a public offering or a recapitalization.

Exit Strategy Comments

Sale: Often the equity holders will seek an outright sale to a strategic buyer, or even another financial buyer Initial Public Offering. While an IPO is not likely to result in the sale of the entire entity, it does allow the buyer to realize a gain on its investment Recapitalization: The equity holders may recapitalize by re-leveraging the entity, replacing equity with more debt, in order to extract cash from the company.

LBO Candidate Criteria

Given the proportion of debt used in financing a transaction, a financial buyer’s interest in an LBO candidate depends on the existence of, or the opportunity to improve upon, a number of factors. Specific criteria for a good LBO candidate include:

  • Steady and predictable cash flow
  • Divestible assets?
  • Clean balance sheet with little debt?
  • Strong management team?
  • Strong, defensible market position?
  • Viable exit strategy?
  • Limited working capital requirements?
  • Synergy opportunities?
  • Minimal future capital requirements?
  • Potential for expense reduction?
  • Heavy asset base for loan collateral?

Criticism of LBOs

Critics of leveraged buyouts argue that these transactions harm the long-term competitiveness of firms involved. First, these firms are unlikely to have replaced operating assets since their cash flow must be devoted to servicing the LBO-related debt. Thus, the property, plant and equipment of LBO firms are likely to have aged considerably during the time when the firm is privately held. In addition, expenditures for repair and maintenance may have been curtailed as well. Finally, it is possible that research and development expenditures have also been controlled. As a result, the future growth prospects of these firms may be significantly reduced.

Others argue that LBO transactions have a negative impact on the stakeholders of the firm. In many cases, LBOs lead to downsizing of operations, and employees may lose their jobs. In addition, some of the transactions have negative effects on the communities in which the firms are located.

Much of the controversy regarding LBOs has resulted from the concern that senior executives negotiating the sale of the company to themselves are engaged in self-dealing. On one hand, the managers have a fiduciary duty to their shareholders to sell the company at the highest possible price. On the other hand, they have an incentive to minimize what they pay for the shares. Accordingly, it has been suggested that management takes advantage of superior information about a firm’s intrinsic value. The evidence, however, indicates that the premiums paid in leveraged buyouts compare favorably with those in inter-firm mergers that are characterized by arm’s-length negotiations between the buyer and seller.

Advantages and Disadvantages

A successful LBO can provide a small business with a number of advantages. For one thing, it can increase management commitment and effort because they have greater equity stake in the company. In a publicly traded company, managers typically own only a small percentage of the common shares, and therefore can participate in only a small fraction of the gains resulting from improved managerial performance. After an LBO, however, executives can realize substantial financial gains from enhanced performance.

This improvement in financial incentives for the firm’s managers should result in greater effort on the part of management. Similarly, when employees are involved in an LBO, their increased stake in the company’s success tends to improve their productivity and loyalty. Another potential advantage is that LBOs can often act to revitalize a mature company. In addition, by increasing the company’s capitalization, an LBO may enable it to improve its market position.

Successful LBOs also tend to create value for a variety of parties. For example, empirical studies indicate that the firms’ shareholders can earn large positive abnormal returns from leveraged buyouts. Similarly, the post-buyout investors in these transactions often earn large excess returns over the period from the buyout completion date to the date of an initial public offering or resale.

Not all LBOs are successful, however, so there are also some potential disadvantages to consider. If the company’s cash flow and the sale of assets are insufficient to meet the interest payments arising from its high levels of debt, the LBO is likely to fail and the company may go bankrupt. Attempting an LBO can be particularly dangerous for companies that are vulnerable to industry competition or volatility in the overall economy. If the company does fail following an LBO, this can cause significant problems for employees and suppliers, as lenders are usually in a better position to collect their money. Another disadvantage is that paying high interest rates on LBO debt can damage a company’s credit rating. Finally, it is possible that management may propose an LBO only for short-term personal profit.

Written By:  Anand Wadadekar, M.A Economics, MBA Finance & Banking, AMFI, DIT, GCIPR

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June 2024