Leveraged buyout
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A leveraged buyout (LBO) is one company's acquisition of another company using a significant amount of borrowed money (leverage) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company. The use of debt, which normally has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition. This is done at the risk of magnified cash flow losses should the acquisition perform poorly after the buyout.
The cost of debt is lower because interest payments often reduce corporate income tax liability, whereas dividend payments normally do not. This reduced cost of financing allows greater gains to accrue to the equity, and, as a result, the debt serves as a lever to increase the returns to the equity.[1]
The term LBO is usually employed when a financial sponsor acquires a company. However, many corporate transactions are partially funded by bank debt, thus effectively also representing an LBO. LBOs can have many different forms such as management buyout (MBO), management buy-in (MBI), secondary buyout and tertiary buyout, among others, and can occur in growth situations, restructuring situations, and insolvencies. LBOs mostly occur in private companies, but can also be employed with public companies (in a so-called PtP transaction – public-to-private).
As financial sponsors increase their returns by employing a very high leverage (i.e., a high
Characteristics
LBOs have become attractive as they usually represent a
The amount of debt that banks are willing to provide to support an LBO varies greatly and depends, among other things, on the quality of the asset to be acquired, including its cash flows, history,
Debt volumes of up to 100% of a purchase price have been provided to companies with very stable and secured cash flows, such as real estate portfolios with rental income secured by long-term rental agreements. Typically, debt of 40–60% of the purchase price may be offered. Debt ratios vary significantly among regions and target industries.
Debt for an acquisition comes in two types: senior and junior. Senior debt is secured with the target company's assets and has lower interest rates. Junior debt has no security interests and higher interest rates. In big purchases, debt and equity can come from more than one party. Banks can also syndicate debt, meaning they sell pieces of the debt to other banks. Seller notes (or vendor loans) can also happen when the seller uses part of the sale to give the purchaser a loan. In LBOs, the only collateral is the company's assets and cash flows. The financial sponsor can treat their investment as common equity, preferred equity, or other securities. Preferred equity pays dividends and has priority over common equity.
In addition to the amount of debt that can be used to fund leveraged buyouts, it is also important to understand the types of companies that private equity firms look for when considering leveraged buyouts.
While different firms pursue different strategies, there are some characteristics that hold true across many types of leveraged buyouts:
- Stable cash flows – The company being acquired in a leveraged buyout must have sufficiently stable cash flows to pay its interest expense and repay debt principal over time. So mature companies with long-term customer contracts and/or relatively predictable cost structures are commonly acquired in LBOs.
- Relatively low fixed costs – Fixed costs create substantial risk for private-equity firms because companies still have to pay them even if their revenues decline.
- Relatively little existing debt – The "math" in an LBO works because the private-equity firm adds more debt to a company's capital structure, and then the company repays it over time, resulting in a lower effective purchase price; it is tougher to make a deal work when a company already has a high debt balance.
- Valuation – Private-equity firms prefer companies that are moderately undervalued to appropriately valued; they prefer not to acquire companies trading at extremely high valuation multiples (relative to the sector) because of the risk that valuations could decline.
- Strong management team – Ideally, the C-level executives will have worked together for a long time and will also have some vested interest in the LBO by rolling over their shares when the deal takes place.
History
History of private equity and venture capital |
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Early history |
(origins of modern private equity) |
The 1980s |
(leveraged buyout boom) |
The 1990s |
(leveraged buyout and the venture capital bubble) |
The 2000s |
(dot-com bubble to the credit crunch) |
The 2010s |
(expansion) |
The 2020s |
(COVID-19 recession) |
Origins
The first leveraged buyout may have been the purchase by
Lewis Cullman's acquisition of
The leveraged buyout boom of the 1980s was conceived in the 1960s by a number of corporate financiers, most notably
1980s
In January 1982, former U.S.
In the summer of 1984 the LBO was a target for virulent criticism by
During the 1980s, constituencies within acquired companies and the media ascribed the "
One of the final major buyouts of the 1980s proved to be its most ambitious and marked both a high-water mark and a sign of the beginning of the end of the boom that had begun nearly a decade earlier. In 1989,
By the end of the 1980s the excesses of the buyout market were beginning to show, with the
Age of the mega-buyout
The combination of decreasing interest rates, loosening lending standards, and regulatory changes for publicly traded companies (specifically the
in 2005.As 2005 ended and 2006 began, new "largest buyout" records were set and surpassed several times with nine of the top ten buyouts at the end of 2007 having been announced in an 18-month window from the beginning of 2006 through the middle of 2007. In 2006, private-equity firms bought 654 U.S. companies for $375 billion, representing 18 times the level of transactions closed in 2003.
In July 2007, turmoil that had been affecting the
Management buyouts
A special case of a leveraged acquisition is a management buyout (MBO). In an MBO, the incumbent management team (that usually has no or close to no shares in the company) acquires a sizeable portion of the shares of the company. Similar to an MBO is an MBI (Management Buy In) in which an external management team acquires the shares. An MBO can occur for a number of reasons; e.g.,
- Ownership wishes to retire and chooses to sell the company to trusted members of management
- Ownership has lost faith in the future of the business and is willing to sell it to management (which believes in the future of the business) in order to retain some value for investment in the business
- Management sees a value in the business that ownership does not see and does not wish to pursue
In most situations, the management team does not have enough money to fund the equity needed for the acquisition (to be combined with bank debt to constitute the purchase price) so that management teams work together with financial sponsors to part-finance the acquisition. For the management team, the negotiation of the deal with the financial sponsor (i.e., who gets how many shares of the company) is a key value creation lever.
Financial sponsors are often sympathetic to MBOs as in these cases they are assured that management believes in the future of the company and has an interest in value creation (as opposed to being solely employed by the company). There are no clear guidelines as to how big a share the management team must own after the acquisition in order to qualify as an MBO, as opposed to a normal leveraged buyout in which the management invests together with the financial sponsor. However, in the usual use of the term, an MBO is a situation in which the management team initiates and actively pushes the acquisition.
MBO situations often lead management teams into a dilemma as they face a conflict of interest, being interested in a low purchase price personally while at the same time being employed by the owners who obviously have an interest in a high purchase price. Owners usually react to this situation by offering a deal fee to the management team if a certain price threshold is reached. Financial sponsors usually react to this again by offering to compensate the management team for a lost deal fee if the purchase price is low. Another mechanisms to handle this problem are earn-outs (purchase price being contingent on reaching certain future profitabilities).
There probably are just as many successful MBOs as there are unsuccessful ones. Crucial for the management team at the beginning of the process is the negotiation of the purchase price and the deal structure (including the envy ratio) and the selection of the financial sponsor.
Secondary and tertiary buyouts
A secondary buyout is a form of leveraged buyout where both the buyer and the seller are private-equity firms or financial sponsors (i.e., a leveraged buyout of a company that was acquired through a leveraged buyout). A secondary buyout will often provide a clean break for the selling private-equity firms and its limited partner investors. Historically, given that secondary buyouts were perceived as distressed sales by both seller and buyer, limited partner investors considered them unattractive and largely avoided them.
The increase in secondary buyout activity in 2000s was driven in large part by an increase in capital available for the leveraged buyouts. Often, selling private-equity firms pursue a secondary buyout for a number of reasons:
- Sales to strategic buyers and IPOs may not be possible for niche or undersized businesses.
- Secondary buyouts may generate liquidity more quickly than other routes (i.e., IPOs).
- Some kinds of businesses – e.g., those with relatively slow growth but which generate high cash flows – may be more appealing to private-equity firms than they are to public stock investors or other corporations.
Often, secondary buyouts have been successful if the investment has reached an age where it is necessary or desirable to sell rather than hold the investment further or where the investment had already generated significant value for the selling firm.[38]
Secondary buyouts differ from
If a company that was acquired in a secondary buyout gets sold to another financial sponsor, the resulting transaction is called a tertiary buyout.
Failures
Some LBOs before 2000 have resulted in corporate bankruptcy, such as
Often, instead of declaring insolvency, the company negotiates a debt restructuring with its lenders. The financial restructuring might entail that the equity owners inject some more money in the company and the lenders waive parts of their claims. In other situations, the lenders inject new money and assume the equity of the company, with the present equity owners losing their shares and investment. The operations of the company are not affected by the financial restructuring. Nonetheless, the financial restructuring requires significant management attention and may lead to customers losing faith in the company.
The inability to repay debt in an LBO can be caused by initial overpricing of the target firm and/or its assets. Over-optimistic forecasts of the revenues of the target company may also lead to financial distress after acquisition. Some courts have found that in certain situations, LBO debt constitutes a fraudulent transfer under U.S. insolvency law if it is determined to be the cause of the acquired firm's failure.[39]
The outcome of litigation attacking a leveraged buyout as a fraudulent transfer will generally turn on the financial condition of the target at the time of the transaction – that is, whether the risk of failure was substantial and known at the time of the LBO, or whether subsequent unforeseeable events led to the failure. The analysis historically depended on "dueling" expert witnesses and was notoriously subjective, expensive, and unpredictable. However, courts are increasingly turning toward more objective, market-based measures.[40]
In addition, the
Banks have reacted to failed LBOs by requiring a lower debt-to-equity ratio, thus increasing the "skin in the game" for the financial sponsor and reducing the debt burden.[citation needed]
See also
- Bootstrap funding
- Divisional buyout
- Envy ratio
- History of private equity and venture capital
- List of private-equity firms
- Vulture capitalist
Notes
- ^ MacKinlay, A. Craig. "The Adjusted Present Value Approach to Valuing Leveraged Buyouts" (PDF). Wharton. Retrieved 30 October 2016.
- ^ On January 21, 1955, McLean Industries, Inc. purchased the capital stock of Pan Atlantic Steamship Corporation and Gulf Florida Terminal Company, Inc. from Waterman Steamship Corporation. In May McLean Industries, Inc. completed the acquisition of the common stock of Waterman Steamship Corporation from its founders and other stockholders.
- The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger, pp. 44–47 (Princeton Univ. Press 2006). The details of this transaction are set out in ICC Case No. MC-F-5976, McLean Trucking Company and Pan-Atlantic American Steamship Corporation – Investigation of Control, July 8, 1957.
- ^ Madoff, Ray D. (June 16, 2019). "Opinion | The Case for Giving Money Away Now". Wall Street Journal – via www.wsj.com.
- ^ "Archived copy". Archived from the original on 2020-08-04. Retrieved 2020-08-28.
{{cite web}}
: CS1 maint: archived copy as title (link) - ^ EST, Carl Sullivan On 1/11/05 at 7:00 PM (January 11, 2005). "THE PHILANTHROPIST DISCUSSES TSUNAMI RELIEF, PUBLIC VERSUS PRIVATE GIVING, AND WHY PARENTS SHOULD LIMIT THEIR CHILDREN'S INHERITANCE". Newsweek.
{{cite web}}
: CS1 maint: numeric names: authors list (link) - ^ "Lewis B. Cullman '41 | Obituaries | Yale Alumni Magazine". yalealumnimagazine.com.
- ^ Trehan, R. (2006). The History Of Leveraged Buyouts. December 4, 2006. Accessed May 22, 2008
- ^ Burrough, Bryan. Barbarians at the Gate. New York : Harper & Row, 1990, pp. 133–136
- TIME magazine, Jul. 16, 1984.
- ^ David Carey and John E. Morris, King of Capital: The Remarkable Rise, Fall and Rise Again of Steve Schwarzman and Blackstone (Crown 2010), pp. 15–16.
- Journal of Finance, 1993.
- ^ Thackray, John "Leveraged buyouts: The LBO craze flourishes amid warnings of disaster". Euromoney, February 1986.
- TIME magazine, Feb. 15, 2007
- ^ TWA – Death Of A Legend Archived 2008-11-21 at the Wayback Machine by Elaine X. Grant, St Louis Magazine, Oct 2005
- ^ King of Capital, pp. 31–44.
- ^ "Barbarians pushing boundaries at Asian gates". NASDAQ.com. 2018-10-10. Retrieved 2018-10-16.
- TIME magazine, 1988)
- ^ Hall, Jessica. "Private equity buys TXU in record deal". U.S. Retrieved 2018-10-16.
- ^ Wallace, Anise C. "Nabisco Refinance Plan Set." The New York Times, July 16, 1990.
- ^ Eichenwald, Kurt (14 February 1990). "THE COLLAPSE OF DREXEL BURNHAM LAMBERT; Drexel, Symbol of Wall St. Era, Is Dismantling; Bankruptcy Filed". The New York Times. Retrieved 2018-10-19.
- ISBN 1-55611-228-9.
- ^ ISBN 0-671-63802-5.
- New York Times, March 17, 2005.
- New York Times, September 8, 2005
- New York Times, September 13, 2005
- New York Times, September 14, 2004
- ^ "Capital Firms Agree to Buy SunGard Data in Cash Deal." Bloomberg, March 29, 2005
- ^ Samuelson, Robert J. "The Private Equity Boom". The Washington Post, March 15, 2007.
- ^ Dow Jones Private Equity Analyst as referenced in U.S. private-equity funds break record Associated Press, January 11, 2007.
- ^ Dow Jones Private Equity Analyst as referenced in Private equity fund raising up in 2007: report, Reuters, January 8, 2008.
- New York Times, July 25, 2006.
- New York Times, April 25, 2007
- ^ Lonkevich, Dan and Klump, Edward. KKR, Texas Pacific Will Acquire TXU for $45 Billion Bloomberg, February 26, 2007.
- New York Times, June 26, 2007
- New York Times, August 12, 2007.
- ^ id=9566005 Turmoil in the markets The Economist July 27, 2007
- ^ See King of Capital, pp. 211–12.
- ^ U.S. Bankruptcy Code, 11 U.S.C. § 548(2); Uniform Fraudulent Transfer Act, § 4. The justification given for this verdict is that the company gets no benefit from the transaction but incurs the debt for it nevertheless.
- )
- ^ U.S. Bankruptcy Code, 11 U.S.C. § 546(e).
- ^ QSI Holdings, Inc. v. Alford, --- F.3d ---, Case No. 08-1176 (6th Cir. July 6, 2009).
External links
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