| Leveraged Buyout (LBO) has been in the news | | | | Specific criteria for a good LBO candidate include:o |
| recently which said that, Corus - an Anglo-Dutch | | | | Steady and predictable cash flowo Divestible assetso |
| company would be taken over by TATA - an Indian | | | | Clean balance sheet with little debto Strong |
| company. | | | | management teamo Strong, defensible market |
| Being a relatively new business concept for us, this | | | | positiono Viable exit strategyo Limited working capital |
| Article aims to highlight what 'LBO' is all about, its | | | | requirementso Synergy opportunitieso Minimal future |
| advantages and disadvantages. It cannot be ruled out | | | | capital requirementso Potential for expense |
| that, India Inc. may have to see take-overs in the | | | | reductiono Heavy asset base for loan collateral |
| form of LBOs, amidst Globalisation. | | | | Criticism of LBOs |
| What does LBO actually mean technically? | | | | Critics of leveraged buyouts argue that these |
| Simply put - it is the purchase of a company by using | | | | transactions harm the long-term competitiveness of |
| a small investment and a large loan. The new owner | | | | firms involved. First, these firms are unlikely to have |
| would gain control with a small amount of invested | | | | replaced operating assets since their cash flow must |
| capital because he or she is able to secure a large | | | | be devoted to servicing the LBO-related debt. Thus, |
| loan for the balance of the amount needed. A | | | | the property, plant and equipment of LBO firms are |
| leveraged balance sheet has a small portion of equity | | | | likely to have aged considerably during the time when |
| capital and therefore a large portion of loan capital. | | | | the firm is privately held. In addition, expenditures for |
| Leveraged Buyout - also called as 'Highly-Leveraged | | | | repair and maintenance may have been curtailed as |
| Transaction (HLT)' - occurs when a financial sponsor | | | | well. Finally, it is possible that research and |
| gains control of a majority of a target company's | | | | development expenditures have also been controlled. |
| equity through the use of borrowed money or debt. | | | | As a result, the future growth prospects of these |
| Typically, the loan capital is borrowed through a | | | | firms may be significantly reduced. |
| combination of prepayable bank facilities and/or public | | | | Others argue that LBO transactions have a negative |
| or privately placed bonds, which may be classified as | | | | impact on the stakeholders of the firm. In many |
| high-yield debt, also called junk bonds. Often, the | | | | cases, LBOs lead to downsizing of operations, and |
| debt will appear on the acquired company's balance | | | | employees may lose their jobs. In addition, some of |
| sheet and the acquired company's free cash flow will | | | | the transactions have negative effects on the |
| be used to repay the debt. | | | | communities in which the firms are located. |
| A leveraged buyout is essentially a strategy involving | | | | Much of the controversy regarding LBOs has resulted |
| the acquisition of another company using a significant | | | | from the concern that senior executives negotiating |
| amount of borrowed money (bonds or loans) to | | | | the sale of the company to themselves are engaged |
| meet the cost of acquisition. Often, the assets of | | | | in self-dealing. On one hand, the managers have a |
| the company being acquired are used as collateral for | | | | fiduciary duty to their shareholders to sell the |
| the loans in addition to the assets of the acquiring | | | | company at the highest possible price. On the other |
| company. The purpose of leveraged buyouts is to | | | | hand, they have an incentive to minimize what they |
| allow companies to make large acquisitions without | | | | pay for the shares. Accordingly, it has been |
| having to commit a lot of capital. In an LBO, there is | | | | suggested that management takes advantage of |
| usually a ratio of 70% debt to 30% equity. LBOs | | | | superior information about a firm's intrinsic value. The |
| today focus more on growth and complicated | | | | evidence, however, indicates that the premiums paid |
| financial engineering to achieve their returns. | | | | in leveraged buyouts compare favorably with those |
| Brief History: | | | | in inter-firm mergers that are characterized by |
| What is believed to be the first leveraged buyout in | | | | arm's-length negotiations between the buyer and |
| business history is through the acquisition of Orkin | | | | seller. |
| Exterminating Company in 1964. However, the first | | | | Advantages and Disadvantages |
| LBO may have been the purchase by McLean | | | | A successful LBO can provide a small business with a |
| Industries, Inc. of Waterman Steamship Corporation | | | | number of advantages. For one thing, it can increase |
| in May 1955. | | | | management commitment and effort because they |
| The Theory of the Leveraged Buyout: | | | | have greater equity stake in the company. In a |
| While every leveraged buyout is unique with respect | | | | publicly traded company, managers typically own only |
| to its specific capital structure, the one common | | | | a small percentage of the common shares, and |
| element of a leveraged buyout is the use of financial | | | | therefore can participate in only a small fraction of |
| leverage to complete the acquisition of a target | | | | the gains resulting from improved managerial |
| company. In an LBO, the private equity firm acquiring | | | | performance. After an LBO, however, executives can |
| the target company will finance the acquisition with a | | | | realize substantial financial gains from enhanced |
| combination of debt and equity, much like an individual | | | | performance. |
| buying a rental house with a mortgage .Just as a | | | | This improvement in financial incentives for the firm's |
| mortgage is secured by the value of the house being | | | | managers should result in greater effort on the part |
| purchased, some portion of the debt incurred in an | | | | of management. Similarly, when employees are |
| LBO is secured by the assets of the acquired | | | | involved in an LBO, their increased stake in the |
| business. The bought-out business generates cash | | | | company's success tends to improve their |
| flows that are used to service the debt incurred in its | | | | productivity and loyalty. Another potential advantage |
| buyout, just as the rental income from the house is | | | | is that LBOs can often act to revitalize a mature |
| used to pay down the mortgage. In essence, an | | | | company. In addition, by increasing the company's |
| asset acquired using leverage helps pay for itself. | | | | capitalization, an LBO may enable it to improve its |
| In a successful LBO, equity holders often receive | | | | market position. |
| very high returns because the debt holders are | | | | Successful LBOs also tend to create value for a |
| predominantly locked into a fixed return, while the | | | | variety of parties. For example, empirical studies |
| equity holders receive all the benefits from any | | | | indicate that the firms' shareholders can earn large |
| capital gains. Thus, financial buyers invest in highly | | | | positive abnormal returns from leveraged buyouts. |
| leveraged companies seeking to generate large | | | | Similarly, the post-buyout investors in these |
| equity returns. An LBO fund will typically try to realize | | | | transactions often earn large excess returns over the |
| a return on an LBO within three to five years. Typical | | | | period from the buyout completion date to the date |
| exit strategies include an outright sale of the | | | | of an initial public offering or resale. |
| company, a public offering or a recapitalization. | | | | Not all LBOs are successful, however, so there are |
| Exit Strategy Comments | | | | also some potential disadvantages to consider. If the |
| Sale: Often the equity holders will seek an outright | | | | company's cash flow and the sale of assets are |
| sale to a strategic buyer, or even another financial | | | | insufficient to meet the interest payments arising |
| buyer Initial Public Offering. While an IPO is not likely | | | | from its high levels of debt, the LBO is likely to fail |
| to result in the sale of the entire entity, it does allow | | | | and the company may go bankrupt. Attempting an |
| the buyer to realize a gain on its investment | | | | LBO can be particularly dangerous for companies that |
| Recapitalization: The equity holders may recapitalize | | | | are vulnerable to industry competition or volatility in |
| by re-leveraging the entity, replacing equity with | | | | the overall economy. If the company does fail |
| more debt, in order to extract cash from the | | | | following an LBO, this can cause significant problems |
| company. | | | | for employees and suppliers, as lenders are usually in |
| LBO Candidate Criteria | | | | a better position to collect their money. Another |
| Given the proportion of debt used in financing a | | | | disadvantage is that paying high interest rates on |
| transaction, a financial buyer's interest in an LBO | | | | LBO debt can damage a company's credit rating. |
| candidate depends on the existence of, or the | | | | Finally, it is possible that management may propose |
| opportunity to improve upon, a number of factors. | | | | an LBO only for short-term personal profit. |