leveraged buyout


  • • 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’s tougher to make a deal work when a company already has a high debt balance.

  • 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.

  • 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.

  • This has, in many cases, led to situations in which companies were “over-leveraged”, meaning that they did not generate sufficient cash flows to service their debt, which
    in turn led to insolvency or to debt-to-equity swaps in which the equity owners lose control over the business to the lenders.

  • Marked by the buyout of Dex Media in 2002, large multibillion-dollar U.S. buyouts could once again obtain significant high yield debt financing from various banks and larger
    transactions could be completed.

  • [29] Additionally, U.S.-based private equity firms raised $215.4 billion in investor commitments to 322 funds, surpassing the previous record set in 2000 by 22% and 33% higher
    than the 2005 fundraising total[30] The following year, despite the onset of turmoil in the credit markets in the summer, saw yet another record year of fundraising with $302 billion of investor commitments to 415 funds[31] Among the mega-buyouts
    completed during the 2006 to 2007 boom were: EQ Office, HCA,[32] Alliance Boots[33] and TXU.

  • 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.

  • [14][15] Many of the corporate raiders were onetime clients of Michael Milken, whose investment banking firm, Drexel Burnham Lambert helped raise blind pools of capital with
    which corporate raiders could make a legitimate attempt to take over a company and provided high-yield debt financing of the buyouts.

  • A secondary buyout will often provide a clean break for the selling private equity firms and its limited partner investors.

  • 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.

  • These investment vehicles would utilize a number of the same tactics and target the same type of companies as more traditional leveraged buyouts and in many ways could be
    considered a forerunner of the later private equity firms.

  • [23] Age of the mega-buyout The combination of decreasing interest rates, loosening lending standards, and regulatory changes for publicly traded companies (specifically the
    Sarbanes–Oxley Act) would set the stage for the largest boom the private equity industry had seen.

  • [13] During the 1980s, constituencies within acquired companies and the media ascribed the “corporate raid” label to many private equity investments, particularly those that
    featured a hostile takeover of the company, perceived asset stripping, major layoffs or other significant corporate restructuring activities.

  • 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.

  • The failure of the Federated buyout was a result of excessive debt financing, comprising about 97% of the total consideration, which led to large interest payments that exceeded
    the company’s operating cash flow.

  • 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.

  • Nevertheless, private equity continues to be a large and active asset class and the private equity firms, with hundreds of billions of dollars of committed capital from investors
    are looking to deploy capital in new and different transactions.

  • Depending on the size of the acquisition, debt as well as equity can be provided by more than one party.

  • As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible
    to finance an 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.

  • 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.

  • Depending on the size and purchase price of the acquisition, the debt is provided in different tranches; senior debt is secured with the assets of the target company and has
    the lowest interest margins, and junior debt, or mezzanine capital, usually has no security interests and thus bears higher interest margins.

  • Nonetheless, the financial restructuring requires significant management attention and may lead to customers losing faith in the company.

  • 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 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, growth prospects, and hard assets; experience and equity supplied by the financial sponsor; and the overall economic environment.

  • 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).

  • However, many corporate transactions are partially funded by bank debt, thus effectively also representing an LBO.

  • Uncertain market conditions led to a significant widening of yield spreads, which coupled with the typical summer slowdown led many companies and investment banks to put their
    plans to issue debt on hold until the autumn.

  • 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.

  • Characteristics LBOs have become attractive as they usually represent a win-win situation for the financial sponsor and the banks: the financial sponsor can increase the rate
    of returns on its equity by employing the leverage; banks can make substantially higher margins when supporting the financing of LBOs as compared to usual corporate lending, because the interest chargeable is that much higher.

  • • 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.

  • MBO situations lead management teams often 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.

  • If a company that was acquired in a secondary buyout gets sold to another financial sponsor, the resulting transaction is called a tertiary buyout.

  • By the end of September, the full extent of the credit situation became obvious as major lenders including Citigroup and UBS AG announced major writedowns due to credit losses.

  • • 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.

  • • 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.

  • Note that in close to all cases of LBOs, the only collateralization available for the debt are the assets and cash flows of the company.

  • 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.

  • The use of debt, which normally has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition.

  • [35][36] The markets had been highly robust during the first six months of 2007, with highly issuer friendly developments including PIK and PIK Toggle (interest is “Payable
    In Kind”) and covenant light debt widely available to finance large leveraged buyouts.

  • 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 3.

  • 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 larger transactions, debt is often syndicated, meaning that the bank who arranges the credit sells all or part of the debt in pieces to other banks in an attempt to diversify
    and hence reduce its risk.

  • 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.

  • Over-optimistic forecasts of the revenues of the target company may also lead to financial distress after acquisition.

  • Typically, debt of 40–60% of the purchase price may be offered.

  • In 2006, private equity firms bought 654 U.S. companies for $375 billion, representing 18 times the level of transactions closed in 2003.

  • [38] Secondary buyouts differ from secondaries or secondary market purchases which typically involve the acquisition of portfolios of private equity assets including limited
    partnership stakes and direct investments in corporate securities.

  • In larger transactions, sometimes all or part of these two debt types is replaced by high yield bonds.

  • [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.

  • Additionally, the RJR Nabisco deal was showing signs of strain, leading to a recapitalization in 1990 that involved the contribution of $1.7 billion of new equity from KKR.

  • Many of the target companies lacked a viable or attractive exit for their founders, as they were too small to be taken public and the founders were reluctant to sell out to
    competitors: thus, a sale to an outside buyer might prove attractive.

  • The increase in secondary buyout activity in 2000s was driven in large part by an increase in capital available for the leveraged buyouts.

  • The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.


Works Cited

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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
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funds break record Associated Press, January 11, 2007.
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39. ^ 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.
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Photo credit: https://www.flickr.com/photos/sherrysrosecottage/3231873181/’]