What is a Leveraged buyout?
A leveraged buyout (LBO) is a form of a business acquisition. However, it differs from an ordinary merger and acquisition (M&A) deal in many ways. First, the acquirer in an LBO is not a traditional corporation as in other acquisitions. Instead, the acquirer is a newly formed non-operating company, made up of the private equity firm and often the party who will manage the daily activities of the business.
Additionally, LBO’s are heavily debt financed, often with as little as 10 to 20% of the purchase price coming from equity investment.[1] In order to secure the large amount of debt necessary to complete the deal, the non-operating company is forced to borrow against the physical assets of the acquired business.[2]
Once the terms of the LBO are agreed to, current shareholders will be compensated with an agreed upon per share price and the ownership will be transferred to the non-operating company (the private equity firm and all other investors).
Why take a company private through an LBO?
Private equity firms are motivated to take the targeted company private in order to unlock potential synergy gains[3]. These synergy gains might come from financial restructuring, change in control, or increased coordination in decision-making.[4]
Firms often create synergy gains through financial restructuring. As discussed before, leveraged buyouts involve heavy debt financing. Debt has a tax benefit not available from equity investment, in that the interest owed on current outstanding debt decreases taxable income, resulting in higher cash flow available to all stakeholders.[5] In other words, debt creates a tax-shield equal to current interest expense multiplied by the effective tax rate.[6] Therefore, increasing the amount of debt within the financial structure of the firm can create value.
Additionally, Private equity firms often look to unlock synergy gains by eliminating the waste associated with inefficient management. By taking the company private, the firm no longer has to seek shareholder approval of management, but instead, can self select the new leadership team.[7] The idea is that the new management team will make better business decisions, increasing revenues and decreasing the associated costs.
Moreover, even if current management is efficiently running the company, there are coordination advantages from taking a company private. Public companies face a folly A/folly B problem. The company wants long-term success. In other words, it wants to make investments that result in the greatest net present value in the long run. However, companies have to respond to shareholders, who reward short-term performance, which results in increased stock price, over long term performance.
By taking the company private, management has flexibility in its decision-making and can focus on long-term performance without having to worry about shareholder repercussions. Also, public companies are often slow to act because there is a shareholder coordination problem. The company must provide information on major changes to all shareholders and must convince owners of a majority of the shares to vote collectively. By taking the company private, ownership is concentrated in a few individuals/entities who can act swiftly.
The potential downside of an LBO
While there are certainly numerous potential sources of synergy gains associated with an LBO, the form of acquisition is not without its risks. When levering a company to such a high debt to equity (D/E) ratio, the company must be able to produce enough cash flow to make its periodic interest payments on the outstanding debt. As a result, the risk of bankruptcy increases and the possibility of receiving the tax shield decreases. Additionally, banks will require higher returns to compensate for the risk associated with the debt. Therefore, private equity firms partaking in LBOs are continuously confronting the issue of how much leverage to implement in the deal.
Additionally, in an LBO, there is a constant conflict between shareholders and bondholders. Shareholders are incentivized to take risk, whereas bondholders prefer sound investments that will allow the company to pay back its debt. Therefore, when securing debt, private equity firms might lose some financial flexibility due to bank-imposed constraints on spending. If not managed properly this can counteract some of the benefits associated with making the move to a private company.
Lastly, by taking a company private, the investors lose access to a liquid market. As a result, it may take longer to recoup the investment. Research has indicated that the median LBO is still in private equity ownership around 9 years after the initial buyout transaction.[8]
Who is a good LBO target?
Given the potential risks associated with an LBO transaction, private equity firms must be careful when deciding whom to target. Private equity firms should look at targets from a three-value driver perspective: leverage, change in control and private-public.[9] The ideal target should be underlevered, inefficiently managed, and should be incurring large costs from staying public.[10] Additionally, companies with large assets and stable free cash-flows (cash cows) can support more debt, making them an attractive target. At the same time, private equity firms want to avoid using an LBO to purchase companies in highly cyclical industries and industries with rapid product obsolescence.[11] Companies in these industries are prone to periods of low to negative free cash-flows, which in turn increases the probability that they will be unable to meet their debts as they come due.
Summary
LBO’s are a form of private equity acquisition, in which the investors form a non-operating company and purchase a public company by implementing primarily debt financing. Taking a public company private can create gains in a multitude of ways, including increased tax shield free cash flows, elimination of inefficient management, and increased coordination of decision making. At the same time, there are many risks associated with an LBO. The risk of bankruptcy increases immensely, resulting in higher lending rates and loss of some financial flexibility. Consequently, private equity firms must be strategic about when to implement an LBO acquisition and realize that it is not always the proper tool.
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[1] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013); Note on Leveraged Buyouts. Center For Private Equity and Entrepreneurship at 1, available at http://pages.stern.nyu.edu/~igiddy/LBO_Note.pdf.
[2] Steven N. Kaplan & Per Stromberg, Leveraged Buyouts and Private Equity, Journal of Economic Perspectives, American Economic Association 23(1), 2009.
[3] Here, synergy gain is a proxy for a long term financial benefit
[4] See Note on Leveraged Buyouts at 2.
[5] Grant Houston, Tax Advantages of a Leveraged Buyout, Chron, http://smallbusiness.chron.com/tax-advantages-leveraged-buyout-24006.html
[6] See id.
[7] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013).
[8] See Kaplan, supra note 2, at 130.
[9] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013).
[10] Id.
[11] Id..