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What’s it: A leveraged buyout (LBO) is an acquisition with debt relied upon to finance the purchase. This strategy is usually adopted by private equity firms. They buy companies hoping to profit without relying too much on internal capital. The target company may be a publicly traded company, which, after the acquisition, becomes private. Or it is an established company with solid cash flow.
The acquirer usually comes from a private equity firm and replaces the old management team with the acquirer’s team. However, in specific cases, the acquirer is the old management team, which takes over the company they work for and takes control away from the shareholders.
The acquirer relies on the target company’s cash flow to service debt. In addition, the acquirer relies on the target company’s assets as collateral to obtain debt.
While immediate returns underlie some transactions, LBOs may also aim to add value by improving operations. For example, a takeover by incumbent management is expected to increase revenues and ultimately increase profits and cash flow.
Why do companies do leveraged buyouts?
From an acquirer’s perspective, LBO allows them to buy good companies with minimal equity. Acquiring a target company requires substantial funds, which is more than can be financed through internal capital (equity). So, through this strategy, the acquirer can make significant acquisitions without spending a lot of owned money. Instead of relying on equity, they can borrow from investors to finance transactions.
Meanwhile, for target companies, LBO is a way to reorganize or restructure the company. For example, it would be a good choice for a public company. They may require internal restructuring or organizational change, which is difficult to do if it is still a public company – they must comply with external regulations and reach a consensus among shareholders.
Management is often at a dead end to overhaul the company to be better, let’s say, more adaptive to changes in the business environment. So, the best way for them is to buy the company before starting the transition. Then, they offer investors and stakeholders the option to cash out their holdings before they take control. This makes a good exit strategy for shareholders; presumably, they receive significant money with the management buyout.
The management team can raise the necessary funds to take over, including partnering with private equity firms. After the transaction, they have full control over the company after making it private. Then, they run the company to add value by improving operations, increasing revenue, and ultimately increasing profits and cash flow.
What are the two types of leveraged buyouts?
There are two categories of LBO, namely:
- Management buyouts (MBOs)
- Management buy-ins (MBI)
Under management buyouts (MBOs), the target company’s management team buys the company they work for and takes control of it. For example, Michael Dell purchased the company he founded from shareholders in 2013, partnering with a private equity firm.
Meanwhile, under management buy-ins (MBI), the target company is purchased, and the old management team is replaced by the acquirer’s team, who then runs the company.
Where do leveraged buyout acquisition funds come from?
As the name suggests, LBOs rely on leverage or debt to acquire. Usually, the ratio is 70% debt and 30% equity. And in fact, it can be 90% debt to 10% equity. In other words, the acquirer takes out 90% of the loan to buy the target company, and the remaining 10% comes from their equity.
The debt used usually comes from bank loans and high-interest bonds. However, some acquisitions may rely more heavily on bank loans than bonds. In addition, the acquirer may also depend on mezzanines as an alternative to high-interest bonds.
Mezzanine financing combines debt and equity by giving lenders the right to convert their debt into equity interests. It may come with a conversion option or with a warrant.
The capital structure used to fund LBOs can vary between transactions. Some influencing factors include:
- Cash flows resulting from transactions
- The equity owned by the target company
- The target company’s leverage level
- The rate of return required by the lender
- The amount and financing alternatives available for the transaction
How is debt repaid in LBO?
The acquirer usually uses the target company’s assets as collateral for the debt. For this reason, these transactions are more attractive from the acquirer’s side if the target company has significant fixed assets because it makes it easier for them to attract investors to lend.
Meanwhile, the acquirer relies on the target company’s cash flow to service debt. They use it to pay regular interest and principal outstanding debts. Thus, companies with solid and sustainable cash flows are the most attractive targets.
What’s the difference between an LBO and a typical acquisition?
LBOs and conventional acquisitions differ in several ways. First, LBOs rely more on debt. That is a crucial feature of LBOs and a differentiator from typical acquisitions.
Meanwhile, conventional acquisitions do not always rely on debt. Instead, the acquirer may rely on internal cash to finance transactions.
Second, LBO is commonly used by private equity firms. Their motive is usually to earn high returns for a shorter period.
Meanwhile, conventional acquisitions may be based more on a long-term strategy. For example, an acquirer buys a target to secure the supply chain. The purchase supports the acquirer’s competitive advantage in the long term rather than simply generating cash in a short time.
What makes a company an attractive target in a leveraged buyout transaction?
The acquirer carefully considers and selects targets. Because they rely on more debt, a failed transaction can weigh on their finances. Several criteria make the company an attractive target.
First, the target company has a solid and sustainable cash flow. Relying on debt forces the acquirer to pay regular interest and principal at maturity. Thus, the free cash flow generated by target companies is vital to paying their obligations.
Second, the stock price is undervalued. So, the acquirer can buy at a low cost, lower than the fair price. Low prices reduce the need to go into debt. In addition, the target company’s share price is expected to rise soon because it is undervalued. Thus, the acquirer can realize the targeted returns more quickly.
Third, the target company’s senior management is cooperative. They are willing to make deals, reducing transaction failures due to their rejection.
Fourth, the company has many assets as collateral for the debt. Thus, it is easier for acquirers to convince investors to provide loans.
Fifth, the target company’s leverage is low. At least, the acquirer is not burdened by debt after the transaction is completed. In addition, the low leverage level increases the opportunity to acquire additional debt to finance the purchase price.
What is an example of a leveraged buyout?
Citing from DealRoom.net, here are 10 famous LBO transactions in history:
- Energy Future Holdings(2007): $45 billion
- HCA Healthcare (2006): $33 billion
- RJR Nabisco (1989): $31 billion
- Hilton Hotels (2007): $26 billion
- Alltel (2007): $25 billion
- Kinder Morgan (2006): $22 billion
- PetSmart (2007): $8.7 billion
- Safeway (1988): $4.2 billion
- McLean Industries (1955): $49 million
- Manchester United Football Club (2005): $790 million
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