Leveraged Buy-Out

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What is a Leveraged Buy-Out? Description

A Leveraged Buy-out is a corporate finance method under which a company is acquired by a person or entity using the value of the company's assets to finance its acquisition. This allows the acquirer to minimize its outlay of cash in making the purchase. In other words a LBO is a method to acquire a company, by which a business can seek to takeover another company or at least gain a controlling interest in that company. Special for a Leveraged Buy-out is, that the corporation that is buying the other business borrows a significant amount of money to pay for (the majority of) the purchase price. Usually over 70% or more of the total purchase price.
Furthermore, the debt which has been incurred is secured against the assets of the business being purchased. Interest payments on the loan will be paid from the future cash-flow of the acquired company.

History of Leveraged Buy-Out

LBOs became very popular in the 1980s, as public debt markets grew rapidly and opened up to borrowers that would not previously have been able to raise loans worth millions of dollars to pursue what was often an unwilling target. LBO activity accelerated, starting from a basis of four deals, with an aggregate value of $1.7 billion in 1980. LBO activity reached its peak in 1988, when 410 buyouts were completed with an aggregate value of $188 billion. The persons or company performing such a "takeover" often used very little of its own money and borrowed the rest, often by issuing extremely risky, but high interest "junk bonds". These junk bonds, since they were high-risk, paid a high interest rate, because little or nothing backed them up. No surprise some of these LBOs in the 1980s ended disastrous, with the borrowers going bankrupt.

Benefits of Leveraged Buy-Out

Typical advantages of the LBO method include:

  • Low capital or cash requirement for the acquiring entity.

  • Synergy gains. By expanding operations outside own industry or business. Compare: Horizontal Integration

  • Efficiency gains. By eliminating the value-destroying effects of excessive diversification.

  • Improved leadership and management. Sometimes managers run companies in ways that improve their authority (control and compensation) at the expense of the companies' owners, shareholders, and long-term strength. Takeovers can weed out and discipline such managers. Large interest and principal payments can force management to improve performance and operating efficiency. This "discipline of debt" can force management to focus on certain initiatives such as divesting non-core businesses, downsizing, costcutting or investing in technological upgrades that might otherwise be postponed or rejected outright. Note: in this manner, the use of debt serves not just as a financing technique, but also as a tool to force changes in managerial behavior.

  • Leveraging. As the debt ratio increases, the equity portion of the acquisition financing shrinks to a level at which a private equity firm can acquire a company by putting up 20-40% of the total purchase price.

Limitations of the Leveraged Buy-Out. Disadvantages

Critics of the Leveraged Buy-out mechanism indicated that bidding firms successfully squeezed additional cash flow out of the target's operations by expropriating the wealth from third parties. For example the federal government. Acquired companies pay less taxes because interest payments on debt are tax-deductible while dividend payments to shareholders are not. Furthermore, the obvious risk associated with a Leveraged Buy-out is that of financial distress, and unforeseen events such as recession, litigation, or changes in the regulatory environment. These can cause: difficulties in paying scheduled interest payments, technical default (the violation of the terms of a debt covenant) or outright liquidation. Weak management at the target company, or misalignment of incentives between management and shareholders, can also pose threats to the ultimate success of an Leveraged Buy-out.

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