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
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
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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