WHAT IS A LEVERAGED BUYOUT?

A Leveraged Buyout is the transaction where one company is acquired by another company using debt (bonds or loans) as the main source of consideration to meet the cost of acquisition. The cash flow and the assets of the company being acquired (also known as the target company) along with the assets of the acquiring company are often used as the collateral for the loans. Since debt is used as the main source of financing the acquisition, it has the effect of lowering the cost of financing since debt has a lower cost of capital than equity. The reason for debt cost to be lower than equity is that interest payments reduce the income tax liability whereas the dividend payments to shareholders are not tax deductible. Since interest payments are tax deductible it allows higher return to equity holders and hence debt acts as a lever to enhance the returns to the equity.

In these types of transactions, the private equity firms borrow money from a variety of lenders usually up to 70% to 80% of the purchase price and balance they fund with their own equity. The main purpose of a leveraged buyout transaction is to acquire a company without committing a lot of their own capital into the transaction. A typical leverage buyout transaction can have a ratio of 90% debt and 10% equity. However, a leveraged buyout can benefit both the acquiring and the target company if done correctly. A target company should have adequate cash flow from operations so as to be able to service the debt obligation of the acquiring company.

The purchase of Pan-Atlantic Steamship Company in 1955 and Waterman Steamship Corporation in May1955 by McLean Industries Inc. is the first leveraged buyout. McLean financed the buyout with borrowed funds of $42 million and issue of preferred stock of $7 million. At the close of the deal $20 million of loan debt was settled using $20 million of cash and assets of Waterman. After the 2008 financial crisis large acquisitions through leveraged buyouts declined. However, large scale leveraged buyouts again started to rise during COVID-19 pandemic and have experienced a resurgence in the early 2020s.

WHY DO BUSINESSES USE LEVERAGED BUYOUTS?

Leveraged Buyout are conducted for the below mentioned reasons:

1. To make a public company private: A leveraged buyout can be used to transfer the shares of the publicly traded company to the private investor who then takes the shares off the market. As a result of Leveraged buyout transaction the investors become the majority shareholders of the company and also assume the debt liability. These investors repackage the business and return to the market as an Initial public offering hence renewing the public’s interest in the company.
2. To spinoff a portion of existing business by selling it: Leveraged buyouts can be used by companies needing cash to spin off a portion or segment of their business. Companies that have been acquired through a leveraged buyout often go for spinoffs and the proceeds are used to repay investors and reduce debts.
3. To transfer private property such as change in small business ownership: Leveraged buyout is also used when an investor group acquires a privately held organization. When a small business owner reaches the retirement age and either cannot find a corporate buyer or do not want to sell the company, often the company’s employees or other people associated with the company can buy the company through a leveraged buyout.
4. To acquire the competition and enter new markets so as to help the company to diversify its portfolio: When a smaller company wants to be acquired by a larger competitor, leveraged buyouts can take place. This allows the smaller company to grow at a new high and reach out new customers and quickly scale up their operations which would not have been otherwise possible without the acquisition. The key staff of the smaller company in such buyouts are kept intact by the acquiring company and can be a good way to bring other knowledgeable leaders and investors on board and take advantage of collaborative contributions made by employees of both the companies.

The Buyers like leveraged buyout because they can report higher Internal rate of return without having to commit a lot of their own capital and the use of debt financing lower the cost of capital and enhances the return to equity.

The Sellers like leveraged buyout in some cases because they are able to get the price they want for their business with a solid plan in place to exit the business.

TYPES OF LEVERAGED BUYOUTS

• Management Buyout (MBO): It is a type of acquisition where a group of people in the current management of the company buys the majority of the shares from the existing shareholders and hence take control of the company. MBO’s are preferred by the business owners if they are retiring or if the shareholders with majority stake wants to exit the company. It is also useful for the large companies to sell of their underperforming divisions. When the business succeeds as a result of MBO, the buyers enjoy greater financial incentive than they would have if they remained the regular employees of the company. Management buyouts also ensure the continuity of operations. Since the management team remains the same, the owner can be ensured of smoother transition of the business. The managers may not have enough wealth to buy majority of the shares and therefor they may raise additional funds through debt or with the help private equity funds.
• Management Buy-In (MBI): Management buy in happens when business is bought out by the external investors or management team purchasing the controlling ownership stake or interest in the company and replacing the company’s existing management team, board of directors and other personnel with their own representatives. Management buy in occurs when a company is underperforming or undervalued.
• Secondary Buyouts: A secondary buyout is buyout of a buyout where both the buyer and seller are private equity firms. A private equity firm acquires a business through leveraged buyout and sells it back to the public as in a traditional leveraged buyout. In Secondary buyouts, the private equity firm instead sell the acquired business to another private equity firm instead. This allows the seller private equity firm a clean break allowing it to end all involvement with the business and giving them immediate liquidity. The buyer private equity firm has the advantage of selling the business back to the public at a higher price. However historically secondary buyouts were perceived as distressed sales, and therefore are not appealing to public stock investors.

STEPS IN A LEVERAGED BUYOUT (LBO)

The steps involved in a leveraged buyout are discussed below:

1. Making assumptions of the Purchase price: The first step in a leveraged buyout (lbo financial model) is to make assumptions on the purchase price of the buyout, interest rate etc.
2. Creating sources and used of fund: Once the assumptions of purchase price and interest rate are made, the acquiring company create sources and uses of fund table. While sources detail out from where the money to finance the transaction is going to come from, the uses tell the amount of money required to give effect to the transaction.

The sources of fund available to finance a leveraged buyout transaction are as follows:

• Revolving credit facility: This facility is a type of senior bank debt that enables the buyer to withdraw money, use it to fund the transaction, repay it and then withdraw it again whenever required. It helps to fund a company’s working capital needs. It’s one of many flexible funding solutions on the alternative finance market today.
• Bank Debt: Bank debt have lower interest rate security than subordinate debt but has more serious debt covenants and have various limitations. In general bank debts require full payback with 5 to 8 years.
• Mezzanine debt: This is a type of financing is a hybrid debt issue that usually sits between senior debt and equity in a company’s capital structure and is typically used to fund the acquisitions and buyouts. This type of capital can either be a debt or equity instrument and have repayment priority between senior debt and common stock equity. It allows for greater flexibility when dealing with bondholders and enhances the value of subordinated debt.
• Subordinated or High-Yield Notes: Commonly known as junk bonds these bonds are sold to the public and in order to compensate them for increased risk command the highest interest rates.  They usually have 8 to 10 years of maturity and may have different maturities and repayment terms.
• Seller Notes: A portion of the leveraged buyout transaction may be financed by the sellers note. In this, the buyer issues a promissory note to the seller, in which it agrees to repay over a fixed period of time. It is generally cheaper than other sources of junior debt which make them attractive source of finance.
• Common Equity: This is the equity capital contributed by the private equity fund.

• Making financial projections: In this step we build the financial model for the target operating company on a standalone basis. A forecast is built for usually five years into the future and calculating the terminal value for the final period. In this step the acquirer prepares the projected financial statements which includes projected income statement, balance sheet and free cash from firm.
• Balance sheet Adjustments: In this step the adjustments for new debt and equity are made in the balance sheet.
• Planning the Exit strategy: After the adjustments are made in the balance sheet, assumptions are made about the withdrawal of the private equity firm from its investment in the target company. In general, it is assumed that the acquirer shall sell the target company after five years at the same implied EBITDA multiple at which the target company was initially acquired.

An exit strategy includes an outright sale of the target company to another financial sponsor or an IPO and helps the financial buyer realize gains on their investments.

• Internal rate of return calculation on the Initial investment: The calculation of the sale value of the target company enables the acquiring company to calculate the value of equity stake of the private equity firm and also analyse its internal rate of return. The Internal rate of return is the discount rate at which the net present value of the company’s cash flows equals to zero. Typically, the Internal rate of return expected by the financial sponsors is around 30%, but in case of adverse economic conditions it may be as low as 15% to 20%.
• Perform Sensitivity analysis: Since the entire leveraged buyout transactions involve making various assumptions, the buyer has to perform sensitivity analysis to check if the buyout will add value to their investment if the assumptions vary due to economic factors outside the company’s control.

CHARACTERISTICS OF TARGET COMPANY FOR LEVERAGED BUYOUT

It is important to check some of the following important characteristics of the target company before going for leveraged buyout:

• Companies with stable cash flows: The acquired company must have stable and sufficient cash flows so that the interest payments and debt principle payments can be made. So the acquirer often looks out for mature companies with predictable cost structure and long term customer contracts so as to ensure sufficient cash flows in future.
• Companies with relatively low fixed cost: The fixed cost acts as a risk for the private equity firms as they have to be paid irrespective of the acquisition making revenues or not.
• Company with relatively lower existing debt: In a leveraged buyout the private equity firm acquires a target company by mainly debt financing and then repaying the debt over time to enhance the return to equity. However, it becomes tough to add value to equity holders if the target company already has a high debt balance.
• Company with moderate valuation: In a leveraged buyout the private equity firms prefer to acquire a company which is moderately to appropriately valued over a company trading at extremely higher valuation because of the risk of the valuations being declined.
• Company with strong management team: A company with strong management team helps the acquiring company to add value to the Leveraged buyout transaction and help in smooth transition of business with strong management team.
• Companies with feasible exit options
• Companies with strong competitive advantage and market position
• Companies with recurring revenue:  A target company with recurring revenue can ensure that the acquirer will be able to service the debt and interest payments timely.
• Companies that are non-cyclical: Non-cyclical or “defensive” industries are more stable regardless of the economic conditions. This makes the financial performance of these companies more predictable and less of a liability for the lenders.
• Companies with low debt to asset ratio : If the debt to asset ratio is low, it allows for a comfortable bank financing to happen for a leveraged buyout to happen.

ISSUES TO BE CONSIDERED IN A LEVERAGED BUYOUT (LBO) ANALYSIS

In a Leveraged buyout transaction some Industry and company characteristics has to analysed before entering into the transaction:

Industry Characteristics:

• Industry type
• Competitive landscape
• Cyclicality of the company
• Major industry drivers
• Factors external to the company like the changing las and regulations, political environment

Company specific characteristics:

• Market share enjoyed by the company
• Growth opportunity
• Sustainable operating margins
• Potential of margin improvement
• Minimum working capital and capex requirement
• Cash balance required to run the business
• The ability and efficiency of the company’s management to operate in a highly levered situation

ADVANTAGES OF A LEVERAGED BUYOUT

Some of the advantages of the leveraged buyout transaction are as follows:

• Financial upside for the investors: Leveraged buyouts require the acquiring company to put in little or none of their own money as long as the target company being acquired can generate sufficient cash flows to service the debt principle an interest on loan timely. The use of debt financing help enhances the return of equity to the investors since interest on debt is tax deductible and reduces the overall cost of capital.
• Continued operation of the business: A company’s financial situation sometimes may worsen to the point of it being shut down. However, in a leveraged buyout with a buyer coming in may provide the company with the opportunity to keep its operation going on, thereby benefiting the shareholders and employees of the target company.
• More control to the acquiring company: With a leveraged buyout transaction a public company is converted to private and the new owners can overhaul a company’s cost structure and operations making it easier for the company to succeed.

DISADVANTAGES OF LEVERAGED BUYOUT

Some of the disadvantages of the leveraged buyout transaction are as follows:

• Poor morale of workers: In case of a hostile takeover the company has no interest in being acquired and the workers often show their resentment by slowing down or stopping the work which further hampers the company’s operations and efforts to succeed.
• Risk of Bankruptcy: It is possible that the company end up declaring bankruptcy if the acquired company cannot generate enough finances to cover the cost of principle loan and interest payments.
• Failure to turn around the business and employee losing jobs: Leveraged buyout is done with a view to turn around the finances of the acquired business positively. However, it may happen that instead of enhancing the cash flow of the acquired business the acquiring company resort to unpopular means to make a company profitable by cutting cost which may involve serious job cuts.

CONCLUSION: A leveraged buyout is a very risk proposition to acquire a company but businesses that have a steady cash flows are a perfect candidate to offset the financial risk of a LBO with the operational certainty in the business. While it is not common in today’s age to hear about a large LBO happen, it is still an acquisition choice that makes a lot of sense for smaller companies acquisition.

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