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What is a Leveraged Buyout and How Does it Work While Acquiring a Company?
9 November 2022
A leveraged buyout or LBO is an acquisition of a company funded by outside capital or debt. Corporate acquisitions are expensive transactions. However, they can be a way to unlock substantial financial gains too. Some buyers use debt to buy a company and try to run it in a way that generates huge profits that are used to pay off the debt.
The transactions usually involve buyers paying a small portion independently and using debt to finance the remainder. These acquisitions using borrowed money instead of corporate earnings are termed leveraged buyouts. Read on as we discuss the meaning of a leveraged buyout in detail, how they work and a few other important pointers
What is a Leveraged Buyout (LBO)?
A leveraged buyout is a financial transaction that uses debt leverage to acquire a company. According to business jargon, leverage means borrowed capital. LBOs usually involve a leverage of up to 90% of the buyout price. The buyer uses their own equity to pay the remaining amount. The collateral for the debt is often an asset of the borrower or the asset of the company being acquired.
For instance, if a buyer acquires a company for $15 million, they could pay $5 million from their own funds and $10 million using loans. If the interest rate on loan is 10%, the borrower will owe $1 million annually to the lender. Now, if the company’s net income is $2.5 million per year, the return after taxes in the first year will be close to 20%, and the entire amount will be recovered in around five years. However, if it is difficult to complete debt payments in case of a financial crisis, the assets given as collateral may need to be liquidated.
How Does a Leveraged Buyout Work?
A leveraged buyout is an acquisition strategy that allows for minimising personal investment and maximising gains while buying another company. The profitability and expected annual growth rate are higher when personal capital investment is lower.
However, as collateral is involved, LBOs are also associated with a higher risk. Especially when the borrower uses the acquired company’s assets as collateral and cannot pay off the debt, it may lead to its bankruptcy.
Thus, before initiating a leveraged buyout, a company must assess their budget and risk appetite. This will help them to know if taking on large amounts of debt is financially feasible and worthwhile. Identifying the right company is an important aspect too. Companies that are too risky may not be suitable for leveraged buyout.
Potential buyers must also look for a stable company capable of yielding significant returns while considering a leveraged buyout to acquire it. There must also be a connection between the work that both companies do. For instance, a company that manufactures fabrics may acquire a thread manufacturer. This could aid better integration and more effective corporate decisions.
An LBO can be Financed Using any of the Following Methods:
Private Equity Firms
Private equity firms are investment companies that finance leveraged buyouts using capital from their company or investor capital. Companies often need to pay higher than usual interest rates when borrowing from private equity firms. Another caveat with this method is that the private equity firm may also want to have a say in the management of the acquired company.
Banks offer revolving credit to both buyers and private equity firms. This means that the borrower can pay back and borrow back if required.
In case of the inability or lack of intent of the buyer to offer a collateral, they can use subordinated debt to secure the amount. That said, the interest rates on subordinated debts are likely to be higher and the company must issue warrants or options to secure this debt.
Bonds facilitate loan transactions between an investor and a borrower. The repayment period is fixed and the investor earns interest till bond expiry or maturity.
How To Analyse a Leveraged Buyout Transaction
Whether a leveraged buyout transaction will be profitable or not depends on its analysis from a financial perspective. The LBO analysis aims to project the rate of return using return metrics, such as the internal return rate (IRR), equity multiple, and net profit. The analysis requires assumptions about the present and future operations of the acquired company, the value of its operations, the amount of debt it carries, and the personal capital.
This is done by deriving the expected value of the organisation’s equity in a fixed time after its acquisition and combining the estimated value with other cash that the company may distribute. Since the cash in an organisation is often used to clear debts or reinvested to aid growth, the distributable cash is limited in most cases.
The most sensible approach is to estimate the company’s expected income and determine its value multiple, i.e. the company’s enterprise value at that time.
Once these values are determined, layer in debt capital costs and repayments at that time to find the future value of the company’s equity. The future income and the company’s enterprise values are mostly presented using earnings before interest, taxes, depreciation and amortisation (EBITDA).
Example of a Leveraged Buyout
Hilton hotels was acquired in 2007 by the Blackstone Group for $26 billion. This was a leveraged buyout where Blackstone group paid $5.5 billion in cash and $20.5 billion in debt. This, however, was followed by the financial crisis of 2008-2009. Consequently, Hilton’s cash flows and revenues declined. While it was a tough time, Hilton refinanced itself at lower rates of interest, operations got better and Blackstone sold the last stakes in Hilton in 2018 at a cumulative profit of nearly $14 billion.
What are the Uses of Leveraged Buyouts For Businesses?
Below are three primary uses of LBO for businesses.
1. Privatising a Publicly-Traded Company
Privatisation of a public-traded company involves the consolidation of public shares in the hands of private investors who can then take them off the market. As a result, the investors will now be owners or a major part of the target company. Since significant capital is required to buy all or most of a company’s net value, they can use debt to finance the transaction.
2. Breaking up a Large Company into Smaller Companies
Many factors may cause a large company to become inefficient. In such a scenario, the worth of the whole organisation may be lesser than the sum of its components and investors may buy the company, break it into smaller entities and sell them individually. For instance, a company that manufactures packaged food, hygiene products and hotel supplies may be divided into different firms that can then be sold to larger companies in specific industries. Here, the investor may opt for a leveraged buyout in the hope that the profits after breaking up and selling the smaller firms will clear the debts.
3. Improving a Company’s Performance
A company may not be performing too well and an investor may recognise its potential and plan to improve its performance. In that case, the buying price of the company will significantly be lesser than the final worth after improving its performance. Thus, a leveraged buyout could be a profitable way to acquire such a company.
Types of Leveraged Buyouts
The buyer in a leveraged buyout can be the management of a company, its employees, or a private equity firm. Based on the above three uses of leveraged buyouts, here are four types of LBOs:
1. The Repackaging Plan
This plan involves leveraged buyout by a private equity firm. The firm uses loans to buy all outstanding stocks of a public company and privatises it. They ultimately aim to repackage the company and sell it as an initial public offering (IPO). The stakeholders, employees or the private equity firm benefit from such a transaction only if major changes are made to the company to save it from failure or generate an offer price higher than the current market price.
2. The Split-up Plan
This plan involves the buyer dismantling the company into small parts and selling them separately to the highest bidders. These deals are often accompanied by restructuring the organisation and may lead to layoffs. While it may seem that this leveraged buyout by a private equity firm only benefits the firm, it often allows the smaller companies to grow to their full potential. This growth may have been difficult in the originally complex corporate structure.
3. The Portfolio Plan
This plan is also termed leveraged buildup and aims to benefit all participants, including the management, employees and the buyer. Here, the company acquires one of the competitors using leverage. This typically helps to increase stock prices, retain current management and grow the company in the new form.
4. The Saviour Plan
This plan involves the management and the employees borrowing money. They do this to save a failing company. The concept may seem good but the chances of success are quite low unless the management team and strategies get a makeover. However, if this type of buyout succeeds, the employees and the management reap significant returns.
Advantages and Disadvantages of a Leveraged Buyout
1. Increased Control
Conversion from public to private enables new owners to increase the chances of success by overhauling the organisational structure and operations.
2. Financial Gains
Since the buyers do not need to invest a lot of personal capital, they reap high financial gains if the company they acquire generates enough cash.
3. Opportunity to Survive
Sometimes a company may be at the edge of shutting down and a buyer can help it stay afloat.
1. Reduced Morale
Sometimes the company being acquired may not be in favour of the transaction. This may lead to hostile takeovers that may have a detrimental impact on employee morale.
2. Risk of Bankruptcy
The inability to repay the debts can lead to bankruptcy.
The buyers may need to adopt aggressive cost-cutting strategies to turn the acquired company around. This may cause job losses.
While leveraged buyouts pose significant risks, they also have a high profitability potential if planned and executed correctly. The buyer must carefully assess affordability and potential before making a leverage-based acquisition decision to ensure that the transaction is beneficial.
Q1. Why do leveraged buyouts happen?
Ans. Leveraged buyouts are a way for competent management teams with vast industry experience to take over and revive companies that may not have adequate financial resources for the same.
Q2. What are the risks of leveraged buyouts?
Ans. If the buyer gets too optimistic with their calculations, they may take on more debt than they can afford to repay. This may lead to financial difficulties and bankruptcy.
Q3. Who benefits from a leveraged buyout?
Ans. If a leveraged buyout yields the expected results, it benefits the investor, along with the management and employees of the acquired company.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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