Leveraged buyout
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A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or "bootstrap" transaction) occurs, when a financial sponsor acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage (borrowed money).
Firms of all sizes and industries may be the targets of a leveraged buyout, but because of the importance of debt and the ability of the acquired firm to make regular loan payments after the completion of a leveraged buyout, some features of potential target firms make for more attractive leverage buyout candidates, including:
- Low existing debt loads
- A multi-year history of consistent and reliable cash flows
- Hard assets (property, equipment, real-estate, inventory) that may be used as collateral for new debt
- The potential for new management to make operational or other improvements to the firm to boost cash flows
- Temporary market conditions that are depressing current valuation or stock price
As a percentage of the purchase price for a leverage buyout target, the amount of debt used to finance a transaction varies according to interest rates, the financial condition and history of the acquisition target, market conditions and the willingness of lenders to extend credit to the LBO's financial sponsors and the company to be acquired. Typically the debt portion of a LBO ranges from 50%-85% of the purchase price, but in some very rare cases debt may represent up to 95% of purchase price. Between 2000-2005 debt averaged between 59.4% and 67.9% of total purchase price for LBOs in the United States.[1]
Leveraged buyouts allow financial sponsors to make large acquisitions without committing all the capital required for the acquisition. The use of debt also significantly increases the returns to a LBO's financial sponsor, as cash flows from the target company, rather than the financial sponsors, are used to pay down the debt used to purchase the company. This, in combination with the fact that financial sponsors pay only a portion of the original purchase price, means that a later sale of the company produces significant returns for the financial sponsor.
As transaction sizes grow, the equity component of the purchase price can be provided by multiple financial sponsors "co-investing" to come up with the needed equity for a purchase. Likewise, multiple lenders may band together in a "syndicate" to jointly provide the debt required to fund the transaction. Today, larger transactions are dominated by dedicated private equity firms and a limited number of large banks with "financial sponsors" groups.
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[edit] History
In the industry's infancy in the late 1960s the acquisitions were called "bootstrap" transactions, and were characterized by Victor Posner's hostile takeover of Sharon Steel Corporation in 1969. The industry was conceived by people like Jerome Kohlberg, Jr. while working on Wall Street in the 1960s and 1970s, and pioneered by the firm he helped found with Henry Kravis and George Roberts, Kohlberg Kravis Roberts & Co. (KKR).
Working for Bear Stearns at the time, Kohlberg and Kravis are credited by Harvard Business School as completing what is believed to be the first leveraged buyout in business history, through the acquisition of Orkin Exterminating Company in 1964. However, the first LBO may have been the purchase by McLean Industries, Inc. of Waterman Steamship Corporation in May 1955. Under the terms of that transaction, McLean borrowed $42 million and raised an additional $7 million through an issue of preferred stock. When the deal closed, $20 million of Waterman cash and assets were used to retire $20 million of the loan debt. The newly elected board of Waterman then voted to pay an immediate dividend of $25 million to McLean Industries. [2]
[edit] Rationale
The purposes of debt financing for leveraged buyouts are two-fold:
- The use of debt increases (leverages) the financial return to the private equity sponsor. Under the Modigliani-Miller theorem,[3] the total return of an asset to its owners, all else being equal and within strict restrictive assumptions, is unaffected by the structure of its financing. As the debt in an LBO has a relatively fixed, albeit high, cost of capital, any returns in excess of this cost of capital flow through to the equity.
- The tax shield of the acquisition debt, according to the Modigliani-Miller theorem with taxes, increases the value of the firm. This enables the private equity sponsor to pay a higher price than would otherwise be possible. Because income flowing through to equity is taxed, while interest payments to debt are not, the capitalized value of cash flowing to debt is greater than the same cash stream flowing to equity.
Germany currently introduces new tax laws, taxing parts of the cash flow before debt interest deduction. The motivation for the change is to discourage leveraged buyouts by reducing the tax shield effectiveness.
Historically, many LBOs in the 1980s and 1990s focused on reducing wasteful expenditures by corporate managers whose interests were not aligned with shareholders. After a major corporate restructuring, which may involve selling off portions of the company and severe staff reductions, the entity would likely be producing a higher income stream. Because this type of management arbitrage and easy restructuring has largely been accomplished, LBOs today focus more on growth and complicated financial engineering to achieve their returns. Most leveraged buyout firms look to achieve an internal rate of return in excess of 20%.
[edit] Management buyouts
A special case of such acquisition is a management buyout (MBO), which occurs when a company's managers buy or acquire a large part of the company. The goal of an MBO may be to strengthen the managers' interest in the success of the company. In most cases, the management will then make the company private. MBOs have assumed an important role in corporate restructurings beside mergers and acquisitions. Key considerations in an MBO are fairness to shareholders, price, the future business plan, and legal and tax issues. One recent criticism of MBOs is that they create a conflict of interest—an incentive is created for managers to mismanage (or not manage as efficiently) a company, thereby depressing its stock price, and profiting handsomely by implementing effective management after the successful MBO.
[edit] Failures
Some LBOs in the 1980s and 1990s resulted in corporate bankruptcy, such as Robert Campeau's 1988 buyout of Federated Department Stores and the 1986 buyout of the Revco drug stores. The failure of the Federated buyout was a result of excessive debt financing, comprising about 97% of the total consideration, which led to large interest payments that exceeded the company's operating cash flow. In response to the threat of LBOs, certain companies adopted a number of techniques, such as the poison pill, to protect them against hostile takeovers by effectively self-destructing the company if it were to be taken over.
The inability to repay debt in an LBO can be caused by initial overpricing of the target firm and/or its assets. Because LBO funds often add value through the resale of assets or selling off business units, any initial overpricing may directly result in insolvency as the expected cash flow is not obtained to sufficiently repay the debt. Another reason is overoptimistic forecasts of the operating cash flows (or revenues) of the target company. Capital structure in an LBO are often based on fairly tight margins, so that any deviations from expected cash flows may result in financial distress costs and risky situations.
[edit] See also
- Private equity
- Bootstrap funding
- Divisional buyout
- Private equity firm
- History of private equity and venture capital
- List of private equity firms
[edit] Notes
- ^ Trenwith Group "M&A Review," (Second Quarter, 2006)
- ^ Marc Levinson, The Box, How the Shipping Container Made the World Smaller and the World Economy Bigger, pp. 44-47 (Princeton Univ. Press 2006). The details of this transaction are set out in ICC Case No. MC-F-5976, McLean Trucking Company and Pan-Atlantic American Steamship Corporation--Investigation of Control, July 8, 1957.
- ^ Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance, and the Theory of Investment," American Economic Review, June 1958.
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