Leveraged Buyouts

Leveraged buyout (LBO) can be defined as the acquisition of another company with the help of a significant amount of money borrowed in order to meet the cost of acquiring the company. The borrowing here is often in form of bonds or loans. The collateral often used to acquire the loan is usually the assets of the company that is being bought and sometimes those of the acquiring company. It is said to occur when a financial sponsor acquires enough interest to control the company being acquired and with a great percentage of the purchasing price being obtained through borrowing.

The objective of a leveraged buyout is to allow the company making the new acquisition to do so without having to commit large amounts of capital. Leveraged buyouts have been targeted to company of all sizes and industries but there are those features the make a certain company or an industry for that matter to be a potential target for leveraged transactions.

These features include, low existing debts loads, hard assets that may be used as collateral for lower cost secured debt and conditions of the market and other perceptions that depress the valuation or even the stock price. Other features include the potential for a new management to make operational improvements to account for a boost in cash flows and years of history of stable and recurring cash flows (Karen, 1999, 56).

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The use of debt in leveraged buyout help to significantly increase the returns to the sponsor as the cash flows from the target company are used to pay down the debt used in purchasing the company. From this point of view and with the knowledge that the financial sponsor only uses a portion of the original purchase price, we can say that a later sale of the acquired company will produce high returns to the financial sponsor. If the transaction amount is large, the equity component of the purchase price can be multiple financial sponsors. In this context, the sponsors will co-invest to come up with the needed equity for the purchase price.

In the same manner, the acquiring company may make use of multiple lenders who then jointly provide the debt required to fund the transaction. The amount of debt used to finance a leveraged transaction is dependent on various factors including the willingness of lenders to extend credit, the market conditions and the history of the targeted company. Other factors include the financial condition of the target as well as interest costs and the ability of the company to cover these costs (Someya, 1998, 144).

The most dominators of leveraged buyouts are the private equity firms and a limited number of banks with financial sponsors. Examples of buyouts in the recent years include the buyout of Dex Media in 2002, The Heltz Corporation and many others between year 2004 and 2005. Also between year 2006 and year 2007 was the buyout of Equity Office Properties, HCA and Alliance Boots.

This has been as a result of declining interest rate, loosening of lending standards and regulatory changes for publicly traded companies. The large cases of buyouts that has been experienced in the recent past has been ignorant of the credit turmoil in the credit market and in fact are increasing in numbers. Private equity continues to be a large and active asset and private equity firms are thus looking to deploy capital in new and different leveraged buyout transactions (Timothy, 2006, 62).

The large beneficiaries of leveraged buyouts as it stand out are the private equity firms and their lenders though this claim does not imply that other stakeholders do not benefit. To begin with, the shareholders stand to gain from the transactions of the leveraged buyouts. As stated earlier, a feature that makes a company to be targeted for leveraged buyout is its potential to offer increased cash flow in the future. If then a company has such a potential, it would imply that the particular company has been subjected to poor management in the past.

The potential improvement in the management then will tend to put these shareholders to benefit from the improved management. This implies that the shareholders stand the chance of gaining from a newly introduced and effective management of the company. The mechanism that drive the management of any given company is the efficient security market and this act as a market for control to the management of the company. It ensures that information about the company or the industry is efficiently reflected in the price of the company’s stock. A low price will tend to imply that the management is pursuing its own interests and not those of the shareholders (Karen, 1999, 64).

However, this does not guarantee the shareholders that the new management brought about by the buyout will entirely cater for their needs and not the self interests of those charged with the management. Also, it is worth noting here that the risk associated with takeover put the managers on high alert for their next job and this can jeopardize the effectiveness of their new job thus the interests of the shareholders. Still, the displine imposed on the company by the high debt burden of the leveraged buyout tend to force the management to strive for an improvement in efficiency, elimination of wasteful expenditure and to avoid value-diluting acquisitions (Alkhafaji, 1990, 36).

Another group of beneficiaries are the private equity firms. The owners of these private equities seek funds from lenders, in an effort to increase the base of their equity. A buyout bring with itself the benefits of economies of scale and thus the leap by these equity owners is bound to increase. This is of course subject to the quality of the management of the newly acquired company and other factors as well. Assuming that the new management is able to run the company efficiently and with balanced interests, the private equity firm in question then stand a chance of gaining high returns from the operations of the new company.

Assuming also that the market conditions allow for the smooth operations of the company, and that the speculation of the equity firm about the potential of the acquired company was right, the benefits then stand to be large for the equity owners. Even if the company was bought to be resold later in future, the gains from such a sale will and in most cases are greater to cater for the cost price of the company and the profits expected (Janice, 1991, 58)

The next group that benefit from the leveraged buyout is the banks and the financial sponsors that helped finance the acquisition of the company. The interest expected from the money rent out to the private equity firms is great and this constitute the factors behind the decision of the lender to lend the money out to the private equity firm. In general therefore, the buyout team stand to gain from wealth creation.

On the other hand, costs associated with leveraged buyouts are many. To start with, a leveraged buyout increases the cost of operation of the private equity firm buying out the company. One of the biggest threats of the leveraged buyout is that it draws the manager’s attention on the short run issues by exposing them to the mercy of the shortsighted market securities. A good example is the tendency of research and developments funds in the post leveraged buyout company to be preempted by debt service obligations. Leveraged buyout causes the firm to cut back on the research and developments funds in an effort to service the debt and also to cater for the enumeration of the human capital among other needs (Alkhafaji, 1990, 87).

The shareholders also bear costs as a result of the buyout. First, the shareholders are much more susceptible to the changes in the cash flows because of the heavy leverage. Secondly, the acquired company has the potential of becoming more productive because the new capital structure increases the management incentives to maximize the productivity. In this regard, the return are not available to the shareholders (selling) because they are partly attributable to the elimination of dispersed public investors. This usually arises where the previous management bypasses the shareholders approval of the buyout transaction which in itself happens (Karen, 1990, 64).

With the new management comes the restructuring of the operations of the acquired company. This makes the existing employees to be vulnerable to losing their jobs and thus becoming jobless. In essence, the new management will device new ways of making the firm to be more efficient. It wouldn’t hurt as such because their sole motive will be effectiveness but again some of the former employees losses their jobs thus an increase in unemployment (Ravenscraft, Scherer, 1997, 34).

Despite the gains realized from the leveraged buyout, it has been argued that the leveraged buyout has bad effects and contributes to unfair wealth distribution and increased instability in the economy. This renders the entire society to lose in the long run instead of benefiting. It is good however to note that, in other perspectives the society do leap some and many of the benefits associated with leveraged buyout. This include the benefits that have been discussed above. However, leveraged buyouts have been claimed to generate gains for the stakeholders at the expense of the original holders of the bonds of the target company.

This imply that the people who benefit from the buyout are the owners of equity but that this creates unfair distribution of weal in the society. Also the growth of leveraged borrowing produces a tax system that is biased for the debt finance. In the process of the buyout, the private equity firms tend to negotiate for a debt-tax shield which reduces the firm’s tax liability increases the firms after tax earning and consequently the market value of the stock of the firm. The observed increase in the value of the stock do take place at the expense of the taxpayers. The reduction in the tax liability offset indirectly the tax liabilities of all taxpayer (Someya, 1988, 123)

Work cited:

Alkhafaji F. Abbass. Restructuring American Corporations: Causes, Effects, and Implications. Westport City, Quorum Books, 1990. pp. 36, 87

Janice Monti-Belkagui, Ahmed Belkagui. Accounting in the Dual Economy. Westport City, Quorum books, 1991.pp. 58

Karen M. Young. The Role of Esops in Public Companies. Westport City, Quorum Books, 1999. pp.56, 64

Ravenscraft J. David, Scherer F. M. Mergers, Sell-Offs, and Economic Efficiency. London, Brookings Institution, 1997. pp. 34

Someya Kyojiro. Accounting Education and Research to Promote International Understanding: The Proceedings of the Sixth International Conference on Accounting Education. Westport, Quorum Books, 1998. pp.123, 144

Timothy Alvin. Strategic Business management: Strategies for Competitive Advantage. London, Routledge, 2006, 62

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