A leveraged buyout (LBO) is the acquisition of a company in which the buyer puts up only a small amount of money and borrows the rest. The buyer's own equity thus "leverages" a lot more money from others. The buyer can achieve this desirable result because the targeted acquisition is profitable and throws off ample cash used to repay the debt. Such transactions are also known as "bootstraps" or HLTs, i.e., "highly leveraged transactions." Since they first appeared in the 1960s and took hold in the 1970s, LBOs have had mixed reviews from business people and other observers. Some see them as tools to streamline corporate structures, to rationalize meaninglessly diversified companies, and to reward neglected stockholders. Others see the LBO as a destructive force destroying economic and social values, the activity motivated by greed-driven predation.
TYPES OF LBOS
LBOs are typically used for three purposes, each in the category of corporate acquisitions generally. These are 1) taking a public company private, 2) financing spin-offs, and 3) carrying out private property transfers frequently related to ownership changes in small business.
Public to Private
The first situation arises when an investor (or investment group) buys all of the outstanding stock of a publicly traded company and thus turns the company into a privately-held enterprise ("taking private" in reverse of "going public"). These deals may be friendly or hostile, the two terms related to management's point of view. Friendly cases typically involve the management buying the company for itself with plans to operate it thereafter as a privately-held entity. Hostile cases involve an investor or investor group intent on buying, reorganizing, and then reselling the company again to realize a high return. The sale of the company may be to another company or may be to the public in a stock offering. In the last case the situation actually amounts to a transaction more aptly labeled public-to-private-to-public. There are other variants in the disposition or in the payback of a third-party investor, although they tend to be rare, such as very high dividend payments and recapitalization by other groups.
Public or private companies often wish to sell off elements of their business to get cash. In some cases the seller may itself have been bought in an LBO and is spinning off assets to pay the investors back. In such situations the spun-off element's management may itself be the buyer or may be passive in the transaction. An LBO is used to purchase the subsidiary or division in question. The fundamental financial logic of such deals, however, remains the same.
The last situation concerns cases where a privately held operation is bought by an investor group. Such cases often arise when a small businesses owner, having reached retirement age, wishes to divest him-or herself of the company and either cannot find a corporate buyer or does not wish to sell to a company. The buying group itself may be the company's employees or individuals associated in some way with the owner. These people organize an LBO because they only have limited equity.
FINANCING AND PAYBACK
The target of an LBO must, almost by definition, be profitable, growing, and produce a suitably large cash flow. In acquisitions jargon this is often abbreviated as EBITDA, meaning earnings before interest, taxes, depreciation, and amortization—the component elements of cash flow as ordinarily defined. Why cash flow? Because repayment of the large, leveraged debt is from future cash flows of the company. Other assets, of course, are also taken into consideration. If cash flow cannot keep pace with repayment, it is desirable that the company has saleable components (e.g., potential spin-offs) or liquid assets. Third party investors cannot be persuaded to put up cash unless the numbers look good, the elements of the company seem easily saleable, the company has lots of cash on its books, or all of the above are present.
The leveraged portion of the LBO may be as high as 90 percent of the deal but can be lower. In periods of unusual frenzy, the percent has even climbed above 90 percent. The rest is in the form of equity. Multiple "layers" of financing are involved: senior debt, senior subordinated debt, subordinated debt, mezzanine debt, bridge financing, and finally purchaser's own equity. The instruments described here are listed in increasing order of risk. In the case of a default, those holding senior debt will be paid first, owners of equity last (if at all); these security relationships are contractually built into the instruments themselves. Mezzanine financing is a hybrid between straight equity and debt, structured so that "mezzanine" holders are just barely paid something in an extreme case where equity holders lose everything. Bridge loans are short-term loans intended to be repaid either from the acquired company's cash holdings or from rapid disposition of company assets. Debt, of course, may be in the form of high-yield and therefore high-risk "junk" bonds.
LBO risks are high because payback depends entirely on the company's future performance. If the economy falters—or some event halts the purchased company in its tracks (a major lawsuit, the loss of a major account)—or if the high re-payments actually hamper the company by starving it of capital, investors may see their money turn into thin air. Healthy, growing, cash-rich companies purchased by an LBO therefore may lose their flexibility by losing their cash and simultaneously acquiring a huge load of debt: small shocks in the past become large shocks in the present. For these reasons investors expect returns above 20 percent per annum.
FOR AND AGAINST
Philosophical views of business go far in explaining positive and negative views of LBOs as well—and LBOs particularly (among merger and acquisition methods) because users of LBOs are predominantly interested in changing companies in order to extract benefits in the process. Those who see corporations predominantly in capitalist terms favor a business model in which stockholder equity is always maximized regardless of any other consideration. Those who view corporations as economic and social institutions with a wide penumbra of other interests also involved—stakeholders including employees, distributors, customers, vendors, etc.—view this method of acquisition, especially if used in hostile takeovers aimed at dismembering the corporation, slashing its employment, and taking it public again as disruptive and predatory.
In more mechanical terminology, proponents of such acquisitions claim multiple benefits. One of these is a more optimal debt-to-capital ratio. High debt and low capital mean lower taxes: interest costs are deductible. Reduced ability to invest in capital good increases the company's efficiency by reducing over-capacity. Companies using their profits for growth rather than dividends short-change the stockholder. Highly diversified companies in many unrelated businesses have much higher overheads—unnecessary if badly fitting parts are spun off. These motives translate into leaner and more profitable ventures producing higher return on investment—all of which favors ownership interests. Opponents, on the contrary, favor control and predictability through diversification, market share gains, flexibility in production and in ability to respond—all of which favors management, employees, and other stakeholders. Ultimately both sides have legitimate points to make, and the controversy, therefore, is likely to continue.
The first LBOs were made in the 1960s; their use took hold in the 1970s and began to boom in the 1980s. LBOs in the first half of the 1980s were very successful, leading to a boom mentality in the second half of the 1980s with extraordinarily high rates of leverage, leading to many bankruptcies and failures in the early 1990s. A legislative reaction at the state level (states control incorporation and rules related to them) went through several cycles. States tightened rules against hostile takeovers; the Supreme Court curbed such activities in a 1982 judgment; states then revised their rules to get around the high court's ruling—and these work-arounds were later approved in another Supreme Court case in the late 1980s. The upshot was to make hostile takeover more difficult, requiring buyers to acquire a higher percent of stock in order to take control. LBO deals diminished in the 1990s but began to heat up again in the new century, reaching another boom in the mid-2000s.
In general, LBOs are highly dependent on the availability of investment funds—money chasing opportunity. When money is tight and less risky ventures pay high returns, LBOs diminish and/or the degree of leverage used declines—buyers having to put up more of their own equity. When the economy is flush with cash, the number of deals and their magnitudes increase, purchase prices balloon, and investors also begin "reaching down" to purchase smaller companies ("microcaps" in the jargon of investment). Second, leveraged deals depend on healthy companies with high and predictable future cash flows—without which investors are difficult to attract to a deal. Hostile LBOs also require publicly traded companies so that the buyer can reach stockholders and persuade them to give the buyer control. As the 2000s roll along, conditions very much favor LBOs. Enormous trade deficits have produced a strong influx of foreign investments and the economy is flush with money. The future will undoubtedly bring a correction as the mid-2000s' exuberance brings a flurry of bankruptcies—echoing the crashes in the 1980s.
see also Mergers and Acquisitions
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A leveraged buyout (LBO) is a restructuring of the capitalization and ownership of a company. The term leveraged refers to the use of debt as the primary method of financing the restructuring. The buyout portion refers to the fact that the method is often used to transform a publicly held company into one that is privately held. There are a number of reasons why this type of transaction might take place. These include cost savings, managerial incentives, and tax benefits.
A private equity firm is an investment manager that buys up companies using one of a number of strategies referred to as private equity; one of these strategies is the LBO. When an investor uses debt to acquire a company, the investor does not have to put down all of the capital required to make the acquisition. Once the company has been acquired, its cash flows are used to repay the debt. The investor makes large returns when the company is sold because the investor only put up a fraction of the original purchasing price. In other cases, the group pursuing the buyout might include the publicly held firm's upper management. This type of action is known as a management buyout (MBO).
Among the multiple parties involved when a public firm is taken private, there normally are both winners and losers. Existing shareholders who have their shares purchased in the buyout often win big. This is because most LBOs involve the payment of a premium over the market price at which the shares were trading prior to the announcement of the takeover. Similarly, the parties taking control of the firm gain managerial control and the enhanced flexibility normally associated with privately run firms. The new owners also have access to the firm's assets and cash flows, which formerly were part of the public corporation.
The biggest losers in an LBO are the firm's existing creditors. Because the buyout is financed primarily with debt capital, existing bondholders become creditors of a much riskier firm. This drives down the market value of outstanding bonds and makes future debt service much more uncertain. During the 1980s, a number of institutional investors who held large bond positions in firms that were the subject of MBOs sued the management of the firms. They claimed that managers knowingly engaged in activities that harmed their economic investment as creditors of the corporation. These suits resulted in settlements and damage awards in several instances.
HISTORY OF LEVERAGED BUYOUTS
When a public firm experiences an LBO, its entire equity is purchased by a small group of investors. In order to entice existing shareholders to sell the firm's outstanding shares, the group often offers a premium above the stock's prevailing market value. The capital they need to purchase the shares is obtained by issuing debt, in the form of bonds, against the firm's assets and cash flows. From a balance-sheet perspective, the action all takes place on the right-hand side. That is, the transaction involves the exchange of debt for equity. The result is that creditors have a larger claim, and owners a smaller claim, on the firm's assets. Note that the assets on the left-hand side of the firm's balance sheet do not change. Instead, what changes is how they are financed.
During the 1980s, leveraged buyouts became a huge part of America's corporate landscape. This largely was the result of a single investment banking firm, Drexel Burham Lambert, and the efforts of one of its principals, Michael Milken. It was Milken who determined that high-yield bonds could fill an existing funding gap in corporate financing. The bonds, commonly referred to as junk bonds because of their riskiness, would be enticing to investors who otherwise might not be willing to take an equity position in high-risk firms. Drexel developed a market for junk bonds and served as the investment bank for corporate raiders and management groups interested in taking over existing corporations. The market flourished for several years, before Milken was prosecuted and convicted of securities violations. Drexel Burham Lambert ultimately went bankrupt, but the firm's legacy lives on in the active market for high-yield debt and private equity firms.
REASONS FOR TAKING A FIRM PRIVATE
The junk bond market enabled small investor groups to raise large sums of money in order to take public companies
private. A number of reasons motivated managers and investors to pursue LBOs.
One advantage that a private firm has over a public one is administrative cost savings. A publicly traded company must produce annual reports, 10-K reports, comply with numerous regulations required by the Securities and Exchange Commission, hold annual shareholder meetings, and respond to shareholder requests. The management of publicly held firms must meet regularly with security analysts who follow the firm's stock, and maintain a shareholder relations department to deal with investor concerns. These costs are not required of a privately held firm.
In a private firm, managers no longer have to answer to the shareholder constituency. Lack of public accountability translates into greater management flexibility, since managers no longer have to focus as strongly on short-term operating results. The intense interest in reported quarterly earnings can bias managers in public firms to devote a great amount of effort and resources on short-term performance. Thus, managers of private firms have the luxury of being able to engage in investment activity that takes longer to produce tangible rewards. This greater flexibility and freedom from having to answer to shareholders is very enticing to upper-level management.
In addition, the process of buying up existing shares of the firm's stock severely diminishes the absolute number of shareholders. Because of their large capital investment and the fact that they now answer to themselves, the shareholders that remain after an LBO are highly interested in the firm's operations. These shareholders play an active role in the firm's management, as opposed to the hundreds of thousands of passive investors that hold a publicly traded firm's common stock.
The new entity's management has enhanced incentives to operate efficiently and profitably. This is because the high amount of debt service resulting from an LBO leaves little room for corporate perks and excess. The combination of having to pay the large interest expense on the debt and, in the case of MBOs, working for themselves as opposed to anonymous shareholders, results in much greater motivation for management to perform. Equity holders remaining after an LBO often have some special expertise or talent that they bring to the firm, such as access to additional capital sources. Shareholders in the new private firm who are not part of active management also have much greater incentive to monitor active management, since their personal stake in the firm is typically high.
Corporate tax shields are another potential advantage of restructuring with debt financing. The corporate tax code in the United States allows companies to deduct the interest paid on debt as an expense for tax purposes. No such deduction is allowed for dividends paid on equity shares. Thus, increased use of debt results in lower tax obligations owed to the Internal Revenue Service. Firms facing large tax liabilities may reap considerable benefits from the tax savings that result from debt financing.
Finally, large publicly held corporations in mature industries typically have access to large amounts of free cash flow. These dollars are valuable, because they can be used to develop new products and markets or invest in other firms. In a public corporation, these cash flows may be used for perquisites such as corporate travel to conventions and trade shows, company cars, membership in clubs, and other types of non-monetary rewards. By taking the firm private, remaining shareholders gain access to the firm's free cash flow and can put it to use, thereby reaping direct benefits.
With the demise of Drexel Burnham Lambert and the default on several prominent junk bond issues associated with 1980s restructurings, leveraged buyout activity slowed considerably in the 1990s. The appetite of investors for new junk bond issues decreased, and some of the firms that had previously gone private subsequently were recapitalized as public corporations.
After a lull in the 1990s, leveraged buyouts began to regain some of their charm in the early part of the twenty-first century. According to Dealogic, a New York-based deal tracker, LBO firms accounted for 10 percent of the $540 billion in mergers and acquisitions announced in the United States, double the average of 5 percent over the previous 10 years. Europe also showed a significant increase in LBO activities throughout the early 2000s. By 2004 and 2005, leveraged buyouts of large companies were becoming common again. The next eighteen months would see a buyout frenzy fuelled by the low cost of debt. From the beginning of 2006 to the middle of 2007, nine of the ten largest buyouts were announced. Kohlberg Kravis Roberts (KKR), TPG, and Goldman Sachs Capital Partners completed a massive buyout in the United States in October 2007 when they acquired TXU CORP for $31.8 billion. In September 2007, a huge leveraged buyout occurred when shareholders approved the acquisition of Canadian phone company BCE by Teachers Private Capital, Madison Dearborn, and Providence Equity for $32.6 billion. According to Dow Jones, private equity firms acquired 654 companies in the United States for $375 billion in 2006. This was eighteen times the value of deals closed in 2003.
In July 2007, problems in the mortgage markets began to impact the leveraged finance and high-yield debt markets. By September, the credit crunch became widely publicized with high-profile writedowns by major banks such as Citigroup and UBS. LBOs petered out as the credit markets
dried up, and it became apparent that another cycle of the private equity boom had come to an end.
SEE ALSO Financial Issues for Managers; Shareholders
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LEVERAGED BUYOUTS. A leveraged buyout (LBO) is one method for a company to acquire another. In an LBO, the acquiring firm typically borrows a large percentage of the purchase price by pledging the assets of the acquired firm as collateral for the loan. Because the assets of the target company are used as collateral, LBOs have been most successfully used to acquire companies with stable cash flows and hard assets such as real estate or inventory that can be used to secure loans. LBOs can also be financed by borrowing in the public markets through the issuance of high-yield, high-risk debt instruments, sometimes called "junk bonds."
An LBO begins with the borrower establishing a separate corporation for the express purpose of acquiring the target. The borrower then causes the acquisition corporation to borrow the funds necessary for the transaction, pledging as collateral the assets it is about to acquire. The target company is then acquired using any number of techniques, most commonly through a public tender offer followed by a cash-out merger. This last step transforms the shares of any remaining shareholder of the target corporation into a right to receive a cash payment, and merges the target corporation into the acquisition corporation. The surviving corporation ends up with the obligation to pay off the loan used to acquire its assets. This will leave the company with a high amount of debt obligations on its books, making it highly "leveraged," meaning that the ratio of debt to equity will be high. Indeed, in the average LBO during the 1980s, when they were most popular, the debt-to-assets ratio increased from about 20 percent to 90 percent.
Following an LBO, the surviving company may find that it needs to raise money to satisfy the debt payments. Companies thus frequently sell off divisions or portions of their business. Companies also have been known to "go public" again, in order to raise capital.
Many LBOs are "management buyouts," in which the acquisition is pursued by a group of investors that includes incumbent management of the target company. Typically, in management buyouts the intent is to "go private," meaning that the management group intends to continue the company as a privately held corporation, the shares of which are no longer traded publicly.
Management buyouts were particularly popular during the 1980s, when they were used in connection with the purchase of many large, prominent firms. Public tender offers by a corporation seeking to acquire a target company were frequently met with a counterproposal of a leveraged buyout by the target company management. One of the most famous takeover battles was the 1988 battle for RJR Nabisco between a management team led by F. Ross Johnson and an outside group led by the takeover firm Kohlberg Kravis Roberts & Company (KKR). Both groups proposed to take the company private using LBOs. This contest, eventually won by KKR when it purchased RJR Nabisco for $31 billion, is the subject of the book and movie Barbarians at the Gate. At the time, it was the most expensive corporate acquisition in history.
In the later years of the 1980s, LBOs became so popular that they were used in situations in which they were poorly suited, and the deals were poorly structured. Beginning in 1989, the number of defaults and bankruptcies of companies that had gone through LBOs increased sharply. As a result, the number of LBOs declined significantly.
Burrough, Bryan, and John Helyar. Barbarians at the Gate: The Fall of RJR Nabisco. New York: Harper and Row, 1990.
Carney, William J. Mergers and Acquisitions: Cases and Materials. New York: Foundation Press, 2000.
Hamilton, Robert W., and Richard A. Booth. Business Basics for Law Students: Essential Terms and Concepts. 2d ed. New York: Aspen Law and Business, 1998.
See alsoMergers and Acquisitions .