Leveraged Buyout (LBO) Explained

Posted on Friday, July 27th, 2018 MarketBeat Staff

“Greed is good”. That famous, cynical line from the movie Wall Street reinforced what many people felt about a kind of investment that’s existed for a long time, but first boomed in the 1980s. It’s called the leveraged buyout and it made “junk bonds” and “Michael Milken” household names. But is a leveraged buyout simply a speculative investment for short-term profit, or can there be benefits to the acquired company?

In the decade between 1979-1989, an estimated 2,000 leveraged buyouts occurred. However, in 1979, there were only 16 LBOs that had a value of over $1 billion. By 1986, there were 76 LBOs valued at over $20 billion. After a brief pause, the leveraged buyout became popular again in the early 2000s and continues to hold some appeal in the financial community today. In this article, we’ll help you understand what a leveraged buyout is, why leveraged buyouts occur, why financing a leveraged buyout is risky, what are the different kinds of leveraged buyouts, and if a leveraged buyout can be good.

What is a leveraged buyout?

In its simplest form, a leveraged buyout is an acquisition of a company that is financed almost entirely by debt. The debt that is secured comes primarily from the targeted company’s assets. The LBO is structured so that the assets and cash flow of the company being acquired become the primary means to pay for the financing.

The concept of a buyer being able to “take over” another entity without putting a lot of their capital at risk is why this is referred to as a “leveraged” buyout. When the transaction is done, the assets of the acquired company are heavily leveraged. This makes them an attractive target for the buyer who may want to sell certain assets to reduce the debt load and get the company back to profitability. However, when you’re talking about corporations being acquired, this idea of breaking off individual pieces and reselling them includes real people with real jobs. And although such a selloff may have to occur for legitimate reasons, this practice got picked up on by the media as a sign of corporate greed.

Why would investors do a leveraged buyout?

A typical leveraged buyout happens because a private equity firm sees an opportunity to take control of a business that has good fundamentals, but needs to operate better. In this case, they may be able to help the company avoid, or create a viable path out of bankruptcy, and help the company return to profitability. The benefit for them is the opportunity to sell the company, for a profit, at a later date.

So if an investor has the ability to be a “turn-around specialist”, an LBO can be similar to a mortgage. If the value of the business increases, the investor stands to make a large profit. However, if things go poorly, and when so much debt is involved, it doesn’t take a lot for that to happen, these investors can lose money very quickly, even though they are holding the majority of the debt.

Why financing a leveraged buyout can be very risky

A leveraged buyout is not, in theory, always a bad thing. Leveraged buyouts have been around for a long time. In fact, one of the first LBOs to make headlines involved the Ford Motor Company in 1919.

Whatever the reason for the leveraged buyout (see "What are the types of leveraged buyouts") the chances of an LBO being successful are much higher if the company that’s being acquired is healthy (i.e. growing and turning a profit). This makes it easy for the buyer to find financing without paying a risk premium.

When looked at like this, an LBO is similar to a homebuyer taking on a mortgage. The homebuyer selects an asset (a house) that they believe will grow in value. They also view their own personal situation as one where their income will be steady and/or growing so they can pay off the debt that they assume to buy the asset. Or that they will be able to sell the house at a future date for more than what they owe on the mortgage.

The purpose of the mortgage is to allow them to use financing from another source to buy the property without using their own cash. The homeowner then pays the mortgage company for the amount they borrowed, plus interest.

The reality is many mortgages and LBOs operate like this and are very successful. But these are not the stories you hear about.

The harsh truth is just as the housing crisis occurred because many homeowners had to default on their mortgages, many leveraged buyouts occur because a business is in trouble. A brief history lesson will explain why LBOs became so popular in the 80s, and are still part of the financial news cycle today.

In the early 80s, many corporations started getting merger happy. This created empires that, in several cases, were unsustainable. In some cases, companies became too diversified and got away from their core competencies. This created an environment where private equity firms, often given the moniker “corporate raiders” could target the company, swoop in and “rescue” them in the form of an LBO.

This is where things get murky. Going back to our example of mortgages, there were many factors that played into the housing crisis that goes beyond the scope of this article. However simply put, as more, and larger, homes were being built, the market needed a supply of buyers not only for these homes but for the homes being sold. This created a supply and demand cycle that opened the door for “non-traditional” lenders to fill the role that many banks would not. As a result, these institutions (frequently using “predatory” practices) financed home buyers who would not otherwise meet the lending criteria of traditional mortgage lenders.

Unfortunately, the highly leveraged homeowners quickly found themselves in a situation where the high level of interest added to the principal of the loan created an unsustainable financial situation.

In the corporate world, as these empires began to crumble, rather than allowing a business to fail, private equity firms, saw the potential for profit and provided financing. But remember, an LBO requires financing from the company being purchased to pay off the existing owner.  And financing an LBO is risky even in the best of situations. This is because investors understand that there is an inherent risk when a business changes hands. That risk gets magnified when you’re a large multi-million dollar corporation with employees and shareholders.

Add to this, that much of the funding for LBOs is spread out among banks, bonds, subordinated debt, or seller financing.

So for these buyers to get the funding they had to pay a much higher yield on the debt to account for the risk. This created the concept of the “junk bond” which was popularized by Michael Milken whose investment bank, Drexel-Burnham. These bonds are not considered investment-grade which means that the issuer feels there is a high likelihood of default. This was just one example of the “shadow banks” and other financial institutions that can issue these bonds because they do not have to follow conventional regulations.

As in the case of the housing crisis, several of these LBOs led to the acquired companies going bankrupt because they were so leveraged. The large interest payments made it impossible for their cash flow to meet their obligations.

What are the types of leveraged buyouts?

Leveraged buyouts usually take place for one of three reasons:

  • A public company wants to go private
  • A company wants to get out of a segment of their business by selling it
  • To transfer private property (this is common when small businesses change hands)

Public to Private

This is a situation where a single investor or investment group acquires the assets of a public company with the intention of running it as a privately owned business. In some cases, the investors come from the company’s existing management team who are looking to move forward as a privately held company (the opposite of “taking a company public”). This is considered a friendly takeover.

What tends to grab headlines is the situation known as the hostile takeover. This is where an investor or investment group seeks to buy a business with the intention of reorganizing and or restructuring the company and then selling it to another entity for a profit. In some cases, they may even sell it to a publicly-held company in a stock offering.

As you can see, the motivation behind the two scenarios is very different. Although both seek to make a profit, the means of achieving that are different.

Spin-Offs

In this scenario, a company wants to sell a particular element, or elements, of their business to generate cash. This may be the case after a company has been acquired as part of another LBO and now is looking to pay their investors back. In this situation, the buyer may be the management team of the business unit being sold.

Private Deals

Succession planning for a small business can be difficult. In some cases, a family-owned business can no longer stay in the family. However, if a company is profitable, the business owner, although ready to retire, may not simply want to close the business but they either can’t find a corporation to buy them or they wish to keep ownership private. In this case, an LBO can be organized sometimes by the existing employees or other individuals who have some stake in the company or personal relationship with the owners. Since these parties are unlikely to have the liquidity to buy the business outright, and LBO can provide the financing so that the seller can sell the business for the fair market value.

Can a leveraged buyout be good?

The simple answer is yes. A leveraged buyout can force a bloated company to become more efficient. It’s also a proven fact that smaller, independently owned companies tend to thrive when they have more autonomy. But there is a fine line between creating operational efficiencies and simply shuffling deck chairs on the Titanic.

In many cases, a leveraged buyout is seen to be successful because a strong economy is causing volatile stock prices and an easier climate to assume debt. If market conditions change, the emperor could be revealed to have no clothes.

The bottom line on leveraged buyouts

As we mentioned earlier, leveraged buyouts have been around for a long time and will continue to be a part of the investment scene. They are what they are. Highly speculative investments based on the assumption of a lot of debt.

Whether they are good or bad really depends on your point of view. For investors who see a corporation as existing only to make a profit, and the purpose of investing to receive a reward for your risk, leveraged buyouts make complete sense. A corporation that is in trouble can be brought back to profitability, or at the very least, the parts of the business that are profitable can be preserved and move forward. Likewise, the inefficient parts would be allowed to fail.

However, if you take the approach that corporations have societal, even moral, obligations, then LBOs can be seen as not much more than legalized gambling. Does the benefit gained by an investor group's ability to turn around a rapid profit offset the lives that are disrupted in the process?

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