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A Leveraged buy-out is a
corporate finance method under which a company is acquired by
a person or entity using the value of the company's assets to finance
its acquisition; this allows for the acquirer to minimize its outlay of
cash in making the purchase. In other words a LBO is a company
acquisition method by which a
business can seek to takeover another company or at least gain
a controlling interest in that company.
Special about leveraged buy-outs is that the corporation that is buying
the other business borrows a significant amount of money to pay for (the
majority of) the purchase price (usually over 70% or more of the
total purchase price).
Furthermore, the debt which has been
incurred is secured against the assets of the business being purchased.
Interest payments on the loan will be paid from the future
cash-flow of the acquired
company.
Leveraged buy-outs became very popular
in the 1980s, as public debt markets grew rapidly and opened up to
borrowers that would not previously have been able to raise loans worth
millions of dollars to pursue what was often an unwilling target. LBO
activity accelerated, starting from a basis of four deals with an
aggregate value of $1.7 billion in 1980 and reaching its peak in 1988,
when 410 buyouts were completed with an aggregate value of $188 billion. The
persons or company doing such a "takeover" often used very little of its own
money and borrowed the rest, often by issuing extremely risky, but high
interest, "junk" bonds. These bonds, since they were high-risk, paid a
high interest rate, because little or nothing backed them up. No
surprise some of these LBO's in the 1980s ended disastrous, with the
borrowers going bankrupt.
Typical advantages of
the leveraged
buy-out method include:
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Low capital
or cash requirement for the acquiring entity
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Synergy gains,
by expanding operations outside own industry or business,
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Efficiency
gains by eliminating the value-destroying effects of excessive
diversification,
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Improved
Leadership and Management. Sometimes managers run companies in ways
that improve their authority (control and compensation) at the expense
of the companies’ owners, shareholders, and long-term strength.
Takeovers weed out or discipline such managers. Large interest and
principal payments can force management to improve performance and
operating efficiency. This “discipline of debt” can force management to
focus on certain initiatives such as divesting non-core businesses,
downsizing, cost cutting or investing in technological upgrades that
might otherwise be postponed or rejected outright.
Note! In this manner, the
use of debt serves not just as a financing technique, but also as a tool
to force changes in managerial behavior. Indeed, the wave of LBO's in
the 1980s has been a major catalyst in the rise of Value Based
Management! (see:
History of VBM)
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Leveraging:
as the debt ratio increases, the equity portion of the acquisition
financing shrinks to a level at which a private equity firm can acquire
a company by putting up anywhere from 20-40% of the total purchase
price.
Critics of
Leveraged buy-outs indicated that bidding firms successfully squeezed
additional cash flow out of the target’s operations by expropriating the
wealth from third parties, for example the federal government. Takeover
targets pay less taxes because interest payments on debt are tax-deductible
while dividend payments to shareholders are not. Furthermore, the obvious
risk associated with a leveraged buyout is that of financial distress, and
unforeseen events such as recession, litigation, or changes in the
regulatory environment can lead to difficulties meeting scheduled interest
payments, technical default (the violation of the terms of a debt covenant)
or outright liquidation. Weak management at the target company or
misalignment of incentives between management and shareholders can also pose
threats to the ultimate success of an Leveraged buy-out.
Compare:
Management buy-out |
Acquisition Integration Approaches |
Core
Competence |
Outsourcing |
Parenting Advantage
|
Greiner |
History of VBM
More finance models
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