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Leveraged Buyout Explained
A leveraged buyout, or LBO, is an acquisition of a company or division of another company financed with significant amount of debt. Later, the acquired company's profits are used for the repayment of the loans. This acquisition method became very popular in the U.S. in the 1980's when easy financing was available through innovative securities like junk bonds. During that time, LBOs were also used by corporate raiders such as Carl Icahn for taking over target companies. It is estimated that more than 400 leveraged buyouts were completed during the 1980's. But in the 1990's, the number of completed LBOs came down drastically due to new legal hurdles and the drying up financing using junk bonds after Michael Milken, the pioneer of junk bond financing, went to jail.
During 2000's, LBOs again became popular and began to spread to countries other than the U.S. led by large Private Equity firms and specialised funds. LBOs are now used even by Indian companies for acquiring foreign companies.
In the earlier days, top mangers of struggling companies were the principal architects of leveraged buyouts with the help of outside financiers. Since they know more about the company, they were in a better position to lead the turnaround if given full control that comes through ownership. Later, corporate raiders and specialized funds began to play bigger role in the field. They usually changed the incumbent management and replaced them with newer people.
Structure of an LBO
Basically a leveraged buyout transaction is funded though a mix of equity and debt, but usually debt will make up the larger part. Debt can be in the form of traditional bank financing, bond offerings, seller financing and loans from specialised funds. During the LBO boom of 1980's, the debt portion was normally as low as 10%. But nowadays, it has increased to up to 40% of the total value of the transaction. The different types of financing instruments used in a leveraged buyout are briefly explained below.
Bank debt: This is the credit facility from sources like commercial banks and other credit companies. This usually consists of about 50% of the total capital in a typical LBO transaction. The repayment period of this type of debt ranges from 5 to 7 years. Comparatively, this carries lower interest rates.
High-yield debt: This is usually in the form of bonds which carry higher interest rates than bank financing. These types of bonds are called junk bonds as they contain more default risk. These are offered to the public or institutions that are ready to bear the higher risk for higher potential returns. Typical repayment period ranges from 7 to 10 years.
Mezzanine debt: This is debt raised from institutions like buyout funds, hedge funds etc. bearing higher interest rates than even high-yield bonds. They are usually issued along with warrants which are options to purchase stock. This form of debt usually contains about 10-20% of the total capital in an LBO transaction.
Equity: Equity part is contributed by the management, private equity funds, investment banks or by an individual. Even though this is the riskiest form of capital, the potential for return is also the highest. Equity portion usually contains 10-30% of a typical LBO transaction.
Selection criteria
A potential LBO candidate should have certain qualities that make it an ideal target. These include steady and predictable cash flow, a clean balance sheet with little debt, strong, defensible market position, limited working capital requirements, minimal future capital requirements, heavy asset base, divestible assets etc.
Value creation
Buying a company using sophisticated financing methods is only the first step in an LBO. The most important thing is enhancing the value of the acquired business. Various methods are applied to achieve this. Expansion, restructuring and operational improvement are the most common methods used by LBO firms.
The expansion strategy is applicable in the case of relatively small businesses with huge potential to grow if more capital and resources are employed.
Restructuring is the most common strategy used by the acquirers since most of the companies bought through LBOs are in bad financial condition. Restructuring of debt, selling non-core assets, cutting salaries, laying of employees, changing management etc. are part of the overall restructuring efforts.
Operational improvement is another strategy used for value creation. This usually involves cost control programs, improving efficiency, bringing more focus to the core businesses, achieving more management effectiveness, outsourcing production and back office operations to low-cast locations etc. This method normally takes more time to produce results when compared to financial restructuring, but it is more sustainable.
Exit strategies
Usually, the acquirer in a leveraged buyout takes the target company private through the transaction. That means it will buyout the entire stake held by the public and delist from the listed stock exchange, if the target is a public company. This can give the acquirer the freedom to execute major changes in the acquired business.
After the reorganization of the business, acquirers such as specialized LBO funds usually exit from the company. Various types of methods are used for the exit. One is selling out the company to a strategic buyer. Another exit strategy is making a fresh IPO if the company has been taken private for realizing the gains. Another option is the recapitalization of the acquired company in a manner that the buyers can extract money from it.
LBOs in India
LBOs completed in India are different from those in the U.S. and other developed countries which are normally carried out by specialized investment funds. Here, they were carried out by business groups or companies to acquire foreign companies with the help of newfound sources for providing large amount of credit as a result of the liberalization of the Indian economy. Moreover, the target companies were usually many times bigger than the Indian acquirers.
The first global LBO in India was the acquisition of Tata Tea's acquisition of UK-based tea company Tetley in March 2000. After that two other companies under Tata Group made similar transactions. They were the acquisition of Corus Group by Tata steel and Jaguar by Tata motors.
Many other Indian companies have carried out LBO transactions after 2000. Birla Group company Hindalco Industries' acquisition of Canada-based aluminum producer Novelis, Chennai-based oilfield equipment producer Aban Offshore's acquisition of 33.76% stake in Norwegian oil rig producer Sinvest, Vijay Mallya's UB Group's acquisition of Glasgow-based whiskey maker Whyte & Mackay, Dr.Reddy Lab's acquisition of German generic drug maker Betapharm, Wind power major Suzlon's acquisition of Germany-based RePower Systems are examples.
Pros and cons of LBOs
Even though hundreds of LBOs were completed in the 1980's and in the later period, studies show that only a small faction of them created compelling shareholder value. Most of them gave the huge profits to investing firms that orchestrated these transactions and exited later. But they destroyed many good companies due to the over-leverage created by the LBO transactions.
Even in India, most of our celebrated overseas buyouts through LBO method are in trouble because of the huge liabilities on the acquirer. These transactions, which were actually intended to increase shareholder value, eventually ended up in depressing stock prices due to the huge debt pile. So the fact is that those acquirers which use prudent use of debt funds in LBO transaction will only create real shareholder value.
http://shareskool.com/articles/ViewArticle.inf?article=Leveraged+Buyout+Explained+&article_Id=37
About the Author
Shareskool.com is an India focused investor education website. It aims to empower investors in India to make independent investment decisions through education and information.
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