Understanding LBOs

Leveraged Buyouts

by Terry Stidham, President of Target Search Group

Wall Street has proven Archimedes' statement, "Give me a lever long enough and a place to stand, and I will move the earth" to be true through their use of Leveraged Buyouts. 

A Leveraged Buyout ("LBO"), is achieved by a Financial Sponsor acquiring a controlling interest in a company by financing a large percentage of the purchase price through leveraged borrowing. The buyer may be the current management, the employees or a private equity firm. The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. Leveraged buyouts use a combination of various debt instruments from bank and debt capital markets. The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the risks involved. Some leveraged buyouts occur in companies experiencing hard times and potentially facing bankruptcy, or they may be part of an overall plan.





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The concept of the process is not complex, and, if used correctly, can lead to a successful future for a company that may be at risk or crisis. 

Companies of all sizes and industries have been the target of leveraged buyout transactions, although because of the importance of debt and the ability of the acquired firm to make regular loan payments after the completion of a leveraged buyout, some features of potential target firms make for more attractive leverage buyout candidates, including:

• Low existing debt loads
• Historical financials that reflect stable and recurring cash flows
• Market conditions and perceptions that depress the valuation or stock price
• The potential for new management to make operational or other improvements to the firm to boost cash flows
• Hard assets (property, plant and equipment, inventory, receivables) that may be used as collateral for lower cost secured debt




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While some LBOs can lead to large layoffs and asset selloffs, some LBOs can be part of a long-term plan to save a company through leveraged acquisitions. Empirical evidence shows that many LBOs, like other types of buyouts, have resulted in significant improvements in firms’ performance (using a range of indicators from cash flow to return on investment), which can be explained by a combination of factors including tax benefits, strengthened management, internal reorganization, and change in corporate culture. 

On the other hand, LBOs, because of the leverage aspect, are controversial because they may cause disruptions and economic hardship in the company purchased: Its assets serve as collateral for the borrowed money, the purchasing company (often a holding company whose only purpose is corporate ownership and control) intending to repay the loan by using the future profits and cash flows from the purchased company or, failing that, by selling its assets (i.e., dismantling the company). 

LBOs have raised issues of ethics, notably about conflicts of interest between managers or acquirers and shareholders, insider trading, stockholders’ welfare, excessive fees to intermediaries, and squeeze-outs of minority shareholders (who may well receive a good price for their shares, an average of 30% to 40% more than the market price, but do not eventually benefit from the massive financial rewards of shrewd post buyout strategies).

Challenges and Demand for LBOs

Although LBOs still have the largest amount of funds available for investments the private equity industry has experienced some decline in their capacity for leveraged buyouts due to external pressures and investor preferences.



Top 7 Reasons for Trend 

 

1. Monetizing portfolio companies are talking longer in recent years. That traps investors' capital, reducing capacity for redeployment in new funds or in some cases for recycling existing funds.  
2. Newly launched buyout funds - even from established managers - are having an increasingly difficult time raising the same amounts of capital they did in earlier funds. Large institutional investors have been cautious on private equity due to liquidity constraints they encountered in 2008 as well as poor return expectations for the whole sector. 
3. Many pensions and endowments are staying away from some of the mega-funds with the belief they are too bulky to achieve superior returns. And in cases where major investors do come into large LBO funds, they often demand to directly co-invest with these funds on buyout deals. These co-investments, on which pensions do not pay fees, become a significant portion of investors' private equity allocations. Pension holding company shares directly on their books limit the amount of capital available for LBO funds. Some years back when deals were too large for a single fund, LBO firms would call each other to club on transactions. Now they call their investors to present co-investment opportunities. 
4. Companies have developed preventive strategies and defensive tactics (with “poison pills” meant to deter hostile bids, typically giving current shareholders particular rights to buy additional shares or to sell shares with severe economic penalties on the LBO acquirer).  
5. Changes in legislation make such takeovers more difficult (e.g., with Delaware’s merger moratorium law or Ohio’s control share acquisition law).
6. The rise of litigation against leveraged bids (for instance with allegations of violations of antitrust and securities laws) contribute to the difficulties in completing a LBO.
7. Ongoing re-balancing in retirement funding. Increasingly employers are shifting from defined benefits to defined contribution pensions. Defined contribution accounts are managed by individuals rather than pension funds and do not have access to alternative investments such as private equity. The slower growth in defined benefits accounts (as well as the ageing population of employees with these benefits) limits the overall demand for private equity, making fundraising for LBO shops enormously challenging in an already competitive environment.

4 Common Buyout Scenarios  

1. The Repackaging Plan - The repackaging plan is when private equity is used to purchase a currently public company. The purchased company is then taken private for a few years and "cleaned up" before being returned to the market as a fresh new IPO. 
2. The Split-Up - Splitting up happens when a company is deemed to be worth more if divided or sold off in pieces. An LBO occurs and then the acquired company is dismantled. This is the most feared form of LBO and is commonly seen with conglomerates. 
3. The Portfolio Plan - The portfolio plan or aggregation uses an LBO to acquire a competitor and thus enhance or add to its portfolio. This is risky because the acquired company must show a return on invested capital that exceeds the cost of acquisition. 
4. The Savior Plan - The savior plan is often drawn up with good intentions, but frequently arrives too late. This scenario is when the management and employees of a company borrow money to save a failing company. This is the least common form of leveraged buyout because to turn a failing company around generally requires changes in management and employees.

Regardless of what they are called or how they are portrayed, LBOs will be a part of our economy as long as there are companies, potential buyers and money to lend. 

Terry Stidham is the President and Founder of Target Search Group. He is a Business Development and Deal Flow Specialist with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment. He has served as the head of entrepreneurial organizations as well as Fortune 500 companies. He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.