Leveraged Buy Out Lecture 11

8/3/2019 Leveraged Buy Out Lecture 11

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Leveraged Buy out

A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or "bootstrap"transaction) occurs when a financial sponsor acquires a controlling interest in acompany's equityand where a significant percentage of the purchase price is financedthrough leverage (borrowing). The assets of the acquired company are used ascollateral for the borrowed capital, sometimes with assets of the acquiring company.The bonds or other paper issued for leveraged buyouts are commonly considered not tobe investment grade because of the significant risks involved.

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

Low existing debt loads; A multi-year history of stable and recurring cash flows; Hard assets (property, plant and equipment,inventory, receivables) that may be

used as collateral for lower cost secured debt; The potential for new management to make operational or other improvements to

the firm to boost cash flows; Market conditions and perceptions that depress the valuation or stock price. Leveraged buyouts involve financial sponsors orprivate equity firms making

large acquisitions without committing all the capital required for the acquisition.To do this, a financial sponsor will raise acquisition debt which is ultimatelysecured upon the acquisition target and also looks to the cash flows of theacquisition target to make interest and principal payments. Acquisition debt in anLBO is therefore usually non-recourse to the financial sponsor and to the equityfund that the financial sponsor manages. Furthermore, unlike in a hedge fund,where debt raised to purchase certain securities is also collateralized by thefund's other securities, the acquisition debt in an LBO is recourse only to thecompany purchased in a particular LBO transaction. Therefore, an LBOtransaction's financial structure is particularly attractive to a fund's limitedpartners, allowing them the benefits of leverage but greatly limiting the degree ofrecourse of that leverage.

This kind of acquisition brings leverage benefits to an LBO's financial sponsor in

two ways: (1) the investor itself only needs to provide a fraction of the capital forthe acquisition, and (2) assuming the economic internal rate of return on theinvestment (taking into account expected exit proceeds) exceeds the weightedaverage interest rate on the acquisition debt, returns to the financial sponsor willbe significantly enhanced.

Prof. C.A. Nitant Trilokekar

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As transaction sizes grow, the equity component of the purchase price can beprovided by multiple financial sponsors "co-investing" to come up with theneeded equity for a purchase. Likewise, multiple lenders may band together in a"syndicate" to jointly provide the debt required to fund the transaction. Today,larger transactions are dominated by dedicated private equity firms and a limited

number of large banks with "financial sponsors" groups. As a percentage of the purchase price for a leverage buyout target, the amount

of debt used to finance a transaction varies according the financial condition andhistory of the acquisition target, market conditions, the willingness of lenders toextend credit (both to the LBO's financial sponsors and the company to beacquired) as well as the interest costs and the ability of the company to coverthose costs. Typically the debt portion of a LBO ranges from 50%-85% of thepurchase price,

Rationale

The purposes of debt financing for leveraged buyouts are two-fold:

1. The use of debt increases (leverages) the financial return to the private equitysponsor. Under the Modigliani-Miller theorem,[29] the total return of an asset to itsowners, all else being equal and within strict restrictive assumptions, isunaffected by the structure of its financing. As the debt in an LBO has a relativelyfixed, albeit high, cost of capital, any returns in excess of this cost of capital flowthrough to the equity.

2. The tax shield of the acquisition debt, according to the Modigliani-Miller theoremwith taxes, increases the value of the firm. This enables the private equitysponsor to pay a higher price than would otherwise be possible. Because income

flowing through to equity is taxed, while interest payments to debt are not, thecapitalized value of cash flowing to debt is greater than the same cash streamflowing to equity.

Historically, many LBOs in the 1980s and 1990s focused on reducing wastefulexpenditures by corporate managers whose interests were not aligned withshareholders. After a major corporate restructuring, which may involve selling offportions of the company and severe staff reductions, the entity would likely beproducing a higher income stream. Because this type of management arbitrage andeasy restructuring has largely been accomplished, LBOs today focus more on growthand complicated financial engineering to achieve their returns. Most leveraged buyout

firms look to achieve an internal rate of return in excess of 20%.


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Leveraged buy-out method analysed

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; thisallows for the acquirer to minimize its outlay of cash in making the purchase. In otherwords a LBO is a company acquisition method by which a business can seek to takeoveranother company or at least gain a controlling interest in that company. Special aboutleveraged buy-outs is that the corporation that is buying the other business borrows a significantamount of money to pay for (the majority of) the purchase price (usually over 70% or more of thetotal purchase price).

Furthermore, the debt which has been incurred is secured against the assets of the business beingpurchased. Interest payments on the loan will be paid from the future cash-flow of the acquiredcompany.

Typical advantages of the leveraged buy-out method include:

Low capital or cash requirement for the acquiring entity Synergy gains, by expanding operations outside own industry or business, Efficiency gains by eliminating the value-destroying effects of excessive diversification, Improved Leadership and Management. Sometimes managers run companies in ways

that improve their authority (control and compensation) at the expense of the companiesowners, shareholders, and long-term strength. Takeovers weed out or discipline suchmanagers. Large interest and principal payments can force management to improveperformance and operating efficiency. This discipline of debt can force management to focus

on certain initiatives such as divesting non-core businesses, downsizing, cost cutting orinvesting 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 atool to force changes in managerial behavior. Indeed, the wave of LBO's in the 1980s hasbeen a major catalyst in the rise of Value Based Management! (see: History of VBM)

Leveraging: as the debt ratio increases, the equity portion of the acquisition financing shrinksto a level at which a private equity firm can acquire a company by putting up anywhere from20-40% of the total purchase price.

Critics of Leveraged buy-outs indicated that bidding firms successfully squeezed additional cashflow out of the targets 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 associatedwith 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 interestpayments, technical default (the violation of the terms of a debt covenant) or outright liquidation. Weakmanagement at the target company or misalignment of incentives between management andshareholders can also pose threats to the ultimate success of an Leveraged buy-out.


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Reverse Leveraged Buyout

What Does Reverse Leveraged BuyoutMean?

The action of offering new shares to the public by companies that initially went privatethrough past LBOs.

Reverse Leveraged Buyout explained

Companies undergoing a reverse LBO are attempting to obtain cash in order to reduce

their debt to more manageable levels. This debt may have been from operating

activities or from the company's previous LBO.


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