Leveraged Buyout (LBO)

Following the stock market crash of 1929, companies strived to keep debt ratios low. Decades later, as corporations began to build large conglomerates of operating companies, novel ideas began to emerge with respect to how buyout deals could be structured. In the early 1960s, investors such as Warren Buffett began using publicly traded holding companies to amass large portfolios of investments.

Through the 1970s and 1980s, the techniques used by corporate raiders such as Jerome Kohlberg and Henry Kravis were refined, as undervalued companies were identified and purchased. This succession of leveraged buyouts was strictly motivated by the thought of excess profits, and entire companies were purchased, dismantled, and sold in pieces.

The boom era of these business transactions continued during the decade of the 1990s through the year 2007; stoked by low interest rates and generous lending practices.

The process typically starts with a private equity firm looking to buy a company using a combination of equity and debt. The interesting twist in the LBO structure is the use of the acquired company's assets to secure a portion of the debt used in the buyout. The private equity firm also uses the cash generated by the acquired company to pay down the debt.

A successful leveraged buyout results in abnormally high returns to equity holders. Once successful, equity holders typically decide to execute an exit strategy that includes options such as:

• Recapitalization: by replacing equity with additional debt, it may be possible to extract even more money from the acquired company.

• Complete Sale: it's possible to sell the entire company if a strategic match can be found among potential buyers.

• Initial Public Offerings: while it's not always possible to sell the entire company, an IPO allows equity holders to realize a gain on their initial investment.

The cost of the LBO can include transaction and lender's fees, bank expenses, and sponsor costs. Most buyouts involve three sources of funding: private equity, mezzanine debt, and senior debt.

• Private Equity: typically funds 25% of the total transaction. This is also the most expensive source of financing. Sources of this equity can include the target company's management team, a pool of funds held by LBO firms, as well as investment banks. Equity structures may include preferred stock held by the LBO firm, while employees and management teams receive common stock.

• Mezzanine Financing: typically funding 25% of the total transaction, this type of financing fills the gap between equity and senior debt. Mezzanine financing is junior to all other debt. For this reason, it carries a higher level of risk and interest rate to compensate investors for that risk.

• Senior Debt: also known as term debt, this will usually fund approximately 50% of the total transaction. This debt is frequently secured by assets of the acquired company, and is the least costly way to fund the buyout.

At a high level, potential LBO candidates would be undervalued stocks with strong cash flows, and relatively low debt. Other characteristics of target companies include:

• Large asset base

• Low future capital requirements

• Potential for process improvements or cost reductions

• Strong market position

• Relatively low enterprise value

Finally, the ideal candidate would be a company that can be easily separated into logical subdivisions and / or presents the acquirer with a clear exit strategy.

The big advantage of using financial leverage is that by increasing the debt held by the company, the equity portion often decreases to the point where the private equity firm only needs to supply around 25% of the total transaction price.

The large interest payments also force the company's management team to increase operating efficiency. For example, the company might be obligated to implement a number of cost-cutting measures that might otherwise go untapped. Since interest expense is tax deductible, and dividend payments are not, the LBO can also create a valuable tax shelter for the target company.

If mismanaged, a leveraged buyout can expose the acquired company to significant risks. That's one of the reasons private equity firms usually work closely with the existing management team to achieve their goals. If the private equity firm can convince the management team to invest in the transaction, they are certain to gain the full support of the management team too.

The real risk of a leveraged buyout is the financial pressure the debt places on the company. If some unforeseen event occurs, it is possible for all the investors to lose their entire stake in the deal. Buyouts are also dependent on precise calculations of the future cash flows required to satisfy creditors. Finally, economic downturns, or an increase in costs, can result in the company's inability to meet all their financial obligations. Deals can turn sour very quickly when this happens.