What is a Leveraged Buyout? Here’s a Guide to Help You Learn More
The Leveraged Buyout (LBO) technique is often used by financial advisors and planners to help companies to make large acquisitions. So what really is a leveraged buyout? In corporate finance, it refers to a business transaction in which the primary financing source for purchasing a firm is debt (bonds or loans) for meeting acquisition costs. LBO has a debt-to-equity ratio of 90:10 and is considered to be one of the best buyout scenarios from an entrepreneur’s viewpoint. Let’s understand more about how LBOs work as well as their pros and cons.
How do Leveraged Buyouts Work
In an LBO, a business attempts to acquire another business by borrowing a sizable sum of money to finance the acquisition. Then, the acquiring firm issues bonds against the combined assets of the two enterprises, which means that the assets of the acquired firm can be used as collateral against it.
Examples of Leveraged Buyouts
The 2006 acquisition of Hospital Corp. of America (HCA) by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch was one of the largest leveraged buyouts in history. HCA was valued by the three firms at around $33 billion.
Although the number of large acquisitions declined after this event, large-scale LBOs experienced a resurgence during the COVID-19 pandemic. In 2021, a group of investors led by Blackstone Group announced a leveraged takeover of Medline, placing a $30 billion valuation on the manufacturer of medical equipment.
What are the Advantages and Disadvantages of Leveraged Buyouts?
Advantages
- Better control: After shifting from public to private ownership, entrepreneurs have a chance to reorganize the organizational structure and activities. This allows them to boost their chances of success and gain better control.
- Financial profits: Since buyers do not have to invest much of their money upfront in a leveraged buyout scenario, they reap high financial gains if the acquired company generates enough cash.
- Chance to survive: Using the LBO approach, a buyer company can save a firm that is about to shut down after huge incurring losses and provide it with a fighting chance to survive.
Disadvantages
- Reduced staff morale: Sometimes the employees of the acquired company are not aligned with the vision of the new leadership. In fact, this creates a hostile work environment and reduces staff morale.
- Bankruptcy risk: If the investor company fails to pay the debts, then bankruptcy becomes a possible risk.
- Layoffs: The buyer company has to adopt aggressive cost-cutting strategies to turn around the purchased firm. Moreover, this ultimately results in employee layoffs.
Why do LBOs Occur?
After understanding what is a leveraged buyout and its pros and cons, let us look at the key reasons why such buyouts occur.
1. To Make a Public Company Private
If a business is publicly traded, owners can utilize a leveraged buyout to transfer public shares to a private investor. Additionally, the investors will then own all or a substantial portion of the business, and take on the associated debt obligations themselves.
2. To Break up a Large Conglomerate
Efficiency tactics have been employed by many business owners to increase the profitability and marketability of their enterprises. However, some businesses grow to be so huge that it is advantageous for a buyer to employ an LBO to divide the large conglomerate into a number of smaller companies to increase efficiency and performance.
3. To Improve a Company’s Performance
A leveraged buyout might be a prudent choice for business owners if their companies are underperforming. Moreover, the investor company would take on the debt in the hope that by keeping the business for a predetermined period of time, its value would rise, enabling them to pay off the debt and turn a profit.
4. To Acquire a Competitor Company
Another important reason for an LBO is when a smaller business seeks to be acquired by a larger competitor. As a result, the smaller business can expand significantly, onboard new clients, and scale rapidly. Usually, the purchasing firm retains key employees, so the acquired firm does not have to worry about layoffs.
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Types of Leveraged Buyouts
1. The Repackaging Plan
In this type, a Private Equity (PE) company uses the leveraged buyout. Under this, the PE company purchases the outstanding stocks of a public company using bank loans and privatizes them. In the end, they repackage the business and sell the ownership through an Initial Public Offering (IPO).
2. The Split-Up Plan
The split-up plan has the buyer company breaking the purchased company into small parts and sells each one to the highest bidder separately. These types of transactions often lead to job losses as the entire organization is restructured using this strategy.
3. The Portfolio Plan
This plan is meant to benefit all participants, including staff, management, and the buyer company. Under this, the buyer company purchases one of the competitor companies. This type of LBO leads to rising stock prices and company expansion in a new dimension with the help of peer elevation.
What are the Risks of Leveraged Buyouts?
Some of the most common risks attached to LBOs are:
Interest Rate Risk
The interest rate on this kind of financial arrangement is frequently high. Hence, the business may go bankrupt if the interest and principal payment schedules are not completed on time. In fact, payments may rise abruptly if there is a fluctuating inflation rate and variable debt. To avoid dire consequences, companies should invest only under fair credit terms and interest rates to make the LBO successful.
Business Risk
A company can easily become insolvent or unable to pay the creditors if it encounters an unforeseen incident or is unable to make the required debt payments. To avoid such conditions, businesses should hire financial planners to build effective strategies that tackle such issues.
What Types of Companies are Attractive for LBOs?
PE firms are more likely to target mature companies in established industries for LBOs, rather than emerging startups or speculative businesses. Buyer companies want to maximize profits, hence they try to invest in a company that has consistent operational cash flows, well-established product lines, effective management teams, and workable exit options.
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Leveraged buyouts are a proven way for competent enterprises with strong strategic plans to take over underperforming companies. Despite being an aggressive acquisition tactic, LBOs interest investors due to their high cash-generative potential. If you belong to the financial sector, or aspire to be a part of it, you can learn more about such concepts through Emeritus’ online courses in finance. These will help you master key financial concepts and nuances of the trade to help you advance in your career in this sector.
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