Buying a company can be a lucrative investment opportunity. Leveraged buyouts (LBOs) are a popular way of acquiring companies, as they are expected to yield a high return on investment. This post will cover What is an LBO is? What makes a good target for a leveraged buyout, and the primary sources of LBO financing.
A leveraged buyout is the most common private equity strategy. It is where a private equity firm uses a small amount of equity and a large amount of debt financing to acquire a company, division, business, or collection of assets. The acquiring company uses the debt to increase its own equity and to reduce the risk of the overall acquisition. Simply speaking, using leverage (debt) increases the private equity firm's expected returns. PE firms can obtain a high return on equity (ROE) and internal rate of return (IRR) by investing as little of their own money as possible, assuming everything goes according to plan. The use of leverage in an LBO is crucial in reaching the intended IRRs because PE firms are compensated depending on their financial returns.
One of the first LBO's to be recorded was the purchase of Pan-Atlantic Steamship Company in January 1955 and Waterman Steamship Corporation in May 1955 by McLean Industries, Inc. This may have been the first leveraged buyout. McLean borrowed $42 million and secured an additional $7 million through a preferred stock offering under the terms of the deal. When the deal closed, Waterman utilized $20 million in cash and assets to pay off $20 million in loan debt.
It wasn't until the early 1980s that leveraged buyouts started to become more prominent. Starting with Michael Milken who invented High Yield Bonds (also known as Junk Bonds). Michael backed some of the biggest hostile takeovers and leveraged buyouts of that era. Some of the famous financiers that Milken backed were Carl Ichan, T. Boone Pickens, and Henry Kravis. The 1980s, on the other hand, could be considered the first golden age of private equity. The Prudent Man Rule, which specifically allowed investments in private equity, was announced by the ERISA in 1978. The buyout business enjoyed one of the largest growths in history, thanks to two reductions in capital gains tax rates (first from 49.5 percent to 28 percent, subsequently to 20 percent) and increased financing availability. The sector proceeded to expand significantly in the years after that. The LBO model was quickly becoming a standard and preferred instrument for many private equity firms at the time, which led to the formation of the LBO Association.
There is a multitude of benefits when it comes to leveraged buyouts:
Leverage has numerous benefits when buying a company. One of the main benefits of debt financing is the tax savings due to the tax-deductibility of interest expenses. As the debt ratio rises, the equity portion of acquisition financing shrinks to levels at which a private equity fund can acquire a company by providing anywhere from 20-40 percent of the total purchase price of the company.
The high interest and principal payments can cause management to feel pressured to improve performance and operating efficiencies. Debt discipline can force managers to focus on divesting unprofitable businesses, cutting costs, or investing in technological upgrades to improve efficiency. Using debt can be both a financing technique and an incentive for changes in managerial behavior.
Equity that is used in leveraged buyouts comes from a pool of funds of committed capital that has already been raised from a pool "of qualified" investors. It's structured as a limited partnership with its principals acting as general partners. Investors in the fund include endowments, insurance companies, pension trusts, sovereign wealth funds, private individuals, and other institutions. The investors in the fund act as limited partners. The general partner is responsible for making all the investment decisions, with the limited partners responsible for transferring committed capital to the fund once given notice by the general partner.
Private equity firms and acquisition entrepreneurs are adaptable in their methodology and search out great acquisition targets. The sorts of target companies they put equity into will change as the economy changes. But there are a few qualities in target companies that are more appealing for leveraged buyouts.
The target business that is being acquired must be able to pay its debt service payments over time. If the target company doesn't have strong recurring revenue or cash flow generation it will be harder for the sponsoring firm to get financing. Given the amount of debt the company will take on, it's critical that cash flows are predictable, with strong margins and modest capital expenditures. The corporation can readily cover its debt because of this consistent cash flow.
When a firm acquires another company solely to prevent another competitor from doing so or to protect its future market position, it is referred to as a defensive acquisition strategy.
The asset base of a target company is critical because it serves as collateral against which lenders can provide loans. When it comes to evaluating the asset base in terms of quality, more liquid collateral is seen as more appealing. Receivables and inventory are more easily monetized than PP&E. Collateral is extremely important in determining the amount of bank debt available for deals that will be financed in the leveraged loan market. A robust asset base not only helps with funding, but it also indicates that the company has significant entry barriers.
Fixed costs pose a significant risk to private equity firms because they must be paid even if revenues fall. For this reason, a company with a high fixed cost base may be viewed as less appealing.
Low capital expenditures are related to a company's ability to generate cash flow. If a company has significant capital expenditure requirements yet has rapid growth and excellent profit margins, it may be appealing depending on the investment firm's investment criteria.
A private equity firm must add more debt to a company's balance sheet in order for an LBO to succeed. After that, the corporation repays the loan over time, resulting in a lower effective purchase price. When a corporation already has a large amount of debt on its balance sheet, it's more difficult to make a deal work.
Growth is obviously appealing, and it can be achieved either organically or through aggressive acquisitions. Obviously, mature enterprises with consistent cash flows are not the most growth-oriented, but if a firm finds a target company with consistent cash flows and the potential to scale the business, it will make an investment opportunity all the more appealing.
Private equity firms and acquisition entrepreneurs like to buy companies that are moderately undervalued to fairly valued; they avoid buying companies with exceptionally high valuation multiples since there is a danger that the valuations will fall.
Hopefully, the target companies' management will have a vested interest in the acquiring companies' or firms' vision for the future of the target company. If not, the buyer should seek to replace the management.
While an ideal LBO candidate would have a strong current business, investment organizations look for ways to improve efficiency and minimize expenses. Sponsors strive to enhance efficiency by streamlining operations, reducing labor expenses, optimizing the supply chain, negotiating better terms with suppliers and consumers, and implementing better systems and processes. An example of a private equity firm that focuses mainly on turnarounds would be Tom Gores' firm Platinum Equity.
Because of the large sums of debt involved, LBOs represent a higher level of risk than typical financial transactions. The company being purchased could go bankrupt if the combined companies can't pay their debt obligations utilizing the combined cash flow of the two companies. Both the acquiring firm and the company being purchased may go bankrupt in some instances.
The debt that is used in an LBO is usually made up of varying debt instruments and securities. Below are some of the common sources of debt used in an LBO:
Senior Debt, also known as Bank Debt financing, typically accounts for the vast majority of an LBO's capital structure. Senior debt is the most common of all the financing instruments used to buy a company via LBO: it has a lower cost of capital than other tranches of the capital structure since it is the first in line to collect value upon the company's dissolution. As a result, it will often have lower interest rates than the company's other debt components. Bank debt is usually the least expensive portion of the financing structure and comes with severe covenants. Bank debt is often interest-bearing and based on a variable rate that is set at a margin above LIBOR. If the spread is linked to the borrower's performance, it might be modified upwards or downwards.
The loan is secured by the borrower's assets in asset-based lending. Accounts receivable, inventory, marketable securities, and property, plant, and equipment are all examples of assets that can be used to secure a loan (PP&E).
High Yield Debt, also known as Subordinated Debt, makes up around 20% to 30% of a newly acquired company's capital structure. The financial costs of high-yield debt are higher than those of senior debt. High-yield debt, on the other hand, often has fewer restrictive covenants or constraints, as well as interest-only payments with a paydown due at the debt's maturity. In the event of a firm liquidation, high-yield debt issuers are ahead of stockholders, but behind Senior Debt. In other words, in the event of a liquidation, high-yield bondholders are often not compensated until the Senior Debt holders have been paid in full. Because the potential loss of investment money is large in many circumstances, high-yield bonds are commonly referred to as junk bonds.
This is where the seller agrees to act as the bank, and carry a portion of the loan.
This is the amount invested by the acquiring investment firm or company. The amount of invested equity in an LBO usually makes up between 20-40% of the financing structure. The equity invested decreases the debt load in case the value of the company falls providing a cushion of safety in case things turned out bad for the company.
Leveraged buyouts since rising in popularity in the late 1970s have continued to garner popularity not just among private equity firms, but also family offices and acquisition entrepreneurs have been increasing their equity allocation to continue the practice of acquiring companies via leveraged buyouts. The low-interest-rate environment over the last couple of decades has made it advantageous for those purchasing companies and the lenders providing debt financing.
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