Cost of capital refers to the finance cost incurred by the company to acquire the physical capital. In every business or investment the goal of investor is to realize returns above the cost of invested capital, most analysts focus on the cost of capital and capital asset pricing since the price/earnings ratio determines shareholder value and the company's performance. This should be every corporate management focus, since the prime aim of every investor is to maximize their portfolios' returns and the management has to work hard towards lowering the cost of capital for the company (Acharya & Kehoe 2008, p. 6).
Most companies and individuals prefer buying an existing business instead of starting a new company or business enterprise from scratch. Buying an existing enterprise can be done either through share acquisition or purchasing of all the company's assets (Ivashina & Kovner 2008, p. 9). The advantage of acquiring an existing business is accrued to the already existing customers' relations, as well as suppliers' relationship with the firm's management which acts to boost firm's capacity in establishing itself in new market. Purchasing an existing business is however expensive, and more often tedious. There are different ways of meeting the cost of capital.
Leveraged buyout is a way of acquiring an existing business with less capital, it refers to an aggressive business practice in which large corporations and investors use debt or borrowed funds (in form of bank loan and bond etc) to finance the acquisition. Those investment firms engaged in leveraged buyouts are presently called private equity firms; these are different from a venture capital firm which typically invests in emerging and small companies without necessarily obtaining their control. Under this arrangement, the assets on both the acquiring company and those of the company acquired used as collateral. In most cases, capital commitment in a leveraged buy out is less, and as such this is reflected by the resulting ratio on debt to equity for the whole amount of purchase price which on average stands at 70% to 30%. The interest accrued in the buy out is paid back using the future cash flow from the acquired company. This practice is sometimes called a hostile takeover or a bootstrap transaction.
A key feature in a leverage buy out is its ability to unlock value from an undervalued company such that the organization can buy a large company or even conglomerates and make huge profits margins by breaking them into small individual pieces whose purchase price is higher than that of the conglomerate (Gaughan 2007, p. 426). Acquiring a company using debt finance gives a tax advantage since the cost of debt servicing is deductible from the tax payable which enables the acquiring company to pay the acquired company more which is also a seller's benefit. If leverage used to iron purchase of a company's outstanding shares, the company managers are able to own a substantial stake, thus enjoy their reward for labor.
Leveraged buyouts began way back in 1980s during Reagan administration when U.S. changed its economic and regulatory rules making mergers and acquisition of firm and corporations constitutional. The relaxation and reduction of the industrial legislation restrictions incited corporate restructuring and acquisition which received a great back up through the use of junk bond which enabled multi-million dollar corporations to buyout other companies with very little capital for competitive reasons.
Management buyout (MBO) is the most common type of buyout agreement where company's management or executive concurs to buyout the company wholly or partially from existing shareholders. This requires considerable amount of capital and more often the firm's management rely on venture capitalists in financing the endeavor whereby a private equity firm invests up-to a maximum of 40 % of a firms purchase price. The company is first made private before being restructured.
One advantage of leveraged buyouts is that poorly managed companies can undertake important corporate restructuring prior to acquisition. This reformation which may involve modification of company's sectors and replacement of top executive and management personnel as well as reduction in expenditures can revitalize a company and enhance substantial returns capacity. Corporate reformation from leveraged buyouts greatly impacts employees where it requires the company to downsize its operations leading to unemployment which negatively affects a society, thus hindering economic growth (Baker & Wurgler 2000, p. 2220). When the takeover is hostile it can affect it can run against desires of the managers of the acquired firm. The 2001 acquisition of Quaker Oats Company by PepsiCo of US is a good example of a take over that was done in a hostile way. Although the merger resulted to the fourth-largest company dealing with consumer goods in the world, most managers of Quaker Oats opposed the acquisition in that it was unlawful and against public interest.
Due to a high ratio of debt-to-equity, large companies can simply acquire minor companies using very little capital. This can increase stockholders financial returns if the returns of the acquired company are more than the debt financing cost, and possibly increase the value of the firm (Demiroglu & James 2007, p. 13). Where returns of the acquired company are less than the debt financing cost, this results to corporate bankruptcy and the leverage buyout imposes high interest rates which challenges those companies whose sale of assets and cash flow are inadequate. As such, this may result in a poor credit line for those who want to invest in buy out. A good example a failed take over was the acquisition of FDS (i.e. Federated Department Stores, whose marketing strategy was ineffective) by Robert Campeau in fiscal 1989, only to fall into bankruptcy due to financial burdens that were raised by very high interest rates.
Management buyout (MBO) is a common practice associated with wounding enterprises or any enterprise requiring management team to be replaced by an outside company. Most analysts have shown that such buy outs promote loyal and efficiency of management as well as external and internal stakeholder's interests. While most MBO are successful, they can substantially create conflicts of interest between the employees and managers especially where buy out arrangements is geared towards personal profit for a short-term basis. This also characterized by company's mismanagement in addition to the firm's depreciated stock. For example, management buy-out of Springfield Remanufacturing Corporation (i.e. SRC) in fiscal 1983 by its employees was an extreme success which has seen the company report exponential growth from shut-down-zone to an assembly of 23 small enterprises with millions of profit today (Andrade & Kaplan 1998, p. 1446).Leveraged buyout has considerable risk in reference to existing economy but the existing economy is solid, the leveraged buyout has chance to bring great success. However, a leverage buy out during recession is normally problematic due to the perceived dollar weakness and poor financial returns.
Decreasing interest rates combined with relaxed lending standards and regulations for publicly traded companies has set a stage for a great boom in private equity. Dex-Media buy out in fiscal 2002 obtained significant yield in debt financing and this was followed by major buy outs in 2004 and 2005 which included the acquisition of the corporations like the SunGard Data Systems, Hertz Corporation and the Metro Goldwyn Mayer. This was followed by the largest buy out in fiscal 2006 which involved 654 billion US dollars worth private equity firms being bought for $375 billion. This was 18 times more as compared to the level of buy out transactions that were closed in 2003, despite the witnessed economic consequences turmoil in the credit markets. The turmoil in the credit markets largely affected mortgage markets and the effects were spilled over to the leverage finance which by August 2007 reported a notable slowdown owing to uncertain conditions in the market that eroded market confidence preventing deals from pricing. The major write-down's announced by Citigroup and UBS AG due to credit losses in fiscal 2007 almost saw the leverage finance markets standstill.
Leverage buy outs have a common advantage in that little capital can be used to acquire small sized enterprises as well as big corporations while at the same time the acquired corporation can gain from necessary restructuring and reform. Management buyout can save a company from shutting down or be sold to outsiders. However, restructuring sometimes can lead to un-intended downsizing associated with hostile takeovers, and the high debt to equity ratio yields high interest rates and eventual corporation's bankruptcy where substantial returns are not generated after acquisition. While management buyouts are mostly successful they can create conflicts of interest among employees and management teams and possible mismanagement by the new owners (Loos 2006, p. 146). Leveraged buy out was a common business practice through out 1980s due to their potential for huge profits hallmarks, and has recently resumed in the modern corporate America.
Finally, although information on non-U.S. private equity fund is not available, private equity analysts say that its clear that its substantially grown as they noted three non U.S private equity firma were among the top twelve private equity firms in the world in 2007. It's however argued that most private equity firms are short term oriented, their holding term ranges between 12 to 60 months since they prefer quick flip of their investments instead of retaining companies ownership to realize their full-potential. They are therefore accused of taking the tax advantage and their superior information and fail to create operational value since they are inclined to market timing. There is empirical evidence of improved performance of companies which are acquired through leveraged buyout though this is largely biased since most private companies do not avail their performance information.
