LBO, LBI, LMBO, BIMBO. ... Behind these increasingly common terms hide complex financial transactions which appeared during the 70s in the Anglo-Saxon countries and then later used widely throughout Western Europe.
The leveraged buyout, LBO in short, is a technique that facilitates the financiang of the sale of a company to its employed directors or to an outside buyer, using specialized investors and banks. These types of transactions are becoming increasingly popular worldwide and especially in developed countries, which enjoy favourable economiest that are ideally suited to this type of transaction.
Companies under the LBO banner often experience improved economic performance. One of the principal reasons this is that this technique incourages better company management through a focus on improving performance.
Such an improvement is required these days and should be seen as a major concern of developing countries who, at the dawn of a new era of globalization, find themselves desperate to strengthen their economies and prepare for fierce competition. Nevertheless, the study of major LBO transactions that have taken place in recent years has demonstrated the short-term logic of investment companies aimed primarily at strengthening the financial performance of companies in order to attain the profitability objectives of the fund, yet unfortunately to the detriment of investment, employment and business strategy.
In fact, investors often focus themselves on financial issues and their concerns for profitability. Is it correct, therefore, for them to overlook the importance of other, more managerial, strategic criteria the targeting and management of their investment portfolios?
The answer to this question cannot be found without correctlyemploying the technique used in LBOs in addition to the analysis of the key factors of the success of these transactions. These two factors will be the focus of the first part of this report.
In the second part, we will introduce the concept of "absorption capacity" in order to highlight its importance in successful capital investment.
Finally, we will try to suggest ways of making this concept operational in relation to targeting strategy and more generally in the management of investment funds.
CONTENTS
PART 1 Principles of LBO transactions and key success factors.
Presentation of the mechanism:
1) Definition and types of LBOs
1.1 Definition
1.2 Types of LBO
Different players, different expectations
2) The factors of a successful LBO transaction
1. The conditions of implementation of the LBO transaction
1.1 The economic environment.
1.2 Review of the qualifications required for the selection of targets.
2. Inherent factors in the transaction.
2.1 The success of the negotiation, the factor which determines the follow-up to the LBO.
2.2 The managerial factor.
2.3 Leaving the LBO: the key to the success of the operation.
PART 2 "absorptive capacity" and targeting companies in the portfolio.
1. Absorptive capacity: criterion in the creation of value
2. The potential of synergies in an LBO
3. The emergence of Leveraged Build Up: new interest for synergies within the portfolios of participating funds.
Part 3 Proposals to operationalize the managerial concept of absorptive capacity during an LBO transaction
GLOSSARY
Mezzanine debt: Bond or bank loan whose repayment is subordinated to another principle debt (generally bank loans).
Leverage: It reflects the impact of debt on the financial returns. It is positive when the economic rate of return exceeds the cost of debt, but otherwise it is negative.
Holding/controlling stake/share: Company owning a stake in the target company, at a level sufficient to ensure control.
LBOs (leveraged management buy-out): Company takeover technique using legal and financial leverage to take control od a holding company to which debt is owed.
LMBI (leveraged management buy-in): Takeover operation carried out by people outside the target company (not being part of its executive).
LMBO (Leveraged management buy-out): LBO conducted by the directors of the target company.
Shareholders Agreement: Set of contractual clauses, orientated toward, firstly, organizing the distribution of power in a compny and, secondly, maintaining or changing the coherence, stability and structure of shareholder ownership.
RES (employee buyout): The legal framework of the French LMBO which provides, under certain circumstances, the deductibility of interest on loans taken by employees to finance the acquisition of securities in the holding company.
The Leverage: This is what takes place in an LBO, when a company is caryiing out a transaction financed largely by borrowing which is repaid with funds generated by the acquired company, or by the sale of its assets.
Legal Leverage: This is a legal procedure used to give the buyer control of a company without requiring him to hold the majority share, enabling it to limit its financial commitment.
Social Leverage: This leverage technique isorientated toward the role played by the buyers in leveraged transactions.. The the group of employees involved in a leveraged transaction must be competent, complementary and motivated.
Fiscal Leverage: The fiscal leverage resulting from measures implemented to minimize the cost of operating an LBO, by by allowing the temporary simultaneous existence of a fiscal deficit in the holding company and a taxable revenue in the target company.
PART 1 Principles of LBO transactions and key factors of success.
I. Presentation of the mechanism:
1. Definition and typologies of the LBO
1.1 Definition
The LBO (Leveraged Buy Out), a very highly valued financial technique in both Europe and the United States, which specifies the transactions to take place during the repurchase of a company using leverage, i.e. recourse to a banking loan in order to limit the initial investment of the puchasers' own capital.
The mechanism which hides behind this denomination can be summarized as follows:
Aninvestment capital company wishing to acquire another company, creates a holding company often called Newco, which will have the role of acquiring the aforementioned company and financed by the capital generated by a group of investors on the one hand (an amount ranging from 20% to 50% of the share value of the of the target company) and a banking loan on the other hand (accounting for 50% to 80% of the value).
Thanks to the dividends payed out by the newly purchased target company, the holding company is able to repay the loans innitialy used to finance the acquisition of the company, but is then obliged to improve the company's management structure, to reorganize it and to set up a powerful management team in order to increase the company's financial performance, in particular their dividends.
The repurchase operation can be followed by a fusion between the holding and the target companies, to create only one entity. This operation of fusion is generally carried out for tax and legal reasons.
In certain cases, the holdings own funds are insufficient to be able to borrow the amount necessary to repurchase the target company (the ratio private funds to loans is not respected). Consequently the traditional banking loan will be doubled by one or more other specialised loans, which act as a buffer between the traditional bank debt and the private investment capital. For this reason the mezzanine debt (convertible bonds, stakeholder purchase bond) is the financial instrument most used in this kind of operation. In addition, other financial instruments specially adapted to the LBO can be used in order to ensure greater flexibility at the setting up stage.
The difficulty in these operations is to create a balanced set up procedure allowing the newly purchased company the opportunity to continue with its future investment strategy andto ensure its future growth and profitability, yet still allowing the holding company to maintain itsit loan repayments and to regularly increase its shareholders' dividends.
Therefore, in order not to choke the newly purchased company , it is necessary to define a very clear financial arrangement in relation to both the holding and newly purchased company and giving particular attention to the future requirements one of both.
The typical diagram of a LBO is as follows:
Investors
Investment capital
Buyer
Investment capital
Bankers
Debt
Holding Company
Acquisition
Target Company
1.2 Types of LBO
The LBO is the generic term of a certain number of transactions, which use the same mechanisms and are subjected to the same rules and regulations, but which differ where it concerns the purchasing parties.
a) Leveraged Management Buy Out (LMBO/MBO)
The LBO (leveraged buy out) is a transaction of partial or total acquisition carried out using a holdong company (legal leverage) and financing, which is primarily composed of debt the repayment of which is ensured by the repurchased company (financial leverage). The LMBO is a particular type of LBO where the purchase is assured by the personnel of the repurchased company. Two factors are decisive in the success of an LMBO: the group of investors directing the purchase and the management of the target company.
b) Leveraged Management Buy In (LMBI/MBI)
LBOs/LMBOs result:, most of the time, from an official sale of the target company caused by a case of absolute necessity, (succession, investment withdrawal, reclassification of shareholding). They are initialized from the inside by the executives of the company which know the conditions of sale perfectly and are able to evaluate the company. On the other hand, the LMBIs rather tend to be initiated by outside buyers where the target company is not necessarily even for sale. They deposit their offer without having any certainty that the management will even be interested in selling.
In all cases, the transaction is carried out in a spirit which preserves the longevity and the independence of the company, while bringing to it the means forstrong development and a reinforcement of its economic and social structure withinits sector. But the new shareholders seek to maximize the value of the company, the focus being put primarily on cash-flow.
This is why LMBIs require a balance between two elements: a target company and a collaboration between buyer and investor. This balance is aimed at minimizing the risks and at guaranteeing the success of the operation.
c) Hybrid operations: BIMBO, MEBO, LBU.
The BIMBO (Buy in Buy-out management) is a hybrid operation in which the both the existing management and a team of managers from the exterior take part.
Among the other alternatives, one can also mention "management and employee buyout" (MEBO), in which the managers and employees use their own funds. These extremely rare transactions, constitute exotic curiosities in the financial context prevailing in France today.
The LBU (Leveraged Build up) was born from the observation that the external financial investment in itself could not be the acreator of true value. The external growth constitutes a privileged means of evolution of the value of the company that is the subject of the LBO. Through external growth, the company can thus strengthen its financial standing, establish itself abroad or quite simply expand to a more interesting size strategically, whether from the point of view of an external buyer or on the stock exchange. The principal difficulty lies with the investors and the directorial team in not overpaying for their complementary acquisitions. Logically, any acquisitions that take place after that of the first target company (which represents the pivotal point of an LBU transaction), should be carried out using smaller amounts of capital.
Company
Shareholders
Lenders
(Banks, Middlemen)
Investor
Financer
Transferor
shareholder
Audits / Accountants
M&A advice
(Transferor / buyer)
Legal Advice
Buyer
Private management
Service providers
Different players, different expectations
A)*the purchaser Profile The candidate investor has an experience of directorate-
a) The buyer
Profile
The candidate buyer should have at least 5 years work experienceat the head office. The fact of having been within a group, managing director of a subsidiary company or director of a satellite company enabling him/her to bring a managerial dimension into the equation, such as his/her capacity to identify key players, strategic thinking, and his/her realistic market projections. This relates to the buyer's leverage encouraging the company's growth. The combination of the experience of head office and the knowledge of the business sector reinforce the chances of success.
In the three countries studied, the candidates 'principal field of study was marketing. As for the average age of the executives' buyers, it is 43 in France, 44 in the United Kingdom and 46 in Germany. It is not a coincidence that this corresponds precisely to the period of life where the frustration of working for someone else other than oneself starts to take hold and or the question of lifestyle choices for the future is set down. As for the amount of money that they have, it is typically 1 MF for the British, 2.5 MF for the Germans and 1.8 MF for the French.
Motivation
The analysis of the motivation of the buyers reveals three primary reasons for the decision to carry out an MBI:
 The feeling of having done everything there is to do in their present post.. Having the impression of stagnating in their personal development and in certain cases to even feel that this lack of development is associated to the heaviness of the group where they work.
 In reaction to this first feeling, the decision to adopt a self-motivated attitude in the creation of their own framework of future development. Thus the choice to become an independent contractor, or the owner of a company in which they will invest both money and of themselves, in order to inject new energy into their professional life.
 Finally an income that has no limitsand the creation of an inheritable entity, which is difficult while salaried.
The buyer's (repurchaser's) expectations:
The patrimonial challenge
The personal challenge
Title of leading shareholder
Being an entrepreneur
Return on investment
Personal Achievement
Tax optimization
Complementary access to the capital
The The buyer's expectations:
Financial performances
Operational Performance
To pay a fair price
Solidity and potential of the company
Optimization of the price, the TRI
Success of the managerial transition
To assure a safe legal and financial agreement
Success of the development plan
Optimization of the delivery price
Creation of industrial value
b) The target company
Several situations adapt well to LBO operations:
Family Companies confronted with problems of strategic development.
Entrepreneurs wishing to extract part of their company's appreciation, while remaining in charge of their company.
Entrepreneurs desiring to take the control of a company.
However these transactions are particularly suitable in situations where there are problems with patrimonial transmission. For example, when a director/founder reaches retirement age without any family successor, he can choose to yield his company to his management team (LMBO) or to an external manager (LMBI) rather than to turn to a competitor. Indeed, a company director who has invested all of his energy and his money in the development of his company, legitimately conciders, it having succeeded, the need to capitalize on the product of his years of effort. Yet still, he remains very attached to his company, its personnel and its partners, and wants to ensure its continuity. The transfer of a company for an industrialist is, therefore, often carried out in private, and would be too expensive to float on the stock exchange, and is both complex and reserved for a restricted number of large SMEs.
As previously indicated, the LBOs technique rests on the debt of the holding company and the capacity of the target company to distribute dividends. This debt generating action has a leverage effect and facilitates the acquisition of the company with the minimum required investment of personal funds. Nevertheless, the proportion between the primary debt and personal funds must be gauged on a case-by-case basis and remains dependant on the distributive capacity of the target, itself dependant mainly on its profitability but also on its financing needs (BFR, investments…).
The viability of the contractual planning thus depends directly on the aptitude of the target company to generate recurring benefit, proportional to the debt of the holding company. This is necessary in order to encourage appreciation and bolstering the credit-worthiness of the holding company
These criteria taken into account: the target company of an LBO operation must be able to meet a certain number of prerequisites, and should be able to demonstrate, notably:
- a significant and recurring profitability with a real growth potential (important sales turnover with faithful customers ensuring a certain visibility for the future, both as well as both good and average results , a relatively moderate rate of debt, working capital needing to be controlled, weak estimated expenditure in future investment, surplus treasury, aptitude to generate dividends, etc);
- assets and competitive advantages (good positioning in a market, little risk from its competitors, maturity of the products or services, capacity for innovation);
- well adapted production machinery and easily transmissible know-how (efficiency of organization, quality and high level of use of the production machinery);
- a solid management team;
- well managed shareholders (the minority shareholders must in particular be favourable to the foreseen LBO operation).
- at least five years of experience in the sector and a certain level of stability, allowing better visibility wher it concerns any future market fluctuations..
If one were to seek the companies which correspond best to this profile or at least those which profit the most out of this kind of operation, we would find Web 1.0 companies , e-trading sites, marketing services, or media companies or large agencies. These companies represent stable economic models, as their activite is based primarily on advertizing, subscriptions or direct sales.
However, this precision does not limit in any way the LBO's battlefield; one may note that there are no favoured sectors. Proof is, for example, the 230 operations pu together by Initiative & Finance since it was created in 1984: anything, from plumbing accessories to the market analysts or even the local governmentl via the food industry or medical imagery… developing countries are thus reassured.
Expectations of the selling shareholder
 Securing Financial Heritage
 Negotiating the transfer price
 Partial reinvestment
 Methods of Payment
 Involvelment of the GAP
 Sustainability of business and jobs
 Regional Ties
 An active post transfer role
c) Lenders
C-1 Commercial banks
Banks expectations:
Commercial Opportunities "the placing of large amounts of outstanding credit"
Protection and /or expansion of market share, develop an expanded commercial relationship (stream, GP, M & A ...)
Focus on debt repayments and setting up of a union
Banking syndicate, rigorous monitoring of compliance with the loan contract.
c-2 Mezzanine Investors
The Mezzaneur is the name given to the financial institution responsible for providing mezzanine financing. The latter is defined as medium to high risk financing and intermediate profit split between personal funds and the traditional debt. The mezzanine, although often cited as a means of financing LBOs, it is not restricted to this. It can be extended to fundfuture expansion, acquisitions, and financing of the Project. In Europe, investments of this kind are never less than 1 million Euros (in the United Kingdom in particular the minimum size of LBO transfers is approximately 2 million pounds).
The sources of these deals lie in the management of a network of specialized business collaborators, substancial capital investment, but also with the banks, consulting firms and auditors. If we restrict ourselves to only to cases that have passed through the filter of a phone call, for ten projects studied a single investment will be conceived. In addition, it should be remembered that mezzanine financing remains a made-to-measure area of specialisation that must be adaptable and innovative. The ratio of investment lines to company must be within about the 6 to 8 range, the number 10 representing a maximum beyond which the monitoring of the transaction will be made very difficult. Indeed, besides the time spent tracking, the mezzanine investor should keep extra time available for the study of new cases
