Leveraged buyout is a tactic through which control of a corporation is acquired by buying up a majority of their stock using borrowed money. A leveraged buyout may also be referred to as a hostile takeover, a highly-leveraged transaction, or a bootstrap transaction. The purpose of leveraged buyouts is to allow companies to make huge acquisitions without having to commit a lot of capital. In LBO, there is usually a ratio of 90% debt to 10% equity. Due to high debt/equity ratio the bonds usually are not investment grade and are referred to as junk bonds. (Investopedia, 2010).
The concept of the leveraged buyout originated sometime in the late 1960s, and for the first decade of its existence remained relatively obscure and quiet. In the 1980s, Congress began examining the practice of the leveraged buyout closely for legislation and the media devoted an enormous amount of attention to high-profile cases of leveraged buyout. By the late 1990s, it was declared that the leveraged buyout was a dead tactic. With the advent of the "New Economy" and seemingly never-ending highs for the market, it appeared the leveraged buyout would remain a historical artifact. Since the dot-com collapse, however, the tactics of the leveraged buyout appear to be making a comeback, albeit in a slightly revised format. (Wise Geek, 2010).
Some advantages of LBO are Low Capital for acquiring entity, Efficiency gains by eliminating the value destroying effects of excessive diversification, Synergy gains by expanding operations outside own industry and business, Improved leadership and management, Leveraging as debt ratio increases, the equity portion of acquisition shrinks to a level at which a private equity firm can acquire a company by putting up anywhere from 20-40% of total price.
How to perform a leveraged buyout?
First research the company which is to be purchased then make sure that the company has adequate assets to secure loans and the company should generate enough cash flow to pay debts.
The management team should be strong so that it will continue with the company after the buyout takes place. This is important because the company will have to work at its best possible way to repay the debt and still make a profit.
The next step is to hire a professional to act as a mediator in negotiations with management, shareholders, potential investors and board members.
Then gather your team of leveraged buyout specialists, investment bankers, accountants and attorneys. The wide and specific financial analysis and legal structuring mandate that experienced professionals take the lead in putting the deal together.
Lastly obtain the majority of funds using the company's assets as security and, if cash is not available solicit the company's management team and outside investors for the remainder of the cash necessary to complete the purchase.
Key features of LBO
The equity of the target firm is held by fewer individuals following the financial reorganization. This increased concentration of ownership is especially typical of a "going-private" transaction in which the stock is no longer publicly traded. Second though the alternate sources are available for ownership and private operation are financed with huge amount of debt leaving the firm in highly leveraged position. The more the leveraging, larger the proportion of claim against firm's assets and operations are fixed obligation. If obligations are not met fully, greater leveraging can erode the firm's insulation from decline in earnings and increases risk of bankruptcy.
Debt finance in LBO
There are two types of debts which are used in LBO operation senior debt and subordinate debt. Senior debt accounts for big proportion, 50% - 60% financing for LBO. It is also called secured debt. If the firm's earning is insufficient to fulfil the debt obligation then the holder of senior debt can sell the pledged property to recover the unpaid interest. Funds through senior debt are often provided by commercial banks, insurance companies and leasing companies. Subordinate debt is more speculative than senior debt because it is issued without a lien against specified property. Subordinate debt holders are secluded when cash is left over after paying other creditors which are available to satisfy the unsecured claims. Subordinated debt is provided by pension funds, insurance companies and limited partnerships.
Are LBO's productive
The growing rate of LBO operations in the market for corporate control has sparked many to question the social value of this activity. Concerns are expressed which predicted implicitly on the notion that the changes in the firm's financial structure associated with the LBO transaction have no positive real effects on that firm's output. If the transaction were merely a device to realize some short term gain, at the expense of long-term growth and a reduction in social wealth, then these concerns would be justified. Some theories suggest that LBO can be productive by going private and highly leveraged financing.
Going private
Corporate finance shows how the distinction between ownership and control, or the differences between the incentives and constraints of the firm's stockholders and those of the firm's managers, can have important implications for the performance of the firm. This distinction can create a situation in which the firm does not achieve its maximum earnings potential i.e. the firm is not being run efficiently from the stockholder's perspective. By going private, the distinction is removed and earnings are increased. Going-private transactions would have no implications for the performance of the firm if the manager's actions are observed simply and cost less. For compensating the manager a contract has been designed by the owner, this contract indicate the actions taken by the manager to maximize firm's value and he would be penalizes if failed to act in accordance with the requirement which ensures that manager always works in interest of owners. To see why the distinction between ownership and managerial control can be important when monitoring incentives are weaker, consider the following extreme example in which a firm has such a large number of owners that no individual finds it worthwhile to monitor the manager at all. As is typical in any publicly owned firm, the owners have voting rights, but do not participate directly in the daily operations and decision-making of the firm. Suppose that the firm's manager, who exercises full control over these operations, has the opportunity to undertake a new project whereby the present value of cash flows can increase. In this example, the distinction between ownership and control is meaningful because the manager does not fully bear the wealth consequences of his actions. In the absence of effective monitoring by the owners, the decisions of the manager, acting on his own behalf, are not likely to maximize the owners' wealth; instead, they will maximize the manager's utility. . The problems that potentially arise from the distinction between ownership and control, called "agency problems," explain why we observe managerial contracts that are more complicated than those that simply specify a fixed income. The problem of "incomplete monitoring" explains why the observed managerial contracts are less complicated than those that could perfectly remove the conflict of interests between owners and managers. A contract that partially links the manager's income to the firm's characteristics observed easily by stockholders can alleviate the conflict. In a going-private transaction, the interests of owners and the manager generally are closely, if not fully, reconciled. Once the manager becomes the owner, there is no conflict; the wealth consequences of the manager's actions are entirely internalized by the firm's reorganization. Even when a third party finances the purchase, monitoring possibilities improve, simply because the transaction decreases the number of owners-or, equivalently, concentrates the ownership of the firm-thereby raising the level of monitoring and the possibility that enforceable contracts can be designed to resolve the conflict of interests more effectively. By improving the organizational efficiency of the firm through a change of ownership, the LBO can increase the firm's earnings.
High Leverage Financing
That most going-private transactions are financed with a large proportion of debt suggests that leveraging itself must augment the potential gains from the buyout. That is, the high degree of leveraging in the buyout need not indicate that the buyers do not have the requisite cash for the transaction. One widely mentioned source of gain from extensive leveraging is based on the incentive structure of the tax system. Because interest payments on debt are tax deductible, debt financing is relatively more attractive than other methods of finance. The double taxation of dividends, first as corporate income and then as shareholder income, further increases the incentive to issue or sell debt to finance the purchase of the firm. The most widely mentioned source of gain from extensive leveraging is based on the incentive structure of the tax system. Because interest payments on debt are tax deductible, debt financing is relatively more attractive than other methods of finance. The double taxation of dividends, first as corporate income and then as shareholder income, further increases the incentive to issue or sell debt to finance the purchase of the firm. The gain from leveraged financing, however, need not be restricted to reducing the tax liability of the target firm. Another motive for the use of debt finance stems from the misalignment of the manager's incentives with those of the owners in cases where the firm faces low growth prospects and a large free cash flow. When the firm's cash flow exceeds what is necessary to finance its own projects that are expected to yield positive net revenues, the firm is said to have a positive free cash flow. That is, the firm has reached its optimal size; additional projects to expand its operations would not maximize its profits. The problem of free cash flow, a particular type of agency problem, can be mitigated in a buyout that is financed with debt. Issuing debt and using the entire proceeds to purchase equity in an LEO enables the stockholders to capture the present value of the future free cash flow that otherwise would be used inefficiently. The firm's increased leveraged position after the transaction, in effect, imposes a binding commitment on the manager to not waste future cash flow; specifically, the manager cannot repudiate the firm's debt obligation to pay out the future free cash flow as interest payments because the bondholders could then push the firm into bankruptcy. By circumventing or reducing the agency problem associated with free cash flow, the use of debt essentially improves the productive efficiency of the firm.
The effects of LBO
The Stockholders
The stockholders of firms that complete an LBO typically receive cash for their shares representing a substantial premium above the market price stock prior to the LBO announcement. The average LBO stockholder premium per year ranged from 31% to 49% over the period 1980's comparable to the premium paid in mergers and acquisitions in general.
The Bondholders
Detrimental effects of LBOs on the bondholders of specific target firms have been widely publicized in the popular financial press. The wealth loss of the original bondholders is argued to be a direct result of the increase in default risk caused by the incremental LBO debt financing.
Taxes
Corporate tax savings are associated with some LBOs. These tax savings primarily result from the incremental interest deductions associated with the buyout financing, and to a lesser extent from the step-up in tax basis of purchased assets and the subsequent application of more accelerated depreciation procedures.
THE LONGER RUN
The relative insensitivity to macroeconomic factors of the sales revenues of firms that subsequently go private provides some assurance that the strong post buyout cash flows are not due entirely to the strength of the recent economy. However, an important consideration is the potential change in operating risk upon the LBO. If the increase in the level of relative operating returns documented during recent periods of economic strength is accompanied by an increase in the risk of operating returns, the high post buyout returns would not be expected to persist in an economic downturn. In contrast, if the LBO is associated with a decline in operating risk, the operating cash flows available to service the debt after the buyout are both stronger and less volatile than for the public predecessor.
SYNOPSIS
Evidence to date provides some answers about the LBO phenomenon and its effects. Stockholders of LBO targets are big winners, experiencing immediate gains averaging 30 to 50 percent from surrendering their shares. These gains cannot be attributed, in general, to bondholder losses Although the value of some nonconvertible debt securities depreciates significantly after LBOs, the average effect on bond value is less clear. Furthermore, stockholder gains appear to be unrelated to bondholder wealth effects, rejecting the hypothesis that bondholder losses are the sole source of stockholder gains.
Considerable corporate tax deductions result from some LBOs, primarily arising from the incremental interest charges on the LBO debt. In some cases, the tax savings implied by the incremental deductions can more than account for the total stockholder premia paid in the buyout
Although the corporate tax deductions associated with some LBOs are substantial, the net effect of LBOs on the revenues of the U.S. Treasury is unclear. The premia paid to stockholders and the interest paid to debtholders may generate federal tax revenues from capital gains and interest income, respectively. Additional financing in the form of the sale of assets with a higher value elsewhere may lead to capital gains taxes at the corporate level. Finally, the increase in management efficiency resulting from the new corporate ownership structure may lead to higher taxable corporate revenues.
The change in ownership structure, in fact, is associated with a significant increase in the average operating returns after LBOs examined to date. This increase in operating returns, another potential source of stockholder gains, most likely reflects the increase in operating efficiency associated with an improvement in management incentives.
The ability to sustain the high operating returns documented in the short postbuyout periods examined is not assured, however. Although allegations of massive reductions in "investments in the future," such as expenditures for maintenance and repairs, advertising, and R&D, are not supported by the evidence, the expropriation of employee rents and the associated effects on employee morale are still an open issue. Furthermore. the postbuyout periods examined to date are concentrated in a period of economic strength, i.e., mid-1980s. A1though the sales of firms that have gone private tend to be more recession-resistant before the buyout than the sales of the typical public firm, the change upon LBOs in the sensitivity of sales and profits to macroeconomic factors has not been examined directly.
Perhaps the biggest gap in our knowledge of the LBO phenomenon is an explanation for the explosion of LBO activity during the past decade. This LBO activity has been attributed by some to incentives provided by the tax code.( n11) Although significant tax benefits do result from some LBOs, the tax code, per se, is unlikely to be the major catalyst for the surge in LBO activity in the 1080s. Even though the tax code does favor debt over equity, it has done so for decades. Furthermore, although the Tax Reform Act of 1986 introduced the corporate tax on asset writeups and reduced the value of interest deductions through the cut in corporate tax rates, the number of LBOs increased to a record high of 125 deals in 1988. The $60 billion volume of LBO activity in 1988 represents 2.5 times the previous record volume of $24 billion in 1985, and almost five times the average annual volume of LBO activity during the five-year period preceding the 1986 Act.
Another explanation offered for the wave of LBO activity in the 1980s is the emergence of "financial innovations," such as junk bonds used to finance the buyouts with unprecedented proportions of debt. Although the junk bond market may have contributed to the feasibility of financing some of the larger, more highly leveraged deals, high weld bonds, in fact, are not new. Furthermore, the question arises as to why the supply of such debt instruments increased so during the past decade.
A third factor alleged to contribute to the LBO activity is the favourable effects of corporate debt on the management efficiency of "cash cows" with strong cash flows and poor investment opportunities as described by Jensen. In spite of empirical evidence consistent with an improvement in management efficiency, the question remains as to why the disciplinary effect of debt on management of these firms became so important in recent years.
Perhaps the most interesting, comprehensive explanation for the growth of LBO activity in the recent decade is offered by Blair and Litan [1959]. They propose that the answer to why the disciplinary effect of debt on corporate management became so important in the 1980s lies in the nature of the investment climate, i.e., the relation between real interest rates and the return on investment earned in various industries. As real interest rates rose in the early 1980s to the highest level since World War II, increasing the cost of capital, some industries experienced the lowest gross and net returns on investment in three decades. The resulting reduction in profitable corporate investment opportunities exacerbated the conflict of interest between managers, tempted to reinvest corporate cash to expand the corporate resources under their control, and stockholders, who could earn higher returns elsewhere. Stockholder tolerance for the corporate retention and reinvestment of earnings may have been reduced further with the elimination of the tax advantage of capital gains over dividend income by the Tax Reform Act of 1986.
