Leveraged buyouts, Financial Management

Leveraged Buyouts (LBOs)

A leveraged buyout is a financing technique where debt is used to purchase the stock of a corporation and it frequently involves taking a public company into a private one. It is used by a variety of entities, including the management of a corporation, or outside groups, such as other corporations, partnerships, individuals or investment groups. The leveraged buyouts are usually cash transactions in which the cash is borrowed by the acquiring firm. The target company's assets are often used as security for the loans acquired to finance the purchase. This type of lending is often called the asset-based lending. Thus, capital-intensive firms with assets having high collateral value can easily obtain such loans. Non-capital intensive firms (like the service industries) having high enough cash flows to service the interest payments on the debt can also obtain such loans.

History of LBOs

LBO transactions started when entrepreneurs in the 1950s and 1960s, who were considering retirement, were often willing to sell their businesses at or below book value to the younger individuals who were willing to expand the entrepreneur's business. Such buyers only provided equity amounting to 20-25% of the purchase price and borrowed the remainder from commercial finance companies using the assets of the target firm as a security to the borrowing. Most of these leveraged transactions were of privately held, small to medium-sized businesses.

Later, in the 1960s a bull market encouraged many businesses to go public rather than to get involved in highly leveraged transactions. Hence, LBO activity fell during the late 1960s. But, in the 1970s in the wake of rising bankruptcies and high P/E ratios, the public excitement for new equity shares had subsided. New interest in LBOs emerged by the late 1980s. Conglomerates that were formed during the 1960s and early 1970s began to divest many of their holdings, which ranged in annual sales from $5 million to more than $250 million. LBOs were very commonly used to finance these transactions.

The value and the number of LBOs increased significantly starting in the early 1980s and peaking by the end of the decade. Larger companies started to become the target of LBOs in mid-1980s. By 1980s LBOs attracted much attention, but were small compared to the mergers in terms of number and volume.

Elements of Typical LBO Operation

A leveraged buyout transaction takes place as follows:

  • The first stage, in an LBO operation consists of raising the cash required for the buyout and devising the management incentive system. Usually around 10 percent of the cash is put up by the firm's top managers and/or the buyout specialists. Managers also receive incentive compensation in the form of stock option or warrants. Hence, the percentage of equity share on the management will be around 30%. Other outside investors provide the remaining equity.
  • Approximately, 50 to 60% of the required cash is raised by borrowing against the company's assets through secured bank loans. The bank loan usually is taken from different commercial banks. This portion of the debt is sometimes also taken from insurance companies, pension funds or from limited partnerships specializing in venture capital investments and leveraged buyouts. The remainder of the cash is obtained by issuing senior and junior subordinated debt in a private placement or in a public offering as high yield notes or bonds like the junk bonds.
  • The second stage of the transaction involves making the firm private. The company can be made private either in a stock purchase format where all the shares of the company are bought or in an asset purchase format where all the assets of the company are purchased. In an asset purchase format, the buying group forms a new privately held corporation. Some of the parts of the business are sold off by the new management to reduce the debt.
  • In the third stage, the management tries to increase the profits and cash flows by cutting operating costs and changing marketing strategies. It may strengthen and restructure the production facilities, change product quality, product mix, customer service, pricing, improve inventory control and accounts receivable management. It may even lay off employees and reduce the expenditure on research and development as long as these are necessary to meet the payment on the huge borrowings.
  • In the fourth stage, the investor group may again take the company public if it has become stronger and the goals of the group are achieved. This process is called a reverse LBO and is achieved through a public equity offering, which is referred to as a Secondary Initial Public Offering (SIPO). The purpose is to provide liquidity to the existing shareholders.

 

Posted Date: 9/11/2012 5:34:23 AM | Location : United States







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