Leveraged Buy out

A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or "bootstrap" transaction) occurs when a financial sponsor acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage (borrowing). The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved. Companies of all sizes and industries have been the target of leveraged buyout transactions, although because of the importance of debt and the ability of the acquired firm to make regular loan payments after the completion of a leveraged buyout, some features of potential target firms make for more attractive leverage buyout candidates, including:

Low existing debt loads; A multi-year history of stable and recurring cash flows; Hard assets (property, plant and equipment, inventory, receivables) that may be used as collateral for lower cost secured debt; The potential for new management to make operational or other improvements to the firm to boost cash flows; Market conditions and perceptions that depress the valuation or stock price. Leveraged buyouts involve financial sponsors or private equity firms making large acquisitions without committing all the capital required for the acquisition. To do this, a financial sponsor will raise acquisition debt which is ultimately secured upon the acquisition target and also looks to the cash flows of the acquisition target to make interest and principal payments. Acquisition debt in an LBO is therefore usually non-recourse to the financial sponsor and to the equity fund that the financial sponsor manages. Furthermore, unlike in a hedge fund, where debt raised to purchase certain securities is also collateralized by the fund's other securities, the acquisition debt in an LBO is recourse only to the company purchased in a particular LBO transaction. Therefore, an LBO transaction's financial structure is particularly attractive to a fund's limited partners, allowing them the benefits of leverage but greatly limiting the degree of recourse of that leverage. This kind of acquisition brings leverage benefits to an LBO's financial sponsor in two ways: (1) the investor itself only needs to provide a fraction of the capital for the acquisition, and (2) assuming the economic internal rate of return on the investment (taking into account expected exit proceeds) exceeds the weighted average interest rate on the acquisition debt, returns to the financial sponsor will be significantly enhanced.

Prof. C.A. Nitant Trilokekar 97

As transaction sizes grow, the equity component of the purchase price can be provided by multiple financial sponsors "co-investing" to come up with the needed equity for a purchase. Likewise, multiple lenders may band together in a "syndicate" to jointly provide the debt required to fund the transaction. Today, larger transactions are dominated by dedicated private equity firms and a limited number of large banks with "financial sponsors" groups. As a percentage of the purchase price for a leverage buyout target, the amount of debt used to finance a transaction varies according the financial condition and history of the acquisition target, market conditions, the willingness of lenders to extend credit (both to the LBO's financial sponsors and the company to be acquired) as well as the interest costs and the ability of the company to cover those costs. Typically the debt portion of a LBO ranges from 50%-85% of the purchase price,

Rationale The purposes of debt financing for leveraged buyouts are two-fold:
1. The use of debt increases (leverages) the financial return to the private equity

sponsor. Under the Modigliani-Miller theorem,[29] the total return of an asset to its owners, all else being equal and within strict restrictive assumptions, is unaffected by the structure of its financing. As the debt in an LBO has a relatively fixed, albeit high, cost of capital, any returns in excess of this cost of capital flow through to the equity. 2. The tax shield of the acquisition debt, according to the Modigliani-Miller theorem with taxes, increases the value of the firm. This enables the private equity sponsor to pay a higher price than would otherwise be possible. Because income flowing through to equity is taxed, while interest payments to debt are not, the capitalized value of cash flowing to debt is greater than the same cash stream flowing to equity. Historically, many LBOs in the 1980s and 1990s focused on reducing wasteful expenditures by corporate managers whose interests were not aligned with shareholders. After a major corporate restructuring, which may involve selling off portions of the company and severe staff reductions, the entity would likely be producing a higher income stream. Because this type of management arbitrage and easy restructuring has largely been accomplished, LBOs today focus more on growth and complicated financial engineering to achieve their returns. Most leveraged buyout firms look to achieve an internal rate of return in excess of 20%.

Prof. C.A. Nitant Trilokekar 98

Leveraged buy-out method analysed

A Leveraged buy-out is a corporate finance method under which a company is acquired by a person or entity using the value of the company's assets to finance its acquisition; this allows for the acquirer to minimize its outlay of cash in making the purchase. In other words a LBO is a company acquisition method by which a business can seek to takeover another company or at least gain a controlling interest in that company. Special about leveraged buy-outs is that the corporation that is buying the other business borrows a significant amount of money to pay for (the majority of) the purchase price (usually over 70% or more of the total purchase price). Furthermore, the debt which has been incurred is secured against the assets of the business being purchased. Interest payments on the loan will be paid from the future cash-flow of the acquired company. Typical advantages of the leveraged buy-out method include:

Low capital or cash requirement for the acquiring entity Synergy gains, by expanding operations outside own industry or business, Efficiency gains by eliminating the value-destroying effects of excessive diversification, Improved Leadership and Management. Sometimes managers run companies in ways that improve their authority (control and compensation) at the expense of the companies owners, shareholders, and long-term strength. Takeovers weed out or discipline such managers. Large interest and principal payments can force management to improve performance and operating efficiency. This discipline of debt can force management to focus on certain initiatives such as divesting non-core businesses, downsizing, cost cutting or investing in technological upgrades that might otherwise be postponed or rejected outright. Note! In this manner, the use of debt serves not just as a financing technique, but also as a tool to force changes in managerial behavior. Indeed, the wave of LBO's in the 1980s has been a major catalyst in the rise of Value Based Management! (see: History of VBM) Leveraging: as the debt ratio increases, the equity portion of the acquisition financing shrinks to a level at which a private equity firm can acquire a company by putting up anywhere from 20-40% of the total purchase price.

Critics of Leveraged buy-outs indicated that bidding firms successfully squeezed additional cash flow out of the targets operations by expropriating the wealth from third parties, for example the federal government. Takeover targets pay less taxes because interest payments on debt are taxdeductible while dividend payments to shareholders are not. Furthermore, the obvious risk associated with a leveraged buyout is that of financial distress, and unforeseen events such as recession, litigation, or changes in the regulatory environment can lead to difficulties meeting scheduled interest payments, technical default (the violation of the terms of a debt covenant) or outright liquidation. Weak management at the target company or misalignment of incentives between management and shareholders can also pose threats to the ultimate success of an Leveraged buy-out.
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Reverse Leveraged Buyout

What Does Reverse Leveraged Buyout Mean? The action of offering new shares to the public by companies that initially went private through past LBOs. Reverse Leveraged Buyout explained Companies undergoing a reverse LBO are attempting to obtain cash in order to reduce their debt to more manageable levels. This debt may have been from operating activities or from the company's previous LBO.

Prof. C.A. Nitant Trilokekar 100