Leveraged buyout

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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.[1]

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.
Characteristics

Diagram of the basic structure of a generic leveraged buyout transaction

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.

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, but in some cases debt may represent
upwards of 95% of purchase price. Between 2000-2005 debt averaged between 59.4%
and 67.9% of total purchase price for LBOs in the United States.[2]

To finance LBO's, private-equity firms usually issue some combination of syndicated

loans and high-yield bonds. Smaller transactions may also be financed with mezzanine
debt from insurance companies or specialty lenders. Syndicated loans are typically
arranged by investment banks and financed by commercial banks and loan fund
managers, such as mutual funds, hedge funds, credit opportunity investors and structured
finance vehicles. The commercial banks typically provide revolving credits that provide
issuers with liquidity and cash flow while fund managers generally provided funded term
loans that are used to finance the LBO. These loans tend to be senior secured, floating-
rate instruments pegged to the London Interbank Offer Rate (LIBOR). They are typically
pre-payable at the option of the issuer, though in some cases modest prepayment fees
apply.[3] High-yield bonds, meanwhile, are also underwritten by investment banks but are
financed by a combination of retail and institutional credit investors, including high-yield
mutual funds, hedge funds, credit opportunities and other institutional accounts. High-
yield bonds tend to be fixed-rate instruments. Most are unsecured, though in some cases
issuers will sell senior secured notes. The bonds usually have no-call periods of 3-5 years
and then high prepayment fees thereafter. Issuers, however, will in many cases have a
"claw-back option" that allows them to repay some percentage during the no-call period
(usually 35%) with equity proceeds.

Another source of financing for LBO's is seller's notes, which are provided in some cases
by the entity as a way to facilitate the transaction.

The acquisition of another company using a significant amount of borrowed money

(bonds or loans) to meet the cost of acquisition. Often, the assets of the company being
acquired are used as collateral for the loans in addition to the assets of the acquiring
company. The purpose of leveraged buyouts is to allow companies to make large
acquisitions without having to commit a lot of capital.

Investopedia Says:
In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high
debt/equity ratio, the bonds usually are not investment grade and are referred to as junk
bonds. Leveraged buyouts have had a notorious history, especially in the 1980s when
several prominent buyouts led to the eventual bankruptcy of the acquired companies.
This was mainly due to the fact that the leverage ratio was nearly 100% and the interest
payments were so large that the company's operating cash flows were unable to meet the
obligation.
As of 2006, the largest LBO to date was the acquisition of HCA Inc. in 2006 by Kohlberg
Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch. According to the
Washington Post, the three companies paid around $33 billion for the acquisition.

It can be considered ironic that a company's success (in the form of assets on the balance
sheet) can be used against it as collateral by a hostile company that acquires it. For this
reason, some regard LBOs as an especially ruthless, predatory tactic.

Related Links:
Learn what corporate restructuring is, why companies do it and why it sometimes doesn't
work. The Basics Of Mergers And Acquisitions
Do you want your company to sandbag or greenmail? Welcome to the dramatic world of
mergers and acquisitions. The Wacky World of M&As
Don't be fooled by the name - junk bonds may be for you if you know how to analyze
them. Junk Bonds: Everything You Need to Know
Despite their reputation, the debt securities known as "junk bonds" may actually reduce
risk in your portfolio. High Yield, Or Just High Risk?

Banking Dictionary:

Leveraged Buyout (LBO)

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Takeover of a company using the acquired firm's assets and cash flow to obtain
financing. Typically, these transactions are done by conglomerates selling or spinning off
an unwanted subsidiary to the company's managers and outside investors. The buyers of
an LBO financing are said to take private the target company. Leveraged buyouts are
risky for the buyers if the purchase is highly leveraged. An LBO can be protected from
volatile interest rates by an Interest Rate Swap, locking in a fixed interest rate, or an
interest rate Cap which prevents the borrowing cost from rising above a certain level.
LBOs also have been financed with high-yield debt, or Junk Bonds and have also been
done with the interest rate capped at a fixed level and interest costs above the cap added
to the principal. For commercial banks, LBOs are attractive because these financings
have large up-front fees. They also fill the gap in corporate lending created when large
corporations begin using commercial paper and corporate bonds in place of bank loans.

Accounting Dictionary:

Leveraged Buyout
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Acquisition of one company by another, typically with borrowed funds. Usually, the
acquired company's assets are used as collateral for the loans of the acquiring company.
The loans are paid back from the acquired company's cash flow. Another possible form
of leveraged buyout occurs when investors borrow from banks, using their own assets as
collateral to acquire the other company. Typically, public stockholders receive an amount
in excess of the current market value for their shares.

Small Business Encyclopedia:

Leveraged Buyouts
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The term leveraged buyout (LBO) describes an acquisition or purchase of a company

financed through substantial use of borrowed funds or debt. In fact, in a typical LBO, up
to 90 percent of the purchase price may be funded with debt. During the 1980s, LBOs
became very common and increased substantially in size, so that they normally occurred
in large companies with more than $100 million in annual revenues. But many of these
deals subsequently failed due to the low quality of debt used, and thus the movement in
the 1990s was toward smaller deals (featuring small- to medium-sized companies, with
about $20 million in annual revenues) using less leverage. Thanks to low stock prices,
looser regulatory restrictions, and a rally in high-yield bonds, Barron's predicted that
2001 would be the biggest year since the 1980s for LBOs.

The most common leveraged buyout arrangement among small businesses is for
management to buy up all the outstanding shares of the company's stock, using company
assets as collateral for a loan to fund the purchase. The loan is later repaid through the
company's future cash flow or the sale of company assets. A management-led LBO is
sometimes referred to as "going private," because in contrast to "going public"—or
selling shares of stock to the public—LBOs involve gathering all the outstanding shares
into private hands. Subsequently, once the debt is paid down, the organizers of the buyout
may attempt to take the firm public again. Many management-led, small business LBOs
also include employees of the company in the purchase, which may help increase
productivity and increase employee commitment to the company's goals. In other cases,
LBOs are orchestrated by individual or institutional investors, or by another company.

According to Jennifer Lindsey in her book The Entrepreneur's Guide to Capital, the best
candidate for a successful LBO will be in growing industry, have hard assets to act as
collateral for large loans, and feature top-quality, entrepreneurial management talent. It is
also vital that the LBO candidate post a strong historical cash flow and have low capital
requirements, because the debt resulting from the LBO must be retired as quickly as
possible. Ideally, the company should have at least twice as much cash flow as will be
required for payments on the proposed debt. The LBO debt should be reduced to 50
percent of overall capitalization within one year, and should be completely repaid within
five to seven years. Other factors improving the chances for a successful LBO include a
strong market position and an established, unconcentrated customer base.
In order to improve the chances of success for an LBO, Lindsey noted that the deal
should be undertaken when interest rates are low and the inflation rate is high (which will
make assets more valuable). It is also vital that a management, employee, or outside
investment group wants to own and control the company. Many LBOs involving small
businesses take place because the owner wants to cash out or retire and does not want to
sell to a larger company. LBOs can be very costly for the acquiring parties, with expenses
including attorney fees, accounting evaluations, the printing of prospectus and proxy
statements, and interest payments. In addition, if either the buyer or the seller is a public
company, an LBO will involve strict disclosure and reporting requirements with both
federal and state government agencies. Possible alternatives to an LBO include purchase
of the company by employees through an Employee Stock Ownership Plan (ESOP), or a
merger with a compatible company.

Advantages and Disadvantages

A successful LBO can provide a small business with a number of advantages. For one
thing, it can increase management commitment and effort because they have greater
equity stake in the company. In a publicly traded company, managers typically own only
a small percentage of the common shares, and therefore can participate in only a small
fraction of the gains resulting from improved managerial performance. After an LBO,
however, executives can realize substantial financial gains from enhanced performance.
This improvement in financial incentives for the firm's managers should result in greater
effort on the part of management. Similarly, when employees are involved in an LBO,
their increased stake in the company's success tends to improve their productivity and
loyalty. Another potential advantage is that LBOs can often act to revitalize a mature
company. In addition, by increasing the company's capitalization, an LBO may enable it
to improve its market position.

Successful LBOs also tend to create value for a variety of parties. For example, empirical
studies indicate that the firms' shareholders can earn large positive abnormal returns from
leveraged buyouts. Similarly, the post-buyout investors in these transactions often earn
large excess returns over the period from the buyout completion date to the date of an
initial public offering or resale. Some of the potential sources of value in leveraged
buyout transactions include: 1) wealth transfers from old public shareholders to the
buyout group; 2) wealth transfers from public bondholders to the investor group; 3)
wealth creation from improved incentives for managerial decision making; and 4) wealth
transfers from the government via tax advantages. The increased levels of debt that the
new company supports after the LBO decrease taxable income, leading to lower tax
payments. Therefore, the interest tax shield resulting from the higher levels of debt
should enhance the value of firm. Moreover, these motivations for leveraged buyout
transactions are not mutually exclusive; it is possible that a combination of these may
occur in a given LBO.

Not all LBOs are successful, however, so there are also some potential disadvantages to
consider. If the company's cash flow and the sale of assets are insufficient to meet the
interest payments arising from its high levels of debt, the LBO is likely to fail and the
company may go bankrupt. Attempting an LBO can be particularly dangerous for
companies that are vulnerable to industry competition or volatility in the overall
economy. If the company does fail following an LBO, this can cause significant problems
for employees and suppliers, as lenders are usually in a better position to collect their
money. Another disadvantage is that paying high interest rates on LBO debt can damage
a company's credit rating. Finally, it is possible that management may propose an LBO
only for short-term personal profit.

Criticism of Lbos

Ever since the LBO craze of the 1980s—led by high-profile corporate raiders who
financed takeovers with low-quality debt and then sold off pieces of the acquired
companies for their own profit—LBOs have garnered negative publicity. Critics of
leveraged buyouts argue that these transactions harm the long-term competitiveness of
firms involved. First, these firms are unlikely to have replaced operating assets since their
cash flow must be devoted to servicing the LBO-related debt. Thus, the property, plant,
and equipment of LBO firms are likely to have aged considerably during the time when
the firm is privately held. In addition, expenditures for repair and maintenance may have
been curtailed as well. Finally, it is possible that research and development expenditures
have also been controlled. As a result, the future growth prospects of these firms may be
significantly reduced.

Others argue that LBO transactions have a negative impact on the stakeholders of the
firm. In many cases, LBOs lead to downsizing of operations, and employees may lose
their jobs. In addition, some of the transactions have negative effects on the communities
in which the firms are located.

Much of the controversy regarding LBOs has resulted from the concern that senior
executives negotiating the sale of the company to themselves are engaged in self-dealing.
On one hand, the managers have a fiduciary duty to their shareholders to sell the
company at the highest possible price. On the other hand, they have an incentive to
minimize what they pay for the shares. Accordingly, it has been suggested that
management takes advantage of superior information about a firm's intrinsic value. The
evidence, however, indicates that the premiums paid in leveraged buyouts compare
favorably with those in inter-firm mergers that are characterized by arm's-length
negotiations between the buyer and seller.

Further Reading:

Fox, Isaac, and Alfred Marcus. "The Causes and Consequences of Leveraged
Management Buyouts." Academy of Management Review. January 1992.

Franecki, David. "Here's the Deal: Leveraged Buyout Revival." Barron's. February 12,
2001.
Kaplan, Stephen. "The Effect of Management Buyouts on Operating Performance and
Value." Journal of Financial Economics. October 1989.

Latif, Yahya. "What Ails the Leveraged Buyouts of the 1980s." Secured Lender.
November/December 1990.

Lindsey, Jennifer. The Entrepreneur's Guide to Capital: The Techniques for Capitalizing
and Refinancing New and Growing Businesses. Chicago: Probus, 1986.

"Return of the LBO." Business Week. October 16, 2000.

See also: Mergers and Acquisitions

US History Encyclopedia:

Leveraged Buyouts
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A leveraged buyout (LBO) is one method for a company to acquire another. In an LBO,
the acquiring firm typically borrows a large percentage of the purchase price by pledging
the assets of the acquired firm as collateral for the loan. Because the assets of the target
company are used as collateral, LBOs have been most successfully used to acquire
companies with stable cash flows and hard assets such as real estate or inventory that can
be used to secure loans. LBOs can also be financed by borrowing in the public markets
through the issuance of high-yield, high-risk debt instruments, sometimes called "junk
bonds."

An LBO begins with the borrower establishing a separate corporation for the express
purpose of acquiring the target. The borrower then causes the acquisition corporation to
borrow the funds necessary for the transaction, pledging as collateral the assets it is about
to acquire. The target company is then acquired using any number of techniques, most
commonly through a public tender offer followed by a cash-out merger. This last step
transforms the shares of any remaining shareholder of the target corporation into a right
to receive a cash payment, and merges the target corporation into the acquisition
corporation. The surviving corporation ends up with the obligation to pay off the loan
used to acquire its assets. This will leave the company with a high amount of debt
obligations on its books, making it highly "leveraged," meaning that the ratio of debt to
equity will be high. Indeed, in the average LBO during the 1980s, when they were most
popular, the debt-to-assets ratio increased from about 20 percent to 90 percent.

Following an LBO, the surviving company may find that it needs to raise money to
satisfy the debt payments. Companies thus frequently sell off divisions or portions of
their business. Companies also have been known to "go public" again, in order to raise
capital.
Many LBOs are "management buyouts," in which the acquisition is pursued by a group
of investors that includes incumbent management of the target company. Typically, in
management buyouts the intent is to "go private," meaning that the management group
intends to continue the company as a privately held corporation, the shares of which are
no longer traded publicly.

Management buyouts were particularly popular during the 1980s, when they were used in
connection with the purchase of many large, prominent firms. Public tender offers by a
corporation seeking to acquire a target company were frequently met with a
counterproposal of a leveraged buyout by the target company management. One of the
most famous takeover battles was the 1988 battle for RJR Nabisco between a
management team led by F. Ross Johnson and an outside group led by the takeover firm
Kohlberg Kravis Roberts & Company (KKR). Both groups proposed to take the company
private using LBOs. This contest, eventually won by KKR when it purchased RJR
Nabisco for $31 billion, is the subject of the book and movie Barbarians at the Gate. At
the time, it was the most expensive corporate acquisition in history.

In the later years of the 1980s, LBOs became so popular that they were used in situations
in which they were poorly suited, and the deals were poorly structured. Beginning in
1989, the number of defaults and bankruptcies of companies that had gone through LBOs
increased sharply. As a result, the number of LBOs declined significantly.

Bibliography

Burrough, Bryan, and John Helyar. Barbarians at the Gate: The Fall of RJR Nabisco.
New York: Harper and Row, 1990.

Carney, William J. Mergers and Acquisitions: Cases and Materials. New York:
Foundation Press, 2000.

Hamilton, Robert W., and Richard A. Booth. Business Basics for Law Students: Essential
Terms and Concepts. 2d ed. New York: Aspen Law and Business, 1998.