17

LEVERAGED BUY-OUT (LBO)

17.1 Introduction
17.2 The concept of LBO
17.3 History of the LBO
17.4 Meaning
17.5 Definition
17.6 Essential Characteristics of LBO
17.7 Classification of LBO
17.7.1 Management buyouts (MBOs)
17.7.2 Management buy-ins (MBIs)
17.7.3 Buy-in Management buy-out (BIMBO)
17.7.4 Institutional buyouts (IBOs)
17.8 Transaction Structure for Leveraged Finance
17.9 Sources of LBO Financing
 Senior debt
 Subordinated debt
 Mezzanine finance
 Loan stock
 Preference shares
 Ordinary shares
17.10 Building an LBO Model
17.11 Stages of LBO Operation
1st Stage: Arrangement of Finance
2nd Stage: Going Private
3rd Stage: Restructuring
4th Stage: Reverse LBO
17.12 The Advantages of LBO
17.13 The Limitations of LBO
17.14 Value generation through LBO
17.15 Summary
Review Questions

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17.1 INTRODUCTION

In the realm of increased globalized economy, mergers and acquisitions have assumed significant
importance both within the country as well as across the borders. Such acquisitions need huge amount
of finance to be provided. In search of an ideal mechanism to finance an acquisition, the concept of
leveraged Buy-out (LBO) has emerged.

Leveraged Buyout in simple terms means purchasing a company or an asset with the combination of
Equity and Debt capital, with a significant portion of Debt in the total capital. The debt capital ranges
between 70%-80% of the total capital. Because of this, it is known as Leveraged Buyout since the
company leverages itself by way of borrowed funds.

In 2016, Detergent major Nirma acquired the cement business of the French major Lafarge India for
about Rs 9,300 crores. Nirma raised Rs 4,000 crores debt to fund the deal, making it the largest rupee
bond sale for a leveraged buyout. "The Rs 4,000-crore five-year bond sale by Nirma offers a yield of
8.68 per cent was oversubscribed 1.5 times. This is the largest rupee bond sale for a leveraged
acquisition as also the largest AA-rated debt

17.2 THE CONCEPT OF LBO

Leveraged buyout (LBO) is very similar to buying a house. Suppose you want to buy a big house what
will you do? You will put down some money as cash and go for a loan for the remaining amount. And
most of the times loan forms a major part of the entire transaction. Similar is the concept in
Leveraged Buyout. If we break down it to simple terms, in an LBO, the “down payment” is called
Equity (cash) and the “Loan” is called Debt.

Maybe it’s clearer to all of us now. So let’s start analyzing what does the term Leverage buyout is all
about. In a Leverage buyout (LBO), you acquire a company or part of a company. But this is a
common thing which you may have heard. So what is the major difference that gives it a name of
“Leveraged Buyout”? The answer is: “The entire process is majorly funded by debt”. Yes, remember
that Debt forms a major part of a LBO transaction. Now coming to the parties involved in the LBO
deals. There is a Buyer and the Target Company. The Buyer mostly is a private equity fund who
invests a small amount of equity and majorly uses leverage or debt to fund the remainder of the
consideration.

Is using so much debt beneficial for the companies? If no, then the question is why this approach?
And is Yes, then the question is how?

So let’s start with a simple example to know why the entire LBO analysis! Let’s say you have Rs.100
with you. But at the same time you are able to borrow Rs.900 more (assuming interest rate at 5%).
So now the total that you have is Rs.1000. Now, let’s say you invest those Rs.1000 and you earn 10%
return on it in one year (So it now goes up to Rs.1100). After you repay your debt of Rs.900 and the
interest of Rs.45 (5% of Rs.900), you are left over with Rs.155 (Rs.1100-Rs.900-Rs.45), which is a
55% return on your money you initially put in. Remember that you put Rs. 100 initially? So if you are
left with Rs.155 now, you have got 55% return. I think now you must have got an idea as to why this
LBO analysis is opted by the companies.

17.3 HISTORY

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While it is unclear when the first leveraged buyout was carried out, it is generally agreed that the first
early leveraged buyouts were carried out in the years following World War II. Prior to the 1980s, the
leveraged buyout (previously known as a “bootstrap” acquisition) was for years little more than an
obscure financing technique.

In the years following the end of World War II the Great Depression was still relatively fresh in the
minds of America’s corporate leaders, who considered it wise to keep corporate debt ratios low. As a
result, for the first three decades following World War II, very few American companies relied on debt
as a significant source of funding. At the same time, American business became caught up in a wave
of conglomerate building that began in the early 1960s. In some cases, corporate governance
guidelines were inconsistently implemented. The ranks of middle management swelled and corporate
profitability began to slide. It was in this environment that the modern LBO was born.

In the late 1970s and early 1980s, newly formed firms such as Kohlberg Kravis Roberts and Thomas
H. Lee Company saw an opportunity to profit from inefficient and undervalued corporate assets. Many
public companies were trading at a discount to net asset value, and many early leveraged buyouts
were motivated by profits available from buying entire companies, breaking them up and selling off
the pieces. This “bust-up” approach was largely responsible for the eventual media backlash against
the greed of so-called “corporate raiders”, illustrated by books such as The Rain on Macy’s Parade and
films such as Wall Street and Barbarians at the Gate, based on the book by the same name.

As a new generation of managers began to take over American companies in the late 1970s, many
were willing to consider debt financing as a viable alternative for financing operations. Soon LBO firms’
constant pitching began to convince some of the merits of debt-financed buyouts of their businesses.
From a manager’s perspective, leveraged buyouts had a number of appealing characteristics:

a) Tax advantages associated with debt financing,

b) Freedom from the scrutiny of being a public company or a captive division of a larger parent,
c) The ability for founders to take advantage of a liquidity event without ceding operational
influence or sacrificing continued day-to-day involvement, and
d) The opportunity for managers to become owners of a significant percentage of a firm’s equity.

17.4 MEANING

The term leveraged buyout (LBO) describes an acquisition or purchase of a business, typically a
mature company, financed through substantial use of borrowed funds or debt by a financial investor
whose objective is to exit the investment after 3-7 years. In fact, in a typical LBO, up to 90 percent of
the purchase price may be funded with debt.

The term ‘leveraged’ signifies a significant use of debt for financing the transaction. The purpose of a
LBO is to allow an acquirer to make large acquisitions without having to commit a significant amount
of capital.

(A typically transaction involves the setup of an acquisition vehicle that is jointly funded by a financial
investor and the management of the target company. Often the assets of the target Company are
used as collateral for the debt. Typically, the debt capital comprises of a combination of highly
structured debt instruments including pre-payable bank facilities and / or publicly or private placed
bonds commonly referred to as high-yield debt. The new debt is not intended to be permanent LBO
business plans call for generating extra cash by selling assets, shaving costs and improving profit
margins. The extra cash is used to pay down the LBO debt. Managers are given greater stake in the
business via stock options or direct ownership of shares).

The term ‘buyout’ suggests the gain of control of a majority of the target company’s equity. (The
target company goes private after a LBO. It is owned by a partnership of private investors who
monitor performance and can set right away if something goes awry. Again, the private ownership is

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not intended to be permanent. The most successful LBOs go public again as soon as debt has been
paid down sufficiently and improvements in operating performance have been demonstrated by the
target company).

17.5 DEFINITION

Despite the ever-expanding literature on LBOs, there does not appear to be a single, clear definition of
what an LBO really is. Loosely speaking, an LBO is simply the purchase of a firm by an outside
individual, another firm or the incumbent management with the purchase being financed by large
amounts of debt; the resulting firm is said to be “highly leveraged.” The target firm can be a free-
standing entity or a division of a public corporation.’

The Leveraged Buyout may be defined in different ways by the experts:

a) According to Miller the Leveraged Buyout is “a financing technique of purchasing a private

company with the help of borrowed or debt capital”.

b) Weston, Chung & Hoag defines LBO as “the acquisition, financed largely by borrowings of all
the stocks or assets, of a hither to public company by a small group of investors”

c) The Center for Private Equity and Entrepreneurship, USA describes a leveraged buyout
as, “the acquisition of a company or division of a company with a substantial portion of
borrowed funds”

The leveraged buyouts are basically cash transaction in nature where cash is borrowed by the
acquiring firm and the debt financing represents 50% or more of the purchase price. Generally the
tangible assets of the target company are used as the collateral security for the loans borrowed by
acquiring firm in order to finance the acquisition. Sometimes, a proportionate amount of the long term
financing is secured with the fixed assets of the firm and in order to raise the balance amount of the
total purchase price, unrated or low rated debt known as junk bond financing is utilized.

17.6 ESSENTIAL CHARACTERISTICS

In order to make a leveraged buyout programme successful, certain characteristics should be fulfilled.
Fulfillments of these characteristics are not always mandatory in nature, but the existence of such
features may be expected to help make the programme fruitful as well as effective. Some important
characteristics are pointed out below:

Efficient and experienced management team

In order to motivate the lenders as well as investors for providing borrowed or loan capital to a
considerable extent and with a view to make the LBO programme successful, a strong management
body comprising of experienced as well as professionally highly qualified chief financial executives,
CEOs, directors, senior managers etc. is quaint essential. The management team should have long
track record in the industry and also should have desirable experience of handling large projections
effectively and efficiently. The existence of such an efficient and experienced management team will
help to create confidence in the minds of the lenders in lending huge amount of fund, to the LBO
candidate.

Assurance of sufficient and stable cash flow

With a view to service the debt borrowed for the acquisition and in order to ensure the smooth
ongoing operations of the firm, the existence of sufficient, strong and secure cash flow is considered
indispensable for a successful LBO programme. A LBO candidate having strong and stable cash flow
can easily impress the lenders to provide huge amount loan capital required for the purpose of
acquisition under the LBO programme and also to produce highest borrowing capacity of the firm. To

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be very much specific, future cash flows based on strong and stable track record of past performance
can easily be used for maximizing the lender’s belief and for generating due impression, which, in turn
will help to make the LBO programme successful.
Lower degree of operating Risk

In a LBO programme, the financial risk is very high since it is mostly based on leveraged capital or
debt capital. Thus, in order to sustain in the market, the degree of operating risk arising out of normal
business activities, should be as less as possible. Companies with strong market positions, diversified
products portfolio, strong customer base and new innovative power to cope with the changing
business world etc. usually have lower operating risk since, their cash flows are less dependent on a
single source of income and they are not subject to the risk arising out of loss of customers,
obsolescence of any existing product, change in the economy of a particular geographical region etc.
Companies with high operating risk may not be able to afford any adverse year because its financial
risk is already high under the LBO programme.
Limited amount of debt

There should have been limited amount of debt in the firm’s balance sheet compared to the value of
the tangible assets of the firm that can be used as collateral securities for raising the loan capital
required to fiancé the LBO programme. The lower the amount of existing debt relative to the collateral
value of such assets, the greater will be the borrowing capacity of the firm. On the other side of the
coin, if the balance sheet of the acquiring company (i.e.; the LBO candidate) is already over-burdened
by debt capital, the acquiring company may have to face difficulties in financing the acquisition
through the option of LBO.

Market leadership in the operating business

This will ensure in cash flows and relatively less capital expenditure requirements to fund growth.

Strong exit opportunities

The target company should convince the financial investor with strong exit opportunities in the form of
trade sale, secondary buyout or initial public offering.

Other factors

Apart from the above mentioned factors, lenders or investors may look for some other important
factors depending upon the nature of the business of the LBO candidate. Such factors may be tangible
or intangible in nature. For instance the existence of strong asset base in the balance sheet of the
company is one of the most important tangible factors because; such assets are used as collateral for
financing the LBO programme. A LBO candidate having strong asset base can easily raise capital to
finance the LBO. On the other hand, timing is another important factor to make a LBO programme
successful. Proper timing is very much important to maximize the probability of making the LBO
transaction successful.

17.7 CLASSIFICATIONS OF LEVERAGED BUYOUTS

17.7.1 Management buyouts (MBOs)

A management buy-out (MBO) usually involves the acquisition of a divested division or subsidiary or
of a private family owned firm by a new company in which the existing management takes a
substantial proportion of the equity. Such acquisitions take place when owners desire to sell off a
division or a company or even close or liquidate it, while the managers on the other hand envision
future growth potential and are willing to place their bets on improving the performance of the division
or company by acquiring it. Since managers may not possess adequate resources to effect such an

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acquisition, they are often compelled to seek financing or even a strategic partnership for this
purpose. In place of the LBO association, MBOs usually require the support of a private equity firm.

Managers may not be able to finance the MBO transaction by themselves due to having only the small
sum of money. Thus they can only acquire the small stake in the target while the majority of the stake
of the transaction will be taken by the private equity who may be the partner with the managers.
Thereafter the business will be running by the new team of management (Management Buyouts,
2008).

In many instances, board approval and shareholder votes are required before the acquisition can be
consummated. However, the buyout group may bypass the board and possibly the voting process by
making the tender offer. If it is successful, the buyout group may be able to cash out remaining
shareholders without their consent.

17.7.2 Management buy-ins (MBIs)

A management buy-in (MBI) is simply an MBO in which the leading members of the management
team are outsiders. Although superficially similar to MBOs, MBIs carry greater risks as incoming
management do not have the benefits of the insiders‟ knowledge of the operation of the business.
Venture capitalists have sought to address this problem by putting together hybrid buy-
in/management buy-outs (so-called BIMBOs) to obtain the benefits of the entrepreneurial expertise of
the outside managers and the intimate internal knowledge of the incumbent management.

The advantages of MBI are there is a wider chance for others who have the better credit than the
existing management team in MBO which can obstruct the other potential buyers to buy the share in
the better price. Also the new management team may have the better contacts and reputation for the
backing. However at the same time there are some disadvantages in MBI also. The new management
team may not have the knowledge about the business; they are not familiar with internal working to
be acquired. So they may be considered as the riskier which make the difficulty for the backing. So a
compromise between MBO and MBI combining some of the benefits from them may be achieved by a
buy-in management buy-out (BIMBO), which combines new and old management.

17.7.3 Buy-in Management buy-out (BIMBO)

A buy-in management buy-out is a compromise between a MBO and a MBI. The existing management
are largely retained, joined by some key new managers, and both take an equity interest in the
company, usually with private equity funding. The features of BIMBO are:

a) It retains the continuity management like MBO but also bring the new management who may
have the better credit or position to raise funding like in the case of MBI.

b) It may cause some uncertainties for the management but it is less than in the case of MBO.

c) It may improve the quality of management like MBI.

d) It is less risky than MBI. However this does mean that BIMBO will always be preferable to a
MBO or a MBI. For example, if the existing management is able to raise enough funding to
match other likely offers, then and MBO would be more straightforward. On the other hand, if
a complete change of management is needed, then MBI would be preferable.

17.7.4 Institutional buyouts (IBOs)

Investor-led buy-outs (IBOs) involve the acquisition of a whole company or a division of a larger group
in a transaction led by a private equity firm and is also referred to as bought deals or financial
purchases. The private equity firm will typically either retain existing management to run the company
or bring in new management to do so, or employ some combination of internal and external
management. Incumbent management may or may not receive a direct equity stake or may receive
stock options. IBOs developed in the late 1990s when private equity firms were searching for

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attractive deals in an increasingly competitive market and where corporate vendors or large divisions
were seeking to sell them through auctions rather than giving preference to incumbent managers.
These deals have similarities with LBOs.

17.8 A SIMPLE TRANSACTION STRUCTURE FOR LEVERAGED FINANCE

Typically, there will be two special purpose vehicles (SPV) established by the sponsor – Holdco and
Newco. Holdco will act as the investment vehicle which the sponsor will use to inject equity. Holdco
will subscribe to the equity of Newco. Newco will act as borrower and acquiring vehicle for the target.

PARTIES INVOLVED IN A LEVERAGED FINANCE TRANSACTION

Sponsor

This is the financial sponsor of the deal and the real economic buyer in a buyout.

Holdco

Holdco will act as the investment vehicle which the sponsor will use to inject equity. Holdco will
subscribe to the equity of Newco.

Newco

Newco is the buyer of the target company. It will be an SPV, which has not previously traded and is
therefore bankruptcy-remote.

Senior lenders

The senior lenders will likely be providing the majority of the acquisition finance for the buyout under
the senior facilities agreement. The senior lenders will consist of banks and institutional lenders. In
larger transactions, the senior facilities will commonly be syndicated after completion of the
acquisition. It is common for some of the lenders to act as co-arrangers and underwrite the acquisition
facilities before syndicating more widely after completion.

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Mezzanine lenders

Mezzanine lenders tend to consist of mezzanine funds, together with hedge funds, leveraged loan
funds and other institutional lenders. As with senior debt, it is common for the mezzanine facilities to
be arranged and underwritten by a select few funders, who will syndicate more widely after the
acquisition.

High-yield bondholders

The high-yield bondholders will comprise of institutional investors that are experienced and active in
the high-yield markets. The timetable for a successful issue of high-yield bonds is usually
unpredictable; therefore the sponsor tends not to align the timetable of issue with the completion of
the acquisition. A bridging loan is often used to fill the funding gap, which is subsequently refinanced
with the proceeds of the bond issue. The arrangers of the high-yield bond, generally known as
managers, will often be one of the mandated lead arrangers under the senior facilities and may also
underwrite the bridging loan. The manager will also negotiate the terms of the high-yield bond on
behalf of the bondholders.

Target

Newco will acquire the shares of the target and thus the target and all its subsidiaries will come under
indirect control of the sponsor. As conditions subsequent to the acquisition, often the target’s
subsidiaries will accede to the principal finance documents as obligors and they will grant share and
asset security to the security trustee (on behalf of the lenders).

Seller

The role of the seller is often distant from the acquisition finance. The seller’s main concern is the sale
of the target and is less concerned with the source of the funds used in to acquire the target.

17.9 SOURCES OF LBO FINANCING

In a leveraged transaction, the majority of a company’s capitalisation is debt financed, which enables
financial sponsors to achieve their IRR targets and corporates to acquire larger companies. The equity
is provided by the buyer and is frequently 30-40% of the total capitalisations.

There are a number of types of financing which can be used in an LBO. These include the following (in
order of their risk):

Senior debt

This is debt which ranks ahead of all other debt and equity capital in the business. Bank loans are
typically structured in up to three trenches: ‘A’, ‘B’ and ‘C’. The debt is usually secured on specific
assets of the company, which means the lender can automatically acquire these assets if the company
breaches its obligations under the relevant loan agreement; therefore it has the lowest cost of debt.
These obligations are usually quite stringent though senior debt is often not subject to reporting
requirements as they are usually unrated. The bank loans are usually held by a syndicate of banks and
specialised funds. Typically, the terms of senior debt in an LBO will require repayment of the debt in
equal annual installments over a period of approximately 7 years.

Senior debt is prepayable and has a floating rate of interest. From the lender’s perspective, this is the
most secure form of financing. A financial buyer will usually want the LBO to be financed by as much
senior debt as possible as it provides the ‘platform’ for the debt financing, since it is the lowest cost
form of financing.

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However, the providers of senior debt will be reluctant to accept very high levels of senior debt (which
may affect their security) or may impose conditions which are unacceptable to the equity investor. As
a result senior debt will often only form about 50% of the total financing

Subordinated debt

This debt ranks behind senior debt in order of priority on any liquidation. The terms of the
subordinated debt are usually less stringent than senior debt. Repayment is usually required in one
‘bullet’ payment at the end of the term. Since subordinated debt gives the lender less security than
senior debt, lending costs are typically higher. An increasingly important form of subordinated debt is
the high yield bond, often listed on Indian markets. High yield bonds can either be senior or
subordinated securities that are publicly placed with institutional investors. They are fixed rate,
publicly traded, long-term securities with a looser covenant package than senior debt though they are
subject to stringent reporting requirements. High yield bonds are not prepayable for the first five
years and after that, they are prepayable at a premium

Mezzanine finance

This is usually high risk subordinated debt (prepayable at a premium), and is regarded as a type of
intermediate financing between debt and equity and an alternative to high yield bonds. An enhanced
return is made available to lenders by the grant of an ‘equity kicker’ (e.g. warrants, options and
shares), which crystallizes upon an exit. A form of this is called a PIK, which reflects interest ‘paid in
kind’, or rolled up into the principal, and generally includes an attached equity warrant (for larger
financings)

Loan stock

This can be a form of equity financing if it is convertible into equity capital. The question of whether
loan stock is tax deductible should be investigated thoroughly with the company’s advisers

Preference shares

This forms part of a company’s share capital and usually gives preference shareholders a fixed
dividend and fixed share of the company’s equity (subject to there being sufficient available profits)

Ordinary shares

This is the riskiest part of an LBOs capital structure. However, ordinary shareholders will enjoy the
majority of the upside if the company is successful. Only some of these forms of financing will be used
in a transaction, unless the transaction is extremely complex. Furthermore, this list is a very general
summary and many of these categories comprise a number of different products. There are also
certain types of financing which do not fall within these categories.
Generally the following typical financial instruments are used for financing a LBO.

% of total Tenure
Elements of Capital Traditional suppliers of capital
capital (in years)

Investment banks and

Senior Debt: Revolving Term 30% - 60% 5-8
commercial banks.

Subordinated debt:
Investment banks, commercial
Senior/subordinated notes, Discount 10% -25% 7-10
banks and mezzanine funds.
notes, Traditional mezzanine etc.

Preferred Stock/Mezzanine
Investment banks, commercial
Securities: preferred stock, Pay-In- 0%-35% 7-10+
banks, Mezzanine funds
Kind (PIK) debt warrants

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Common equity : Common equity
Private equity fund ,
Vender loan notes (deeply 25%-40% 3-7, 10-12
Vendor loan notes
subordinated)

17.10 BUILDING AN LBO MODEL

A basic LBO model is similar in many respects to a standalone DCF model in that exactly the same
methodology is used to derive the company’s financial statements. The major difference is that an
LBO analysis, unlike a DCF, takes account of interest charges and debt repayments. As a result, the
financial statements need to be adjusted to include these payments. The key steps in completing an
LBO model are as follows:

Forecast cash flows

Projected cash flows should be modeled in exactly the same manner as for a DCF valuation. The
forecast period should end no earlier than the latest date on which an exit is expected or the latest
date on which the debt is expected to be repaid in full (whichever is later). While a DCF valuation
requires the unlevered free cash flows to be discounted to provide enterprise value, an LBO uses free
cash flows to derive IRRs.

Estimate debt capacity

The next step is to estimate the amount of debt that the company can take on. The financial
statements should make provisions for interest and debt costs. The company can only bear debt to the
extent that it has available cash flows. Note that all existing debt will need to be refinanced. When
modeling, consult your team about the financing assumptions to be used. These will vary according to
market conditions, industry characteristic and company specific issues. Consultation with the
leveraged finance team or the financial sponsors group is advisable, since they have more day-to-day
experience about the current parameters in the marketplace.

Set out below are some parameters that will influence financing considerations for the model:
o Minimum interest cover (times)
o Total debt/EBITDA (times)
o Senior debt repayment (in years)
o Mezzanine debt repayment (in years)
o Senior debt interest rate
o Subordinated interest rate
o Mezzanine finance exit IRR
It may also be appropriate to model the potential sale of non-core assets in order to ensure maximum
leverage. Note that, when modeling interest charges, a circular reference is likely to be encountered
resulting from calculating interest payable as the average of the debt at the start and end of the
relevant period. This is to be expected and iterations can be used to resolve the circular reference. The
best way to avoid this is to copy the formula to another cell and delete the cells generating the circular
reference before making any amendments to the model. When all changes have been made, you can
copy the formula back into the relevant cells.

Estimate equity required

The equity required is, in simplistic terms, the cost of acquiring the company (including existing debt)
less its debt capacity. The total cost of the company comprises both the purchase price and
transaction expenses. The level of transaction costs should not be underestimated – these can often
amount to approximately 3% of the purchase price, particularly for smaller transactions.

Estimate the exit price

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A financial buyer will typically wish to exit within 3 – 5 years. The expected value of the company at
that time is critically important to the buyer. Therefore, an estimate of the value of the business
should be made, usually as a multiple of EBIT or EBITDA, at the end of that period. As a base case,
the multiple should normally be no more than the multiple paid for the business by the financial buyer.
Furthermore, a discount of 10 – 15% should be included if an IPO is the most likely exit route.

Calculate the IRR

There is an Excel function which can be used to estimate the IRR.

17.11 STAGES OF LBO OPERATION

Four distinct but related stages are envisaged for the proper implementation of an LBO program,
which are described below.

1st Stage: Arrangement of Finance

The first stage of the operation consists of raising the cash required for the buyouts and working out a
management incentive system. The equity base of the new firm consists of around 10% of cash put up
by the company’s top management or buyout specialists. Outside investors like merchant bankers,
venture capitalists and commercial banks then arrange to provide the remaining equity. Usually 50
percent of the cash is raised by borrowings against company’s assets in secured bank acquisition loans
from commercial banks. Rest of the cash is obtained by issuing certain debts in a private placement,
usually with pension funds, insurance companies, venture capital firms or public offerings through
high-risk high-yield junk bonds. Private placement and junk bonds are subordinated forms of debts
(often referred to as ‘mezzanine money’) and they secure a place in between the secured debts from
banks and risky residual claims of shareholders.

2nd Stage: Going Private

In this stage, the organizing or sponsoring group purchases all the outstanding shares of the target
company and takes it private through stock purchase format or purchase all assets through asset
purchasing format. For the latter case, the purchasing group forms another new, privately held
corporation. To reduce the debt by paying off a part of bank loans, the new owners sometimes sell off
part of the corporation and may begin disposing off the inventory.

3rd Stage: Restructuring

In this stage, the new management would try to enhance the generation of profit and cash flows by
reducing certain operating costs and changing the marketing strategy. For this operation, it may adopt
any or all of the below given policies: viz.

(i) Consolidation and reorganization of existing production facilities;

(ii) Changing the product mix (thereby changing the quality of the product) and changing the
policy relating to customer services and pricing;
(iii) Trimming employment through attrition;
(iv) Phasing out employees in turn and reduction on spending on research and development,
new plants and equipment etc., so long as there is a need to redeem the fresh acquired
debts;
(v) Extraction and implementation of better terms from various suppliers.

However, while undertaking the above stated restructuring activities due attention should be given for
the approval of genuine capital expenditure programs for the growth of the firm, otherwise, the long-
term growth of the firm would hamper.

4th Stage: Reverse LBO

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Under this stage, the investor group may take the company to public again, if the already restructured
company emerges stronger and the goals set by the LBO groups have already been achieved. This is
known as the process of ‘Reverse LBO’ or the process of ‘Going Public’, where the process is effected
through public equity offerings. The sole purpose of this exercise is to create liquidity for existing
shareholders. This type of reverse LBO is executed mostly by ex-post successful LBO companies.

17.12 THE ADVANTAGES OF LBO

Certain important advantages can be obtained from LBO programme. The major advantages of the
LBO are stated below:

a) With the help of LBO strategy, the acquiring company can be benefited from the acquisition of
international brand without having significant impact of the additional funding costs on the
Balance Sheet of the firm. In other words, the acquiring company can expand its business
network in the international market based on leveraged capital i.e. without occurring huge
amount of outlay from the internal resources of the firm.
b) Since in the LBO system, a new company is created to procure the debt capital as well as other
sources of finance required for the acquisition, the volatility of earnings of that new created
company, popularly known as special purpose vehicle dose not affect the business of the
acquiring company. After the passage of certain years, when debts are fully repaid, the parent
acquiring company gets merged with its SPV which was created purposefully. As a result, the
parent acquiring company can enjoy the benefits of entire acquisition without confronting the
adverse business as well as financial risk arising out of such acquisition.
c) Moreover, the newly created company can enjoy tax benefits in operating the business for a
considerable time period of five to six years. Due to the existence of high amount of leveraged
or debt capital, in the capital structure of the company, tax benefits can be achieved in respect
of payment of interests. Moreover, higher amount of assets set up will provide greater amount
of tax savings in the form of depreciation expense.
d) The LBO system helps stimulating the cross border acquisition since; this system ensures the
supply of required amount of capital needed for large acquisitions. As a result, a firm can
enlarge its business network not only in the domestic market, but also in the international
market as well.
e) High gearing tends to be a discipline on management, since a company’s cash flow is usually
quite tight due to the necessary pay-down of interest and debt. Management is therefore likely
to focus on driving down costs and controlling capital expenditure
f) In a highly leveraged company, a relatively small increase in the company’s enterprise value can
lead to a substantial increase in the value of its equity. In a bull market, the attractiveness of an
LBO will therefore increase. Of course, the gearing effect also means that high gearing increases
an equity investor’s risk, since a relatively small decline in enterprise value could severely
impact the value of the equity investment. Moreover, high interest charges increase the risk of
default by the company

17.13 THE LIMITATIONS OF LBO

Even though value so created through an LBO exercise, it cannot be claimed to be free from criticisms.
The most important drawbacks of the LBO system are stated below:

a) The LBO programme is subject to high degree of financial risk since; it is mostly based of
borrowed capital. On the other hand, if the degree of operating risk of the LBO candidate is also
high, it may be difficult for the firm to service the debt properly which, in turn, may lead to the
firm into bankruptcy in near future. In addition to that, the fluctuation in interest rate is another

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 important point to be considered here. The rise in interest rate may create genuine problem for
firm that has more variable debt rate. In order to meet all these categories of risk, a strong and
stable cash flow is quintessential. The lack of such secure and stable cash flows may raise
meaningful questions about the existence of the concerned firm.

b) In order to implement the LBO programme, a LBO candidate should have strong asset base that
can be used as collateral for financing the acquisition. Moreover, an experienced as well as
efficient team of management is also important. Thus, a firm that lacks these requirements may
not be able to finance its acquisition plan.

Finally, if the firm cannot afford the interest burden to be boned by it due to any reason, the ultimate
liability of repayment of the huge amount of loans will confer into the shoulder of that firm. Naturally,
the acquiring firm should always be remained aware regarding the fact that, the LBO programme is
subject to high degree of risk.

17.14 VALUE GENERATION THROUGH LBO

Every restructuring program must generate some additional values for the business, owners,
shareholders etc. So an LBO exercise also creates certain additional values for various groups involved
in such an operation.

In order to identify the basic sources of value generation in an LBO, one must consider its underlying
assumptions:

 that the current price of the target firm understates the original value of the firm;
 so some values are created by taking the firm private;
 the values so created is transferred to the shareholders and buyout groups from other parties
involved in such an operation.
Since the assumptions clearly reflect the position of value creation through an LBO operation, one
must identify the sources of value so generated. The sources are as follows:

a) Reduction in agency cost is the most important source of value in an LBO. An LBO refers to take
a public corporation to private. In case of a public corporation, the management is different from
its owners. In practice, however, the management sometimes takes some suboptimal decisions
without the prior approval of its owners, which are proved to be costly and detrimental to the
growth of the firm and beneficial to the management. On the contrary, when a public
corporation goes private, the owners and the management are the same and in all cases, the
management takes decisions which are not only cost effective, but also for the growth of the
organization. Agency cost refers to the difference of the firm value when management and
owners are the same than that of the firm value when different groups function as owners and
managers. By taking a public corporation to private, an LBO exercise tries to eliminate such an
agency cost that is considered as a value gain for a restructured firm.

b) The second source of value gain is associated with efficiency. It is argued that a private firm is
much more efficient in taking decisions in relation to a changing environment than that of a
public corporation, where every decision is not required to be ratified by the general body before
implementation. Thus action can be taken more speedily since major new programs do not have
to be justified by detailed studies and reports to the board of directors. It is this efficiency in
decision-making that creates value for an LBO. Again production and portfolio efficiencies are
perceived with an LBO operation because of the involvement of specialized LBO firms. Such
efficiencies create ‘synergistic’ benefits, which ultimately generate value.

c) Another source of value gain in case of an LBO is tax benefits as in such an operation; the
interest obligation of the private firm is expected to certain tax benefits. Again, the concept of

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 stepping up of assets for depreciation as an ingredient of LBO calls for additional tax
advantages.

d) Finally, it is understood that management or investors in an LBO deal have more information on
the value of the firm, than the ordinary shareholders. Because of this information, a buyout
proposal gives indication to the market that the post-buyout scenario would certainly provide
more operating incomes than previously expected or that the firm is less risky than perceived by
the public at present. It is this asymmetric information, which adds value to an LBO and because
of this value; the buyout investors do not mind paying large premiums on such deals.

The value so created through an LBO exercise are exclusively meant for the shareholders of
restructured firm and partly for the specialists engaged in such an operation. Basically, this is
considered as a ‘wealth transfer’ mechanism in a sense that because of the financial leverage, the gain
achieved by the shareholders came at the expense of the firm’s debt holders. Thus it can be inferred
that “the value gains to shareholders are partly the result of efficiency gains, tax benefits, better
information and a reduction in agency cost” (Bansal & Yuyuenyongwatana, 1996).

17.15 SUMMARY

Leveraged buyout is one of the interesting routes for those investors who do not have the high equity
in the pocket and can acquire another target company. The investors can come up with the control
over the management of the target company. In case the investors have the experience to manage
the target company‟ business especially in the case of management buyout which the business of the
target company will be run by the insiders then the investors can use the cash flow coming to such
company to repay the loan taking from the bank. However, there are some certain risks if the
investors cannot revive the business of the target company and finally the expectation of such cash
flow for the loan repayment will not happen. The high interest rates from such loan may make the
extra burden to investors to return the interest and the loan to the bank. Consequently there is the
chain of the business collapse not only the target company but also the bank which gives the loan to
the investor to acquire such company. In the case of management buyout it can also cause the
conflict of interest among employees, executives and the management team. Thus the stability and
experience of the investors are significance factors for running the leveraged buyout investment.

REVIEW QUESTIONS

1. Define Leveraged buyout and state how it is undertaken?

2. Sketch the historical developments of Leveraged Buyout (LBO).

3. Describe the essential characteristics of Leveraged Buyout.

4. Briefly explain the various sources of LBO financing.

5. Discuss the key steps involved in a LBO model.

6. Elaborate on the different stages of LBO operation.

7. List and explain the advantages and limitations of LBO.

8. Write short notes on

a) Objectives of a LBO

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 b) Management Buyout (MBO)

9. Write a critical note on the value generated through LBO.

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