A leveraged buyout (LBO) is the acquisition of a company in which the buyer puts up only a small amount of money and borrows the rest. The buyer's own equity thus "leverages" a lot more money from others. The buyer can achieve this desirable result because the targeted acquisition is profitable and throws off ample cash used to repay the debt. Such transactions are also known as "bootstraps" or HLTs, i.e., "highly leveraged transactions." Since they first appeared in the 1960s and took hold in the 1970s, LBOs have had mixed reviews from business people and other observers. Some see them as tools to streamline corporate structures, to rationalize meaninglessly diversified companies, and to reward neglected stockholders. Others see the LBO as a destructive force destroying economic and social values, the activity motivated by greed-driven predation.
TYPES OF LBOS
LBOs are typically used for three purposes, each in the category of corporate acquisitions generally. These are 1) taking a public company private, 2) financing spin-offs, and 3) carrying out private property transfers frequently related to ownership changes in small business.
Public to Private
The first situation arises when an investor (or investment group) buys all of the outstanding stock of a publicly traded company and thus turns the company into a privately-held enterprise ("taking private" in reverse of "going public"). These deals may be friendly or hostile, the two terms related to management's point of view. Friendly cases typically involve the management buying the company for itself with plans to operate it thereafter as a privately-held entity. Hostile cases involve an investor or investor group intent on buying, reorganizing, and then reselling the company again to realize a high return. The sale of the company may be to another company or may be to the public in a stock offering. In the last case the situation actually amounts to a transaction more aptly labeled public-to-private-to-public. There are other variants in the disposition or in the payback of a third-party investor, although they tend to be rare, such as very high dividend payments and recapitalization by other groups.
Public or private companies often wish to sell off elements of their business to get cash. In some cases the seller may itself have been bought in an LBO and is spinning off assets to pay the investors back. In such situations the spun-off element's management may itself be the buyer or may be passive in the transaction. An LBO is used to purchase the subsidiary or division in question. The fundamental financial logic of such deals, however, remains the same.
The last situation concerns cases where a privately held operation is bought by an investor group. Such cases often arise when a small businesses owner, having reached retirement age, wishes to divest him-or herself of the company and either cannot find a corporate buyer or does not wish to sell to a company. The buying group itself may be the company's employees or individuals associated in some way with the owner. These people organize an LBO because they only have limited equity.
FINANCING AND PAYBACK
The target of an LBO must, almost by definition, be profitable, growing, and produce a suitably large cash flow. In acquisitions jargon this is often abbreviated as EBITDA, meaning earnings before interest, taxes, depreciation, and amortization—the component elements of cash flow as ordinarily defined. Why cash flow? Because repayment of the large, leveraged debt is from future cash flows of the company. Other assets, of course, are also taken into consideration. If cash flow cannot keep pace with repayment, it is desirable that the company has saleable components (e.g., potential spin-offs) or liquid assets. Third party investors cannot be persuaded to put up cash unless the numbers look good, the elements of the company seem easily saleable, the company has lots of cash on its books, or all of the above are present.
The leveraged portion of the LBO may be as high as 90 percent of the deal but can be lower. In periods of unusual frenzy, the percent has even climbed above 90 percent. The rest is in the form of equity. Multiple "layers" of financing are involved: senior debt, senior subordinated debt, subordinated debt, mezzanine debt, bridge financing, and finally purchaser's own equity. The instruments described here are listed in increasing order of risk. In the case of a default, those holding senior debt will be paid first, owners of equity last (if at all); these security relationships are contractually built into the instruments themselves. Mezzanine financing is a hybrid between straight equity and debt, structured so that "mezzanine" holders are just barely paid something in an extreme case where equity holders lose everything. Bridge loans are short-term loans intended to be repaid either from the acquired company's cash holdings or from rapid disposition of company assets. Debt, of course, may be in the form of high-yield and therefore high-risk "junk" bonds.
LBO risks are high because payback depends entirely on the company's future performance. If the economy falters—or some event halts the purchased company in its tracks (a major lawsuit, the loss of a major account)—or if the high re-payments actually hamper the company by starving it of capital, investors may see their money turn into thin air. Healthy, growing, cash-rich companies purchased by an LBO therefore may lose their flexibility by losing their cash and simultaneously acquiring a huge load of debt: small shocks in the past become large shocks in the present. For these reasons investors expect returns above 20 percent per annum.
FOR AND AGAINST
Philosophical views of business go far in explaining positive and negative views of LBOs as well—and LBOs particularly (among merger and acquisition methods) because users of LBOs are predominantly interested in changing companies in order to extract benefits in the process. Those who see corporations predominantly in capitalist terms favor a business model in which stockholder equity is always maximized regardless of any other consideration. Those who view corporations as economic and social institutions with a wide penumbra of other interests also involved—stakeholders including employees, distributors, customers, vendors, etc.—view this method of acquisition, especially if used in hostile takeovers aimed at dismembering the corporation, slashing its employment, and taking it public again as disruptive and predatory.
In more mechanical terminology, proponents of such acquisitions claim multiple benefits. One of these is a more optimal debt-to-capital ratio. High debt and low capital mean lower taxes: interest costs are deductible. Reduced ability to invest in capital good increases the company's efficiency by reducing over-capacity. Companies using their profits for growth rather than dividends short-change the stockholder. Highly diversified companies in many unrelated businesses have much higher overheads—unnecessary if badly fitting parts are spun off. These motives translate into leaner and more profitable ventures producing higher return on investment—all of which favors ownership interests. Opponents, on the contrary, favor control and predictability through diversification, market share gains, flexibility in production and in ability to respond—all of which favors management, employees, and other stakeholders. Ultimately both sides have legitimate points to make, and the controversy, therefore, is likely to continue.
The first LBOs were made in the 1960s; their use took hold in the 1970s and began to boom in the 1980s. LBOs in the first half of the 1980s were very successful, leading to a boom mentality in the second half of the 1980s with extraordinarily high rates of leverage, leading to many bankruptcies and failures in the early 1990s. A legislative reaction at the state level (states control incorporation and rules related to them) went through several cycles. States tightened rules against hostile takeovers; the Supreme Court curbed such activities in a 1982 judgment; states then revised their rules to get around the high court's ruling—and these work-arounds were later approved in another Supreme Court case in the late 1980s. The upshot was to make hostile takeover more difficult, requiring buyers to acquire a higher percent of stock in order to take control. LBO deals diminished in the 1990s but began to heat up again in the new century, reaching another boom in the mid-2000s.
In general, LBOs are highly dependent on the availability of investment funds—money chasing opportunity. When money is tight and less risky ventures pay high returns, LBOs diminish and/or the degree of leverage used declines—buyers having to put up more of their own equity. When the economy is flush with cash, the number of deals and their magnitudes increase, purchase prices balloon, and investors also begin "reaching down" to purchase smaller companies ("microcaps" in the jargon of investment). Second, leveraged deals depend on healthy companies with high and predictable future cash flows—without which investors are difficult to attract to a deal. Hostile LBOs also require publicly traded companies so that the buyer can reach stockholders and persuade them to give the buyer control. As the 2000s roll along, conditions very much favor LBOs. Enormous trade deficits have produced a strong influx of foreign investments and the economy is flush with money. The future will undoubtedly bring a correction as the mid-2000s' exuberance brings a flurry of bankruptcies—echoing the crashes in the 1980s.
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