Leveraged Buyout – LBO
Definition
When you borrow a significant amount of money in order to complete the acquisition of another company, then this will be termed as a leveraged buyout. Now, since the amount of loans taken for acquiring the company is pretty high, so to pay them off, the assets of the acquired company are put to use. They are often kept as a collateral for the loans to the creditors. Sometimes, the acquiring company also uses its own assets to keep as a collateral for the loans. Now, the main reason behind this buyout is to make sure that when a company is being acquired, the acquiring company is not committing a lot of capital.

Historical aspects regarding Leveraged Buyout

The infamous history of leveraged buyouts suggests that they hadn’t been much successful in the past. Most importantly, when the 1980s are kept into account, there were various much important buyouts that happened and led to the eventual bankruptcy of acquired companies. Mainly, this was because of the pretty high leverage ratio that amounted to almost 100%. The interest payments were also so large that the operating cash flows of the company just couldn’t make it to meet the exceedingly high amounts and thus, they eventually got bankrupted.
One of the largest LBOs on record was in 2006 when Kohlberg Kravis Roberts & Co. (KKR), Merrill Lynch and Bain &Co. acquired the Hospital Corporation of America (HCA). The three companies had to pay a whopping amount of $33 billion in order to acquire HCA.

What are the reasons behind LBOs?

When a company is taking so much loan just to acquire another company, it raises questions and puts the acquiring company’s finances at great risk. So, one does wonder the reasons behind such a buyout. Well, there are three important reasons as to why companies come to this point.

1. First reason is when the company wants to take over a public company and make it private
2. When someone is trying to sell a portion of his existing business for its spin-off.
3. The third reason might be the transfer of any private property, or the case where a small change is to be made in the ownership of a specific business.
However, in all the cases, there is one common requirement that the acquired entity must be a profitable and growing venture. So that, spending all the large amount and acquiring all the loans are worth it.

Break down of LBOs
Usually, there is a ratio of 10% equity to 90% debt in an LBO. Due to the excessive ratio, usually the bonds issued in this buyout are referred to as the junk bonds instead of the investment grade. Moreover, a lot of people are of the view that the tactic of LBOs is highly predatory and ruthless because the target company never actually sanctions it. Moreover, it is pretty much ironic that the assets responsible for a company’s success are actually being used against the same company by the predator company as a collateral.

The process of LBO
The leveraged buyouts often contain many complexities and hence they take some time for completion. For instance, consider the example of JAB holding company. It is a private firm which makes investments in healthcare companies, coffee and luxury goods. In May 2016, JAB holding company started the leveraged buyout of Krispy Kreme Doughnuts, Inc. The acquired company came at a whopping price of $1.5 billion, out of which there was a leveraged loan of $350 million along with a revolving credit facility of $150 million through the Barclays investment bank.
However, the Krispy Kreme Doughnut Inc. already had a debt on its balance sheet which was also needed to be sold. Barclays made it more attractive by adding an additional 0.5% interest rate to it. Thus, the LBO was made quite intricate and the deal was almost cancelled. Nevertheless, on July 12, 2016, they went through with the deal and closed it.

Attractive aspects of LBO

An LBO generally represents a win-win situation for banks as well as financial sponsors, thus they are quite attractive. In case of financial sponsor, he can employ the leverage and thus enhance the rate of returns on his equity. The banks can also make it different from the corporate lending and thus attain some significantly high margins by supporting the finances of LBOs. This is because the banks will be charging a much higher interest. Moreover, the banks can obtain security or collateral too as a proof or surety that they will get repaid.
How much amount can the banks provide for an LBO
As mentioned, the LBO requires a lot of debt and this depends on how much amount the banks are actually willing to provide for supporting an LBO. The amount varies and is dependent on several factors that are mentioned as follows:
• Overall economic environment
• The quality of the company that is being acquired i.e. whether the operating cash flows of the company are stable, its history, the prospects of growth and the hard assets etc.
• The experience and history of the financial sponsor.
• How much equity is being offered by the financial sponsor.
Characteristics of leveraged buyouts
The leveraged buyouts greatly differ in many aspects. However, some characteristics are there that hold true in almost every LBO mentioned as follows:
• Strong management team – The chief executives will have worked with each other and by rolling over their shares in the LBO deal, they might have some vested interests.
• Relatively lesser existing debt – The private equity firm will add up more debt in the capital structure of the company which is to be repaid over time. Thus, this results in a lesser effective purchasing price. If the company already has acquired a huge debt balance, then the deal is very tough to be closed.
• Relatively lesser fixed costs – the fixed costs are to be repaid even if the revenues of private equity firms decline, thus the fixed costs pose risk for the private equity firms.
• Stability in cash flows – the acquired company in the LBO must have a stable operating cash flow.