A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. In simple words, a leveraged buyout takes place when someone purchases a company using almost entirely debt. The purchaser secures the debt with the help of the assets of the purchased business.
Let us say there is a business that has no debt and generates a net income of $1.5 million. Pretax, after paying tax the owner of the business, Robin, gets a net income of $1 million. After many years, Robin wants to sell the business and a woman called Tracy is willing to buy it for a sum of $10 million. It is an excellent deal for Robin, but Tracy may not have the entire sum of money or may not want to use up $10 million upfront. So, she decides to put only $1 million from her pocket and she would get the remaining $9 million from a bank as a loan with a 10% interest rate. Now that seems risky because she’d have a debt of $9 million, but in reality, it is a great deal. By taking a $9 million loan, Tracy is buying the company using leverage. The company makes $1.5 million a year pretax & the advantage of corporate interest is that it is deductible from the pre-tax amount, which means after paying interest of $900K and tax, the net income is 400K.
If you look at the math, it’s a great deal!
Advantages of Leveraged Buyouts:
- Return of Equity: Leveraged buyouts are based on using a capital structure with large amounts of debt, which allows them to increase returns utilizing the seller’s assets.
- Tax Benefits: Corporate interests are generally applied to pretax amounts which causes great tax benefits.
- Sale at the Desired Price: Leveraged Buyouts are an excellent way to sell businesses at a desired price.
Uses of Leveraged Buyouts:
- To Privatize A Public Company: Taking a publicly-traded company private means consolidating public shares in the hands of private investors who take those shares off the market. Those investors will now own either all or a majority of the target company. This requires enough capital to purchase all or most of the company's net value. Since these investors will now own the company, they can have the company assume the debt liability for this transaction.
- To Break Up a Large Company: Sometimes a company may grow large and inefficient, so the whole is worth less than the sum of its parts. In such a case, an investor may purchase the company, split it and sell it as a series of smaller companies. For example, a company that manufactures cars, airplanes and tanks might get split up into an automotive, aerospace, and defense firm, each of which would get sold to larger companies in relevant industries.
- To Improve an Underperforming Company: An investor might believe that a firm is significantly underperforming, when it comes to its potential. In this case, the purchase price of the company would be worth much less than what the company could eventually be worth, making a leveraged buyout a good option.
- To Enrich Shareholders and Owners: When a company is purchased, the purchase price flows to all owners, and the stock price generally surges. For a privately held firm, the individual owner(s) collects that money directly minus any partnerships or other liabilities. For a publicly held firm, the purchase capital accrues to shareholders. This typically enriches executives and members of the board of directors. The former group will often have their compensation tied to stock performance, while the latter group typically comprises some of the company's largest shareholders. However, this means that a leveraged buyout comes with a significant conflict of interest.
The decision-makers in charge of approving any acquisition may stand to personally make a lot of money off the resulting deal, even if it means saddling the company with unsustainable debt obligations. In fact, in cases where an investor is purchasing the firm, often that investor will already own significant holdings in the target firm, giving them a stake in this personal enrichment. Here, the company takes on significant financial liability in a transaction that directly enriches the individuals making that decision.
Criticism of Leveraged Buyouts:
The major criticism of leveraged buyouts is that it is a predatory tactic. In many cases, it has killed healthy businesses for the benefit of the buyers. Many businesses have had to file for bankruptcy because of unsustainable debt payments.
Leveraged Buyouts are sometimes confused with hostile takeovers, but they are slightly different. LBOs happen when a company is acquired using debt as the main source of consideration. Unlike a hostile takeover, an LBO is not dependent on the target company rejecting the deal.