How Leveraged Buyouts Drive Business Growth And Innovation

Leveraged buyouts drive business growth and innovation by making available funding for purchasing viable companies. On the face of it, taking on significant amounts of debt typically raises the risks of failure. Disasters are common; several high-profile case studies have demonstrated what can go wrong.

The biggest leveraged buyout ever was the purchase of TXU, the largest electricity utility in Texas. A consortium including Kohlberg Kravis Roberts & Co., Texas Pacific Group (TPG Capital), and Goldman Sachs purchased the company.

They created Energy Future Holdings, which filed for bankruptcy seven years later. It is considered one of the 10 biggest nonfinancial bankruptcies in history.

Yet another example is the Hilton Hotel acquisition by the Blackstone Group, partnering with Bear Stearns and Lehman Brothers. The latter two collapsed in 2007 when the real estate bubble burst.

Although several examples of failed leveraged buyouts exist, strategic planning and sound business decisions can benefit the stakeholders. Read ahead for detailed information about LBOS or leveraged buyouts and the best way to extract maximum value.

Understanding Leveraged Buyouts

When the buyer of a company raises a significant amount of debt to purchase a company, that’s a leveraged buyout. The buyer leverages the acquired company’s assets as collateral for the debt. They may also estimate that the company will pay off the debt out of the revenues it generates.

Buyers are typically private equity firms or the company’s management that believe in the company’s viability. They believe in the value they can derive from the deal and that it will supersede the risks they may have to carry.

The debt raised to purchase the company may vary, but typically, it comprises 70% to 80% of the total value. The buyer may cover the balance amount with equity, loans, and bonds.

Sometimes, the debt-to-equity ratio can also be 10% to 90%, where the buyer invests just 10%. And raises the balance by 90% from external sources. The higher the debt-to-equity ratio, the higher the risk factor.

A smaller private equity firm purchasing a publicly traded company is also a leveraged buyout. The buyer may partner with a group of financiers who provide the necessary funding to buy the company.

How Leveraged Buyouts Work

Buyers fund the acquisition using a combination of different funding sources, such as the company’s cash reserves and assets. They may also purchase equity and borrow funding from third-party investors. The company’s current owners sell a major chunk of their stock to the buyers.

Once the deal closes, the buyer takes over the company’s debt. As the new owner, they can use the company’s assets as collateral and cash flows to repay the debt. Since the new owners have a controlling stake in the company, they can use its assets for other purposes.

These objectives may include funding the buyer’s own company’s growth and operations. It is not uncommon for buyers to restructure the management and set up new objectives and goals.

Leveraged buyouts can be management buyouts where the target company’s management buys the company entirely or in portions. Alternatively, external buyers may partner with the company’s top executives to buy the business, which is a management buy-in deal.

Usually, in the case of a management buyout, the buyers may use their personal assets, both monetary and non-monetary. They may also raise bank loans and use their pension funds. Approaching private equity firms, family offices, and trust companies is also a strategy.

Leveraged buyouts are often considered predatory practices. That’s because the buyer may issue bonds using the acquired company’s assets as collateral to raise money. It can be argued that the buyers use the company’s own assets against its interests.

The bonds offered are also referred to as junk bonds because they are based on a high debt-equity ratio. They are not exactly considered investment-grade.

How Leveraged Buyouts Drive Business Growth and Innovation

Leveraged buyouts can drive business growth and innovation if the new owners choose to replace the management with new talent. If the company has been underperforming, the owners may bring fresh skill sets and expertise.

The new executives could turn the company around and ensure it scales and becomes profitable. Alternatively, the buyer may choose to retain the existing team and set up new goals. They may also restructure compensation packages to include more incentives for C-Suite executives to perform.

Whatever the strategy, new owners are typically closely involved with the company’s operations at a board level. Having raised debt from the market, their objective is to generate cash flows and profits to pay it back quickly.

Leveraged buyouts, where a private company purchases a publicly traded company, are also a form of reverse takeover. The smaller private company executes an asset swap and share issue to take control of the larger company.

This strategy enables it to go public without navigating the expensive, lengthy, and complex IPO procedures. The buying company gains voting rights, and its board takes over the management of the acquisition. The acquirer can combine and reorganize the assets to form a new private company.

On the other hand, giant corporations may choose to spin off a specific division and allow it to work independently.

The parent company may hold a controlling stake in the new company but allow it to continue with R&D. The new brand can release an entirely distinct product portfolio for profitability.

Essentially, the target company is taking on debt by using its assets as collateral, which translates into substantial tax benefits. Partnering with a new acquirer adds to its credibility, and the company can benefit from more customers and projects.

Benefits of Leveraged Buyouts

Leveraged buyouts drive business growth and innovation in more ways than one. Here are some of the reasons why:

• When a private company acquires a public company by way of a reverse merger, the new owners can restructure it. By overhauling its operations and costs, the LBO can give the public company a new lease of life. This factor is particularly relevant to shell companies or firms that have failed products or R&D. These downsides may have led to drastic drops in their stock prices.
• Leveraged buyouts are an excellent solution for distressed businesses in danger of going bankrupt. A takeover by a private equity firm can inject new capital and talent to salvage the company from closing down.
• Leveraged buyouts allow acquirers to purchase a company without investing much of their own capital. This strategy works well if the targeted company has the potential to generate cash flows and revenues. This factor allows the buyers to pay off the loan quickly.

 

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Downsides of Leveraged Buyouts

Although leveraged buyouts have benefits for companies, these acquisitions do come with their downsides.

• Since buyers may leverage the acquired company’s assets to finance the sale, it runs the risk of bankruptcy. Chances are that the company is unable to keep up with monthly payments. Several reasons can contribute to non-payment, such as macro-environment changes or unforeseen conditions, such as political or climatic factors.
• In the case of a hostile takeover, employee morale may take a huge hit. Attrition and loss of top talent may result in the company running losses and failing. Buyers in a leveraged buyout often make radical changes in the management and bring in their own board members. This factor can change the company culture, mission, and vision that the workforce does not accept.
• The new owners may resort to drastic cost-cutting measures for leaner operations to improve profitability. That may include firing employees in the acquired company.
• Buyers must make large monthly payments because of the substantial amount of funding needed to execute the leveraged buyout. Keeping up with this debt service can be very challenging, particularly during an unexpected economic downturn.

Selecting the Right Candidate for a Leveraged Buyout

Private equity firms or other acquirers typically target well-established, mature companies in stable verticals for purchasing. When evaluating the target, their objective is steady cash flows, robust financials, a great product portfolio, and a strong customer base.

Although management is also on the list of priorities, they can always replace it with their own board members. Companies that demonstrate great exit strategies are also good candidates for a leveraged buyout. Ultimately, the buyer’s objective is to realize profits quickly and cover the debt.

The target company would also need to have high margins and low capital expenses to make that happen. Servicing the debt consistently will mean that the acquirer is rid of the debt sooner.

How the Leveraged Buyout Proceeds

When evaluating a company for a leveraged buyout, acquirers start by creating a detailed financial model. This analysis involves understanding the company’s stability and sustainability. In addition, buyers conduct a predictive analysis for five years on average.

The objective is to ascertain its future cash flows and potential for generating revenues. Buyers may also calculate the terminal value, which is the total sum of the value of all future cash flows. But outside of a specific projected time frame.

The results of this analysis are then communicated to banks and other lenders with the objective of raising debt funding. Buyers would also want to maximize the returns on the equity they invest. Once this information is in place, investors determine the final terms and conditions of the deal.

When negotiating the terms of a leveraged buyout, buyers also communicate their business plan to investors. This plan includes information about their intended strategies to improve operations, lower costs, and maximize profits.

At this time, buyers also estimate the cash flows and the Internal Rate of Return (IRR) they can get. These figures consider the monthly payments and interest payable on the debt.

Due diligence is a crucial part of the process, and all the stakeholders conduct independent evaluations to determine viability.

Once the transaction closes, the buyer, private equity firm, or management gets to work to add value to the acquisition.

They may restructure the company to eliminate unnecessary costs and overheads and appoint new members to the board. That’s how leveraged buyouts drive business growth and innovation.

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Why Buyers Use the Leveraged Buyout Funding Strategy

Private equity firms and buyers can maximize their returns using the leveraged buyout strategy. Since they are investing only a small portion of their own money, they can hope for a higher ROE or the return on equity.

They can also hope for a higher internal rate of return (IRR), which can be typically 20% to 30% or higher.

The debt funding from investors is paid back along with interest, leaving returns for owners. However, this factor also raises the risk level. The possibility of the acquisition being unable to service the debt is a real factor.

If that happens, the buyers stand to lose all their anticipated returns on equity.

On the other hand, if the company successfully pays off the debt and stabilizes, buyers can assess the best exit strategy. For instance, taking the company to an IPO or selling it for a higher return, as is the case with most PE firms.

Alternatively, the acquirer may sell the company to a bigger private equity firm with a better strategy to scale the company further.

In Conclusion

Historically, LBOs attracted a lot of flak from critics because of their hostile takeover practices. They are also known for using the company’s assets to pay off the debt, which can be against its interests.

However, with the right business plan and approach, leveraged buyouts drive business growth and innovation. A struggling company or an owner looking for a profitable exit can use this option to salvage the company. Buyers may infuse capital and talent to grow the company profitably.

The ultimate principle is to acquire a company leveraging debt funding from sponsors and investors. Although viewed as predatory if owners are unwilling to exit, the strategy can have several benefits for the company.

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