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Leveraged Buyout : Is it Worth the Risk ?

Posted in Finance Articles, Total Reads: 8174 , Published on July 19, 2011

A leveraged buyout or LBO is the acquisition of a company or division with borrowed funds.  In LBO, the firm acquiring the target company will finance the acquisition with a combination of debt and equity. It is similar to individual buying a rental house with a mortgage. In case of mortgage, it is secured by the value of the house being purchased and in some cases; rental income from the house is used to pay down the mortgage.  Similarly, some portion of the debt incurred in an LBO is secured by the assets of the acquired business. The cash flow generated by bought out service is used to service the debt incurred in its buyout.

Leveraged Buyout

In successful LBOs, equity holders tend enjoy higher gains as debt holder are locked to fixed returns.  Since majority of the financing is done using borrowed funds, buyer’s need to be very cautious before deciding the suitable target for LBO. Some of the characteristics which a buyer may look into before deciding on the target are:

  • Steady and predictable cashflow
  • Clean balance sheet with little debt
  • Less working capital requirements.
  • Less future capital requirements
  • Heavy asset base for loan collateral
  • Divestible assets
  • Viable exit strategy
  • Synergy Opportunities
  • Potential expense reduction.

How does the buyer finance the transaction?

Most leveraged buyouts make use of multiple tranches of debt to finance the transaction. Following are some of them in decreasing order of seniority.

  • Bank Debt:  It is generally provided one or more commercial banks. Bank debt has the senior claim on the assets of the Company, with bank debt principal and interest payments taking precedence over other, junior sources of debt financing. Bank debt is comprised of two components, revolving credit facility and term debt. Revolving credit facility is designed to offer bought out firm flexibility in terms of their capital needs. Most of the times it is used to cover the working capital requirements and to meet any unexpected increase in the expenses. Credit facilities usually have maximum borrowing limits and conservative repayment terms. Company uses excess cash flow to repay outstanding borrowings against its credit facility. Term debt is secured by the assets of the bought out firms and is provided by banks and insurance companies in the form of private placements. The interest rate for term debt is generally kept above treasury notes with a maturity of five to ten years.
  • Mezzanine Financing: It exists in the middle of the capital structure and generally fills the gap between bank debt and equity in the transaction. It is a junior form of debt and can take the form of subordinated notes from the private placement market or high-yield bonds from the public markets. It is higher risk financing and often compensated by higher interest rates.
  • Equity financing: Most of the times private equity invest alongside management to ensure the alignment of management and shareholder interests. In large LBOs, private equity firms will sometimes team up to create a consortium of buyers, thereby reducing the amount of capital exposed to any one investment. Generally, private equity owns anywhere between 70%-90% of the equity while rest of the equity is held by management and former shareholders.

Pros and Cons of Leverage Buyout

  • Large principal and interest payments can force management to improve performance and operating efficiency. Debt discipline may force management to take strict measures for cost cutting, downsizing which leads to overall shareholder return.
  • Interest payments on debt are tax deductible, while dividend payments on equity are not. Thus, tax shields are created and they have significant value.
  • The most obvious risk associated with LBO is that of financial distress. Recession, drastic change in environmental variables, change in regulatory environment can lead to difficulties in interest payments which may lead to debt default resulting in equity holders losing their entire investment.
  • Increase in fixed costs from higher interest payments can reduce a leveraged firm’s ability to weather downturns in the business cycle.

Valuations used for companies which are acquired using LBO funds are generally done using market comparisons or discounted cash flow analysis. In case of market comparisons metrics such as multiples of revenue, net earnings and EBITDA that can be compared among public and private companies. DCF Analysis is based on the concept that the value of a company is based on the cash flows it can produce in the future.

LBO route for acquisition is considered to be one of risky way of acquisition and due diligence is required before going for acquisition.

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