Pros and Cons of Leveraged Buyout
The leveraged buyout (LBO) model sounds almost like a sleight of hand. Rather than pay cash to take over a corporation, you use debt. Your collateral is the very company you're trying to buy. If things go south after the LBO, you may lose your new acquisition, but your risk is otherwise low. Even so, you should know the LBO advantages and disadvantages before rolling the dice.
Purchasing a company via an LBO buyout appeals to several kinds of investors:
- It may interest those investors who want to take a public company private. Using an LBO to purchase a majority of the shares and take them off the market is one way to do it.
- It may interest investors who want to break up a company. For a leveraged buyout example, suppose you analyze a large company and realize it's so inefficient and unwieldy that the parts are worth more than the whole. You buy the company via the leveraged buyout model and then sell enough branches or divisions to pay off the loan.
- The buyer thinks the company is poorly managed and could be worth a lot more under new ownership. If you purchase the company and then improve operations, you can sell it for more than you paid for it. Alternatively, you can pay off the LBO loan with the increased profits.
- Current stockholders will see the price of their shares surge under the leveraged buyout model. Investors who go LBO often hold substantial shares already.
- You're part of current management, and you think you could manage better if you didn't answer to the current owners. This is an LBO subcategory: the management buyout.
- Private equity firms receive compensation based on the rate of return on investments. Because the equity investment is relatively small, the returns look large.
If you've found a potential purchase, the first step is to do lots of number crunching. The leveraged buyout model is complicated. You'll need lots of financial data to get a sense of the particular LBO advantages and disadvantages.
- How stable and predictable is the potential acquisition? If the company tanks in value down the road, that could wreck your ability to pay off the debt.
- What do the financial forecasts for the target look like? If there are none available, you may have to pay someone to draw one up.
- What's the corporation's cash flow? Is it predictable? Steady cash flow is essential if your acquisition is to pay off the debt you've borrowed.
- How much debt do you want to assume to make the buyout? How much debt can you afford?
- How much interest will you have to pay off?
- If you're hoping for private-equity funding, what sort of return will they get?
- Run a sensitivity analysis of the possible outcomes. That's business speak for looking at what-if scenarios resulting from the LBO. For example, are there variables that could change and screw up your financial projections?
There are two main ways to structure an LBO. One is to gain control of the company and then take over its assets. The other is to absorb the company into your own. Some investors prefer the first choice, as it shields them from inheriting the other company's liabilities.
There are also several different ways to finance the debt side of the purchase:
- Conventional bank lending.
- Bonds, often junk bonds.
- Mezzanine lending. These are loans subordinate to more senior loans, so if everything falls apart, the mezzanine lender may not get paid. The rate of interest is high enough to compensate for that.
- Seller financing. You give the seller a promissory note that you'll pay off over time. This is common for small or midsize LBOs.
- Taking out loans against the target's assets. This is an option if they have new equipment or substantial real estate.
When you have the financing lined up, you approach the board and owners of the target company with an offer and see if they bite.
The leveraged buyout model offers a lot of benefits. You acquire another company at almost no risk, and they pay off the debt, not you. Like most business strategies, the LBO has advantages and disadvantages, but the advantages are considerable:
- You'll have to put some money into the purchase, but nowhere near as much as in a regular buyout. The premise of the leveraged buyout model is that debt does most of the work.
- If the acquisition tanks after the purchase and can't pay off the debt, your company and personal finances are safe. You don't owe the money.
- Because the purchase is debt driven, an LBO can give your company some tax advantages.
- If everything goes well, you can expect an excellent rate of return on the equity you put into the company.
- The seller usually won't object to selling the company as long as the price is good enough. However, your lenders may want a protracted investigation into the company, which can frustrate the seller if they're ready to exit.
Despite the benefits of going LBO, the cons to using a leveraged buyout are considerable too. The big one is that you're saddling your acquisition with a massive debt load. If you can't make the company as profitable as your financial projections indicated, it may not be able to pay off the debt.
Even if your management skills are top notch, there's no guarantee. The acquisition's debt burden is equal to almost the value of the company, which is a lot to pay off. If it breaks under the strain, you may lose your investment, and you won't realize the big returns for which you hoped.
From 2007 to mid-2014, LBO defaults represented a third of the total volume of defaulted debt. One 2019 study found that 20% of LBO purchases go bankrupt within a decade as compared to 2% of a control group. There is very little margin of error in an LBO.
Another consideration is that even if the target company has the cash flow to make debt payments, it will have much less money to spend.
- It's harder to replace assets or to repair and maintain them. By the time the debt is paid off, physical assets may have aged a lot.
- The company may have to curtail R&D expenses, pulling the company away from the cutting edge of the industry.
- The leveraged company may downsize, which puts a lot of employees out of work.
Executives and board members typically gain from an LBO. The stock goes up, which boosts top executives' pay, while the board gains from selling its stock in the company. This raises the possibility of a conflict of interest and litigation arising out of it.
The board and managers of the company have a fiduciary duty to look to the company's interests. Giving them stock options or bonuses based on stock prices is supposed to tie them together. An LBO offer for their stock, however, could make them rich even if the company files for bankruptcy later.
In one leveraged buyout example, the Tribune company went through an LBO and then filed for bankruptcy. In the wave of lawsuits that followed, creditors and shareholders charged former directors and officers with a breach of fiduciary duty. It took several years before a court decided that the directors could not be held liable.