Leveraged Buyouts

In one our articles titled 'Money management as a lucrative business', we had mentioned about the leveraged buyouts, commonly referred to as LBOs. We had promised to carry out research and are pleased to give more details on the subject. A leveraged buyout (or LBO) or highly-leveraged transaction (HLT) or "bootstrap" transaction occurs when a financial agency gains control of a majority of a target company's equity through the use of borrowed money or debt in the form of bonds or loans. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. 

The purpose of leveraged buyouts is to allow companies to make larger acquisitions without having to commit a lot of their own capital. In a high risk LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the bonds issued are not investment grade and are referred to as junk bonds. Because of extensive past failures, this ratio is rarely observed in practice. In a medium risk LBO, the ratio is approximately 70% debt to 30% equity or 2:1. This is similar to the techniques in the martial art of Judo, in which a Judoka uses the strength of the opponent to throw him or her down. In the LBO industry's infancy in the late 1960s, the acquisitions were called "bootstrap" transactions. The industry was conceived by people like Mr. Jerome Kohlberg, while working on Wall Street in the 1960s and 1970s and pioneered by the firm he helped found with Mr. Henry Kravis - Kohlberg, Kravis, Roberts & Co. (KKR). This is the most well known, aggressive firm noted for its bold, large and successful bids.

A leveraged balance sheet has a small portion of equity capital and therefore a large portion of loan capital which is essentially a debt. The return (profit) of the firm will be "leveraged" to the equity capital and produce a large return on equity (ROE) for the owners risking their money. Typically, the loan capital is borrowed through a combination of prepayable bank facilities and/or public or privately placed bonds, which may be classified as high-yield debt, also called junk bonds. The debt will appear in the acquired company's balance sheet and the acquired company's free cash flow will be used to repay the debt.

Historically, many LBOs in the 1980s and 1990s focused on reducing wasteful expenditures by corporate managers whose interests were not the same as shareholders. After a major corporate restructuring, which may involve selling off portions of the company or assets, called asset stripping, and severe staff reductions, the entity would be producing higher income streams. Because this type of management arbitrage and easy restructuring has largely been accomplished, LBOs today focus more on growth and complicated financial engineering to achieve their returns. Most leveraged buyout firms look to achieve an internal rate of return in excess of 20%.

Leveraged buyouts have had an infamous history, especially in the 1980s, when several prominent buyouts led to the eventual bankruptcy of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100% and the interest payments were so large that the company's operating cash flows were unable to meet the obligation. This is referred to as 'bottom falling apart'. In response to the threat of LBOs, certain companies adopted a number of techniques, such as the poison pill to protect themselves against hostile takeovers by effectively self-destructing the company, if it were to be taken over. This is not a wise technique and akin to committing suicide. But the fact remains that a determined predator can afford to bide his time and keep the war ongoing because that is his business. This is basically a guerilla tactics. However, the target company's management will lose its focus from its real business. 

It is ironical that a company's success, in the form of assets on the balance sheet, can be used against it as collateral by a company that acquires it. For this reason, some regard LBOs as a ruthless predatory tactic. Many insecure companies may even consider going private and delisting from the exchanges. This however does not mean that they are safe or such firms will not bid for them or they will not sell out to such firms, if the price is right. In October - November 2006 alone, the much respected and regarded Canadian promoter of Four Seasons Hotel sold his highly reputed chain to Mr. Bill Gates and a Saudi Arabian Prince in a friendly buyout. The May family sold their radio stations to an investment group. Wallace family promoted 'The Readers Digest' was acquired by another private equity firm. Though they are commonly known as the 'Barbarians at the Gate', there is nothing barbaric in their techniques. Rather they use highly advanced and sophisticated financial engineering techniques. They just know how to use money power when the prey is fat, juicy, attractive, mouth watering and weak. The Cheetah spots it prey amongst the large numbers in a herd and is very focused. It may go hungry, if it fails on rare occasions, but does not change its target. It is a jungle out there and if you are careless, you will definitely get gobbled up. There is no point in name calling. The LBO firms can be compared to the Cheetahs. Amongst all large predators, the Cheetah is the most dangerous. It is very sleek, fast, ferocious and focused. 

References:

Wikipedia web site www.investopedia.com

The Washington Post The New York Times Bloomberg News Google News Summary  

The above article is an abridged and condensed version of the original published under the same name by www.madgopes.com on November 19, 2006. Paying members of madgopes.com can access the original article from its article index page.

Copyright. November 14, 2007. www.madgopes.com . All rights reserved.

To learn more about this author, visit Madhavan T Gopalachary's Website.

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