Leverage is the term used for funding a project through debt financing. A leveraged buyout is the use of borrowed capital to acquire a company. Private Equity firms actively perform LBOs to acquire public companies, convert them to private firms, and then sell them off. An LBO is one of the several types of mergers and acquisitions of a company.
A Leveraged Buyout happens when a company is acquired through debt financing as the main source of funding.
The leverage ratio in LBOs is typically higher ranging from 70-90% with minimum possible equity contribution.
How Do Leveraged Buyouts work?
The prime motive behind the Mergers and Acquisitions is gaining Synergy. The acquirer company looks to gain access to greater market share, potential financial gains, or access to significant assets. Access to intangible assets such as patents or research resources has become a modern motive behind the M&As.
The acquirer company pitches acquisitions bids to the acquired company shareholders. Acquirer firms use hostile tactics to ensure their bids get approved by the target company’s BOD. The acquirer company’s aim to fund the takeover is through leveraged financing here.
In an LBO, the acquirer companies use the target company’s assets as collateral to raise debt financing. However, the acquiring firm can also pledge its own assets as additional cover to secure large debts.
The Private Equity firm or acquirer begins with an estimation of the target company’s valuation. They perform the sensitivity analyses of the takeover against the forecasts. The acquiring firm then includes the debt costs and analyze them against the forecast financial model. The forecast financial model is used to convince the lenders to fund the buyout. The PE firm embeds the interest costs and debt servicing costs and calculates a forecast rate of return on investment.
Methods of Financing Leveraged Buyouts
A leveraged buyout can be financed in several ways. The aim is to utilize maximum debt financing sources. The acquiring firm also has to use a portion of the equity in the buyouts.
Private Equity Firms
Private Equity firms actively sponsor the leveraged buyouts. They seek a high rate of return on the investment. With a large investment in a buyout, the private equity firms also take significant control of the target company’s management as well.
As the acquirer firm uses the target company’s assets as collateral, in the sense the target company facilitates the borrowing. Once the acquisition completes the acquired firm becomes part of the acquirer.
Large buyouts require significant debt financing. The sponsoring private equity firms also use the bank financing options to fund the buyout. Usually, they utilize different banking loans to fund total takeover costs.
A revolving line of credit secured senior debt, and term debts are common forms of bank financing in an LBO. The banks almost always are interested in issuing senior debts backed by the first right in the lien. These loans are also secured by the target company’s assets as collateral. The sponsoring firms may also use their own assets as collateral to keep the bank financing secure. A secured bank loan would offer lower interest costs.
Subordinate Debt Financing
The acquiring firm and their sponsoring PE can also use subordinated loans. These are unsecured loans without any collateral pledge. The lenders would usually approve such loans at the applicant’s creditworthiness. The interest rates are significantly higher with subordinate loans. The lenders may sometimes ask for warranties from the borrowers with subordinate loans.
Bonds and Notes
Like other investments, a company can fund the leveraged buyout with bonds and notes as well. Large companies can issue bonds in capital markets to raise the funds. Unlike, coupon bonds, these bonds work as a debt instrument and not a source of income.
Why Leveraged Buyouts Happen
A common notion with leveraging is to reduce the cost of capital. The cost of equity is typically higher than the cost of debt financing. Debt financing reduces tax liability with interest deductions. Other common reasons for such high ratio leveraged transactions include lack of equity sources, access to debt financing, lucrative returns, and long-term investors, etc.
Motives behind Leveraged Buyouts
Leverage buyout is a tactic used in mergers and acquisitions. The motives behind a leveraged buyout are similar to that in the acquisition of another company. However, in a leveraged buyout, the acquiring firm aims to utilize the borrowed capital to acquire the target firm.
Acquiring a target firm with 10-20% of equity business remains a lucrative investment option for many private equity firms. Moreover, the acquiring firm pledges the target company’s assets as collateral to secure debt financing.
Apart from returns on investment, there are other key motives behind leveraged buyouts:
- Gaining control over a target firm that may be the competitor.
- Gaining greater efficiencies through synergy effects after the acquisition.
- Access to valuable tangible and intangible assets of the target company.
- Access to wider market share and customer base.
- Long-term investment with lucrative returns on debt financing.
- Access to technology, patent, and research of the target company adding value to the acquirer.
Most private equity firms acquire companies through LBOs to set them on IPOs in few years though. There can be several motives behind any M&A, similarly endless reasons to use the leverage buyout option.
Pros and Cons of Leveraged Buyouts
Leveraged buyouts present conflicting benefits and risks for both parties in the takeover. Hostile firms seek to maximize their financial gains. Target firms often see it as unethical and destructive.
Not all takeovers end up successful in the long-term. Similarly, if done rightly, the LBOs can yield significant synergy effects for both firms. The notorious reputation of LBOs comes with staff and management layoffs, company sell-offs, and split-ups.
Many leveraged buyouts end up as sell-offs of assets or parts of large companies within a few years. Private Equity firms also go for IPOs almost certainly once they acquire a target company and make it private.
Some key points regarding Leveraged Buyouts:
- Financing a hostile takeover with debt financing represents an unethical practice in many analysts’ views.
- LBOs encourage asset stripping.
- The acquired firm may not sustain the expected growth and go to bankruptcy.
- It results in layoffs and creates more joblessness in the market.
- Excessive risky financing such as LBOs may result in economic crunches as seen in the past in the GFC of 2008.
- Management and key employees of the target firm may pose resistance.
- It may not be easy to overcome the corporate culture differences and the synergic gains may not seem achievable.
If done correctly, a leveraged buyout may bailout a looming firm as well. The risks and returns with Mergers and Acquisitions are never straightforward. The use of leverage makes these transactions further complicated. However, leverage Buyouts can be a great way of combining two firms and creating added value for both investors and the acquired firm.