Leveraged buyout

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A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or "bootstrap" transaction) occurs when a financial sponsor gains control of a majority of a target company's equity through the use of borrowed money or debt.

A leveraged buyout is a strategy involving the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. 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 large acquisitions without having to commit a lot of capital. In an LBO, there is usually a ratio of 70% debt to 30% equity.

In the industry's infancy in the late 1960s the acquisitions were called "bootstrap" transactions, and were characterized by Victor Posner's hostile takeover of Sharon Steel Corp. in 1969. The industry was conceived by people like Jerome Kohlberg, Jr. while working on Wall Street in the 1960s and 1970s, and pioneered by the firm he helped found with Henry Kravis, Kohlberg Kravis Roberts & Co. (KKR).

KKR is credited by Harvard Business School as completing what is believed to be the first leveraged buyout in business history, through the acquisition of Orkin Exterminating Company in 1964. However, the first LBO may have been the purchase by McLean Industries, Inc. of Waterman Steamship Corporation in May 1955. Under the terms of that transaction, McLean borrowed $42 million and raised an additional $7 million through issue of preferred stock. When the deal closed, $20 million of Waterman cash and assets were used to retire $20 million of the loan debt. The newly elected board of Waterman then voted to pay an immediate dividend of $25 million to McLean Industries. ^[1]

A special case of such acquisition is a management buyout (MBO), which occurs when a company's managers buy or acquire a large part of the company. The goal of an MBO may be to strengthen the managers' interest in the success of the company. In most cases, the management will then take the company private. MBOs have assumed an important role in corporate restructurings beside mergers and acquisitions. Key considerations in an MBO are fairness to shareholders, price, the future business plan, and legal and tax issues.

A leveraged balance sheet has a small portion of equity capital and therefore a large portion of loan capital. 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. Often, the debt will appear on the acquired company's balance sheet and the acquired company's free cash flow will be used to repay the debt.

The purposes of debt financing for leveraged buyouts are two-fold:

1. The use of debt increases (leverages) the financial return to the private equity sponsor. Under the Modigliani-Miller theorem,^[2] the total return of an asset to its owners, ceteris paribus and within strict restrictive assumptions, is unaffected by the structure of its financing. As the debt in an LBO has a relatively fixed, albeit high, cost of capital, any returns in excess of this cost of capital flow through to the equity.
2. The tax shield of the acquisition debt, according to the Modigliani-Miller theorem with taxes, increases the value of the firm. This enables the private equity sponsor to pay a higher price than would otherwise be possible. Because income flowing through to equity is taxed, while interest payments to debt are not, the capitalized value of cash flowing to debt is greater than the same cash stream flowing to equity.

Historically, many LBOs in the 1980s and 1990s focused on reducing wasteful expenditures by corporate managers whose interests were not aligned with shareholders. After a major corporate restructuring, which may involve selling off portions of the company and severe staff reductions, the entity would likely be producing a higher income stream. Because this type of management arbitrage and easy restructuring has largely been accomplished, LBOs today (2006) 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%.

Failures

Some LBOs in the 1980s and 1990s resulted in corporate bankruptcy, such as Robert Campeau's 1988 buyout of Federated Department Stores and the 1986 buyout of the Revco drug stores. The failure of the Federated buyout was a result of excessive debt financing, comprising about 97% of the total consideration, which led to large interest payments that exceeded the company's operating cash flow. In response to the threat of LBOs, certain companies adopted a number of techniques, such as the poison pill to protect them against hostile takeovers by effectively self-destructing the company if it were to be taken over.

Notable leveraged buyout firms

• ABRY Partners
• Bain Capital
• Bear Stearns Merchant Banking
• Belvedere Capital
• The Blackstone Group
• The Carlyle Group
• Goldman Sachs Capital Partners
• Hellman & Friedman
• Kohlberg Kravis Roberts & Co.
• Madison Dearborn Partners
• Providence Equity Partners
• Silver Lake Partners
• TA Associates
• Francisco Partners
• Texas Pacific Group
• Thomas H. Lee
• Warburg Pincus
• Welsh, Carson, Anderson & Stowe

Europe-based

• Apax Partners
• BC Partners
• Bridgepoint Capital
• Candover
• Cinven
• CVC Capital Partners
• Permira
• Terra Firma Capital Partners
• 3i

See also

• Private equity
• Bootstrap
• LBO

 

Notes

1. ^ Marc Levinson, The Box, How the Shipping Container Made the World Smaller and the World Economy Bigger, pp. 44-47 (Princeton Univ. Press 2006). The details of this transaction are set out in ICC Case No. MC-F-5976, McLean Trucking Company and Pan-Atlantic American Steamship Corporation--Investigation of Control, July 8, 1957.
2. ^ Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance, and the Theory of Investment," American Economic Review, June 1958.

External links

• Takeovers and Leveraged Buyouts
• Financial dictionary: Bootstrap transaction
• Feb 1993 - The CPA Journal Online (accounting for a bootstrap transaction)