A leveraged buyout (LBO) is through which a company acquires another with capital borrowed. The capital is financed through loans or bonds. The assets of the firm being purchased are sometimes used as collateral for the repayment of loans. Despite that, due to the risks involved the financing for leveraged buyouts is often seen as high risk. The risks involved are usually tied to the valuation of the business acquired, and the possible costs of integrating both companies. Therefore the acquiring company will often have to pay a hefty interest expense.
Leveraged buyouts can sometimes lead to proxy fights, if either the management or some shareholders are opposed to the acquisition. This can lead to a tedious and extenuating process between both sides of the acquisition. Leveraged buyouts were exceptionally common during the 1980s when this practice really boomed. Recently leveraged buyouts have become an attractive acquisition method for private equity companies looking to improve their return on equity.
What is the process of a leveraged buyout?
Leveraged buyout begins with selecting targets. Oftentimes the acquirer will look for companies within its own industry, in order to diversify and grow. The buyout may involve horizontal or vertical integration, depending on the available options and the strategy employed. Management will then research their acquisition targets in order to understand their financials and the possible value they could add if both companies were to be combined.
In some cases, companies will benefit from a leveraged buyout. If they operate in the same industry there are clear advantages to combining both businesses. One of them is the possible reduction of expenses due to integration.
Once the research is done, and the estimated value of the company is calculated, analysts will project and estimate the future value of the combined companies. They will also project the financial results of the new combined entity. The research, estimates, and projections are then presented to lenders in order to raise financing to conduct the acquisition. If the acquisition seems feasible and the risk is within a certain threshold, investment banks will then assist the company in choosing the best financing option.
Once everything is approved, the acquirer can then proceed to make an offer on the buyout target.
Why are leveraged buyouts common?
Leveraged buyouts have become increasingly more common because they do not require extensive amounts of capital. Therefore private equity firms usually see this as a great opportunity to expand the assets they control, without committing capital. As long as the acquirer has a strong balance sheet, they will most likely be able to get financing to acquire their buyout target.
- It does not require lots of capital
- A leveraged buyout may be beneficial to both companies
- Low-interest rates facilitate leveraged buyouts
- The acquisition can lead to lower expenses
- Allows the acquiring company to improve its return on equity
- The acquirer can control more assets without a lot of capital
- Financial institutions financing the buyout are able to generate great returns
Benefits of a leveraged buyout
There are certainly several risks associated with leveraged buyouts but there are also some advantages both to the acquirer and the acquiree.
Leveraged buyouts are usually attractive due to the increased return on equity firms are able to generate.
They also allow the company to control more assets without needing lots of capital initially. Since leveraged buyouts are funded with the buyout target’s assets.
Another clear advantage stems from taking a company from public to private. This allows the management to be less scrutinized, by shareholders and other entities. Therefore it can swiftly enforce many business-related changes. This can have a very positive impact on the company’s financial performance. Without being questioned by shareholders, and board members publicly.
Leveraged buyouts can also be a way of dealing with deteriorating reputation challenges. Being a private company has several advantages, and less public attention allows management to make changes easier.
Drawbacks of a leveraged buyout
There are some clear risks associated with leveraged buyouts. Perhaps the most daunting is the possibility that the company will eventually go bankrupt. However, there are some other potential damaging consequences that are not so direct.
The acquired company might see its balance sheet deteriorate significantly, and the additional debt burden could drastically affect its financial results.
Another direct consequence of a leveraged buyout is the increase in the company’s interest expense. A leveraged buyout will often have a high debt-to-equity, and therefore its bonds and loans are viewed as high risk. Bonds issued with the purpose of conducting a leveraged buyout are often seen as junk bonds, due to the risks associated. This also means that their coupon rate is usually higher. Therefore this could put additional financial pressure on the acquiring firm. Since their interest expense will certainly be higher following the leveraged buyout.
Sometimes the acquirer will often enforce cost-cutting changes that could include layoffs. This poses a reputational threat to the company.
A leveraged buyout can also lead to a proxy fight and a hostile takeover scenario. This in turn can create all sorts of negative indirect consequences. Most of them are related to the management, and the decisions and operational side of the business.
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