17 Feb Leveraged Buyouts
Previously, we blogged about leveraged buyouts. Here, I will discuss a bit more on what goes in with a leveraged buyout and what are some of the positives and negatives which are associated with this type of business financing. First, what is a leveraged buyout? As the name suggests, it is a simple reference to the use of leverage (or debt) to fund the purchase of a business. A company will “lever-up,” taking a very small portion of their own funds to purchase a business, while borrowing the remainder which could represent a great deal of money.
Here is how a leveraged buyout will generally go down (in the simplest terminology possible):
1. A company is purchased using an inordinate amount of debt.
2. The holding company(many times a private equity group) will hold the company for for a limited period of time.
3. Sometimes cash is taken out prior to selling.
4. In 3 to seven years you hopefully will sell for a massive return (IPO or an M&A exit) and reap the rewards of a great return.
Who are some of the more well-known companies who have engaged in such transactions? Bain Capital (Mitt Romney’s little babe), KKR, Cerberus, Texas Group and even Berkshire Hathaway has engaged in them (yes, they are more than a buyout fund).
Ah, yes, but how do LBOs add value? This is a fairly controversial question, especially among academics, but tax shields play a huge factor in the value created through leveraged buyouts. The practitioners themselves will claim LBOs help in the following ways:
- An LBO promotes debt disciplines for managers which forces cost cutting within the organization (RJR Nabisco anyone?)
- They can give companies better access to capital
- When the firm is not public, it gives more short-term access to potential necessary capital
- Assuming the PEG (private equity group) or purchasing entity holds better management expertise than the selling company, then expertise can help turn the company around, producing greater profits when the company is later sold.
And what types of firms are generally the type of candidate that would fit an LBO? Mature and declining industries with low growth and steady cash flows who are in need of necessary cost discipline implementation. In some cases, leverage can also help in bargaining with unions, but this particular benefit has never worked with Chrysler.
This will be the first in a series of posts surrounding LBOs. Please check back later for more information.