Leveraged Buyout (LBO) is a term which is used to indicate the leverage or loan taken to buy out a company by the current management or employees or any other private equity firm. The key idea is to fund the cost of acquisition mainly by taking loans from other financial institutions rather than using own money. In this case, huge amount of fund (as high as high 90% of deal amount) are borrowed from the market in order to complete the acquisition which leads to very high debt to equity ratio as well.
So the first question will come to our mind, how come such a big amount of loan is approved for Leveraged buyouts. That is because; assets of the new company as well as the acquiring company are used as collateral to get the loan. Also the management capability and current economic condition play an important role in getting the huge fund as loan.
The purpose of Leveraged buyout is to enable companies to make large acquisitions (sometimes higher than its own size) without investing lot of own capital. Also it increases debt burden on the acquiring company significantly which also leads to financial discipline for the management team, more cost cutting, selling of unused assets, huge layoffs.
Leveraged Buyout Plan Scenarios
There are different scenarios when a Leveraged Buyout is to acquire a company or part of a company. The scenarios are explained below:
1. The Repackaging Plan
The first scenario is Repackaging Plan in which a private equity fund or management use leveraged loans to buy all the listed shares of company to convert to a private company from public listed company in order to repackage the company and come back to stock market again after the desired change. Sometimes, conversion of public company to private company is necessary so that the repackaging or restructuring can happen smoothly without any interference of the shareholders. Post successful repackaging, the company can list its shares again through fresh Initial Public Offering (IPO).
For this plan to be successful, the offer price has to be higher than the current market price so that shareholders willingly sells all the shares and also the plan to repackage the company should show the desired result in order to sustain in the business and give desired return to the Private Equity firm and the management.
2. The Split-Up
The second scenario is “Split Up” (also known as “slash and burn” and “cut and run”) which aims to get the maximum valuation of different businesses or units of a big company by splitting them in different units so that the maximum valuation and growth can be achieved. This is applicable for big conglomerates which have acquired or moved into different types of businesses over the years but unable to manage all of them due to losing interest and lower growth of some businesses. It becomes a liability over the time, if the desired growth is not achieved over a period of time.
In this scenario, a big conglomerate is broken up in different entities and sold all of the businesses with lower interest considering current economic and business scenario. The conglomerate keeps only the key business with higher interest and economic value. Private equity firms acquire the other parts of company and invest on them so that they can grow on their own. Sometimes, the parts are sold to other companies as well with the similar line of business. Once the growth is achieved, Private equity firms sell these parts at a much higher price with handsome profit.
This scenario often leads to huge layoffs and management restructuring. That’s why it is a very tough decision to make by the management of a company.
3. The Portfolio Plan
This is the third scenario in which a company uses leverage buyout facility to acquire one of its competitor in the same business line in order to achieve high synergy and higher growth. In this case, both the companies look to achieve higher growth using the synergy but this is a very risky approach.
The success formula of this scenario is that the return on invested capital or growth has to be higher than cost of acquisition or merger. Once successful, then all parties involved in the transaction including shareholders of acquired and acquiring company, employees and management will benefit out of it.
4. The Savior Plan
This is the fourth scenario in which management and employees of a struggling company borrow money from a private equity company in order to save the company. As the name indicates, this plan aims to save a falling company through borrowed cash. Mostly this plan comes very late when all the other methods were used to save the company and failed.
Once successful, everyone associated with the company as well as the investor got benefited.
Disadvantages of LBO
There are some disadvantages associated with Leveraged Buyout.
In spite of all the disadvantages, LBO can be used to successfully revive a struggling company if it is planned properly and timing is right. Companies with a very low debt level can also use LBO to acquire competitor companies to expand business.