A leveraged buyout (LBO) is when one company buys another company using mostly borrowed money. The buyer puts up the company being bought as collateral for the loan, and the purchased company assumes the debt on the loan. If the newly acquired company cannot pay back the debt, the lender can then take over the company and sell its assets to satisfy the debt.
Leveraged buyouts are common for companies during acquisitions. If another company is acquiring your company or if you are planning on purchasing a company through a leveraged buyout, it is crucial that you understand the dos and don'ts of a leveraged buyout.
Our team of experienced corporate lawyers here at Newburn Law can help you every step of the way.
When do companies use leveraged buyouts?
Companies use LBOs primarily in three ways:
1) To privatize a public company,
2) To break up a large company by selling off parts of it, and
3) To improve a company that's not performing well.
With leveraged buyouts, the overall goal is to increase the company's equity value as the debt is paid off. Therefore, making more profits for investors.
Purchasing a company through an LBO is similar to taking a mortgage on a home. You make a down payment on the home and borrow the rest of the money from the bank. You then pay down your mortgage over time. Your home is used as collateral for the loan. While you are paying off your debt on your home, your equity in the home is increasing. You may also make improvements to the home, which further increases its value. Later, when you sell your home, you can make a profit from the increased equity and value of your home.
How does a company's value increase after a leveraged buyout?
The same general concept applies to LBOs. When a company is acquired through an LBO, the purchaser, usually a private equity firm, borrows most of the money to make the purchase. As the debt is paid down, the equity in the company grows.
At the same time, the new company may also make improvements to its business, increasing the company's value. When the investor later sells its shares in the company, it hopes to make a profit.
Who conducts LBOs?
Private equity firms conduct most LBOs. However, any entity with access to lenders can buy a company through an LBO. Nonetheless, a typical LBO involves a private equity firm that raises funds using different types of debt to pay for the purchase. Investors put their money into the private equity firm for the LBOs, expecting an eventual return on their investment.
Paying Back the Debt
LBOs are made on the assumption that the newly acquired company will be able to make enough money to pay back the debt on the loan. The debt-to-equity ratio for a typical LBO is 90% debt and 10% equity.
Since LBOs are primarily funded through debt, they have historically happened more often when interest rates are low. LBOs are popular partly because if the company goes south, the debt can be written off as a tax loss. But critics argue that LBOs often benefit private equity firms at the expense of the company's employees, noting that about 20 percent of companies acquired through LBOs file for bankruptcy within ten years.
Additionally, some critics refer to LBOs as predatory. In some instances, private equity firms engage in so-called hostile takeovers, which means the target company's upper management and employees oppose the buyout.
Typical Leveraged Buyout Structure/Methods
In the typical LBO, the private equity firm will form a new entity to acquire the company they are purchasing. After the purchase, the target company becomes a subsidiary of the new entity.
A common LBO structure is where a private equity firm uses the LBO to privatize a public company. The purchaser takes out a loan and then buys up all of the company's outstanding shares, using the company as collateral for the loan. This is basically the opposite of what happens when a private company goes public. In that case, the private company sells shares to the general public.
With a public to private LBO, the company is buying up the shares from the public and creating private equity. The new company can later go public again, with the owners selling the stock shares for a profit.
Best Practices for a Leveraged Buyout
Some companies are better targets for LBOs than others. For an LBO to succeed, for example, the target company needs to have a track record of solid, predictable revenue to repay the loan. The main goal for investors in LBOs is to implement cost-cutting programs while increasing revenue to grow the company and improve EBIDTA.
To meet those goals, companies will often look at the following factors:
The company should have a good cash flow. Cash flow is the cash a company has on hand and is readily accessible. The more cash flow a company has, the easier it will be to make payments on the debt, particularly if there's a downturn in the economy and the company is bringing in lower revenues. Businesses with high cash flows tend to be mature companies with strong brands, high customer demand, and long-term sales contracts.
Tangible and Strong Asset Structures
Good LBO candidates will also have tangible and strong asset structures that can serve as solid collateral for loans, such as inventory and cash, and physical assets such as property, plants, and equipment. Assets like these are easily valued, so a purchasing company can get a cheaper loan when acquiring a business with these assets. A company with divested assets is also a good LBO target if the company can easily sell the assets to pay off debt.
Companies with clear potential for better management and cost-cutting—in other words, companies that have strong potential for growth and increased profits—are also good LBO candidates. Along these lines, savvy purchasers will target companies they deem to be undervalued.
No or Low Existing Debts
Additionally, companies with no or low existing debts are good LBO candidates. Companies with debt on their balance sheets are riskier because they're already paying out of their cash flow to pay their debts. The higher the cash flow, the quicker the company can pay off the debt. An LBO purchaser may face lawsuits from the shareholders of an acquired company if the purchaser uses an LBO to load up the company with debts that cannot be repaid.
Solid Exit Strategy
Finally, an effective LBO will have a solid exit strategy. This means the purchaser has options in case a deal goes bad. For example, there should be solid assets in the newly acquired company that can be sold to pay off the debt if the company fails. There should also be willing buyers for the newly acquired company if the private equity firm decides to sell the company.
Key Things to Look Out For
As we mentioned previously, various factors can determine whether an LBO is a good strategy for an investor, private equity firm, acquiring company, or company being acquired. To summarize, a good LBO will have the following characteristics:
- Where the buyers have maximized shareholder value by making the company more profitable
- Where the increased debt levels have brought down the acquired company's taxable income, therefore increasing the company's value
- Where a public to private LBO resulted in better management and increased profits
- Where the company's revenues are higher than the interest payments, resulting in a higher return for the equity holders in the company
- Where the purchaser has a solid exit strategy
However, every LBO is different. You should always consult with an experienced corporate attorney to understand whether an LBO is a right option for you.
Types of Financing in a Leveraged Buyout
There are various types of financing for LBOS, including, most commonly, through:
- Private investments
These types of financing all require collateral for the loans. A different kind of financing sometimes used is mezzanine debt, which refers to debt without collateral to secure it.
These types of loans are more expensive than collateralized debt. Finally, in what is known as seller financing, the seller company will sometimes defer payments on the purchase price to the newly acquired company.
Examples of Famous Leveraged Buyouts
There are many examples of leveraged buyouts, both successful and unsuccessful. Some of these include:
Hilton Brand Hotels
One famous example of a highly successful LBO was the purchase of the Hilton brand hotels by private equity firm Blackstone Group in 2007. Blackstone bought Hilton for $26 billion, financing almost 80% of the purchase. Blackstone bought all of the common stock, paying $47.50 a share.
Of course, this was just a year before the real estate bubble burst in 2008 and the stock market crashed. Just 18 months after the LBO, Hilton's revenues were down by 20 percent, and Hilton's value was down by almost $4 billion.
But Blackstone went on to turn Hilton into a wildly successful company. It did this by first determining that Hilton was poorly managed, leading to poor customer experiences. Blackstone hired CEO Chris Nassetta, the then CEO of Host Hotels, to turn the company around and make it more profitable.
Blackstone also hired a new management team, requiring them to spend their first three days working at the hotel's front desk, housekeeping, and dining areas. Blackstone also implemented an employee performance evaluation system, digitized the Hilton Honors rewards system, and placed Hilton into international markets with new Hilton brands. Finally, Blackstone restructured Hilton's debt, which allowed it to pay down the debt more quickly.
In 2013, Blackstone took Hilton public, with an IPO share price of $20, with Blackstone owning 76% of the shares. Between 2013 and 2018, Blackstone slowly reduced its stake in Hilton. When Blackstone later sold its last 5% stake in the company in 2018, it had made a whopping $14 billion profit.
The Hilton LBO was successful for several reasons. First, Blackstone was already in the hospitality business and knew how to run worldwide companies. Next, Hilton was already a mature company with a strong brand. Hilton also had strong assets—its properties—that could be used as collateral for the debt. Finally, Blackstone had a solid exit strategy if it couldn't turn Hilton into a more profitable company—it could simply sell the Hilton's properties to pay off the debt.
On the opposite spectrum, a good example of a failed LBO was the purchase of Texas energy company TXU Corporation for $45 billion in 2007, the largest LBO in history at the time. The new company was renamed Energy Future Holdings Corporation. The buyers calculated that natural gas prices would rise with increased demand and dwindling supply. But natural gas costs soon plummeted, and the investors, including Warren Buffet's Berkshire Hathaway company, lost hundreds of millions of dollars. In 2014, Energy Future Holdings filed for Chapter bankruptcy.
Toys R Us
In another failed LBO, private equity firms Bain Capital and KKR and real estate investment firm Vornado bought the children's retail store Toys R Us in 2005, taking the company private. The retail giant was already saddled with $1.86 billion in debt when it was bought and had poor cash flow. After the buyout, it had more than $5 billion in debt. Moreover, the buyers didn't account for the rise of Amazon and the competitors for market share, such as Walmart and Target. In 2017, Toys R Us filed for bankruptcy, closing all of its retail stores in the United States by 2021.
The Future of Leveraged Buyouts
LBOs saw an uptick in 2021 as the economic effects of the COVID-19 pandemic lessened. As interest rates remain low and private equity firms have accumulated historically high capital reserves, LBOS are on the rise. In June 2021, in the largest LBO since the 2008 financial crisis, a consortium of private equity firms bought Illinois-based Medline Industries, a family-owned medical equipment maker, for $30 billion. The family selling Medline Industries stands to receive $22 billion from the sale and will retain 25% ownership in the company, with existing management continuing to run the company.
If you have any questions about leveraged buyouts, how they work, and whether or not a leveraged buyout is a right fit for you and your company, contact us today. We can answer any questions you might have through a free consultation.