IN THIS CHAPTER
Understanding why leveraged buyouts are done
Examining the characteristics of target firms in leveraged buyouts
Understanding the importance of cash flow to leveraged buyouts
Finding out how returns on leveraged buyout deals are computed
Finding out how leveraged buyouts are exited
Leveraged buyouts (LBOs) are often viewed as the mystery thriller of the financial world. They’ve attracted the attention of the media and general public because of the high-profile players involved and the vast fortunes that have been made with them. The most famous LBO of all time was initiated by private equity firm KKR & Co. and involved the purchase of RJR Nabisco. This transaction was the subject of the book Barbarians at the Gate, by Bryan Burrough and John Helyar (Harper & Row), and spawned a movie with the same name.
Hollywood treatment of LBOs makes them seem full of intrigue, but most of the time, they’re not all that complicated. Private equity firms pool investors’ funds together and make investments in, among other things, leveraged buyouts and venture capital. The term private equity became widely known in the 2012 U.S. presidential campaign, because Mitt Romney was a principal in the private equity firm Bain Capital — a firm that engages extensively in LBOs. Much of the media focus was on the potential negative consequences of LBOs such as downsizing and job losses, but the media often neglected to focus on the very positive aspects of LBOs, which may include a more efficient allocation of resources, greater economic efficiency, and job creation in the long run. Like anything else, LBOs are neither universally good nor universally bad. In this chapter, we lay it out all out for you.
An LBO is conceptually a very simple transaction in which an undervalued or underappreciated company or a division of a company is purchased by a private equity or other sponsor firm. The purchased company is then transformed from being publicly traded — owned by shareholders who can freely buy and sell their shares of the firm — to one that is privately held by a much smaller group of investors who hold sizeable and largely illiquid — that is, very difficult to sell — ownership blocks.
As the name implies, leverage (or debt) plays a major role in this purchase and transformation. In fact, the primary source of funding is debt secured by the assets of the company being purchased — similar to how a homeowner borrows money via a mortgage to purchase a home. The home itself serves as collateral for the loan, and the lender’s recourse is to seize the assets in the event of default. Collateral is the specific property that a borrower pledges to a lender to secure repayment of a loan. In much the same way that the automobile serves as collateral for a car loan, specific assets of the firm will be pledged as collateral for specific loans in an LBO.
Unlike home flippers, the changes made by LBO sponsors are not new kitchens and bathrooms; instead, they’re often focused on cutting costs and making meaningful changes in the way the company operates. Some ways LBO sponsors may improve a company would be assembling the product overseas rather than domestically or jettisoning certain divisions of the company or simply changing the way a product is distributed or marketed. This is where private equity and LBOs have a negative connotation with some in the media and popular culture, because LBOs are often associated with job losses and downsizing.
Hawkers at sporting events often shout, “You can’t tell the players without a program!” The same is true in the world of LBOs. The major players involved in LBOs are investment banks, big institutions, company management, and the company’s stock and bond investors. They work together to transform the way companies operate and hopefully improve the way economies allocate scarce financial capital.
Investment banks are often accurately characterized as making money on all aspects of the investment process from helping take firms public through initial public offerings (IPOs) to advising those same firms as they become private through LBOs. In fact, some firms seem to be in an endless ownership cycle. They go public, private, and public again, often with the help of the same investment banks. It is, as they say, good work if you can get it and generates enormous fee income for investment banks.
Firms look to their investment bank to advise them when either they already have been identified as the target of an LBO or when they want to position themselves to be an attractive candidate for an LBO. There are many steps firms can take to put themselves in the best position to profit from an LBO and some of these characteristics are listed in the “Identifying companies that can work in a leveraged buyout” section, later in this chapter. Investment banks often utilize their extensive networks of contacts to gauge the interest of potential purchasers for firms who may be interested in being the target of an LBO.
Alternatively, investment bankers could be called upon to utilize their extensive network of contacts to find a strategic buyer who will pay top dollar for the new and improved firm. A strategic buyer is another firm that believes that when the company is merged into the strategic buyer’s firm, it will be a good and profitable fit. Finally, investment bankers may counsel the firm through a secondary leveraged buyout, effectively recapitalizing the firm once again. A secondary leveraged buyout simply takes the firm through another round of borrowing and transfers ownership to another private equity sponsor.
Private equity firms and leveraged buyout firms pool investors’ assets and invest in a variety of companies. Sponsoring LBOs is a major activity of private equity firms. Some of the biggest private equity firms include Apollo Global Management, Blackstone Group, Carlyle Group, and KKR & Company. Some of the major investment banking firms such as Goldman Sachs and JPMorgan Chase are also major sponsors of LBOs and have private equity partnerships that their clients can invest in.
Almost all LBO and private equity sponsors set up their funds as limited partnerships. A limited partnership is a form of business organization that has at least one general partner, who manages the business and assumes legal debts and obligations. As the name implies, the partnership typically has many limited partners who are entitled to the cash flow from the partnership but are legally liable for debts only to the extent of their original investments. Thus, the investors in LBOs are typically limited partners in a fund set up by one of the private equity firms.
The LBO sponsor serves as the general partner and retains an ownership interest in the target firm. The general partner has management control of the limited partnership and shares in the profit of the partnership. But, unlike the limited partners, the general partner is responsible for the debts of the partnership, which means the general partner has much greater liability. Therefore, unlike most securities issued with the help of investment banks, the sponsor firms retain an ownership interest and have a major incentive to ensure that the deals are profitable. This alignment of incentives between investors and the private equity sponsors is often cited as a major advantage of the private equity form of ownership.
The commitments investors make are to a particular fund that makes specific investments. The typical private equity company will sponsor many different funds, and these funds are not comingled. Consequently, some funds of sponsors may be very successful, while others may suffer large losses. Also, unlike mutual funds, private equity funds are designed to be in existence for a limited time period — typically ten years.
The typical LBO transaction involves a sponsor firm partnering with management of the target firm. That is, most LBOs are not “hostile” and do not involve an entity taking the firm over and replacing the management team with a new group of leaders. A hostile takeover is one in which another organization takes control of a corporation by purchasing a majority of the equity of the firm against the wishes of the current management. LBO sponsors specifically look for well-managed firms that are, for whatever reason, underappreciated by the financial markets as their typical targets. In fact, many LBOs are initiated by the management team and are referred to as management buyouts (MBOs). An MBO is just a form of an LBO that is initiated by the management team and results in the management team having a large proportion of the ownership in the target firm.
MBOs often happen when the founder of a company is looking to exit and realize his big payoff and the management team is interested in buying the company because they believe in the future prospects of the company and want to retain their positions in the firm. The management team may also want to take the company in a direction that the founder was not interested in going.
This isn’t to say that the private equity sponsor is a passive investor – one who is hands off and simply allows the management team to control the firm. In fact, they’re far from being hands off. Private equity sponsors often help bring additional management expertise to the firm and are actively involved in fundamental decisions that help unlock the value inherent in the target firm. They often serve as advisors to the management team and will have seats on the board of the reconstituted company.
Management is also typically given a share of the equity — often through equity options or warrants — to help incentivize them to make decisions that are in the best interest of creating long-term value for the owners of the firm. Equity options or warrants are a form of a derivative (a security whose value depends upon, or is derived from, the value of something else). In this case, the equity option or warrant values increase dramatically if the value of the company increases, but they have no value if the value of the company declines. Unlike publicly traded firms, the ownership of private firms is much more concentrated and has a much longer time horizon. In this type of ownership structure, management can focus on making decisions that are in the best long-term interest of the firm and not worry about the short term and the next quarter’s earnings or meeting growth targets set by market analysts.
The stakes for management are generally much higher in an LBO structure than in the typical publicly traded firm. Because LBO firms have a much higher degree of financial leverage than the typical firm, there is a higher risk of failure. In the event of failure, managers of LBO target firms stand to lose a great deal — their jobs, their reputations, and the value of the equity stake they’re provided in the firm. That’s why many people consider this form of organization to be an efficient method of more closely aligning the interests of the owners with the interests of managers.
Investing in LBOs has become commonplace for most institutional investors such as insurance companies, public pension funds, university endowments, and foundations. However, these institutions typically don’t invest directly in LBOs — that is, they don’t sponsor their own LBOs. Instead, they invest through funds sponsored by the plethora of private equity companies.
Many institutional investors invest in private equity through fund of funds. A relatively recent innovation in the private equity landscape, a fund of private equity funds, as the title suggests, is a pool of money that invests in a wide variety of private equity limited partnerships. That way, the institutional investor doesn’t have to concern itself with the detailed due diligence involved in the selection of the specific private equity fund. The strategy of gaining exposure to private equity through a fund of funds is particularly popular with smaller institutional investors who may not have the resources or expertise to undertake the due diligence involved with specific fund investing yet want exposure to this asset class. Of course, the downside of investing in a fund of funds is the additional layer of fees that the fund of funds sponsors extract.
In the early 2000s, with the success of the “Yale model” of investing popularized by investment guru David Swensen, more and more institutional investors flocked to so-called alternative investments and allocated a larger and larger percentage of their assets to these asset classes. Typically, any asset class outside of stocks, bonds, and cash is referred to as an alternative investment. The most popular types of alternative investments include hedge funds, private equity, commodities, and real estate.
The Yale model advocates equity investment at the expense of fixed income commitments and doesn’t consider the lack of liquidity inherent in these types of investments to be a major concern. The idea is that, over the long run, these equity investments will provide higher returns and, because institutional investors have long time horizons, they should allocate the bulk of their investments to equity. During the financial crisis, that lack of liquidity due to the credit crunch became paramount and caused major problems at many institutions. This lack of liquidity led to substantial losses in the portfolios of many of these institutional investors as there was very little appetite for illiquid investments when the credit markets became frozen. As a result of this experience, many institutional investors have scaled back their investments in these types of relatively illiquid assets, but these asset classes still occupy a significant percentage of institutional investors’ assets.
Some companies make good LBO candidates while others are not positioned to be successful targets of an LBO sponsor. The bottom line of any potential LBO analysis involves the ability of the reconstituted firm to generate sufficient cash flow to not only make the required payments on the new debt but also to provide a substantial return to the new equity investors.
Interestingly, individual investors can somewhat benefit from LBOs by trying to identify, before the announcement, which firms will be the targets of future LBOs. If a company is the target of an LBO and there are firms in that same industry with similar characteristics, it’s often beneficial to buy shares of those firms because they often rise in anticipation that the competitor firms might be the target of future LBOs — sort of guilt by association, but in a positive sense. For instance, if there are several firms in the department store industry that have recently been the targets of LBOs, investors will speculate that other similarly positioned firms in the industry will be the subject of future LBOs.
In some time periods in the financial markets, it seems like all firms are candidates for LBOs. There are boom and bust periods in LBOs much like there are cycles in other sectors of investment markets. For instance, in the late 1980s, the junk bond market fueled a bubble in LBOs and firms like Drexel Burnham Lambert enjoyed tremendous success and individuals like Michael Milken amassed great fortunes and became titans of finance. At other times, for instance at the height of the financial crisis, the LBO market dries up, and the limited partnership interests suffer a loss in value as investors flee this sector of the market.
Notwithstanding the boom and bust periods, there are certain underlying characteristics of companies that make them attractive targets for LBOs. The characteristics include the following:
We’ve all heard the phrase “Cash is king,” and this really applies to LBOs. The ability to generate sufficient cash flow to make the required interest payments and to pay down the principal on the debt is of paramount importance to the success of any LBO. When prospective investors, prospective lenders, and analysts alike scrutinize LBO deals they look at the expected return in cash flow terms on the investment. In addition, private equity sponsors focus on the rate of return (the percentage return) they expect to receive on their investment, as well as the rate of return the limited partners of their funds expect to earn.
There are almost as many variations for computing cash flow as there are analysts out there, but the basic methodology is that you simply take a company’s net income and add back all non-cash expenses. An important variation of cash flow is free cash flow (discussed in detail in Chapter 12). Free cash flow is simply cash flow, minus any required capital expenditures to maintain the firm’s operations at the current level. Capital expenditures include things such as the purchase of new machines to replace machines that are worn out. Investment bankers often calculate the value of the firm as the present value of all future free cash flows to the firm.
Lenders often use multiples of a measure of cash flow to determine how much in total debt they are willing to provide to an LBO deal. The most common cash flow measure in this context is earnings before interest, taxes, depreciation, and amortization (EBITDA). Lenders generally gauge how much they’re willing to lend as some multiple of EBITDA — for instance, five- or six-times EBITDA. The exact multiple of EBITDA varies over time. When LBOs are more popular and lenders have a more favorable view of equity markets, the multiple will increase.
Rates of return are central concepts in the investment world. Investors often compare their performance to that of other investors, other investments and stock indexes by comparing rates of return. In the private equity world, rates of return are calculated by computing the internal rate of return (IRR) of an investment. The IRR is simply defined as the discount rate (or rate of return) that equates the present value of the projected costs (cash outflows) of an investment with the present value of the projected cash inflows from the investment. Another way of looking at IRR is that it’s the interest rate that equates the present value of all cash flows (where a cash outflow is negative and a cash inflow is positive) to zero. The concept of present value is discussed in detail in Chapter 11.
To compute the IRR of an investment, you simply solve for the term IRR in the following equation:
For instance, if an investment required an initial cash outlay of $100 million the projected cash flows were $30 million in each of the next three years and $150 million four years from today, the equation for calculating the IRR is:
In this case, the IRR for this investment is 33.1 percent. Not a bad rate of return. (By the way, IRR can be computed using any standard financial calculator or via an Excel spreadsheet.)
Famed investor Warren Buffett’s preferred holding period is “forever.” He wants to identify investments that involve only one decision — the purchase decision. Buffett has very little turnover of holdings in his portfolio and seeks to invest in businesses that will be profitable for a long period of time. Private equity sponsors, on the other hand, know that even before they purchase a company, they’ll be preparing for the day when they’ll sell the firm. Identifying a proper exit strategy in both form and time are among the most important decisions made by any LBO sponsor. A well-thought-out exit strategy can make or break a private equity deal.
Private equity LBO sponsor firms generally have a relatively short timetable in mind when they purchase a firm through an LBO transaction. This is largely due to the fact that most of the private equity structures are limited partnerships that have a planned life of ten years or less.
As noted earlier, the exit is all-important, and not all LBOs are unwound in the same manner. There are three primary methods for LBO sponsors to exit their positions and realize the ultimate return on their investment: an IPO, a sale to a strategic buyer, and another LBO.
The Holy Grail for LBO sponsors is often a successful IPO of the target firm. Of course, this is the case only if the resulting organization is seen by investors as a desirable individual company whose future prospects are bright and the firm can command a premium price in the financial markets. If timed properly, an IPO allows the LBO sponsor to effectively cash in on the investment in the firm and provides the desired cash flow to limited partner investors in the private equity sponsor firm. In addition, the IPO of an LBO target often allows a much needed infusion of equity into the target firm that is likely still often highly leveraged, even several years after the LBO.
The LBO sponsor enlists the help of a lead investment bank to bring the company public. The lead investment bank is responsible for determining the value of the company and arriving at the IPO share price. Determining what the market will bear is an extremely important function of the lead investment bank, as a price that is set too high will result in an undersubscribed new issue, and investors will see the share price decline upon initial trading in the public markets. This leads to very unhappy IPO investors and negatively impacts the reputation of the investment banking firm with investors of future IPOs. On the other hand, a significantly underpriced issue — one whose price increases dramatically upon public trading — results in an opportunity loss for the sponsor firm.
There are horror stories — from the standpoint of the investment banks and the LBO sponsors — of firms that have gone public and the share price in the secondary market is soon multiples of the recent IPO price. For example, in May 2019, on the first day of public trading, the shares of plant-based meat maker Beyond Meat closed at $64.75, a gain of 163 percent over the $25 IPO price. Billions of dollars were left on the table by the private owners of Beyond Meat. It was a windfall for the new shareholders who bought the firm at the IPO price. But such a result would give pause to other firms who were considering using those investment bankers to bring their deals public because they’d worry that their deal would be significantly underpriced.
Now, investment banks don’t operate alone when bringing firms to market. Investment banks generally form a syndicate of other investment banks to ensure widespread distribution of the issue. A syndicate is simply a group of investment banks that gets together to help sell the shares in the IPO to its various customer bases. Each member of the syndicate agrees to be responsible to sell a certain portion of the issue. This makes distribution of the issue easier and spreads the risk among several investment banking firms.
The biggest disadvantage of this exit strategy is that IPOs generally involve high transaction costs. Those investment bankers don’t buy their homes in the Hamptons and their luxury automobiles because they work for free. The investment banking infrastructure and due diligence necessary to ensure a smooth public offering is costly.
This exit strategy is the most common, and the one that is most preferred in the private equity industry because it’s quick and simple. A strategic buyer is an entity that believes that the target company offers synergy to its existing business line. Simply put, synergy is the concept that one plus one can equal three, that some businesses are worth much more in the hands of one entity than another.
Synergies can be realized in any number of ways involving, for example, product line expansion, geographical expansion, or the purchase of suppliers or distributors. For instance, a soft drink company may purchase a sports drink manufacturer that underwent an LBO. The sports drink product line can be marketed and distributed through the same channels that the soft drink product line is currently utilizing.
From the seller’s standpoint, this exit strategy is very clean because the LBO sponsor is negotiating directly with the strategic buyer and their investment banking advisors. The strategic buyer is also likely to pay a premium for the purchase because the buyer is likely in a position to realize the most value for the purchase. The firm is worth much more in the hands of the strategic buyer because of the synergies that can be realized.
The exit strategy for a minority of private equity deals involves simply selling the company to another private equity firm that will essentially put the firm through a secondary LBO. This can happen when the original LBO sponsor needs to exit the deal, most likely because the partnership holding the deal is being unwound and capital is being returned to the limited partners.
The biggest disadvantage of exiting an investment using a secondary LBO is that the sponsor private equity firm is dealing with another professional private equity firm that will likely drive a hard bargain. The over-exuberance sometimes witnessed in the IPO market by individual investors is less likely to be realized in a market characterized by sophisticated buyers who realize that the seller is likely under some pressure to unwind the deal and realize their return.