Chapter 2: Leveraged Buyouts: The Purpose
Why do a leveraged buyout? Why would anyone go through the trouble? The answer is quite simple: money. The goal of any LBO transaction is to achieve higher returns on the initial equity investment of the investor. Leveraged buyouts are designed to enhance the returns attainable by equity investors; they do so by decreasing the size of the initial equity investment.
“The goal of any LBO transaction is to achieve higher returns on the initial equity investment of the investor.”
For example, a company is purchased for $100 million with 100% equity and the company is streamlined over the course of a year and later sold for $110 million. The investor just made a 10% return on investment. (Let’s ignore the time value of money for now.)
Alternatively, if the investors were able to get a secured loan on the company’s assets for $90 million and made an initial equity investment of $10 million, they would still be able to purchase the $100 million company. They would have to pay interest expense on the loan, which happens to be 7% annually. After one year, the investors are able to sell the company for $110 million. With the proceeds from the sale of the company the investors do the following:
- pay down the $90 million loan
- pay $6.3 million in interest expense due.
After paying interest expense and paying back the loan, investors are left with approximately $13.7 million for themselves. That represents a return of about 37%, more than triple the return on equity of the 100% equity transaction!
The bottom line is that leveraged buyouts are about achieving greater returns on equity for investors.
While levered transactions present several advantages to investors, at the same time they bring significant risks. It is the ability of corporations to execute restructuring plans (post LBO) that determine whether a company can sufficiently handle the interest burden taken on as a result of the leveraged buyout and drive the earnings that determine whether greater returns on investment can be realized by investors.
Advantages of Leverage
Given that the purpose of leveraged buyouts is to realize greater returns on investment, perhaps it would be useful to examine the several advantages that go hand in hand with leveraged transactions.
The advantages come in a number of diverse forms. Some advantages come in the form of the ability to close transactions while others come in the form of limiting losses. In the end the investor has to make a judgment call as to whether these advantages and the potential for returns are greater than the risks that are also taken on with every transaction.
Bigger is possible
One of the major advantages of leveraged buyouts is the smaller initial equity investment required to close a transaction. In our example $100 million transaction above, the investor would be required to put up the full $100 million to acquire the company. However, in the case of the leveraged buyout, the investor would only need to hand over $10 million dollars to get the deal done. The other $90 million, we are assuming, could be obtained in the form of a loan secured by the assets of the company being taken over. (We are assuming the company has limited debt prior to any transaction.)
The point is, if the investor did not have $100 million dollars, without leverage the investment would have been out of reach. Leverage allows the transaction to close with only a fraction of the upfront equity commitment. Now an investor can be the proud owner of a $100 million dollar company, even if he only has the ability to invest $10 million.
Alternatively, let’s say that the investor does have the $100 million. Rather than tie up the entire $100 million in this one investment, she may want to invest in several different investment opportunities. Using leverage allows her to do that. Our rich investor may wish to invest $10 million in our example opportunity as well as invest in nine other $10 million opportunities. By using leverage, our savvy investor has invested the entire $100 million dollars, but has diversified her risk across several different investments.
Limited losses
One of the beauties of equity investing is that you can only lose what you put in. The same truth applies with most leveraged buyouts. One of the main advantages for investors is the limited losses that accompany buying a company mainly with debt secured by the assets of that same company. You can substitute the word ‘debt’ in this case with ‘Other People’s Money’.
When an investor is required to commit just 10% of the capital required to purchase a company, it is significantly less than that of the 100% pure equity investor. The potential losses and therefore risk of the pure equity investor are far greater than those of the LBO equity investor. The levered investor has much less capital at risk should the acquired company not succeed. In the case of failure (or bankruptcy), the levered equity investor would almost certainly lose their entire investment, but that would most likely pale in comparison to the total losses realized by a 100% equity investor.
“One of the main advantages for investors is the limited losses that accompany buying a company mainly with debt secured by the assets of that same company.”
Reduced taxes
Depending on where on the globe you transact, interest expense may be tax deductible. So, while it would be great if money could be borrowed for free and used for LBOs, the consolation is that the tax burden can be reduced based on realized interest expense.
Risks of Leverage
For all of its advantages, leverage comes with risk. While it is possible to breakdown the various advantages of leverage into different descriptions the risk of leverage is singular in nature. The risk of leverage is greater default risk.
When times are good and a company is producing earnings to pay its suppliers, employees and officers, leverage is a beautiful thing. However, in times of trouble, when the company is not generating profits, leverage can be a death blow that does not allow a company to get itself back on its feet. Even in times of trouble, interest payments are still required on top of the regular operating expenses that come with operating a company.
“For all of its advantages, leverage comes with risk. The risk of leverage is greater default risk.”
The creditors have prepared for the day of failure since before the original credit agreements were signed. In the case of a failing business (or bankruptcy), the creditors stand in line ahead of the equity partners to get their money back. Only after all the creditors get their money back is there any chance of equity investors recouping their investment capital and usually by that time there is nothing left to recoup.
If a company were to not have any debt, but were to fall on tough financial times, the outcome would be somewhat different. The biggest difference would be that there would be less chance of bankruptcy. (We are presuming that there are no unsecured creditors like employees or vendors that have supplied goods or services without being paid.) The company could sell any assets it has on its balance sheet. From the proceeds of the asset sale, the equity partners of the company could keep all the money and help stave off bankruptcy.
Leverage comes with the risk not being able to meet the interest expense obligation. In good times, leverage seems like a wonderful idea. It allows a company to get the most out of the assets on its balance sheet and assists the growth of the company. However, in bad times, the interest burden can weigh on the company so greatly that it becomes a weight around the company’s proverbial neck and sinks the company in an ocean of debt.
Outcomes
Given what we now know about the advantages and risk associated with leveraged buyouts, let’s take a look at a simple example on how a transaction can potentially unfold, for better and then for worse.
In our example we have an investor that has identified a target company for a leveraged takeover. The target company produces essential engine parts for trains and has been doing so, profitably, for nearly 90 years. The target company has very little debt on its balance sheet and strong, steady cash flows. The company has been family owned since its inception and the family is looking to sell 100% of the company.
After conducting his due diligence and analysis the investor calculates a value range for the target company. The analysis, which we will cover in detail later, includes: 1) the market pricing for similar companies as a multiple of EBITDA (Earnings Before Interest Depreciation and Amortization), 2) purchase pricing in previous acquisitions of similar companies, as well as, 3) a discounted cash flow analysis – which also relies on multiples of earnings to derive the implied enterprise value of the company.
The investor carefully analyzes the impact of the target company taking on additional debt and its ability meet the interest payments over a decided time period. From this analysis the investor gains a measure of comfort in the target company’s ability to continue to generate earnings, service the debt, and eventually provide a satisfactory return on investment.
Based on his analysis and research, the investor decides to put forth an offer to the current owners of the company. The bid is accepted and the purchase transaction closes successfully at a price of $100 million.
Positive outcome
Now that the leveraged buyout transaction has been completed the hard work begins for those tasked with the job of running the business and ultimately generating earnings. Business managers will focus on operating efficiency and try to identify areas within the company where unnecessary costs can be reduced. They will also try to identify additional revenue-generating opportunities.
The economy continues to grow and businesses are shipping goods by train as much as ever. The company experiences growth in demand for its train engine parts by 5% every year for the next five years. Under these circumstances, the company is able to meet is regular interest payments and realize a return on equity.
As time goes on, the company continues its profitable ways, steadily paying down debt and using its profits to expand operations, which will result in greater revenues and ultimately profits down the road. The company also increases the dividends paid out to owners.
Five years after the original acquisition of the company, our investor decides that he is ready to sell the company. At this point, significant value has been created within the company. Business operations have expanded, and with it, revenue and earnings have also increased. The firm has generated significant positive cash flows that have been used to expand the business and pay the owners, in the form of dividends.
Using the same methodology that was used to value the purchase of the company, the investor is now selling the company at a price that will result in a handsome return on investment. With a large portion of the debt now paid down and turned into equity, our investor is selling a considerably larger portion of the company as equity than he actually bought on the day of purchase. That coupled with the fact that earnings have also grown over the past five years contributes to the returns that the investor expects to realize.
“Five years later, if a large portion of the debt is paid down and turned into equity, an investor can sell a considerably larger portion of the company as equity than he actually bought on the day of purchase.”
In the end, our investor identifies a buyer that is willing to purchase the company at the same multiple of EBITDA he purchased the company at. It doesn’t sound very exciting at first, but the key facts are that the company’s EBITDA has grown 30% over the past five years and while our investor only put up 10% of the purchase price in the form of an initial equity investment, his equity share now accounts for 40% of the company’s capital structure. The short summary of this positive outcome is that our investor has made a lot of money on this deal by increasing the company’s earnings (EBITDA), paying down debt and amassing a larger portion of shareholders’ equity in the firm over time.
Negative outcome
Now that the leveraged buyout transaction has been completed the hard work begins for those tasked with the job of running the business and ultimately generating earnings. Business managers will focus on operating efficiency and try to identify areas within the company where unnecessary costs can be reduced. They will also try to identify additional revenue-generating opportunities.
“Faced with a bleak economic horizon, and all of its available cash paying down large interest expenses, a company can find itself in serious trouble.”
The greater economy stalls and businesses are not shipping as many goods as they do under normal economic circumstances. The weakening demand for new trains and less expensive alternatives from overseas result in significantly weaker demand for the company’s engine parts. Revenues decrease on average by 5%, annually, over the next five years.
The company’s cash flow and earnings shrink with the decreasing revenue. The company is faced with difficult decisions – whether, for instance, to make certain capital expenditures, and whether or not to lay off staff. The company is now feeling the weight of the debt burden. All of the company’s available cash is going towards paying the large interest expense. Eventually, available cash runs out, the company misses a payment and defaults on its debt.
Faced with a bleak economic horizon and stiff, less expensive competition overseas, the company decides to file for Chapter 7 bankruptcy and is liquidated through the sale of its assets. The lenders are first in line to receive any proceeds from the sale of the company’s assets. The company made few capital investments due to economic uncertainty and many of the large corporate assets such as plant property and equipment have approached the end of their useful lives, which translates into the assets fetching very little at the time of sale in bankruptcy. The lenders recoup a portion of the debt they extended the company in the leveraged transaction and the equity investor is wiped out of his original 10% equity investment.