Treasury Today Country Profiles in association with Citi

in association with

J P Morgan

Leveraged buyout

Leveraged buyout (LBO) is the term given to the acquisition of a company through the use of borrowed money or debt. It can also be called a bootstrap transaction or a highly leveraged transaction and can be used in a hostile takeover.

In an LBO the assets of the target company are often used as collateral against the loans. A leveraged buyout enables a company to make a large acquisition without having to commit a significant amount of capital. Debt to equity ratios in an LBO are often in the region of 70:30, but can reach up to 90:10.

The loan capital in an LBO is usually raised through a combination of bank facilities and bonds. These bonds are usually called ‘junk bonds’ because they are seldom investment grade, due to the high debt to equity ratios involved. The debt will usually appear on the acquired company’s balance sheet and its free cash will be used to repay the debt. Once the company has been acquired it is often made private so that its new owners have more freedom to maximise their profits. This can involve methods such as splitting the company and selling the components, or liquidating some or all of the company’s assets.

History

LBOs have been around since the late 1960s, but the concept remained relatively obscure until the 1980s, when LBOs became more popular as a result of the expanding public debt markets. The practice also gained a higher profile due to a number of cases of LBOs that resulted in the failure of the acquired company. In many cases, this was because the debt to equity ratio was so high that the company was unable to meet the massive interest payments.

This led to LBOs becoming regarded as a particularly ruthless tactic, also due in part to the way in which the assets of the target company are used against it as collateral.

Poison pill

During the high profile LBOs of the 1980s, companies came up with a number of tactics to reduce their vulnerability, including the poison pill. Using this method, a company ensures its own destruction in the event of a hostile takeover.

For example, the company’s management team might threaten to leave in its entirety if the company is taken over (a ‘people pill’), or a crucial division might be sold off in the event of a takeover (the ‘crown jewels’ strategy).

Poison pills may also focus on the target company’s stock, perhaps allowing shareholders other than the acquirer (sometimes described as a white knight) to buy additional shares at a low price in certain circumstances, in turn diluting the value of the any shares acquired by the company trying to acquire aggressively. By engineering a massive decline in value should a takeover take place, a company removes any incentive for its acquisition.

By the 1990s, LBOs were going out of fashion, although they have been experiencing a modified resurgence ever since the dot-com collapse. The current credit squeeze means that the most highly leveraged transactions are not achievable under current market conditions.

Why use an LBO?

Investors are often attracted by the low capital outlay required to perform an LBO. Once a company has been acquired, it can be reorganised to improve performance and efficiency, increasing returns for the shareholders.

LBOs are often used for the short term privatisation of a company in order to effect changes that may have been difficult in a public environment. These changes may include re-organisation, layoffs and divestitures that might have had a negative impact on a publicly traded company. In these cases the LBO is not classed as a hostile takeover and existing managers of the company may sometimes make up part of the buyout team.

Hostile takeovers generally aim to change the direction of a company and turn it into a more efficient profit-making enterprise. For this reason, companies experiencing operating problems and those in need of major restructuring are most likely to be targets for LBOs.