A Leveraged Buyout, colloquially known as an LBO is a form of takeover or “buyout” initiated in most instances by a private equity firm using large amounts of borrowed capital. Although the leveraged buyout definition does not specify the level of leverage typically used in these deals, makes them a distinct class of their own and gives rise to their specific moniker. Another characteristic is that the assets of the business are often used as collateral for the loans.
Additional common factors found in Leveraged Buyout may, amongst others, include the following
- Cash flows – The target firm must have an established business model, preferably a household name selling a physical product. This helps ensure the stability of incoming cash flow used to service the debt used in the acquisition.
- Existing debt level – one of the ways LBO’s are profitable is the changing of the capital structure to adds more debt. Repayment over time results in a lower effective purchase price. It is therefore imperative the target does not already have a high debt level relative to the total value of the deal.
- Fixed costs – Fixed costs are payable regardless of profit levels. Private Equity firms tend to avoid this risk or eliminate them as soon as possible.
- Strong management team – C-level executives with lengthy experience both in the industry and working together are preferred. A vested interest in the LBO by way of management stock holding may also be preferred.
- Valuation – Valuation is key and can often depend on the appropriate metric being used for the correct firm or industry. Obviously, private equity firms prefer companies that are moderately undervalued, but not so much so as to suggest there is a fundamental problem with the firm.
LBO Financing
A typical ratio in a leveraged buyout (LBO) would be 90% debt to 10% equity although there is no official definition. Due to the high debt/equity ratio, bonds issued in the buyout are not usually of investment grade. Bonds such as these are referred to as junk bonds. Using leverage levels as high as these can enhance the expected returns to the private equity firm. By investing a small amount their own capital, the PE firms can achieve an outsized return on equity (ROE) or internal rate of return (IRR). As PE firms are often compensated based on their financial returns, the use of leverage is vital in achieving a sufficient return to the private equity fund.
However, with outsized returns comes increased risk. Multiple tranches of debt adds to the interest that needs to be serviced. For this reason, targets with strong cash flows as mentioned above are preferred. If the debt cannot be repaid, a restructuring may have to take place causing significant losses to the private equity firm. Following the completion of the buyout, non-core business will divested quickly to help pay down the loan. Although this strategy may depend on the structure of the financing involved.
LBO’s are often regarded as a ruthless or predatory tactic often used in hostile takeovers. This is because the acquisition is rarely solicited by the target company. This may cause the merger arbitrage spread to be wider than it would otherwise and almost certainly be more volatile. Before the COVID-19 pandemic sent the markets into tailspin, the takeover approach by Vintage Capital of Red Robin Gourmet Burgers (RRGB) was a good example of this merger arbitrage spread characteristic.
Leveraged Buyout Example
Perhaps one of the most well-known leveraged buyout examples in history is the acquisition of RJR Nabisco in 1989. Despite taking place over thirty years ago, it is still perhaps the most iconic and famous private equity LBO of all time. At the time of completion, the deal was valued at $31 billion, or approximately $55 billion when adjusted for inflation in 2020. The story had everything required to make the episode legendary. To begin with, it involved Kohlberg, Kravis, Roberts & Co. (KKR) the notorious private equity firm famous for its bold takeover approaches. There was also a bidding war against management trying to push through their own Management Buyout (MBO). Thus driving the eventual offer price way above market estimations indicating buyer’s remorse would be a forgone conclusion. Junk bond financing was able to supply the capital required for the acquisitions accompanied by bankers epitomizing the excesses of the period.
It will come as no surprise that this story was told in many well-known books such as “Barbarians at the Gate: The Fall of RJR Nabisco” by Bryan Burrough and made into a film of the same name. We won’t spoil the ending for you, but we assume the more astute reader may have already guessed the ultimate outcome.
