What is a Leveraged buyout?
Leverage buyout is a transaction in which a company is acquired using debt as the primary source of acquisition costs. The assets of the target company and the assets of the acquiring company are also used as collateral for the loans. This whole process is understood as a leveraged buyout from the company’s assets to fund its acquisition.
Private equity funds use this method to buy companies with minimum capital to earn maximum return on investment. By using this method one can acquire undervalued portfolio companies and improve their operations, increase their efficiency, and create value through better management.
There are various forms of leveraged buyouts,
- Management buyout (MBO) – when the senior management team of a company purchase all or a part of the business.
- Buy-in management buyout – when external buyers collaborate with the management to purchase a business.
- Financial Sponsor buyouts – when a private equity firm or a financially responsive entity purchases the company with the use of borrowed funds.
- Public-to-private buyouts – when a publicly traded company is required by a private investor or a group of private investors.
How does a Leveraged Buyout work?
Now that we have understood what is a leveraged buyout, the next step is to understand how this process works. Basically leveraged buyout happens when one company desires to buy another company by borrowing a large amount of funds to finance the cost of acquisition.
Here, the purchase is made using a combination of various funds, including the company’s existing cash in hand, borrowed funds, and the purchase of new equity by the acquirer.
Let’s understand the process step by step,
- The first step of a leveraged buyout is to identify the target company. In this task, you have to look for potential acquisitions with stable cash flow, potential for future growth, undervalued assets, etc..
- Start by building a financial model for the target company to forecast its future in five years.
- Secure the loans with the target company’s assets, including property, inventory and equipment. The company’s assets may also need to be leveraged, which will reduce the lender’s risk and make it easy to obtain financing.
- Secure debts by presenting the analysis to the bank and other lenders to secure maximum debt.
- Link the financial statements and calculate the free cash flow. These cash flow projections are important to determine the viability of the leveraged buyout. These projections will ensure that the target company’s future cash flow will be sufficient to pay the operational expenses and interest payments.
- Now that after raising capital and securing financing, the buyer has control over the target company, they impose operational and financial changes to increase profitability.
Reason behind the companies using Leveraged Buyouts
There can be numerous reasons why a leveraged buyout happens, some only which can be,
- Turning a Public company into a private one or spinning off a portion of an existing business by selling the business.
- Leveraged buyout provides the opportunity for growth in the target company.
- This method improves the target company’s profitability by streamlining operations, implementing new strategies, cost-cutting policies, proper utilisation of resources, etc.
- Private equity firms acquire companies through leveraged buyouts to generate higher returns. This can be done by improving its operations and financial performance.
- To gain strategic control over the target company to achieve your goals. This control allows flexibility to make decisions per the company’s working model.
Pros and Cons of Leveraged Buyout
Just like any other acquisition, a leveraged buyout also has its pros and cons. Let’s understand them both.
Advantages of leveraged buyout
- Better control – Through leveraged buyout, private equity buyers gain increased control over the target company when the conversion happens. This allows them to make strategic decisions without any interference from the public shareholders. Allowing flexibility also increases the chances of better growth and quicker decisions
- Efficient operations – LBOs vanishes the risk of the company’s getting shut down because of the retarded financial situation and allow the company to continue its operations. New measures of cost-cutting and strategic planning help the target company to increase its profitability, making the company more efficient.
- Better return on investment – Any acquirer looking to acquire a particular company expects growth and better returns, and a leveraged buyout makes it easier. If the plans, strategies, and measures of a private equity firm succeed, there are chances of a higher return on invested capital.
- Tax benefits – Interest of Tax is applicable for a tax deduction making it a big-time benefit for the company as it reduces the burden of the acquired company.
Disadvantages of Leveraged Buyout
- Risk of shutting down – If the plans, policies, strategies and measures of the private equity firms do not work, there are higher chances of the target company getting shut down. This will result in operational risk and heavy losses.
- Higher debts – If the cash flow projections of the company are insufficient to cover the debt payments, both the acquirer and the target companies could face the risk of bankruptcy.
- Negative image – When an acquired acquires a company against their wishes as a hostile takeover, the workers can be disappointed and unhappy about the situation. Employees’ layouts can also create a negative image and affect employee morale, creating a negative impact on the company as a whole.
- Economic factors – External economic factors can also affect the company in various ways. Factors such as increased interest rates, vital changes in market conditions, and changes in investors’ choices can affect the success of leveraged buyouts drastically.
Bottom line
A leveraged buyout is a popular method of acquisition that helps private equity firms acquire companies using borrowed funds from the target company itself. This method has various forms and pros and cons.
Generally, Private equity firms conduct leveraged buyouts to make higher returns on their investment by implementing cost-cutting measures, new management, and new effective operational techniques.