By Marc Empey
Buyouts and LBOs tend to come from one of three groups; current management (of the company in question), another company, or a private, non-public equity firm.
A leveraged buyout happens when one company secures or borrows a lot of capital in order to buy out another one. In an LBO, private investors (often in a group and typically including senior management), tend to borrow against the assets and cash flows of the firm that they wish to buy out and begin to buy the public interest in common stock, taking over the firm with a shareholder majority. LBOs mostly occur in private companies, but it can also be utilized with public companies in a so-called Public to Private (PtP) transactions.
One of the most often used types of leveraged buyout procedures is to purchase all the remaining shares and assets of the stock, using business resources as security for a loan to fund the acquisition.
The big advantage of using stock and financial leverage is that by increasing the debt held by the company, the equity portion typically decreases where investors involved in the LBO may only need to supply around 25% of the price of the total transaction.
Secondary buyouts differ from secondaries or secondary market purchases. This method typically involves the acquisition of portfolios of private equity assets including limited partnership stakes and direct investments in corporate securities.
Securing An LBO
Different firms pursue different strategies, there are some characteristics that hold true across many types of leveraged buyouts. Many LBOs are often “management buyouts,” in which the acquisition is pursued by a group of investors that includes incumbent management of the target company.
LBOs have been most effectively used to acquire companies with stable cash flows and hard assets (such as real estate or inventory) that can be used to secure loans as assets of the target company or firm are then used as collateral.
The next steps in the model include the calculation of the expected cash flows and capital from the leveraged buyout, the money structure of the costs of debt and equity and the final conclusions.
To proceed with an acquisition, private equity funds ensure that the assets of the takeover target can be used as warranty (collateral) for the loan needed for the acquisition.
The inability to repay debt associated in an LBO can be caused by initial overpricing of the target firm and/or its assets.
Companies are preferred by private equity firms. The companies are typically undervalued to appropriately valued and they prefer not to risk an acquisition of acquiring companies that are trading at very high valuation multiples, due in part to the risk that valuations could decline.
Low Cost and Stable Cash Flow
Fixed costs are a potential risk for Private Equity firms since many companies still need to pay them even if their incoming revenue declines. The business that is being assimilated in a leveraged buyout should be able to show stable cash flow to pay the expense in interest and to reimburse debt principal.
LBOs have become an attractive and lucrative practice as they usually represent a win-win situation for the monetary sponsor/s and a bank involved. The financial guarantor can grow the rate of returns on their equity by using the leverage; banks can build higher margins in support of the financing of LBOs, similar to usual lending for corporations, because the chargeable interest is abundantly higher.