Leveraged buyout

A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or "bootstrap" transaction) occurs when a financial sponsor gains control of a majority of a target company's equity through the use of borrowed money or debt.

A leveraged buyout is essentially a strategy involving the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. In an LBO, there is usually a ratio of 70% debt to 30% equity.

History

In the industry's infancy in the late 1960s the acquisitions were called "bootstrap" transactions, and characterized by Victor Posner's hostile takeover of Sharon Steel Corp. in 1969. The industry was conceived by people like Jerome Kohlberg while working on Wall Street in the 1960s and 1970s and pioneered by the firm he helped found with Henry Kravis, Kohlberg Kravis Roberts & Co. (KKR).

O. Wayne Rollins, Rollins Inc. (ROL), is credited by Harvard Business School as completing what is believed to be the first leveraged buy-out in business history through the acquisition of Orkin Exterminating Company in 1964. However, the first LBO may have been the purchase by McLean Industries, Inc. of Waterman Steamship Corporation in May of 1956. Under the terms of that transaction, McLean borrowed $42 million and raised an additional $7 million through issue of preferred stock. When the deal closed, $20 million of Waterman cash and assets were used to retire $20 million of the loan debt. The newly-elected board of Waterman then voted to pay an immediate dividend of $25 million to McLean Industries. Marc Levinson, The Box, How the Shipping Container Made the World Smaller and the World Economy Bigger, pp. 44-47 (Princeton Univ. Press 2006). The details of this transaction are set out in ICC Case No. MC-F-5976, McLean Trucking Company and Pan-Atlantic American Steamship Corporation--Investigation of Control, July 8, 1957.

A management buyout (MBO) occurs when a company's managers buy or acquire a large part of the company. It is a special case of such acquisition. The goal of such a buyout may be to strengthen the managers' interest in the success of the company. In most cases, the management will then take the company private. MBOs have assumed an important role in the corporate restructurings besides mergers and acquisitions. The key considerations are the fairness to shareholders, the price, the future business plan, and legal and tax issues.

Structure

A leveraged balance sheet has a small portion of equity capital and therefore a large portion of loan capital. The return (profit) of the firm will be "leveraged" to the equity capital and produce a large return on equity (ROE) for the owners risking their money.

Typically, the loan capital is borrowed through a combination of prepayable bank facilities and/or public or privately-placed bonds, which may be classified as high-yield or junk bonds. Often, the debt will appear on the acquired company's balance sheet and the acquired company's free cash flow will be used to repay the debt.

Generally, after major corporate restructuring, which may involve selling off portions of the company and severe staff reductions, the financial sponsor will sell the target company to another company, sell shares in a public offering or pay itself a dividend payment in a refinancing. Most leveraged buyout firms look to earn a return on investment in excess of 20%.

Controversy

Proponents of LBOs claimed that they caused companies to make more efficient use of their resources. Opponents claimed that they tended to destroy value and cause great economic hardship through the economic disruptions they caused.

This strategy was widely used in the 1980s, with both success and dramatic failure. A very well-known LBO was the purchase of RJR Nabisco in 1989 by KKR, as chronicled in the book The Fall of RJR Nabisco.

Failures

Some LBOs in the 1980s and 1990s resulted in corporate bankruptcy, such as Robert Campeau's 1988 buyout of Federated Department Stores and the buyout in 1986 of Revco drug stores. The failed buyout was a result of excessive debt financing, which comprised about 97% of the total consideration, and led to large interest payments that exceeded Federated's operating cash flow. In response to the threat of LBOs, certain companies adopted a number of techniques, such as the poison pill which protected them against hostile takeovers by effectively self-destructing the company if it were to be taken over.

Notable leveraged buyout firms

Notes

External links

Buyout Blog
Going Private (Another Buyout Blog)
Takeovers and Leveraged Buyouts
Financial dictionary: Bootstrap transaction
Feb 1993 - The CPA Journal Online (accounting for a bootstrap transaction)

private equity

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