A leveraged buyout (LBO) is a type of acquisition that involves a high degree of financial leverage, where the acquirer uses a high proportion of debt relative to equity to pay for the target, sometimes as high as 80 per cent or 90 per cent.
What is a leveraged buyout?
An LBO is often a way to take a public company private. The acquirer is typically a buyout firm that offers to purchase the target’s ordinary shares from its existing shareholders. The takeover is financed using money that investors contributed to one of the buyout firm’s funds (that’s the equity slice), but because the amount available usually represents only a fraction of the purchase price, the buyout firm must turn to banks and/or capital markets for borrowings (that’s the debt slice). These borrowings can take the form of leveraged loans or bonds, including high-yield ones.
When possible, the buyout firm teams up with management to take over the target. Although the target’s managers may provide funds, their major contribution is to continue running the company. Because the target’s cash flows are used to pay the interest on the borrowings and to repay the principal, it is critical that the company performs well, and relying on a management team with a proven track record is usually the key to success.
Why are LBOs not more popular in the Middle East?
While there are many private equity firms in the Middle East, LBOs are not popular here. Historically, regional investors have not had an appetite for the high debt levels that are assumed in an LBO. There will even be strict governing rules against such high levels of debt for Sharia-compliant funds, which have seen a rapid rise in popularity. On the supply side, many family-owned Middle Eastern businesses are likely to be hesitant to sell to investors that take a very hands-on management approach to restructuring the company’s operations in order to realise high returns for paying down the new debt.
Why is the number of LBOs on the rise in other regions lately?
LBOs come in waves. The first wave in the 1980s took place primarily in the United States and peaked with the $25 billion hostile takeover of RJR Nabisco. Another wave between 2003 and 2007 spread globally. The volume of LBOs exceeded $400 billion in 2007, but this enthusiasm collapsed with the financial crisis. Although LBO activity has picked up since 2010, the annual volume of LBOs has remained around $100 billion since. Some market participants see in the recent announcements of the Heinz and Dell LBOs the potential start of a new wave.
What are the drivers of LBOs?
Like all acquisitions, LBOs are tied to economic cycles; the number of deals usually increases during periods of economic growth. The outlook is now brighter than it was five years ago. Because the financing of LBOs relies heavily on borrowings, LBO activity is also tightly connected with credit cycles. Debt is currently cheap due to low interest rates and credit spreads.
In addition, investors’ appetite for leveraged transactions has returned, making it easier for buyout firms to raise debt, either through leveraged loans or high-yield bonds. Many buyout firms also have dry powder, committed but unused capital that needs to be put to work. All these factors explain the surge in larger and more leveraged deals lately. If the economic recoveries were to stall, or interest rates were to move back up, LBO activity could fall again.
LBOs have a rather bad reputation. Buyout firms have been repeatedly called “asset-strippers” or even “locusts”. Some activists, politicians and journalists are asking for more regulation of LBOs; a few go as far as advising to ban these transactions all together.
Studies have shown that the operating performance of companies going through an LBO improves: productivity rises, and earnings and cash flows increase. Others argue that these improvements are temporary and often reversed in the long run, particularly when the buyout firm exits, either by taking the company public again via an initial public offering (IPO) or by selling it to a third party. In addition, evidence regarding the effect of LBOs on employment, wages and employee morale is mixed.
The issue with LBO is not so much whether they create value or not (many argue that they do, although they may disagree about why), but who benefits the most from them. Buyout firms and managers who are part of the deal tend to profit from these transactions far more than other stakeholders — employees, customers, suppliers or even investors in buyout funds. The tax deductibility of debt that is a significant motivation for highly-leveraged transactions has also come into the debate lately.
Yes, some do. The late 1980s were marked by several large bankruptcies and the collapse of the high-yield bond market. Some companies that were taken private via LBOs in the years leading to the financial crisis either filed for bankruptcy or had to be restructured. Restructurings are usually a better course of action than bankruptcies, although both have negative effects not only on investors, but also on the company’s employees, customers and suppliers. Overall, society is better off when these deals succeed.
— Barbara Petitt , Ph.D., CFA is Director, Curriculum Projects — Europe, Middle East and Africa at CFA Institute and Amer Khansaheb, president of CFA Society Emirates.