Leveraged buyouts (LBOs) have probably had more bad publicity than good because they make great stories for the press. While the stories surrounding LBOs are exciting, the concept of the process is quite simple, and, if used correctly, can lead to a successful future for a company that may be in crisis. Read on to find out how.

Leveraged Buyouts
The media would like the average investor to believe that a buyout, whether leveraged or not, is ruthless in nature, leads to massive restructuring and layoffs, rips off the common man and eventually bankrupts the company as the fat cats get rich. LBOs remind many people of the movie "Barbarians at the Gate" (1993), based (some say loosely) on the true story of when then-CEO Ross Johnson made plans to buy out the rest of the R.J.R. Nabisco company after seeing the results of the failure of Premier,
the company's smokeless cigarette. The drama unfolds as Johnson's character initially discusses doing the LBO with Henry Kravis and his company, but attempts to use Shearson Lehman Hutton instead. In this case, a certain level of pride and greed was involved and the drama ended with an inflated buyout price and an incredible debt load.

LBO is the generic term for the use of leverage to buy out a company. The buyer can be the current management, the employees or a private equity firm known as outsiders. Some leveraged buyouts occur in companies experiencing hard times and potentially facing bankruptcy, or they may be part of an overall plan. Not all LBOs are regarded as predatory.

Common Buyout Scenarios and Positive and Negative Effects of LBOs
Leveraged buyouts can have positive and negative effects, depending on which side of the deal you are on. There are many scenarios driving a buyout, but four examples are the repackaging plan, the split-up, the portfolio plan and the savior plan.

The Repackaging Plan
The repackaging plan usually involves a private equity company using leveraged loans from the outside to take a currently public company private by buying all of its outstanding stock. The buying firm's goal is to repackage the company and return it to the marketplace in an initial public offering (IPO).

The acquiring firm holds the company for a few years to avoid the watchful eyes of shareholders. This allows the acquiring company to repackage the company behind closed doors, making adjustments here and there and dressing it up. When this is done on a large scale, private firms can buy many companies at once in an attempt to diversify their risk among various industries. Once the acquired company is dressed up, it is offered back to the market as an IPO with some fanfare.

Those who stand to benefit from a deal like this are the original shareholders (if the offer price is greater than the market price), the company's employees (if the deal saves the company from failure) and the private equity firm that generates fees from the day the buyout process starts and holds a portion of the stock until it goes public again. Unfortunately, if no major changes are made to the company, it's a zero-sum game and the new shareholders get the same financials the old company had.

The Split-Up
The split-up is considered to be predatory by many and goes by several names, including "slash and burn" and "cut and run." The underlying premise in this plan is that the company, as it stands, is worth more when broken up or with its parts valued separately. This is fairly common with conglomerates that have acquired various businesses in relatively unrelated industries over many years. The buyer is an outsider and may use aggressive tactics. If successful, the company is dismantled after it is bought out and the parts are sold off to the highest bidder.

This method is the most feared by employees and management, as they know their jobs are just numbers on a page in this situation. These deals usually involve massive layoffs as part of the restructuring process. While it may seem like the equity firm is the only party to benefit from this type of deal, the pieces off of the company that are sold off have the potential to grow on their own and may have been stymied before by the chains of the corporate structure. There will ultimately be two sides of the story, but the thought that any company could be taken out like this should inspire all levels of management to keep their companies as healthy as possible.

The Portfolio Plan
The portfolio plan has the potential to benefit all participants, including the buyer, the management and the employees. Another name for this method is the leveraged build-up, and the concept is both defensive and aggressive in nature. In a competitive marketplace, a company may use leverage to acquire one of its competitors (or any company where it could achieve synergies from the acquisition). The plan is risky: the company needs to make sure the return on its invested capital exceeds its cost to acquire, or the plan can backfire. If successful, all parties can benefit: the shareholders may receive a good price on their stock, current management can be retained and the company may prosper in its new, larger form.

The Savior Plan
The savior plan is often drawn up with good intentions, but frequently arrives too late. This scenario typically involves a plan involving management and employees to borrow money to save a failing company. The term "employee owned" often comes to mind after one of these deals goes through. While the concept is commendable, if the same management and tactics stay in place, the likelihood of success is low. On the other hand, if the company turns around after the buyout, everyone benefits.

The Bottom Line
LBOs carry negative connotations to most people because they are presented to us as predatory by the media and by Hollywood. They are perceived as complex deals requiring teams of analysts and experts, but in reality, they just use borrowed money to buy companies. While there are forms of LBOs that lead to massive layoffs and asset selloffs, some LBOs can be part of a long-term plan to save a company through leveraged acquisitions. Regardless of what they are called or how they are portrayed, they will always be a part of an economy as long as there are companies, potential buyers and money to lend.

Related Articles
  1. Investing Basics

    The Merger - What To Do When Companies Converge

    Learn how to invest in companies before, during and after they join together.
  2. Personal Finance

    What Investors Can Learn From M&A Payment Methods

    How a company pays in a merger or acquisition can reveal a lot about the buyer and seller. We tell you what to look for.
  3. Forex Education

    Mergers & Acquisitions: An Avenue For Profitable Trades

    When major corporate transactions have a big impact on the currency markets, you can benefit.
  4. Entrepreneurship

    Why Successful Business Owners Sell Out

    Learn the motives that drive companies into the arms of an acquirer.
  5. Options & Futures

    Reverse Mergers: The Pros And Cons

    Reverse mergers can provide excellent opportunities for companies and investors, but there are still some downsides and risks.
  6. Bonds & Fixed Income

    Conglomerates: Risky Proposition?

    Investing in a corporate giant may not be as safe as you think.
  7. Mutual Funds & ETFs

    Corporate Takeover Defense: A Shareholder's Perspective

    Find out the strategies corporations use to protect themselves from unwanted acquisitions.
  8. Options & Futures

    What Makes An M&A Deal Work?

    Do you know why companies merge? Here we'll take a look at three successful company acquisitions and why they succeeded.
  9. Insurance

    The Wonderful World Of Mergers

    While acquisitions can be hostile, these varied mergers are always friendly.
  10. Fundamental Analysis

    The 3 Best Investments When Bull Markets Slow Down

    Find out why no bull market lasts forever, and why investors should shift their assets away from growth and toward dividends when stocks slow down.
  1. How is a leveraged buyout different from a buyout?

    In finance, a buyout refers to a purchase of voting stock of a target firm by an acquiring company, where the acquirer gains ... Read Full Answer >>
  2. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  3. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  4. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  5. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  6. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Full Answer >>
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center