Understanding Leveraged Buyouts

By Michael Schmidt AAA

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.

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