Leveraged Buyback Definition

Leveraged Buyback

Investopedia / Julie Bang

What Is a Leveraged Buyback?

A leveraged buyback is a corporate finance transaction that enables a company to repurchase some of its shares using debt—reducing the number of shares outstanding increases the remaining owners' respective shares.

Also known as a leveraged share repurchase, a leveraged buyback has similar impacts as leveraged recapitalizations and dividend recapitalizations, in which companies employ leverage to pay a one-time dividend. The difference is that dividend recapitalizations do not change the ownership structure.

Key Takeaways

  • A leveraged buyback is a financial transaction that lets a company repurchase some of its stock by using debt. 
  • The process boosts the remaining owners' shares by limiting the number of shares that are outstanding.
  • Companies sometimes use leveraged buybacks to protect themselves from hostile takeovers by having extra debt on their balance sheets.
  • More often, the purpose of these kinds of buybacks is to increase earnings per share and improve other financial metrics.
  • The Inflation Reduction Act of 2022 includes an excise tax of 1% on certain share buybacks.

How a Leveraged Buyback Works

Theoretically, leveraged buybacks should have no immediate impact on a company's share price, net of any tax benefits from the new capital structure, and higher interest payments. But the extra debt provides an incentive for management to be more disciplined and improve operational efficiency through cost-cutting and downsizing, in order to meet larger interest and principal payments; a justification for the extreme levels of debt in leveraged buyouts.

Leveraged buybacks are sometimes used by companies with excess cash to decapitalize their balance sheets to avoid overcapitalization. Increasing the debt on the balance sheet can provide shark repellant protection from hostile takeovers.

But more often than not, leveraged buybacks, like other share repurchases, are simply used to increase earnings per share (EPS), return on equity (ROE), and price-to-book (P/E) ratio.

Don't confuse a leveraged buyback with a leveraged buyout. While the former involves the repurchase of corporate shares, the latter involves the use of debt to acquire another company.

Leveraged Buybacks and EPS

Boosting EPS through leveraged buybacks can be an effective tool for companies to use, but it does not signify an improvement in underlying performance or value. It can even do damage to the business if financial engineering comes at the expense of not investing capital productively for the long term.

Executives say there are not enough investment opportunities. But there is clearly a big conflict of interest, given that executive compensation is linked to EPS in most American companies.

Financial markets have rewarded companies using buybacks as a substitute for improving operational performance. So it is no wonder that buybacks became one of Wall Street's favorite tools since the global financial crisis.

Between 2008 and 2018, companies in the United States spent over $5 trillion buying back their own stock, or over half their profits. And for large companies like Procter & Gamble, Mondelez, and Eli Lilly, approximately 40% of EPS growth has been a result of buybacks.

Buybacks are a mixed bag, they can increase EPS and improve other financial metrics but also put a firm's credit ratings at risk.

Leveraged Buyback Returns

In 2017, leveraged buybacks were reported to have made a big comeback in the U.S., where share repurchases have exceeded free cash flow since 2014. They were also used to avoid having to repatriate cash and pay U.S. taxes.

The buyback boom increased the risk for both bondholders and shareholders. Even investment-grade companies were willing to sacrifice their credit ratings in order to reduce the number of shares. For example, McDonald’s, whose executives depend on EPS metrics as a component of their performance incentive payout, had borrowed so heavily to fund buybacks that its credit rating fell from A to BBB between 2016 and 2018.

Rising interest rates can impact leveraged buybacks. But so could politicians. The Inflation Reduction Act of 2022, which was signed into law by President Joe Biden on Aug. 16, 2022, includes an excise tax of 1% on share buybacks that exceed $1 million after Dec. 31, 2022.

Senate Democrats strongly criticized the buyback boom, arguing that Trump's tax reform didn't trickle down to workers. They wanted to regulate buybacks, which were seen as a form of market manipulation before the Securities and Exchange Commission (SEC) gave them the green light in 1982 when it adopted Rule 10b-18. That protected corporations from charges of stock market manipulation if buybacks on any given day are no more than 25% of the previous four weeks’ average daily trading volume.

Biden 2023 State of the Union Address

In his State of the Union address in February 2023, President Biden said he would propose quadrupling the tax on corporate stock buybacks. It was not clear from his statements whether such a proposal would also impact leveraged buybacks. Further, analysts like EvercoreISI strategist Tobin Marcus suggested that the likelihood of the passage of a buyback tax was low. Still, investors may keep future buyback-related legislation in mind when developing strategies.

Biden's announcement follows a Dec. 2021 push from SEC Commissioner Allison Herren Lee in support of corporate share repurchase policies enhancing transparency "by requiring more detailed, timely, and structured disclosures" of buybacks.

What are leveraged buybacks?

Leveraged buybacks are a form of stock repurchase in which a corporation repurchases a quantity of its shares by leveraging its own debt.

What is the impact of a leveraged buyback?

There are many potential effects of a leveraged buyback. The earnings per share for the company may increase as a result of the overall reduction of the total number of outstanding shares. Companies can also use leveraged buybacks to fend of hostile takeovers by increasing their debt.

What is on the horizon for leveraged buyback regulation?

In the Inflation Reduction Act of 2022 there is a 1% excise tax on buybacks exceeding $1 million as of Jan. 1, 2023. President Biden also announced in his Feb. 2023 State of the Union address that he would propose quadrupling the tax on corporate stock repurchases, although this is yet to be officially announced and it is unclear whether it would apply to leveraged buybacks specifically.

The Bottom Line

Leveraged buybacks are corporate finance transactions through which a company repurchases a quantity of its shares using debt. With added debt, many companies that complete a leveraged buyback also institutes cost-cutting or downsizing measures. Leveraged repurchases are often used to increase a corporation's earnings per share buy reducing the overall number of shares outstanding. This does not fundamentally impact the company's underlying performance or value. This technique can also help to decapitalize a balance sheet. Buybacks in general have been a target of the Biden administration, first through a 1% excise tax in the Inflation Reduction Act of 2022 and more recently via comments the president made in the 2023 State of the Union address.

Article Sources
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