Leverage Buyout: A Widespread Strategy

Leverage Buyout: A Widespread Strategy

Since they fell out of favor in the wake of the 2008 financial crisis, leveraged buyouts have been making a comeback. Although they are regarded as a predatory method of conducting business, especially true when one considers that the assets of the target company can be used as collateral, leverage buyouts have the potential to produce great value for shareholders.

In this article, we will explore the concept of a leveraged buyout and discuss its effectiveness in the financial markets.

Leverage Buyout, the Definition

A leveraged buyout (LBO) occurs when the acquirer of a firm assumes considerable debt in conjunction with the acquisition. The purchaser utilizes the acquired company's assets as security and intends to repay the loan with future cash flows.

In a leveraged buyout, the purchaser assumes control of the firm. This enables the latter to establish new objectives for the firm and rearrange the management team in order to accomplish those goals.

Two widespread types of leveraged buyouts are:

  • Management buyout (MBO) – When a firm's management team purchases all or a portion of the company.
  • Buy-in management buyout (BIMBO) – When outside investors join forces with top management to acquire a business.

Typically, private equity companies use a leveraged buyout to acquire an existing firm with its income streams, assets, debt, and growth commitments from other existing enterprises. It is also a method for acquiring and expanding a firm by enhancing the effectiveness of its present processes, methods, or strategies.

Financing is advantageous to purchasers and investors in a private equity LBO because it gives the buyer power. This implies that a buyer may only be required to contribute 15% of the business's acquisition price, with the remaining balance funded by investors via loans that must be returned over time from the company's cash flow. The business reimburses the investor as it pays off its loan. The investor therefore benefits from a lucrative investment structure, while the buyer does not need to obtain all of the cash at once to acquire a major or even controlling ownership in the firm.

Figure 1: Leverage buyout structure. Source: Dealroom

The attractiveness of this technique is that every penny spent in the acquisition of a firm yields a return. In addition, after the loan is returned, the cash flow returns to the firm, and investors have extra earnings to give to the new owners, reinvest, or use to acquire other businesses with more strategies and synergies. As this approach develops, it also enables investors to enhance the company via the beneficial contributions of all their holdings; operational efficiency, the capacity to decrease expenses, and a rise in the firm's total worth.

Why Firms Undertake Leverage Buyouts

Leveraged buyouts provide significant benefits to the buyer, making it an appealing approach. These consist of:

  • Better rate of return on investment – In theory, LBOs lead to a higher rate of return on investment than ventures in which the investor uses their own capital, despite the fact that less money is required up front.
  • Access to a greater number of transactions – The buyout team that is proposing the LBO will have a greater number of opportunities to access deals if they have more funds.
  • Tax benefits – Significant tax benefits are often associated with leveraged buyouts (LBOs) due to the fact that these transactions entail the target business taking on more debt.
  • Enhanced business plan – In order to achieve superior outcomes, leveraged buyouts (LBOs) should, in principle if not usually in fact, place highly qualified managers in control of businesses that have outstanding business plans.

Then, the possible exit possibilities depend on how the purchasers have executed their strategic strategy, as well as the market conditions at the time of sale.

The most prevalent exit strategy is putting the firm on a public index and selling its shares (IPO). Other methods include finding a comparable company in the same sector willing to purchase the company or selling it to another private equity group that reckons it can extract even more value through a fresh strategic plan.

Examples of Leverage Buyouts

The purchase of Hospital Corporation of America (HCA) in 2006 by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch was one of the biggest leveraged buyouts in the history of the industry. HCA was estimated to be worth around $33 billion by the three firms. One year later, just before the 2008 global financial crisis, Blackstone Group purchased Hilton Hotels for $26 billion, having utilized just $5.5 billion (or around 21%) of its own cash. The group ultimately earned $14 billion via a phased exit from the transaction, roughly doubling its original investment.

Huge-scale leveraged buyouts started to increase during the COVID-19 outbreak, despite the fact that the frequency of such large purchases has decreased since the financial crisis that occurred in 2008. Medline, a maker of medical equipment, was estimated to be worth $34 billion in 2021 when a consortium of bankers headed by Blackstone Group launched a leveraged buyout plan to acquire the company.

Leveraging Buyouts, a Multipurpose Strategy

Leveraged buyouts (LBOs) are frequently employed to take a public firm private or to sell a portion of an existing company. They may also be used to transfer private ownership, such as when a small firm changes hands. The primary benefit of a leveraged buyout is that the acquiring business may purchase a much bigger company with a very little amount of its own assets.

For leveraged buyouts, investment firms often target established and mature sectors rather than new or more speculative ones. The strongest prospects for a leveraged buyout (LBO) often have robust and dependable operational cash flows, well-established product lines, strong management teams, and credible exit options that enable the acquirer to reap advantages.

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