Leveraged buyout
A
leveraged buyout (or
LBO, or highly-leveraged transaction (HLT), or "
bootstrap" transaction) occurs when a financial sponsor gains control of a majority of a target company's
equity through the use of borrowed money or
debt.
A leveraged buyout is essentially a strategy involving the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. In an LBO, there is usually a ratio of 70% debt to 30% equity.
In the industry's infancy in the late 1960s the acquisitions were called "bootstrap" transactions, and characterized by
Victor Posner's
hostile takeover of Sharon Steel Corp. in 1969. The industry was conceived by people like
Jerome Kohlberg, Jr. while working on
Wall Street in the 1960s and 1970s and pioneered by the firm he helped found with
Henry Kravis,
Kohlberg Kravis Roberts & Co. (KKR).
O. Wayne Rollins, Rollins Inc. (ROL), is credited by Harvard Business School as completing what is believed to be the first leveraged buy-out in business history through the acquisition of Orkin Exterminating Company in 1964. However, the first LBO may have been the purchase by McLean Industries, Inc. of Waterman Steamship Corporation in May of 1955. Under the terms of that transaction, McLean borrowed $42 million and raised an additional $7 million through issue of preferred stock. When the deal closed, $20 million of Waterman cash and assets were used to retire $20 million of the loan debt. The newly-elected board of Waterman then voted to pay an immediate dividend of $25 million to McLean Industries.
[ Marc Levinson, The Box, How the Shipping Container Made the World Smaller and the World Economy Bigger, pp. 44-47 (Princeton Univ. Press 2006). The details of this transaction are set out in ICC Case No. MC-F-5976, McLean Trucking Company and Pan-Atlantic American Steamship Corporation--Investigation of Control, July 8, 1957. ]A management buyout (MBO) occurs when a company's managers buy or acquire a large part of the company. It is a special case of such acquisition. The goal of such a buyout may be to strengthen the managers' interest in the success of the company. In most cases, the management will then take the company private. MBOs have assumed an important role in the corporate restructurings besides mergers and acquisitions. The key considerations are the fairness to shareholders, the price, the future business plan, and legal and tax issues.
A
leveraged balance sheet has a small portion of equity capital and therefore a large portion of loan capital. The return (profit) of the firm will be "leveraged" to the equity capital and produce a large return on equity (ROE) for the owners risking their money.
Typically, the loan capital is borrowed through a combination of prepayable bank facilities and/or public or privately-placed
bonds, which may be classified as high-yield or
junk bonds. Often, the debt will appear on the acquired company's balance sheet and the acquired company's
free cash flow will be used to repay the debt.
The purposes of debt financing for leveraged buyouts are two-fold:1) The use of debt increases (leverages) the financial return to the private equity sponsor. Under the
Modigliani-Miller theorem, the total return of an asset to its owners, ceterus paribus, is unaffected by the structure of its financing. As the debt in an LBO has a relatively fixed, albeit high, cost of capital, any returns in excess of this cost of capital flow through to the equity.2) The
tax shield of the acquisition debt enables the private equity sponsor to pay a higher price than would otherwise be possible. Because income flowing through to equity is taxed, while interest payments to debt are not, the capitalized value of cash flowing to debt is greater than the same cash stream flowing to equity.
Historically, many LBOs in the 1980s and 1990s focused on reducing wasteful expenditures by corporate managers whose interests were not aligned with shareholders. After a major corporate
restructuring, which may involve selling off portions of the company and severe staff reductions, the entity would be producing higher income streams. Because this type of management arbitrage and easy restructuring has largely been accomplished, LBOs today (2006) focus more on growth and complicated financial engineering to achieve their returns. Most leveraged buyout firms look to achieve an
IRR in excess of 20%.
Proponents of LBOs claimed that they caused companies to make more efficient use of their resources. Opponents claimed that they tended to destroy value and cause great economic hardship through the economic disruptions they caused.
This strategy was widely used in the
1980s, with both success and dramatic failure. A very well-known LBO was the purchase of
RJR Nabisco in 1989 by KKR, as chronicled in the book
Barbarians at the Gate: The Fall of RJR Nabisco.
Some LBOs in the
1980s and
1990s resulted in corporate
bankruptcy, such as Robert Campeau's 1988 buyout of
Federated Department Stores and the buyout in 1986 of
Revco drug stores. The failed buyout was a result of excessive debt financing, which comprised about 97% of the total consideration, and led to large interest payments that exceeded Federated's operating cash flow. In response to the threat of LBOs, certain companies adopted a number of techniques, such as the
poison pill which protected them against hostile takeovers by effectively self-destructing the company if it were to be taken over.
*
American Capital Strategies*
Bain Capital*
The Blackstone Group*
The Carlyle Group*
Charterhouse Group*
Evercore Partners*
Forstmann Little & Company*
Goldman Sachs Capital Partners*
Harvest Partners*
Hellman & Friedman*
Hicks, Muse, Tate & Furst*
JP Morgan Partners*
Kohlberg Kravis Roberts & Co.*
Madison Dearborn Partners*
Providence Equity Partners*
Silver Lake Partners*
Texas Pacific Group*
Thomas H. Lee*
Warburg Pincus*
Welsh, Carson, Anderson & StoweEurope-based
*
Apax Partners*
BC Partners*
Bridgepoint Capital*
Candover*
Cinven*
CVC Capital Partners*
Permira*
Terra Firma Capital Partners*
3i*
Private equity*
Bootstrap*
Buyout Blog*
Going Private (Another Buyout Blog)*
Takeovers and Leveraged Buyouts*
Financial dictionary: Bootstrap transaction*
Feb 1993 - The CPA Journal Online (accounting for a bootstrap transaction)
