Leveraged buyout

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A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or "bootstrap" transaction) occurs when a financial sponsor acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage (borrowing). The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved.

Companies of all sizes and industries have been the target of leveraged buyout transactions, although because of the importance of debt and the ability of the acquired firm to make regular loan payments after the completion of a leveraged buyout, some features of potential target firms make for more attractive leverage buyout candidates, including:

  • Low existing debt loads;
  • A multi-year history of stable and recurring cash flows;
  • Hard assets (property, plant and equipment, inventory, receivables) that may be used as collateral for lower cost secured debt;
  • The potential for new management to make operational or other improvements to the firm to boost cash flows;
  • Market conditions and perceptions that depress the valuation or stock price.

Contents

[edit] Characteristics

Diagram of the basic structure of a generic leveraged buyout transaction

Leveraged buyouts involve financial sponsors or private equity firms making large acquisitions without committing all the capital required for the acquisition. To do this, a financial sponsor will raise acquisition debt which is ultimately secured upon the acquisition target and also looks to the cash flows of the acquisition target to make interest and principal payments. Acquisition debt in an LBO is therefore usually non-recourse to the financial sponsor and to the equity fund that the financial sponsor manages. Furthermore, unlike in a hedge fund, where debt raised to purchase certain securities is also collateralized by the fund's other securities, the acquisition debt in an LBO is recourse only to the company purchased in a particular LBO transaction. Therefore, an LBO transaction's financial structure is particularly attractive to a fund's limited partners, allowing them the benefits of leverage but greatly limiting the degree of recourse of that leverage.

This kind of acquisition brings leverage benefits to an LBO's financial sponsor in two ways: (1) the investor itself only needs to provide a fraction of the capital for the acquisition, and (2) assuming the economic internal rate of return on the investment (taking into account expected exit proceeds) exceeds the weighted average interest rate on the acquisition debt, returns to the financial sponsor will be significantly enhanced.

As transaction sizes grow, the equity component of the purchase price can be provided by multiple financial sponsors "co-investing" to come up with the needed equity for a purchase. Likewise, multiple lenders may band together in a "syndicate" to jointly provide the debt required to fund the transaction. Today, larger transactions are dominated by dedicated private equity firms and a limited number of large banks with "financial sponsors" groups.

As a percentage of the purchase price for a leverage buyout target, the amount of debt used to finance a transaction varies according the financial condition and history of the acquisition target, market conditions, the willingness of lenders to extend credit (both to the LBO's financial sponsors and the company to be acquired) as well as the interest costs and the ability of the company to cover those costs. Typically the debt portion of a LBO ranges from 50%-85% of the purchase price, but in some cases debt may represent upwards of 95% of purchase price. Between 2000-2005 debt averaged between 59.4% and 67.9% of total purchase price for LBOs in the United States.[1]

[edit] History

History of private equity
and venture capital

Early History
(Origins of modern private equity)
•
The 1980s
(LBO boom)
•
The 1990s
(LBO bust and the VC bubble)
•
The 2000s
(Dot-com bubble to the Credit crunch)
 v • d • e 
Main article: History of private equity and venture capital

[edit] Origins of the leveraged buyouts

Main article: Early history of private equity

The first leveraged buyout may have been the purchase by McLean Industries, Inc. of Pan-Atlantic Steamship Company in January 1955 and Waterman Steamship Corporation in May 1955.[2] Under the terms of that transaction, McLean borrowed $42 million and raised an additional $7 million through an 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.[3] Similar to the approach employed in the McLean transaction, the use of publicly traded holding companies as investment vehicles to acquire portfolios of investments in corporate assets was a relatively new trend in the 1960s popularized by the likes of Warren Buffett (Berkshire Hathaway) and Victor Posner (DWG Corporation) and later adopted by Nelson Peltz (Triarc), Saul Steinberg (Reliance Insurance) and Gerry Schwartz (Onex Corporation). These investment vehicles would utilize a number of the same tactics and target the same type of companies as more traditional leveraged buyouts and in many ways could be considered a forerunner of the later private equity firms. In fact it is Posner who is often credited with coining the term "leveraged buyout" or "LBO"[4]

The leveraged buyout boom of the 1980s was conceived by a number of corporate financiers, most notably Jerome Kohlberg, Jr. and later his protégé Henry Kravis. Working for Bear Stearns at the time, Kohlberg and Kravis, along with Kravis' cousin George Roberts, began a series of what they described as "bootstrap" investments. Many of the target companies lacked a viable or attractive exit for their founders, as they were too small to be taken public and the founders were reluctant to sell out to competitors. Thus a sale to a financial buyer might prove attractive. Their acquisition of Orkin Exterminating Company in 1964 is among the first significant leveraged buyout transactions.[5][unreliable source?]. In the following years the three Bear Stearns bankers would complete a series of buyouts including Stern Metals (1965), Incom (a division of Rockwood International, 1971), Cobblers Industries (1971), and Boren Clay (1973) as well as Thompson Wire, Eagle Motors and Barrows through their investment in Stern Metals. [6] By 1976, tensions had built up between Bear Stearns and Kohlberg, Kravis and Roberts leading to their departure and the formation of Kohlberg Kravis Roberts in that year.

[edit] Leveraged buyouts in the 1980s

Main article: Private equity in the 1980s

In January 1982, former US Secretary of the Treasury William Simon and a group of investors acquired Gibson Greetings, a producer of greeting cards, for $80 million, of which only $1 million was rumored to have been contributed by the investors. By mid-1983, just sixteen months after the original deal, Gibson completed a $290 million IPO and Simon made approximately $66 million.[7] The success of the Gibson Greetings investment attracted the attention of the wider media to the nascent boom in leveraged buyouts. Between 1979 and 1989, it was estimated that there were over 2,000 leveraged buyouts valued in excess of $250 billion[8]

During the 1980s, constituencies within acquired companies and the media ascribed the "corporate raid" label to many private equity investments, particularly those that featured a hostile takeover of the company, perceived asset stripping, major layoffs or other significant corporate restructuring activities. Among the most notable investors to be labeled corporate raiders in the 1980s included Carl Icahn, Victor Posner, Nelson Peltz, Robert M. Bass, T. Boone Pickens, Harold Clark Simmons,Kirk Kerkorian, Sir James Goldsmith, Saul Steinberg and Asher Edelman. Carl Icahn developed a reputation as a ruthless corporate raider after his hostile takeover of TWA in 1985.[9][10] Many of the corporate raiders were onetime clients of Michael Milken, whose investment banking firm, Drexel Burnham Lambert helped raise blind pools of capital with which corporate raiders could make a legitimate attempt to take over a company and provided high-yield debt financing of the buyouts.

One of the final major buyouts of the 1980s proved to be its most ambitious and marked both a high water mark and a sign of the beginning of the end of the boom that had begun nearly a decade earlier. In 1989, KKR closed in on a $31.1 billion dollar takeover of RJR Nabisco. It was, at that time and for over 17 years, the largest leverage buyout in history. The event was chronicled in the book (and later the movie), Barbarians at the Gate: The Fall of RJR Nabisco. KKR would eventually prevail in acquiring RJR Nabisco at $109 per share marking a dramatic increase from the original announcement that Shearson Lehman Hutton would take RJR Nabisco private at $75 per share. A fierce series of negotiations and horse-trading ensued which pitted KKR against Shearson Lehman Hutton and later Forstmann Little & Co. Many of the major banking players of the day, including Morgan Stanley, Goldman Sachs, Salomon Brothers, and Merrill Lynch were actively involved in advising and financing the parties. After Shearson Lehman's original bid, KKR quickly introduced a tender offer to obtain RJR Nabisco for $90 per share—a price that enabled it to proceed without the approval of RJR Nabisco's management. RJR's management team, working with Shearson Lehman and Salomon Brothers, submitted a bid of $112, a figure they felt certain would enable them to outflank any response by Kravis's team. KKR's final bid of $109, while a lower dollar figure, was ultimately accepted by the board of directors of RJR Nabisco.[11] At $31.1 billion of transaction value, RJR Nabisco was by far the largest leveraged buyout in history. In 2006 and 2007, a number of leveraged buyout transactions were completed that for the first time surpassed the RJR Nabisco leveraged buyout in terms of nominal purchase price. However, adjusted for inflation, none of the leveraged buyouts of the 2006–2007 period would surpass RJR Nabisco.

By the end of the 1980s the excesses of the buyout market were beginning to show, with the bankruptcy of several large buyouts including Robert Campeau's 1988 buyout of Federated Department Stores, the 1986 buyout of the Revco drug stores, Walter Industries, FEB Trucking and Eaton Leonard. Additionally, the RJR Nabisco deal was showing signs of strain, leading to a recapitalization in 1990 that involved the contribution of $1.7 billion of new equity from KKR.[12]

Drexel Burnham Lambert was the investment bank most responsible for the boom in private equity during the 1980s due to its leadership in the issuance of high-yield debt.

Drexel reached an agreement with the government in which it pleaded nolo contendere (no contest) to six felonies—three counts of stock parking and three counts of stock manipulation.[13] It also agreed to pay a fine of $650 million—at the time, the largest fine ever levied under securities laws. Milken left the firm after his own indictment in March 1989.[14] On February 13, 1990 after being advised by Secretary of the Treasury Nicholas F. Brady, the SEC, the NYSE and the Federal Reserve, Drexel Burnham Lambert officially filed for Chapter 11 bankruptcy protection.[14]

[edit] Age of the mega-buyout 2005-2007

Main article: Private equity in the 21st century

The combination of decreasing interest rates, loosening lending standards and regulatory changes for publicly traded companies (specifically the Sarbanes-Oxley Act) would set the stage for the largest boom private equity had seen. Marked by the buyout of Dex Media in 2002, large multi-billion dollar U.S. buyouts could once again obtain significant high yield debt financing and larger transactions could be completed. By 2004 and 2005, major buyouts were once again becoming common, including the acquisitions of Toys "R" Us[15], The Hertz Corporation [16][17], Metro-Goldwyn-Mayer[18] and SunGard[19] in 2005.

As 2005 ended and 2006 began, new "largest buyout" records were set and surpassed several times with nine of the top ten buyouts at the end of 2007 having been announced in an 18-month window from the beginning of 2006 through the middle of 2007. In 2006, private equity firms bought 654 U.S. companies for $375 billion, representing 18 times the level of transactions closed in 2003.[20] Additionally, U.S. based private equity firms raised $215.4 billion in investor commitments to 322 funds, surpassing the previous record set in 2000 by 22% and 33% higher than the 2005 fundraising total[21] The following year, despite the onset of turmoil in the credit markets in the summer, saw yet another record year of fundraising with $302 billion of investor commitments to 415 funds[22] Among the mega-buyouts completed during the 2006 to 2007 boom were: Equity Office Properties, HCA[23], Alliance Boots[24] and TXU[25].

In July 2007, turmoil that had been affecting the mortgage markets, spilled over into the leveraged finance and high-yield debt markets.[26][27] The markets had been highly robust during the first six months of 2007, with highly issuer friendly developments including PIK and PIK Toggle (interest is "Payable In Kind") and covenant light debt widely available to finance large leveraged buyouts. July and August saw a notable slowdown in issuance levels in the high yield and leveraged loan markets with only few issuers accessing the market. Uncertain market conditions led to a significant widening of yield spreads, which coupled with the typical summer slowdown led to many companies and investment banks to put their plans to issue debt on hold until the autumn. However, the expected rebound in the market after Labor Day 2007 did not materialize and the lack of market confidence prevented deals from pricing. By the end of September, the full extent of the credit situation became obvious as major lenders including Citigroup and UBS AG announced major writedowns due to credit losses. The leveraged finance markets came to a near standstill.[28] As 2007 ended and 2008 began, it was clear that lending standards had tightened and the era of "mega-buyouts" had come to an end. Nevertheless, private equity continues to be a large and active asset class and the private equity firms, with hundreds of billions of dollars of committed capital from investors are looking to deploy capital in new and different transactions.

[edit] Rationale

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,[29] the total return of an asset to its owners, all else being equal and within strict restrictive assumptions, 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, according to the Modigliani-Miller theorem with taxes, increases the value of the firm. This 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.

Germany currently introduces new tax laws, taxing parts of the cash flow before debt interest deduction. The motivation for the change is to discourage leveraged buyouts by reducing the tax shield effectiveness.[citation needed]

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 likely be producing a higher income stream. Because this type of management arbitrage and easy restructuring has largely been accomplished, LBOs today focus more on growth and complicated financial engineering to achieve their returns. Most leveraged buyout firms look to achieve an internal rate of return in excess of 20%.

[edit] Management buyouts

Main article: Management buyout

A special case of such acquisition is a management buyout (MBO), which occurs when a company's managers buy or acquire a large part of the company. The goal of an MBO may be to strengthen the managers' interest in the success of the company. In most cases, the management will then make the company private. MBOs have assumed an important role in corporate restructurings beside mergers and acquisitions. Key considerations in an MBO are fairness to shareholders, price, the future business plan, and legal and tax issues. One recent criticism of MBOs is that they create a conflict of interest—an incentive is created for managers to mismanage (or not manage as efficiently) a company, thereby depressing its stock price, and profiting handsomely by implementing effective management after the successful MBO.

[edit] Failures

Some LBOs in the 1980s and 1990s resulted in corporate bankruptcy, such as Robert Campeau's 1988 buyout of Federated Department Stores and the 1986 buyout of the Revco drug stores. The failure of the Federated buyout was a result of excessive debt financing, comprising about 97% of the total consideration, which led to large interest payments that exceeded the company's operating cash flow. In response to the threat of LBOs, certain companies adopted a number of techniques, such as the poison pill, to protect them against hostile takeovers by effectively self-destructing the company if it were to be taken over.

The inability to repay debt in an LBO can be caused by initial overpricing of the target firm and/or its assets. Because LBO funds often attempt to increase the value of an acquired company by liquidating certain assets or selling underperforming business units, the bought-out firm may face insolvency as depleted operating revenues become insufficient to repay the debt. Over-optimistic forecasts of the revenues of the target company may also lead to financial distress after acquisition. The LBO debt may constitute a fraudulent transfer under U.S. insolvency law if it is determined to be the cause of the acquired firm's failure. [30]

[edit] Secondary buyouts

A secondary buyout is a form of leveraged buyout where both the buyer and the seller are private equity firms or financial sponsors (i.e. a leveraged buyout of a company that was acquired through a leveraged buyout). A secondary buyout will often provide a clean break for the selling private equity firms and its limited partner investors. Historically, however, secondary buyouts were perceived as distress sales by both seller and buyer, were considered unattractive by limited partner investors and were largely avoided.

The increase in secondary buyout activity was driven in large part by an increase in capital in the leveraged buyout space. Often, selling private equity firms will pursue a secondary buyout for a number of reasons:

  • Sales to strategic buyers and IPOs may not be possible for niche or undersized businesses
  • Secondary buyouts may generate liquidity more quickly than other routes (i.e., IPOs)
  • Secondary buyouts are a much faster path to liquidity than IPOs

Often, secondary buyouts were successful if the investment has reached an age where it is necessary or desirable to sell rather than hold the investment further or where the investment had already generated significant value for the selling firm.

Secondary buyouts differ from secondaries or secondary market purchases which typically involve the acquisition of portfolios of private equity assets including limited partnership stakes and direct investments in corporate securities.

[edit] See also

[edit] Notes

  1. ^ Trenwith Group "M&A Review," (Second Quarter, 2006)
  2. ^ On January 21, 1955, McLean Industries, Inc. purchased the capital stock of Pan Atlantic Steamship Corporation and Gulf Florida Terminal Company, Inc. from Waterman Steamship Corporation. In May McLean Industries, Inc. completed the acquisition of the common stock of Waterman Steamship Corporation from its founders and other stockholders.
  3. ^ 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.
  4. ^ Trehan, R. (2006). The History Of Leveraged Buyouts. December 4, 2006. Accessed May 22, 2008
  5. ^ The History of Private Equity Investment U
  6. ^ Burrough, Bryan. Barbarians at the Gate. New York : Harper & Row, 1990, p. 133-136
  7. ^ Taylor, Alexander L. "Buyout Binge". TIME magazine, Jul. 16, 1984.
  8. ^ Opler, T. and Titman, S. "The determinants of leveraged buyout activity: Free cash flow vs. financial distress costs." Journal of Finance, 1993.
  9. ^ 10 Questions for Carl Icahn by Barbara Kiviat, TIME magazine, Feb. 15, 2007
  10. ^ TWA - Death Of A Legend by Elaine X. Grant, St Louis Magazine, Oct 2005
  11. ^ Game of Greed (TIME magazine, 1988)
  12. ^ Wallace, Anise C. "Nabisco Refinance Plan Set." The New York Times, July 16, 1990.
  13. ^ Stone, Dan G. (1990). April Fools: An Insider's Account of the Rise and Collapse of Drexel Burnham. New York City: Donald I. Fine. ISBN 1556112289. 
  14. ^ a b Den of Thieves. Stewart, J. B. New York: Simon & Schuster, 1991. ISBN 0-671-63802-5.
  15. ^ SORKIN, ANDREW ROSS and ROZHON, TRACIE. "Three Firms Are Said to Buy Toys 'R' Us for $6 Billion ." New York Times, March 17, 2005.
  16. ^ ANDREW ROSS SORKIN and DANNY HAKIM. "Ford Said to Be Ready to Pursue a Hertz Sale." New York Times, September 8, 2005
  17. ^ PETERS, JEREMY W. "Ford Completes Sale of Hertz to 3 Firms." New York Times, September 13, 2005
  18. ^ SORKIN, ANDREW ROSS. "Sony-Led Group Makes a Late Bid to Wrest MGM From Time Warner." New York Times, September 14, 2004
  19. ^ "Capital Firms Agree to Buy SunGard Data in Cash Deal." Bloomberg, March 29, 2005
  20. ^ Samuelson, Robert J. "The Private Equity Boom". The Washington Post, March 15, 2007.
  21. ^ Dow Jones Private Equity Analyst as referenced in U.S. private-equity funds break record Associated Press, January 11, 2007.
  22. ^ Dow Jones Private Equity Analyst as referenced in Private equity fund raising up in 2007: report, Reuters, January 8, 2008.
  23. ^ SORKIN, ANDREW ROSS. "HCA Buyout Highlights Era of Going Private." New York Times, July 25, 2006.
  24. ^ WERDIGIER, JULIA. "Equity Firm Wins Bidding for a Retailer, Alliance Boots." New York Times, April 25, 2007
  25. ^ Lonkevich, Dan and Klump, Edward. KKR, Texas Pacific Will Acquire TXU for $45 Billion Bloomberg, February 26, 2007.
  26. ^ SORKIN, ANDREW ROSS and de la MERCED, MICHAEL J. "Private Equity Investors Hint at Cool Down." New York Times, June 26, 2007
  27. ^ SORKIN, ANDREW ROSS. "Sorting Through the Buyout Freezeout." New York Times, August 12, 2007.
  28. ^ Economist.com/finance/displaystory.cfm?story_id=9566005 Turmoil in the markets The Economist July 27, 2007
  29. ^ Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance, and the Theory of Investment," American Economic Review, June 1958.
  30. ^ U.S. Bankruptcy Code, 11 U.S.C. § 548(2); Uniform Fraudulent Transfer Act, § 4. This is because the company usually gets no direct financial benefit from the transaction but incurs the debt for it nevertheless.


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