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Advantages and Disadvantages of Leveraged Buyout

What is a leveraged buyout?
A leveraged buyout or LBO is a type of aggressive business practice whereby investors
or a larger corporation utilizes borrowed funds (junk bonds, traditional bank loans,
etc.) or debt to finance its acquisition. Both the assets of the acquiring corporation
and acquired company function as a form of secured collateral in this type of business
deal. Often times, a leveraged buyout does not involve much committed capital, as
reflected by the high debt-to-equity ratio of the total purchase price (an average
of 70% debt with 30% equity). In addition, any interest that accrues during the
buyout will be compensated by the future cash flow of the acquired company. Other
terms used synonymously with an LBO are “hostile takeover,” “highly-leveraged transaction,”
and “bootstrap transaction.”

Going private
Once the control of a company is acquired, the firm is then made private for some
time with the intent of going public again. During this “private period,” new owners
(the buyout investors) are able to reorganize a company’s corporate structure with
the objective of making a substantial profitable return. Some comprehensive changes
include downsizing departments through layoffs or completely ridding unnecessary
company divisions and sectors. Buyout investors can also sell the company as a whole
or in different parts in order to achieve a high rate on returns.

The 1980’s buyout boom
Historically, leveraged buyouts soared in the 1980s due to various U.S. economic
and regulatory factors. First, the Reagan administration of the 1980s employed very
liberal federal anti-trust and securities legislation, which greatly endorsed the
merger and acquisition (M&A) of corporations. Second, in 1982, the Supreme Court
declared any state law against takeovers as unconstitutional, further promoting
corporate M&A. Third, deregulation (relaxation, reduction, or complete removal)
of many industry-related legislation restrictions incited further proceedings of
corporate reorganization and acquisition. In addition, the use of risky high-interest
bonds (also known as junk bonds) made it possible for multi-million dollar companies
to buyout enterprises with very little capital.

Management buyouts or MBO
The most common buyout agreement is the management buyout or MBO. In this corporate
arrangement, the company’s management teams and/or executives agree to “buyout”
or acquire a large part of the company, subsidiary, or divisions from the existing
shareholders. Due to the fact that this financial compromise requires a considerable
amount of capital, the management team often employs the assistance of
venture capitalists
to finance this endeavor. As with traditional leveraged
buyouts, the company is made private and corporate restructuring occurs. Many financial
analysts will agree that MBOs will greatly increase management commitment since
they are involved in the high stake of a company.

Pros and cons of leveraged buyouts
Financial analysts strongly believe there are many pros and cons in the leveraged
buyout of a company.

Corporate restructuring

Pros- One positive aspect of leveraged buyouts is the fact that poorly managed
firms prior to their acquisition can undergo valuable corporate reformation when
they become private. By changing their corporate structure (including modifying
and replacing executive and management staff, unnecessary company sectors, and excessive
expenditures), a company can revitalize itself and earn substantial returns.

Cons- Corporate restructuring from leveraged buyouts can greatly impact employees.
At times, this means companies may have to downsize their operations and reduce
the number of paid staff, which results in unemployment for those who will be laid
off. In addition, unemployment after leveraged acquisition of a company can result
in negative effects of the overall community, hindering its economic prosperity
and development. Some leveraged buyouts may not be friendly and can lead to rather
hostile takeovers, which goes against the wishes of the acquired firms’ managers.

An example of a hostile takeover occurred when the PepsiCo acquired the Quaker Oats
Company, an American food company well-known for its breakfast cereals and oatmeal
products. In 2001, PepsiCo, in an attempt to diversify its portfolio in non-carbonated
drinks, primarily acquired Quaker Oats because QO owned the Gatorade brand. Even
though this merger created the fourth-largest consumer goods company in the world,
many of Quaker Oats’ managers were against the acquisition, claiming that such a
merger was unlawful and contrary to the public interest.

Small amount of capital requirements

Pros- Since this type of acquisition involves a high debt-to-equity ratio,
large corporations can easily acquire smaller companies with very little capital.
If the acquired company’s returns are greater than the cost of the debt financing,
then all stockholders can benefit from the financial returns, further increasing
the value of a firm.

Cons- However, if the company’s returns are less than the cost of the debt
financing, then corporate bankruptcy can result. In addition, the high-interest
rates imposed by leveraged buyouts may be a challenge for companies whose cash-flow
and sale of assets are insufficient. The result cannot only lead to a company’s
bankruptcy but can also result in a poor line of credit for the buyout investors.

An example of an unsuccessful leveraged buyout is the Federated Department Stores.
The Federated Department Stores had many stores nationwide and tailored primarily
to high-end retailers. However, they lacked an effective marketing strategy. In
1989, Robert Campeau, a Canadian financier, bought out Federated with the hope to
make considerable changes. Only one year later, and only after some reforms, Federated
could not keep up with the financial burdens of high interest payments and had to
file bankruptcy for 258 stores.

Management buyout

Pros- As mentioned earlier, management buyout of a company is a common business
practice. Often times, MBOs occur as a last resort to save an enterprise from permanent
closure or replacement of existing management teams by an outside company. Many
analysts strongly believe management buyouts greatly promote executive and shareholder
interests as well as management loyalty and efficiency.

Cons- Not every MBO turns out to be successful as planned. Management buyouts
can generate substantial conflicts of interest among employees and managers alike.
Management and executive teams can easily be lured to propose a short-term buyout
for personal profit. In addition, they can also corruptly mismanage a company, leading
to an enterprise’s depreciated stock.

An example of a successful management buyout is Springfield Remanufacturing Corporation,
or SRC, an engine remanufacturing plant located in Springfield, Missouri. In 1983,
SRC was at risk for permanent closure and was being bought by an outside company
until their employees decided to buyout the company. The management buyout of SRC
resulted in extreme success. Since 1983, it has grown exponentially from one company
within $10,000 of being shut down to a proud assembly of 23 small businesses with
a combined profit of over $120 million today.

Economy

Pros- Every leveraged buyout can be considered risky, especially in reference
to the existing economy. If the existing economy is strong and remains solid, then
the leveraged buyout can greatly improve its chances for success.

Cons- On the other hand, a weak economy is highly indicative of a problematic
LBO. During an economic crisis, money may be difficult to come by and dollar weakness
could make acquiring companies result in poor financial returns. In addition, acquisition
can affect employee morale, increase animosity against the acquiring corporation,
and can hinder the overall growth of a company.

Conclusion

There are many advantages and disadvantages concerning leveraged buyouts. First,
this type of agreement can allow many large companies to acquire smaller-sized enterprises
with very little personal capital. Second, since corporate restructuring can take
place, the acquired company can benefit from necessary reorganization and reform.
In addition, management buyout can prevent a company from being acquired by external
sources or from being shut down completely. However, there are many disadvantages
imposed by LBOs as well. Often times, the restructuring can lead a company to downsize
and can even result in hostile takeovers. The high interest rates from the high
debt-to-equity amounts can result in a corporation’s bankruptcy, especially if the
company is not generating substantial returns after acquisition. Lastly, management
buyouts can produce conflicts of interest among employees, executives, and management
teams as well as possible mismanagement by the buyout owners. With the potential
for enormous profit, it is no wonder that leveraged buyout strategies expanded throughout
the 1980s and have recently made a comeback in modern corporate America.

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