In the last few years, the private equity market has continued to balloon. In 2015, there was $2.4 trillion in private equity assets under management and the market as a whole saw an aggregate value of total buyout deals hit $411 billion.1 In comparison, there was $716 billion of total assets under management in the…
Tag: Leveraged Buyouts
New Chapter for Fraudulent Conveyance in LBOs?
In the wake of the 2008 financial crisis, many companies that were the targets of Leveraged Buyouts (LBOs) filed for bankruptcy.1 In an LBO, creditors secure their loans against the target company’s assets, subordinating the claims of the target’s pre-LBO creditors. Thus, should the LBO fail and the target company file for bankruptcy, its pre-LBO…
In Re Lyondell Chemical Company, The Long Arm of a Failed LBO
To the interested observer of private equity, a typical leveraged buyout follows a relatively predictable sequence. Most buyouts begin with a sponsor such as KKR or Blackstone forming a limited partnership, serving as the general partner, and acquiring initial capital from investors who form the partnership’s limited partners.1 Once a target company has been identified,…
What is Real Estate Private Equity?
Since the 2008 Economic Recession, many of the maxims that investors have lived by have been challenged and proven wrong. One of these, albeit hasty and uninformed, maxims—that real estate is a safe investment that will continuously appreciate in value over time—has been convincingly disproven to anyone who has paid attention to the volatility of…
Taking Back the Castle: Michael Dell, Silver Lake, and the Battle for Dell Inc.
On September 13, 2013, shareholders of the personal computer giant Dell Inc. voted to approve the proposed leveraged buyout of the company by founder Michael Dell and the private equity firm Silver Lake.1 The vote put an end to the nearly year-long saga that pitted two of the country’s wealthiest men against one another. Although…
A Flash of Light in a Dark Holding Environment? Apollo’s Resuscitation of the Quick Flip
The peak purchase prices private equity firms secured immediately prior to the financial crisis have left many firms stuck with poor exit options after portfolio valuations plunged in the aftermath of the crisis. The decrease in portfolio valuations resulted in increased holding times across the private equity industry as profitable exit options disappeared.1 For example,…
Private Equity and the Leveraged Buyout: Taking a Public Company Private
What is a Leveraged buyout?
A leveraged buyout (LBO) is a form of a business acquisition. However, it differs from an ordinary merger and acquisition (M&A) deal in many ways. First, the acquirer in an LBO is not a traditional corporation as in other acquisitions. Instead, the acquirer is a newly formed non-operating company, made up of the private equity firm and often the party who will manage the daily activities of the business.
Additionally, LBO’s are heavily debt financed, often with as little as 10 to 20% of the purchase price coming from equity investment.[1] In order to secure the large amount of debt necessary to complete the deal, the non-operating company is forced to borrow against the physical assets of the acquired business.[2]
Once the terms of the LBO are agreed to, current shareholders will be compensated with an agreed upon per share price and the ownership will be transferred to the non-operating company (the private equity firm and all other investors).
Why take a company private through an LBO?
Private equity firms are motivated to take the targeted company private in order to unlock potential synergy gains[3]. These synergy gains might come from financial restructuring, change in control, or increased coordination in decision-making.[4]
Firms often create synergy gains through financial restructuring. As discussed before, leveraged buyouts involve heavy debt financing. Debt has a tax benefit not available from equity investment, in that the interest owed on current outstanding debt decreases taxable income, resulting in higher cash flow available to all stakeholders.[5] In other words, debt creates a tax-shield equal to current interest expense multiplied by the effective tax rate.[6] Therefore, increasing the amount of debt within the financial structure of the firm can create value.
Additionally, Private equity firms often look to unlock synergy gains by eliminating the waste associated with inefficient management. By taking the company private, the firm no longer has to seek shareholder approval of management, but instead, can self select the new leadership team.[7] The idea is that the new management team will make better business decisions, increasing revenues and decreasing the associated costs.
Moreover, even if current management is efficiently running the company, there are coordination advantages from taking a company private. Public companies face a folly A/folly B problem. The company wants long-term success. In other words, it wants to make investments that result in the greatest net present value in the long run. However, companies have to respond to shareholders, who reward short-term performance, which results in increased stock price, over long term performance.
By taking the company private, management has flexibility in its decision-making and can focus on long-term performance without having to worry about shareholder repercussions. Also, public companies are often slow to act because there is a shareholder coordination problem. The company must provide information on major changes to all shareholders and must convince owners of a majority of the shares to vote collectively. By taking the company private, ownership is concentrated in a few individuals/entities who can act swiftly.
The potential downside of an LBO
While there are certainly numerous potential sources of synergy gains associated with an LBO, the form of acquisition is not without its risks. When levering a company to such a high debt to equity (D/E) ratio, the company must be able to produce enough cash flow to make its periodic interest payments on the outstanding debt. As a result, the risk of bankruptcy increases and the possibility of receiving the tax shield decreases. Additionally, banks will require higher returns to compensate for the risk associated with the debt. Therefore, private equity firms partaking in LBOs are continuously confronting the issue of how much leverage to implement in the deal.
Additionally, in an LBO, there is a constant conflict between shareholders and bondholders. Shareholders are incentivized to take risk, whereas bondholders prefer sound investments that will allow the company to pay back its debt. Therefore, when securing debt, private equity firms might lose some financial flexibility due to bank-imposed constraints on spending. If not managed properly this can counteract some of the benefits associated with making the move to a private company.
Lastly, by taking a company private, the investors lose access to a liquid market. As a result, it may take longer to recoup the investment. Research has indicated that the median LBO is still in private equity ownership around 9 years after the initial buyout transaction.[8]
Who is a good LBO target?
Given the potential risks associated with an LBO transaction, private equity firms must be careful when deciding whom to target. Private equity firms should look at targets from a three-value driver perspective: leverage, change in control and private-public.[9] The ideal target should be underlevered, inefficiently managed, and should be incurring large costs from staying public.[10] Additionally, companies with large assets and stable free cash-flows (cash cows) can support more debt, making them an attractive target. At the same time, private equity firms want to avoid using an LBO to purchase companies in highly cyclical industries and industries with rapid product obsolescence.[11] Companies in these industries are prone to periods of low to negative free cash-flows, which in turn increases the probability that they will be unable to meet their debts as they come due.
Summary
LBO’s are a form of private equity acquisition, in which the investors form a non-operating company and purchase a public company by implementing primarily debt financing. Taking a public company private can create gains in a multitude of ways, including increased tax shield free cash flows, elimination of inefficient management, and increased coordination of decision making. At the same time, there are many risks associated with an LBO. The risk of bankruptcy increases immensely, resulting in higher lending rates and loss of some financial flexibility. Consequently, private equity firms must be strategic about when to implement an LBO acquisition and realize that it is not always the proper tool.
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[1] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013); Note on Leveraged Buyouts. Center For Private Equity and Entrepreneurship at 1, available at http://pages.stern.nyu.edu/~igiddy/LBO_Note.pdf.
[2] Steven N. Kaplan & Per Stromberg, Leveraged Buyouts and Private Equity, Journal of Economic Perspectives, American Economic Association 23(1), 2009.
[3] Here, synergy gain is a proxy for a long term financial benefit
[4] See Note on Leveraged Buyouts at 2.
[5] Grant Houston, Tax Advantages of a Leveraged Buyout, Chron, http://smallbusiness.chron.com/tax-advantages-leveraged-buyout-24006.html
[6] See id.
[7] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013).
[8] See Kaplan, supra note 2, at 130.
[9] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013).
[10] Id.
[11] Id..
Is the 2013 Private Equity Boom Sustainable?
2013 has seen an early resurgence in the volume of mergers and acquisitions conducted globally. Since January, there have been in excess of 1000 deals with an aggregate value of over $160 billion,1 the fastest start since 2005.2 This boom has been anchored by several large, and sometimes unprecedented, buyouts, including the $23 billion takeover of…
Dividend Recapitalization: A Controversial Trend
In a slow economy, with low interest rates, private equity firms are adding debt to the companies they own in order to create returns for investors. This controversial practice is now reaching record pace.[1] The resurgence is due to investors’ desires of achieving high yielding debt at a time of historically low interest rates.[2] Some of the most prominent private equity firms, such as Leonard Green & Partners LP, Bain Capital LLC, and the Carlyle Group LP are a few of the firms using this tactic, which became popular before the financial crisis.[3] Between 2003 and 2008, companies borrowed $69 billion primarily to pay dividends to private-equity owners, according to Standard & Poor’s Corp.[4] That compares with $10 billion in the previous six years.[5]
“In these deals, known as ‘dividend recapitalizations,’ private-equity-owned companies raise cash by issuing debt. The proceeds are distributed in the form of dividends to buyout groups.[6] In other words, private equity firms are creating returns for their shareholders by leveraging the companies that they own. This financing method allows the private equity fund to recoup part, if not all, of the fund’s initial investment and leaves open the possibility of benefiting from any future increase in value, since no sale transaction occurs.[7] Despite the creation of high returns for shareholders, this trend of dividend recapitalization may prove to be extremely costly to a recovering economy.
First, many private equity funds, especially the mid-sized and smaller funds, are likely to feel pressure to sell off portfolio companies to create liquidity for their investors and build a track record that will support future fund raising efforts.[8] Although the main goal for private equity firms is to create returns for investors, this is not the way that private equity firms traditionally went about fulfilling that goal. In the traditional sense, multiple parties with diverging interest potentially benefited from private equity firms taking over a struggling company. A struggling company would be made profitable through changes made by the private equity firm, and the private equity firm would sell the company once they thought they could get a return on their investment. With “dividend recapitalization,” the only party that benefits is the stockholders. They are getting paid, but the companies that the private equity firm owns are not any better off. In many cases they are worse off, as private equity firms may be unwisely leveraging the companies they own.
Second, through dividend recapitalizations, private equity funds maintain high leverage on portfolio companies capable of paying down their debt, thereby maintaining risk of insolvency.[9] In times of economic uncertainty, it does not seem like a wise move to create unnecessary debt. One has to wonder what would be the consequence if some of these companies started going bankrupt. It all probably depends on how greedy the private equity firms are. There is one thing that will probably keep them in check, their public image. Leonard Green & Partners LP, Bain Capital LLC, and the Carlyle Group LP do not want to be known as the people who shut down American companies.
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[1] Ryan Dezember & Matt Wirz, Debt Fuels a Dividend Boom, Wall St. J., Oct. 18, 2012, (http://online.wsj.com/article/SB10000872396390444592704578064672995070116.html?mod=WSJ_Markets_LEFTTopStories)
[2] Id.
[3] Id.
[4] Louis S. Freeman, General Overview And Strategies In Representing Sellers, 825 PLI/Tax 7
[5] Id.
[6] Dezember & Wirst, supra note 1.
[7] Alan S. Gutterman, et al., Review of Major Developments Affecting Mergers, Acquisitions and Divestitures, 28 No. 12 Corp Acq Ideas 1
[8] Louis S. Freeman, General Overview And Strategies In Representing Sellers, 825 PLI/Tax 7
[9] Id.