Question

Briefly explain why the share-market impact of the announcement of an LBO might be so different to that of the other corporate restructuring transactions studied by Eckbo and Thorburn.

Answer 1

Share market impact of leveraged buyout announcements:

An ALBO is the process of acquiring another company using a significant amount of borrowed money or debt to meet the acquisition cost. Collateral used for issuing debt are the assets of the company being acquired along with the assets of the acquiring company. The purpose is to allow the acquirer make large acquisitions without committing a lot of capital.
LBOs are conducted for three main reasons:

1. Privatization of the public companies
2. To sell a part of the existing business
3. To transfer private property
   

LBOs have been considered as a predatory technique for corporate structuring and the profitability completely depends on the current performance of the acquired companies. The direct impact of such LBOs on the share market is usually negative because of the following reasons:

1. There is usually a ratio of 90% debt to 10% equity which makes them a burden on the operating cash flows of the acquiring company.
2. They are not considered as investment opportunities by the investors and are referred to as junk bonds instead.
3. They are not usually sanctioned by the target company. Further, it is seen as against the growth of the acquired company because its assets on the balance sheet can be used against it as collateral by a hostile company.
4. The history of LBOs had not been very colorful as it has led to eventual bankruptcy of the acquired companies. The leverage ratio is high up to 100% that the acquiring company leads into credit default leading the investors losing their money.

Positive impacts of LBO on share market.

1. LBO could have a positive impact on the share prices of acquired public company because there are benefits of going private. The management is separated from the ownership which usually leads to increase in earnings of the public company.
2. The financial structure of the acquiring firm changes which permits it to reorganize altering its incentive structure and leads to increase in its earning potential.
3. LBOs can create wealth for stockholders of the acquiring company because of the redistribution of the stock structure. The acquired firm brings in junk bonds that are known for very high yields.