Question

Discuss the following aspects of leveraged buyouts and management buyouts. What type of company makes the ideal target for a leveraged buyout or a management buyout? How is the capital structure of the typical LBO or MBO formed? What is the source of high risk and cost reduction in the capital structure of the typical LBO or MBO? What is the second source of cost savings in the LBO or MBO? What is the ultimate goal of the insider owners who initiate the LBO or MBO?

Answer 1

First let's understand what a Leveraged Buyout(LB) or Management Buyout(MB) is -

A leveraged buyout is a a transaction wherein a company acquires another company using a large amount of money that is borrowed (hence, the term leverage) in order to contribute towards the acquisition cost of a company. The assets of the company being acquired is pledged a collateral for this loan, along with the assets of the parent/acquiring company. The purpose of these buyouts is to acquire companies without having to invest a lot of capital. The ratio of debt to equity is generally 90% and 10%, making the company very leveraged.

A management buyout is a a form of acquisition wherein the company's senior management purchases the either all or a large part of the company that they manage. The financing required for a management buyout is really significant too and is generally a combination of debt and equity. However, the assets of the company aren't pledged as collateral here.

What time of a company would make the ideal target for a leveraged buyout and a management buyout?

For a leveraged Buyout - 1. A company with a very clean balance sheet, i.e, has no or a very low amount of outstanding debt - A company with low debt and a significant amount of free cash flows could be a right target, considering the fact that you can buy the company with a good amount of debt and and use the free cash flows for repayment

2.A company with a great competitive advantage in the market - If the company is in a steady position, it will be able to generate cash flows and maintain a good position consistently. Thus, it will be beneficial to acquire a company of this kind

For a management buyout -

A company that has a good track record of profitability and good future prospects with low risk and an owner who is wanting to retire is a good opportunity for a management buyout because the managers can be the owners of the company instead of being the employees. It increases their probability of getting rewards for the future development of the company directly, than they would as employees. Also, it will be easy to handle a business that they already have a deep understanding of, with no distinct learning curve involved.

Capital structure of LBO - This involves the components of financing used in order to acquire a company.

The largest percentage of LBO financing is debt.

Eg- Bank Debt(Senior Debt), i.e, the cheapest form of financing, followed by high yield debt and mezzanine debt and equity that comprises not more than 20%-30% of the capital structure. Junk bonds are also issued (high-yield bonds) because of the high amount of leverage as a source of financing.

Capital Structure of MBO - Private equity funds also play a role here along with bank debt. A loan can also be taken from the seller of the company in some cases . ( Also called vendor loan notes)

Source of high risk in an LBO is the high percentage of the debt that is taken in order to fund the acquisition. Also, the debts are always collateralized by the firm's assets, which is another major risk that is involved. This makes the firm very leveraged. The source of cost reduction is that not a lot of capital has to be invested in this kind of a transaction.

Source of high risk in a MBO is various lines of financing taken, i.e, private equity, bank debt, seller's contribution etc. There is a liability to pay off the debts for these various lines at different rates of interest

The source of cost reduction is the a team of managers contribute towards the acquisition together, and that reduces the amount of debt that is to be taken and increases financial flexibility

Another source for cost savings for an LBO is the fact that since the debts are collateralized, they do not involve as much of a rate of interest and is lower than the cost of sponsor's equity.

Another source of cost reduction for a MBO is the private equity financing they are able to get, which generally carries a lower rate of interest, given that there is a dedicated management team

The ultimate goal for initiating an LBO is to make large acquisitions without having to commit a lot of capital for the investment. At times, it is used to make a public company private, or to take advantage of the cash flows of a growing and profitable company by acquiring it.

The ultimate goal for initiating a MBO is because the managers want to become owners rather than remaining employees of the company, usually when the owner wants to retire. They also have a really good understanding of the business in place and hence want to reap rewards directly by purchasing the company that they will definitely be able to handle.