Question

Chapter 13: Financing the Deal and (LBO's). This takeover structure is used but not limited by private equity firms when taking over a company using heavy leverage along with some equity. This excessive leverage can magnify financial returns and also increase risks. Assets are usually acquired and used as collateral for the extensive loans that are taken out. RJR Nabisco was one the largest LBOS’ in history. This is an Important topic in Mergers!Provide your thoughts about the LBO’s method of financing deals. Are they successful and why do they create value, downside risks, costs, tax Issues, deal structures and many other examples along with an advantages along with a risk. In order to give everyone a chance, don’t answer all of these, which are just some examples where you can take any ONE item (or provide another) about LBO’s to discuss. This can also include an example of a company currently undergoing or has undergone an LBO in the real world. Also, Write 300-350 words

Answer 1

Financing the deal and LBOs:

Leverage Buyouts or LBO is the process of acquiring a target company by a firm by borrowing money significantly from Financial organizations rather than using their own capital. This is made possible by submitting the assets of the target company as collateral to these financial institutions for the loans taken. In LBOs the range of Debt:Equity can go as high as 9:1.

LBO approach of acquiring is generally followed by Private Equity firms. Now some of the established companies are also following this approach to acquire distressed companies.

Uses and Benefits:

• Large acquisitions made possible without investing major chunk of capital/equity
• Can be used to convert Public company to Private

	No Debt	LBO
Investment/Equity (millions)	10	1
Debt (millions)	0	9
Total Assets(millions)	10	10
EBIT (millions)	1.5	1.5
Interest rate	0%	10%
Pretax income (milions)	1.5	0.6
Tax rate	33.33%	33.33%
Net Income (millions)	1.00	0.40
ROE (Net Income/Equity)	10.00%	40.00%

From the table it can be seen that ROE has increased significantly for the acquirer if the company goes for LBOs. Hence using only a small portion of the equity we can get higher returns by following the LBO method.

Disadvantages:

• Historically some of the LBOs has led to Bankruptcy
• The Bonds if issued for Buyouts are not Investment grade and are classified as Junk Bonds due to high risk.
• If cash flows didn't match the interest obligation to Banks can result in Bankruptcy of the company.
• Can be used for Predatory tactics and the target company not always favour the same

Some of the examples of LBO are given below:

• Georgia-Pacific LLC acquisition by Koch Industries
• PetSmart Inc acquisition by BC Partners in 2014
• Acquisition of Freescale Semiconductor, Inc by a group of Investors which included the famous Blackstone group.