Question

Describe the potential benefits and costs of LBOs to stakeholders, employers, lenders, customers, and communities in which the firm undergoing the buyout may have operations. Do you believe that on average LBOs provide a net benefit or cost to society? Explain your answer

Answer 1

A LBO or leveraged buyout is a kind of financial mechanism wherein a firm is purchased using not just equity but also using leverage, I.e debt. Here the debt is repaid using the expected future cash flows from the firm. Thus for LBO to be a profitable to the debtor, the firm should be able to generate sufficient cash flows. This is generally used by VCs or such players who takeover a existing firm when they see the possibility of improving the profitability of the firm through better management or other improvement. The fund sufficient for such structural changes may not be sufficient if replies only on equity and thus a leveraged buyout serves 2 primary tasks;

1. Shared responsibility for losses if any

2. Availability of sufficient funds.

The above points acts as the main pros for LBOs. The cons are:

1. Huge debt diminishes the firms ability to experiment or try different markets

2. Focus on cash flows and not margins or profits or any other parameters limits the focus of management on short term rather than long term growth and profit

An average LBO provides a net profit to the society as this helps provide a chance to renew the operation of a firm which might close down if not provided a helping hand. This can lead to huge employment losses to people. Moreover funds will have value only when they are being used and not when hoarded without any alternate use. Thus LBOs act as a method of using funds alternatively.