Question

Explain why and when a Leveraged Buy Out occurs and discuss its risk. Include a discussion of the relevant Principal-Agent problem and Debt Ratio plus TIE.

Answer 1

A leveraged buyout is an acquisition of a company that is financed almost entirely by debt. The debt that is secured comes primarily from the targeted company’s assets. The LBO is structured so that the assets and cash flow of the company being acquired become the primary means to pay for the financing.

A typical leveraged buyout happens when a private equity firm sees an opportunity to take control of a business that has good fundamentals, but needs to operate better. In this case, they may be able to help the company avoid, or create a viable path out of bankruptcy, and help the company return to profitability. The benefit for them is the opportunity to sell the company, for a profit, at a later date.

So if an investor has the ability to be a “turn-around specialist”, an LBO can be similar to a mortgage. If the value of the business increases, the investor stands to make a large profit. However, if things go poorly, and when so much debt is involved, it doesn’t take a lot for that to happen, these investors can lose money very quickly, even though they are holding the majority of the debt.

The principal-agent problem is a conflict in priorities between a person or group and the representative authorized to act on their behalf. An agent may act in a way that is contrary to the best interests of the principal.The principal-agent problem is as varied as the possible roles of principal and agent. It can occur in any situation in which the ownership of an asset, or a principal, delegates direct control over that asset to another party, or agent.

The debt ratio is a financial ratio that measures the extent of a company’s leverage. The debt ratio is defined as the ratio of total debt to total assets, expressed as a decimal or percentage. It can be interpreted as the proportion of a company’s assets that are financed by debt. A ratio greater than 1 shows that a considerable portion of debt is funded by assets. In other words, the company has more liabilities than assets. A high ratio also indicates that a company may be putting itself at a risk of default on its loans if interest rates were to rise suddenly. A ratio below 1 translates to the fact that a greater portion of a company's assets is funded by equity.

The times interest earned (TIE) ratio is a measure of a company's ability to meet its debt obligations based on its current income. The formula for a company's TIE number is earnings before interest and taxes (EBIT) divided by the total interest payable on bonds and other debt.The result is a number that shows how many times a company could cover its interest charges with its pretax earnings.