Question

Explain how the threat of a leveraged buyout or a takeover can actually address the problem of moral hazard.

Answer 1

Leveraged buyout involves acquisition or purchase of a company through borrowed funds which are a mix of debt and equity. One thing which makes leveraged buyout distinct is that, borrowed funds are used for acquisition instead of own funds.

Most of the corporations are confronted with the problem of principal and agent relationship. Agent is a person who is hired by principal to perform tasks on behalf of him. Thus, in public corporations, manager is the agent and owners are principal. The objective of owners is to maximize profit and shareholders wealth whereas the managers might have some other objectives. The managers get a fixed salary and generally a bonus which is linked to the performance of the company, hence there is less incentive for them to take additional risk and work towards profit maximization. On the other hand, the only return to shareholders is the profit, hence they look for policies in the best interest of them.

The existence of leveraged buyout and takeover opportunities in the global market poses a threat for underperforming companies and the managers have a fear of losing out on their job if their company is a target for potential acquisition. This forces the managers to seek for higher returns and have their objectives in alignment with company’s.