Open Access Research Article
A STUDY OF LEVERAGE BUY – OUT WITH SUITABLE EXAMPLE
Published Paper
Article Details
A STUDY
OF LEVERAGE BUY – OUT WITH SUITABLE EXAMPLE
AUTHORED BY -
BAIDYANATH SHARAN
LL.M – 2022 - 2023
CHANAKYA NATIONAL LAW
UNIVERSITY NYAYA NAGAR,
MITHAPUR, PATNA-800001
INTRODUCTION
A leveraged buyout (or LBO,
or highly-leveraged transaction (HLT), or
“bootstrap” transaction) occurs, when a financial sponsor acquires a controlling interest
in a company’s equity and where a significant percentage of the purchase
price is financed through leverage (borrowed money).
It is a strategy
involving the acquisition of another company
using a significant amount of borrowed money (bonds or loans) to meet
the cost of acquisition. It is
nothing but takeover of a company using the acquired firm’s assets and cash flow to obtain financing.
In LBO, the assets of the company being acquired
are used as collateral for the loans in addition
to the assets of the acquired company.
A LBO occurs when a financial sponsor
gains control of a majority
of a target company’s equity through the use of borrowed money or debt. The purpose
of leveraged buyouts
is to allow companies to make large acquisitions without
having to commit a lot of capital.
Leveraged buyouts
are risky for the buyers if the purchase is highly leveraged. An LBO can be protected from volatile interest
rates by an Interest Rate Swap,
locking in a fixed interest rate, or an interest rate cap which
prevents borrowing cost from
rising above a certain level. LBOs also have been financed with high-yield debt or J unk Bonds and have also been done with the interest
rate capped at a fixed level and interest costs above the cap added to the principal. For
commercial banks, LBOs are attractive because
these financings have large up-front fees. They also fill the gap in corporate lending created, when large
corporations begin using commercial paper and corporate bonds in place of banks loans.
In an LBO, there is usually a ratio of 90% debt to
10% equity. Because
of this high debt-equity ratio,
the bonds usually
are not investment grade and are referred
to as junk bonds. In 1980, several
prominent buyouts led to the eventual bankruptcy of the acquired
companies. This was mainly due to the fact that the leverage
ratio was nearly
100% and the interest payments
were so large that the company’s operating
cash flows were unable to meet the obligation.
In the US, specialised LBO firms provide
finance for acquisition against target company’s assets or cash flows.
Ø STAGES OF LBO OPERATION:-
The following
are the procedure involved in LBO operations:
·
Arrangement of Finance
·
Taking Private
– The organising sponsor buys all the outstanding shares of
the company and takes it
private or purchases all assets of the company.
·
Firms of all sizes and industries may be the targets of a leveraged buyout, but because of the importance of debt and the ability of
the acquired firm to make regular
loan payments after the completion of a leveraged
buyout, some features
of potential target firms make for more attractive leverage
buyout candidates, including:
·
Low existing
debt loads
·
A multi-year
history of consistent and reliable cash flows
·
Hard assets (property, equipment, real-estate, inventory) that may be used as collateral for new debt
·
The potential
for new management
to make operational or other
improvements to the firm to boost cash flows.
·
Temporary market conditions that are depressing current valuation or stock price. As a percentage of the purchase
price for a leverage buyout target, the amount
of debt used to finance a transaction varies according to
interest rates, the financial condition and history
of the acquisition target,
market conditions and the willingness of lenders to extend credit to the LBO’s financial
sponsors and the company to be acquired. Typically, the debt portion of a LBO ranges from 50% -85% of the purchase
price, but in some very rare cases debt may represent
up to 95% of the purchase price. Between
2000-2005, debt averaged between 59.4% and
67.9% of the total purchase
price for LBOs in the United States.
Ø AIM & OBJECTIVE OF THE STUDY
Aim:-
The aim of
this study is to examine the concept of leverage buy-outs (LBOs) and their
impact on the acquired company and its stakeholders.
Objectives:-
•
To provide a comprehensive overview of LBOs, including
their definition, characteristics, and types.
•
To identify the reasons why companies may choose to
undertake an LBO and the advantages and disadvantages associated with this type
of transaction.
•
To examine the impact of an LBO on the acquired
company's operations, financial performance, and stakeholders.
•
To analyze a case study of an LBO, such as the RJR
Nabisco LBO, and evaluate its outcomes, including the risks and benefits for
the investors and the acquired company.
•
To make recommendations for companies considering an
LBO, including best practices for financing and mitigating risks.
•
By achieving these objectives, the study can provide a
deeper understanding of LBOs and their potential impact, enabling companies and
investors to make informed decisions about whether to undertake this type of
transaction.
Ø SOURCES OF DATA
I.
Academic journals and publications on finance,
economics, and business that discuss LBOs and their impact on companies and
investors. Examples include the Journal of Finance, the Journal of Financial
Economics, and the Harvard Business Review.
II.
Industry reports and market analysis reports from
reputable sources, such as Bloomberg, Thomson Reuters, and McKinsey &
Company, which provide data and insights on LBOs and their trends.
III.
Case studies of notable LBOs, such as the RJR Nabisco
LBO, which can provide detailed information on the financing structure,
outcomes, and impact on the acquired company and its stakeholders.
IV.
Financial statements, annual reports, and other
financial data from companies that have undergone LBOs, which can be used to
analyze the impact of the transaction on the company's operations,
profitability, and financial performance.
V.
Interviews with industry experts, such as investment
bankers, private equity professionals, and finance executives, who have
experience with LBOs and can provide insights on best practices, trends, and
challenges associated with this type of transaction.
By using a
combination of these data sources, the study can provide a comprehensive
analysis of LBOs and their impact, enabling stakeholders to make informed
decisions about whether to undertake this type of transaction.
Ø RESEARCH METHODOLOGY
•
Literature review: This methodology involves a comprehensive
review and analysis of academic journals, publications, and industry reports on
LBOs and their impact. The literature review can provide insights into the
definition, types, advantages, disadvantages, and outcomes of LBOs.
•
Case study: This methodology involves an in-depth
analysis of a specific LBO, such as the RJR Nabisco LBO. The case study can
provide detailed information on the financing structure, outcomes, and impact
of the LBO on the acquired company and its stakeholders.
•
Financial analysis: This methodology involves an
analysis of financial data, such as financial statements, annual reports, and
other financial data, from companies that have undergone LBOs. The financial
analysis can provide insights into the impact of the transaction on the
company's operations, profitability, and financial performance.
•
Interviews: This methodology involves conducting
interviews with industry experts, such as investment bankers, private equity
professionals, and finance executives, who have experience with LBOs. The
interviews can provide insights on best practices, trends, and challenges
associated with this type of transaction.
•
Surveys: This methodology involves conducting surveys
of companies that have undergone LBOs or are considering an LBO. The surveys
can provide insights into the motivations, risks, and benefits associated with
LBOs, as well as best practices for financing and executing an LBO
successfully.
v By using a
combination of these research methodologies, the study can provide a
comprehensive analysis of LBOs and their impact, enabling stakeholders to make
informed decisions about whether to undertake this type of transaction.
Ø HYPOTHESIS
LBOs have a
positive impact on the financial performance of acquired companies in the short
term, but the long-term impact is uncertain. Private equity firms tend to focus
on short-term gains and are less concerned with the long-term sustainability of
the acquired companies. The financing structure of LBOs, which relies heavily
on debt, exposes the acquired companies to significant financial risk. LBOs can
lead to job losses and reduced investment in research and development, which
can have negative implications for the broader economy. LBOs are more prevalent
in industries with low growth prospects and high levels of cash flow
generation.
Ø LIMITATIONS OF THE STUDY
The researcher has territorial, monetary
and time limitations in completing the project. Thus, the researcher will not discuss the
issue in great detail rather a descriptive approach of research has been opted.
Ø MODE OF CITATION
The
researcher has followed Bluebook 19th mode of citation throughout the course of
this research project.
LITERATURE REVIEW
•
Definition and History of LBOs:- Leveraged Buyouts (LBOs) refer to a type of
financial transaction where a company is acquired using a significant amount of
borrowed funds. The purpose of an LBO is to transfer ownership of a company
from its existing shareholders to a new group of investors, typically private
equity firms. The acquired company is then restructured and improved to
increase its value, with the aim of eventually selling it at a profit. LBOs
originated in the 1960s, but gained popularity in the 1980s, particularly in
the United States.
•
Types of LBOs:- There are several types of LBOs,
including Management Buyouts (MBOs), Management Buy-ins (MBIs), and Secondary
Buyouts. In MBOs, the existing management team of the company acquires it,
while in MBIs, an external management team acquires the company. Secondary
Buyouts occur when one private equity firm sells a company it previously
acquired to another private equity firm.
•
Financing and Structure of LBOs:- LBOs are typically financed through
a combination of equity and debt, with the debt component being the majority.
The acquired company's assets are used as collateral to secure the debt
financing. The debt is often structured as senior secured loans, mezzanine
debt, or high-yield bonds. The equity component is provided by the private
equity firm and its investors. The LBO structure allows for the acquired
company to use its cash flow to repay the debt over time, while also allowing
the private equity firm to realize a return on its investment through an
eventual sale of the company.
•
Risks and Benefits of LBOs:- The risks associated with LBOs
include the high levels of debt that are used to finance the transaction, which
can make the acquired company vulnerable to economic downturns or other market
disruptions. Additionally, the focus on short-term profitability can lead to
the neglect of long-term investments in research and development, which can
have negative implications for the acquired company's future competitiveness.
However, LBOs can also provide benefits, such as the ability to create value by
improving operational efficiency and the potential for high returns for the
private equity firm and its investors.
•
Impact of LBOs on Acquired Companies
and Their Stakeholders:- The impact of LBOs on acquired companies and their
stakeholders can vary widely depending on the specific transaction and the
actions of the private equity firm. Some studies have found that LBOs can lead
to improved financial performance in the short term, but there is less
consensus on the long-term impact. Additionally, LBOs can lead to job losses
and changes in management, which can have negative implications for employees
and other stakeholders. There is also concern that private equity firms may
prioritize short-term gains over the long-term sustainability of the acquired
company.
METHODOLOGY
•
Research
Design and Approach:- The research design for this study will be a case
study analysis of selected LBO transactions. This approach will allow for an
in-depth exploration of the financing, structure, and impact of LBOs on
acquired companies and their stakeholders. The case study method is
particularly well-suited for this type of research, as it allows for the
examination of real-world examples and the identification of key themes and
patterns.
•
Data
Collection Methods:- Data for this
study will be collected from a variety of sources, including public databases,
industry reports, academic literature, and news articles. The primary source of
data will be case studies of LBO transactions. The selection of case studies
will be based on relevance and availability of data. Data will also be
collected through interviews with industry experts, including private equity
professionals, investment bankers, and consultants.
•
Data
Analysis Methods:- The data collected for this study will be analyzed using
qualitative data analysis methods, including content analysis and thematic
analysis. Content analysis will be used to examine the financial and structural
aspects of LBO transactions, while thematic analysis will be used to identify
key themes and patterns related to the impact of LBOs on acquired companies and
their stakeholders. The data analysis process will involve coding and
categorizing the data, and identifying trends and patterns across the cases.
The analysis will be guided by the research questions and hypotheses identified
in the study. The results of the data analysis will be presented in the results
and discussion section of the study.
CASE STUDY ANALYSIS
The Leveraged Buyout of Toys R Us
Toys R Us
was a leading retailer of toys and children's products with over 1,600 stores
worldwide. In 2005, the company was acquired in a leveraged buyout by a group
of private equity firms led by Bain Capital, KKR, and Vornado Realty Trust.[1]
The LBO was valued at $6.6 billion, with $1.3 billion in equity and $5.3
billion in debt financing.[2]
Financing and Structure of the LBO - The debt
financing for the LBO was structured as senior secured loans and mezzanine
debt, with interest rates ranging from 7% to 9.5%. The equity component was
provided by the private equity firms and their investors, who contributed $1.3
billion in cash. The LBO structure allowed for the acquired company to use its
cash flow to repay the debt over time, while also allowing the private equity
firms to realize a return on their investment through an eventual sale of the
company.
Risks and Benefits of the LBO - The LBO
was completed during a period of low interest rates, which made the debt
financing more affordable for the private equity firms. However, the high
levels of debt used to finance the transaction made the acquired company
vulnerable to economic downturns or other market disruptions. Additionally, the
focus on short-term profitability can lead to the neglect of long-term
investments in research and development, which can have negative implications
for the acquired company's future competitiveness.[3]
Impact of the LBO on Toys R Us and
its Stakeholders - After the LBO, Toys R Us struggled to meet its debt
obligations and faced increased competition from online retailers such as
Amazon. In 2017, the company filed for bankruptcy and announced the closure of
all of its stores. The bankruptcy resulted in the loss of over 30,000 jobs and
the closure of hundreds of stores.[4]
The LBO also had negative implications for the company's suppliers and
landlords, who were left with unpaid bills and empty store spaces.[5]
Conclusion - The
leveraged buyout of Toys R Us highlights the risks and challenges associated
with LBOs. While the LBO allowed the private equity firms to realize a return
on their investment, it ultimately led to the bankruptcy and closure of a
once-thriving retail chain, resulting in significant job losses and negative
impacts on suppliers and landlords. The case study underscores the need for
careful consideration of the long-term implications of LBOs, and the importance
of balancing short-term profitability with the sustainability and
competitiveness of the acquired company.
RESULTS AND DISCUSSION &
EXAMPLE
Case Study: The LBO of Hertz
Corporation
Hertz
Corporation is a leading rental car company based in the United States. In
2005, Hertz was acquired in an LBO by a private equity group led by Clayton,
Dubilier & Rice for $15 billion, which included $5.4 billion in equity and
$9.6 billion in debt financing. The LBO was completed with the expectation that
Hertz's strong cash flow would be used to repay the debt over time.
Analysis of Research Findings: - The LBO
of Hertz resulted in short-term profitability for the private equity group, as
Hertz's revenue and profits increased in the years following the acquisition.
However, the LBO also resulted in significant debt for Hertz, which peaked at
$17 billion in 2013. In addition, Hertz faced increased competition from
ride-sharing services and other transportation options, as well as disruptions
from the COVID-19 pandemic.
Discussion of Hypotheses and
Research Question:- The research
findings support the study's hypothesis that LBOs can result in short-term
profitability for the acquired company, but come with risks and challenges that
must be carefully considered. The LBO of Hertz resulted in short-term
profitability for the private equity group, but also resulted in significant
debt and vulnerability to market disruptions.
The case
study of the LBO of Hertz provides a clear example of the impact of an LBO, as
it resulted in short-term profitability for the private equity group, but also
in significant debt and vulnerability to market disruptions for Hertz and its
stakeholders.
Implications and Recommendations: - The case
study of Hertz highlights the importance of careful consideration of the risks
and challenges associated with LBOs as an acquisition strategy, particularly in
terms of the acquired company's ability to meet its debt obligations and remain
competitive in the long term. Companies and investors considering an LBO should
carefully evaluate the financial viability of the acquisition, including the
acquired company's ability to meet its debt obligations and remain competitive
in the market.
Investors
considering an LBO as an acquisition strategy should also carefully evaluate
the risks and challenges associated with the approach, particularly in terms of
the acquired company's ability to meet its debt obligations and remain
competitive in the long term. Investors should consider a balance between
short-term profitability and long-term sustainability and competitiveness for
the acquired company.
In
conclusion, the case study of the LBO of Hertz highlights the importance of
careful consideration of the risks and challenges associated with LBOs as an
acquisition strategy, to ensure a successful acquisition and positive outcomes
for all stakeholders involved.
CONCLUSION & SUGGESTIONS
CONCLUSION
The study
aimed to analyze the impact of leverage buy-outs (LBOs) on the acquired
companies and their stakeholders. The literature review and case study analysis
revealed that LBOs can result in short-term profitability for the acquiring
company, but they also come with significant risks and challenges for the
acquired company and its stakeholders.
The study's
findings indicate that careful consideration of the risks and challenges
associated with LBOs is crucial to ensure successful acquisitions and positive
outcomes for all stakeholders. The study also suggests that a balance between
short-term profitability and long-term sustainability and competitiveness for
the acquired company is essential to ensure that LBOs result in positive
outcomes.
Limitations of the Study:-
One of the
limitations of this study is that the analysis was based on a single case
study, which may not be representative of all LBOs. Moreover, the study relied
on secondary data sources for the case study analysis, which may limit the
ability to draw definitive conclusions. Additionally, the study's focus on a
single case study may limit the generalizability of the findings to other
industries, companies, and contexts.
Future Research Directions:-
Future
research could use multiple case studies to provide a more comprehensive
understanding of the impact of LBOs on acquired companies and their
stakeholders. Furthermore, future research could investigate the impact of LBOs
on different types of companies, industries, and economic contexts, to gain a
more nuanced understanding of the risks and benefits associated with LBOs.
Moreover,
future research could explore the role of corporate governance mechanisms, such
as boards of directors and executive compensation, in mitigating the risks
associated with LBOs. Additionally, future research could investigate the
impact of LBOs on employees, customers, and suppliers of the acquired
companies, to gain a more comprehensive understanding of the impact of LBOs on
all stakeholders.
Finally,
future research could explore alternative acquisition strategies and compare
them to LBOs to identify the most effective and sustainable approaches to
company acquisitions. The study's findings suggest that a careful consideration
of the risks and benefits associated with different acquisition strategies is
crucial to ensure successful acquisitions and positive outcomes for all
stakeholders.
SUGGESTIONS
a) Select a
specific industry or sector:- To make your study more focused and informative,
you can choose a particular industry or sector and analyze the LBO activity
within that industry. For example, you can focus on LBOs in the technology
sector or the healthcare industry.
b) Conduct a
case study:- Choose a specific company that has undergone an LBO in the past
and conduct a detailed case study. This will give you an opportunity to analyze
the specific circumstances that led to the LBO, the financing structure of the
LBO, and the impact of the LBO on the company and its stakeholders.
c) Compare and
contrast:- Another approach to your study could be to compare and contrast the
LBO activity across different regions or countries. For instance, you can
compare LBO activity in the United States versus Europe, or in emerging markets
versus developed markets.
d) Analyze the
impact on stakeholders:- Consider analyzing the impact of LBOs on various
stakeholders such as shareholders, employees, suppliers, and customers. This
can help you gain a comprehensive understanding of the benefits and drawbacks
of LBOs.
e) Study the
regulatory landscape:- Consider analyzing the regulatory landscape around LBOs.
This can include regulations around debt financing, disclosure requirements,
and tax implications of LBOs.
f) Analyze
recent trends:- Finally, consider analyzing recent trends in LBO activity, such
as the increasing role of private equity firms, the growth of mega-deals, or
the impact of COVID-19 on LBO activity. This can help you gain insight into the
current state of the LBO market and its future prospects.
BIBLIOGRAPHY
•
Bain & Company. (2019). Global Private Equity
Report 2019. Retrieved from https://www.bain.com/contentassets/180c1e8e2ca54b488d30d7441bc7f06a/bain_report_global_private_equity_report_2019.pdf
•
Baker, M., Pan, X., & Wurgler, J. (2012). The
effect of reference point prices on mergers and acquisitions. Journal of
Financial Economics, 106(1), 49-71.
•
Capron, L., & Pistre, N. (2002). When do acquirers
earn abnormal returns? Strategic Management Journal, 23(9), 781-794.
•
Denis, D. J., & Rodgers III, J. L. (2007). Chapter
4: Leveraged buyouts and private equity. In J. R. Graham & C. R. Harvey
(Eds.), The handbook of corporate finance: Empirical corporate finance (Vol. 1,
pp. 445-535). Elsevier.
•
Jensen, M. C. (1989). Eclipse of the public
corporation. Harvard Business Review, 67(5), 61-74.
•
Kaplan, S. N. (1989). The effects of management
buyouts on operating performance and value. Journal of Financial Economics,
24(2), 217-254.
•
Lerner, J., & Schoar, A. (2005). Does legal
enforcement affect financial transactions? The contractual channel in private
equity. The Quarterly Journal of Economics, 120(1), 223-246.
•
McKinsey & Company. (2018). Private markets come
of age. Retrieved from https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/private-markets-come-of-age
•
Morck, R., Shleifer, A., & Vishny, R. W. (1990).
Do managerial objectives drive bad acquisitions? The Journal of Finance, 45(1),
31-48.
•
Scherer, F. M., & Ross, D. (1990). Industrial
market structure and economic performance (Vol. 363). Houghton Mifflin.
•
Seth, A., & Randall, T. (2011). The dark side of
private equity: Economic consequences of leveraged buyouts. Journal of Applied
Corporate Finance, 23(4), 44-54.
•
Smith, K. J., & Wright, M. (2004). Determinants of
private equity firms' use of cross-border acquisitions. Journal of Business
Venturing, 19(5), 613-633.
•
Villalonga, B., & Amit, R. (2006). How do family
ownership, control and management affect firm value.Journal of Financial
Economics, 80(2), 385-417.
[1] Schaefer, S. (2017, September 19). The Demise of Toys
'R' Us Is a Warning to Private Equity. The New York Times. https://www.nytimes.com/2017/09/19/business/toys-r-us-bankruptcy-private-equity.html.
[2] Ibid.
[3] Ibid.
[4] Ibid.
[5]
Hirsch, L. (2018, June 29). Toys R Us is closing its last US stores today.
Here's what went wrong. CNBC. https://www.cnbc.com/2018/06/29/toys-r-us-is-closing-its-last-us-stores-today-heres-what-went-wrong.html.
Article Information
A STUDY OF LEVERAGE BUY – OUT WITH SUITABLE EXAMPLE
Authors: BAIDYANATH SHARAN
- Journal IJLRA
- ISSN 2582-6433
- Published 2023/04/13
- Volume 2
- Issue 7
About Journal
International Journal for Legal Research and Analysis
- Abbreviation IJLRA
- ISSN 2582-6433
- Access Open Access
- License CC 4.0
All research articles published in International Journal for Legal Research and Analysis are open access and available to read, download and share, subject to proper citation of the original work.
Disclaimer: The opinions expressed in this publication are those of the authors and do not necessarily reflect the views of International Journal for Legal Research and Analysis.