Leverage Buyout

Leverage Buyout is the process of acquiring a firm in which the investment for acquiring is made partially by equity and partially by other debt instruments (borrowing). The acquisition of the company or a segment of the company is funded by debt. The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. A financial buyer say private equity fund invests small amount of equity, as compared to the total purchase price and uses leverage also called gearing (using debt or other non equity based source of funding) to fund the remainder. LBOs involve institutional investors and financial sponsors who make large acquisitions, without committing all the capital required for the acquisition.

Financial sponsor raises debt by issuing bonds or securing a loan which is secured by the assets of the acquisition target or for that matter the cash flow of the target so as to make the timely payment of interest and principal amount.

If the transaction size or the purchase price is huge, syndicate is also applicable as a viable option for funding. Multiple lenders band together in a “syndicate” to pool in the total debt required for the transaction to take place, on the other hand many financial sponsors too can join hands to provide the part of equity required and thus complete the transaction.

Purposes of Debt Financing for LBOs

Following are the purposes of debt financing for LBOs:

• Increased use of debt increases the leverage which results in increased financial return to the private equity sponsor. The debt in an LBO has a relatively fixed cost of capital, thus any return in excess of this cost of capital flows to the equity investor.
• The benefit of tax shield is also applicable in case of high debt. This results in higher valuation as well. Income flowing to equity is taxed on the other hand, the interest payments to debt are not. Thus the capitalized value of cash flowing to debt is greater than the same cash stream flowing to equity.

Management Buyout (MBO)

MBO or the Management Buyouts are a special case of a leveraged acquisition. As the name very well suggests it occurs when a company’s managers buy or acquire a large part of the company. The goal of an MBO may be to strengthen the managers’ interest in the success of the company. One of the most widely discussed and thought after issue of MBOs is that they create a conflict of interest. There is always an incentive created for managers to mismanage or inefficiently manage the firm so as to lower its stock price for executing a handsome profitable MBO.

LBO and India

Following table shows the list of successful LBO by Indian company. The first being done by Tata Tea in 2000 for UK based Tetley.

LBOs can again be differentiated based on the country of existence. In the case where the target company is located in countries such as the United Kingdom or the United States, the acquiring Indian companies or the financial investors for that matter are able to obtain financing for the leveraged buyouts from foreign banks and the buyout is governed largely by the laws and regulations of the target company’s country.

On the other hand, a leveraged buyout of an Indian company by either an Indian or a foreign acquirer needs to comply with the legal framework in India and the scope of execution permissible in India. Owing to the stringent laws and regulations imposed by the GoI, Ministry of Finance, RBI, etc. LBO is not seen as a viable solution for companies. Some of the laws and restrictions are mentioned as under:

• Reserve Banks restriction on Lending
• Underdeveloped Corporate Debt Market
• Prohibition on Borrowing from Indian Banks – FIPB
• Restrictions on Public Companies from Providing Assistance to Potential Acquirers
• Restrictions Relating to Exit Through Public Listing
• Restriction in FDI and FII investment in India
• Existence of FDI cap across many sectors in India.

These issues prevent the companies to go for Leveraged Buy Out and thus it is not seen as a feasible.

Risk associated with the Execution of LBO

Following are the risk associated with LBOs:

i) Equity holders – Significant risk arises due to financial leverage. Interest costs for the debt are “fixed costs” which can lead to default of a company if not paid within the stipulated time. Changes in enterprise value (EV) of a company can have immense impact on the equity value. (Provided the debt remains fixed)

ii) Debt holders – Risk of default always lies with the debt holder which lies with high leverage. Owing to the fact that debt holders retain the most senior claims on the assets of the company, they are likely to suffer less risk compared to others. They are likely to realize a partial, if not full, return on their investments, even in bankruptcy.

Return for an LBO

As we have already seen in an LBO transaction, financial buyers generate high returns on equity investments. Also financial leverage (debt) is used to increase the potential returns. Investment opportunity is evaluated using IRR which measure returns on invested equity. IRR as we know is the discount rate at which the NPV of cash flows equals zero. IRR is then compared with the hurdle rate (minimum required IRRs) to evaluate the earnings and potential to profit making. Success of an LBO is also sometimes measured using metric called “cash-on-cash” or the CoC which is calculated as the final value of the equity investment at exit divided by the initial equity investment. It is expressed as multiple. An investor getting a COC of 3.0x is said to have “tripled its money“.

Following are the three factors which drives the return for an LBO:

• De-levering (paying down debt)
• Operational improvement (e.g. margin expansion, revenue growth)
• Multiple expansion (buying low and selling high).

Things to Consider in an LBO Transaction

Before going for an LBO transaction, it is important to study the following characteristics about an LBO transaction:

I. Industry characteristics

• Type of industry
• Competitive position
• Cyclicality of the industry
• Major players and drivers of the industry
• Potential outside factors (politics, changing laws and regulations, etc.).

II. Company-specific characteristics

• Strategic positioning within the industry in terms of market share
• Growth opportunity
• Operating leverage
• Sustainability of operating margins
• Potential for margin improvement
• Working capital requirements
• Cash requirement to run the business
• Ability of management to operate effectively in a highly levered situation

III. Market conditions

• Accessibility and cost of bank and high yield debt
• Expected equity returns.