During the 1980s, leveraged buyouts (LBOs) became increasingly common and increased substantially in size. In a leveraged buyout, a company or division is purchased by a group of private investors, which frequently includes the management of the economic unit. To demonstrate their commitment, the managers will normally be expected to purchase a significant equity stake in the transaction. This will usually be a proportion of the equity since the transaction is financed with large amounts of debt and little equity. After an LBO, the firm ceases to be publicly traded. The interest and borrowings are expected to be repaid from the target's cash flow, particularly with tax benefits obtainable for the interest payments. Subsequently, once the debt is paid down, the organizers of the buyout attempt to take the firm public again.
The nature of the debt used in LBOs is typically subordinated debentures. In fact, most LBOs are financed with a high proportion of so-called "junk" (i.e., high-yield) bonds. The remainder of the financing usually comes from a mix of private sources and banks.
A successful buyout candidate has certain characteristics that can increase its chances of surviving and providing returns to lenders, investors, and managers. Factors that can be found in a successful LBO include: proven earnings growth; a strong market position; an asset base indicating unused debt capacity; an established, unconcentrated customer base; proven management; and a significant opportunity for cost reductions.
The occurrence of LBOs is positively related to the existence of target firms that have large and stable cash flows and the possibility of future tax savings Finally, LBO incidence increases when there is potential for employment reductions and redeployment, particularly among corporate staff. Therefore, after the LBO, there should be significant improvements in profitability and operating efficiency.
Empirical studies indicate that the acquired firms' shareholders earn large positive abnormal returns from leveraged buyouts. Similarly, the postbuyout investors in these transactions often earn large excess returns over the period from the buyout completion date to the date of an initial public offering or resale.
An outstanding introduction to LBOs is the film Barbarians at the Gate. This movie, which loosely chronicles the LBO of RJR Nabisco, has found its way into many finance classrooms.
Studies have identified several potential sources of value in leveraged buyout transactions. These include: wealth transfers from old public shareholders to the buyout group; wealth transfers from public bondholders to the investor group; wealth creation from improved incentives for managerial decision making; and wealth transfers from the government via tax advantages. These potential motivations for leveraged buyout transactions are not mutually exclusive; it is possible that a combination of these may occur in a given LBO.
Much controversy regarding LBOs has resulted from the concern that senior executives negotiating the sale of the company to themselves are engaged in self-dealing. On one hand, the managers have a fiduciary duty to their shareholders to sell the company at the highest possible price. On the other hand, they have an incentive to minimize what they pay for the shares. Accordingly, it has been suggested that management takes advantage of superior information about a firm's intrinsic value. The evidence, however, indicates that the premiums paid in leveraged buyouts compare favorably with those in interfirm mergers that are characterized by arm's-length negotiations between the buyer and seller.
Since leveraged buyout transactions are financed largely with debt, the existing debt of the buyout company, if not covenant protected, becomes more risky and less valuable. Accordingly, it has been argued that there is a transfer of wealth from bondholders to pre-and postbuyout equity investors. The empirical evidence, however, indicates that the transfers from bondholders do not appear to be a major source of value. These studies find that many leveraged buyout companies do not have any publicly traded debt in their capital structures. Moreover, the losses experienced by those firms with non-covenant-protected, publicly traded debt are much smaller than the positive abnormal returns earned by equity investors.
Another potential source of value in LBOs is derived from the reduction in agency costs that accompanies management's increased ownership stake in the company. In a publicly traded company, managers typically own only a small percentage of the common shares, and therefore can share only a small fraction of the gains resulting from improved managerial performance. After an LBO, however, executives can realize substantial financial gains from enhanced performance. This improvement in financial incentives for the firm's managers should result in greater effort on the part of management. The empirical evidence is consistent with efficiency gains in leveraged buyout transactions.
Because of the greater interest expense related to the increased levels of debt that the new company supports after the LBO, taxable income, everything else remaining equal, will decline, leading to lower tax payments. Therefore, the interest tax shield resulting from the higher levels of debt should enhance the value of firm. Studies indicate that these tax advantages are a significant source of value in LBO transactions.
Critics of leveraged buyouts argue that these transactions harm the long-term competitiveness of the firms involved. First, these firms are unlikely to replace operating assets since the firms' cash flow must be devoted to servicing the LBO-related debt. Thus, the property, plant, and equipment of the LBO firms are likely to have aged considerably during the time when the firm is privately held. In addition, expenditures for repair and maintenance may have been curtailed as well. Finally, it is possible that research and development expenditures have also been controlled. As a result, the future growth prospects of these firms may be significantly reduced.
Others argue that these transactions have a negative impact on the stakeholders of the firm. In many cases, LBOs lead to downsizing of operations, and many employees lose their jobs. In addition, some of the transactions have negative effects on the communities in which the firms are located.
Towards the end of the 1980s, the prices paid in leveraged buyouts increased, and buyout organizers invested less equity. As a result, a number of high-profile buyouts, such as Revco Drug Stores, filed for bankruptcy protection. Lenders reacted by tightening the supply of LBO credit and demanded changes in deal structures to lower risk.
[ Robert T Kleiman ,
updated by Ronald M. Horwitz ]
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Sirower, Mark L. The Synergy Trap: How Companies Lose the Acquisition Game. Free Press, 1997.