LEVERAGED BUYOUTS

A leveraged buyout (LBO) is a restructuring of the capitalization and ownership of a company. The term leveraged refers to the use of debt as the primary method of financing the restructuring. The buyout portion refers to the fact that the method is often used to transform a publicly held company into one that is privately held. There are a number of reasons why this type of transaction might take place. These include cost savings, managerial incentives, decreasing the total number of owners, tax benefits, flexibility, and control. Oftentimes, the group pursuing the buyout includes the publicly held firm's upper management. This type of action is known as a management buyout (MBO).

Among the multiple parties involved when a public firm is taken private, there normally are both winners and losers. Existing shareholders who have their shares purchased in the buyout often win big. This is because most LBOs involve the payment of a premium over the market price at which the shares were trading prior to the announcement of the takeover. Similarly, the parties taking control of the firm gain managerial control and the enhanced flexibility normally associated with privately run firms. The new owners also have access to the firm's assets and cash flows, which formerly were part of the public corporation.

The biggest losers in an LBO are the firm's existing creditors. Because the buyout is financed primarily with debt capital, existing bondholders become creditors of a much riskier firm. This drives down the market value of outstanding bonds and makes future debt service much more uncertain. During the 1980s a number of institutional investors who held large bond positions in firms that were the subject of MBOs sued the management of the firms. They claimed that managers knowingly engaged in activities that harmed their economic investment as creditors of the corporation. These suits resulted in settlements and damage awards in several instances.

HISTORY OF LEVERAGED BUYOUTS

When a public firm experiences an LBO, its entire equity is purchased by a small group of investors. This group often includes the firm's current upper management. In order to entice existing shareholders to sell the firm's outstanding shares, the group often offers a premium above the stock's prevailing market value. The capital they need to purchase the shares is obtained by issuing debt, in the form of bonds, against the firm's assets and cash flows. From a balance-sheet perspective, the action all takes place on the right-hand side. That is, the transaction involves the exchange of debt for equity. The result is that creditors have a larger claim, and owners a smaller claim, on the firm's assets. Note that the assets on the left-hand side of the firm's balance sheet do not change. Instead, what changes is how they are financed.

During the 1980s leveraged buyouts became a huge part of America's corporate landscape. This largely was the result of a single investment banking firm, Drexel Burham Lambert, and the efforts of one of its principals, Michael Milken. It was Milken who determined that high-yield bonds could fill an existing funding gap in corporate financing. The bonds, commonly referred to as junk bonds because of their riskiness, would be enticing to investors who otherwise might not be willing to take an equity position in high-risk firms. Drexel developed a market for junk bonds and served as the investment bank for corporate raiders and management groups interested in taking over existing corporations. The market flourished for several years, before Milken was prosecuted and convicted of securities violations. Drexel Burham Lambert ultimately went bankrupt, but the firm's legacy lives on in the active market for high-yield debt.

REASONS FOR TAKING A FIRM PRIVATE

The junk bond market enabled small investor groups to raise large sums of money in order to take public companies private. A number of reasons motivated managers and investors to pursue LBOs.

One advantage that a private firm has over a public one is administrative cost savings. A publicly traded company must produce annual reports, 10-K reports, comply with numerous regulations required by the Securities and Exchange Commission, hold annual shareholder meetings, and respond to share-holder requests. The management of publicly held firms must meet regularly with security analysts who follow the firm's stock, and maintain a shareholder relations department to deal with investor concerns. These costs are not required of a privately held firm.

In a private firm, managers no longer have to answer to the shareholder constituency. Lack of public accountability translates into greater management flexibility, since managers no longer have to focus as strongly on short-term operating results. The intense interest in reported quarterly earnings can bias managers in public firms to devote a great amount of effort and resources on short-term performance. Thus, managers of private firms have the luxury of being able to engage in investment activity that takes longer to produce tangible rewards. This greater flexibility and freedom from having to answer to shareholders is very enticing to upper-level management.

In addition, the process of buying up existing shares of the firm's stock severely diminishes the absolute number of shareholders. Because of their large capital investment and the fact that they now answer to themselves, the shareholders that remain after an LBO are highly interested in the firm's operations. These shareholders play an active role in the firm's management, as opposed to the hundreds of thousands of passive investors that hold a publicly traded firm's common stock.

The new entity's management has enhanced incentives to operate efficiently and profitably. This is because the high amount of debt service resulting from an LBO leaves little room for corporate perks and excess. The combination of having to pay the large interest expense on the debt and working for themselves, as opposed to anonymous shareholders, results in much greater motivation for management to perform. Equity holders remaining after an LBO often have some special expertise or talent that they bring to the firm, such as access to additional capital sources. Shareholders in the new private firm who are not part of active management also have much greater incentive to monitor active management, since their personal stake in the firm is typically high.

Corporate tax shields are another potential advantage of restructuring with debt financing. The corporate tax code in the United States allows companies to deduct the interest paid on debt as an expense for tax purposes. No such deduction is allowed for dividends paid on equity shares. Thus, increased use of debt results in lower tax obligations owed to the Internal Revenue Service. Firms facing large tax liabilities may reap considerable benefits from the tax savings that result from debt financing.

Finally, large publicly held corporations in mature industries typically have access to large amounts of free cash flow. These dollars are valuable, because they can be used to develop new products and markets or invest in other firms. In a public corporation, these cash flows may be used for perquisites such as corporate travel to conventions and trade shows, company cars, membership in clubs, and other types of nonmonetary rewards. By taking the firm private, remaining share-holders gain access to the firm's free cash flow and can put it to use, thereby reaping direct benefits.

THE 1990S

With the demise of Drexel Burnham Lambert and the default on several prominent junk bond issues associated with 1980s restructurings, leveraged buyout activity slowed considerably in the 1990s. The appetite of investors for new junk bond issues decreased, and some of the firms that had previously gone private subsequently were recapitalized as public corporations.

THE 2000S

After a lull in the 1990s, leveraged buyouts began to regain some of their charm in the early part of the twenty-first century. According to Dealogic, a New York-based deal tracker, LBO firms accounted for 10 percent of the $540 billion in mergers and acquisitions announced in the United States, double the average of 5 percent over the previous 10 years. Europe also showed a significant increase in LBO activities throughout the early 2000s.

Although leveraged buyouts relinquished the center stage they once held in American corporate finance, the concept of restructuring by replacing equity with debt and continuing under private management remains a significant opportunity for investors. Management in the modern corporation has greater incentive to operate efficiently and pay attention to shareholder concerns, lest the threat of a buyout cost them their positions with the firm.