Mergers and acquisitions are common place in the business world. Besides cash, or cash and share buyouts, there’s a common, yet controversial strategy, called the Leveraged Buyout (LBO) that private equity funds have been known to use.
What is a Leveraged Buyout?
A LBO is a way for one company or person to acquire another company for very little of their own cash, or credit. This can work if the company to be acquired has strong cash flow, a significant value in tangible assets and very little debt on their balance sheet.
In the simplest form, the buyer acquires the selling company with debt against the assets of the selling company. The buyer essentially uses the debt to purchase controlling interest in the company.
The acquiring company has highly leveraged their purchase with very little of their own cash with the goal of improving the business and selling the company in the future (or IPO). The acquired company has an increased debt load, but the plan is for growing earnings to cover the debt repayments.
A Practical Example
Say that company Buyer Inc. is looking to purchase private company Seller Inc. If Buyer Inc was looking to use the LBO strategy, they would negotiate the final price based on cash flow and the amount of debt or repayments that Seller Inc cash flow can cover. Buyer Inc. would then setup a new company NewCo Inc. and approach lenders (banks, other investors) for a loan to help cover a large portion of the purchase price with the assets of Seller Inc. used as collateral. NewCo Inc. would need to place a down payment on that loan, this amount would depend on the terms of the deal.
Once ownership is transferred, Seller Inc moves under NewCo Inc. The new company would then attempt to improve efficiencies and improve earnings to ensure cash flow is enough to cover the new debt burden.
The most popular example in recent Canadian history is the attempted $52 billion LBO of Bell Canada (BCE) by the Ontario Teachers Pension Plan. The buyout would have forced $32 billion in additional debt on BCE’s balance sheet. This deal ultimately failed due to solvency clause which was amplified when the markets turned weak in 2008.
The biggest risk with LBO’s is the financial strain that the additional debt puts on the acquired company. This risk can be mitigated through proper due diligence, but in the case of a sudden market down turn, the acquired company can face financial trouble, sometimes insolvency. Like with any strategy with leverage, it may enhance the upside, but it also can increase the speed of a downward spiral.
If any readers have any experience with business acquisitions, I’d like to hear your stories in the comments.
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