Leveraged Buyback - Explained
What is a Leveraged Buyback?
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Table of ContentsWhat is a Leveraged Buyback?How Does a Leveraged Buyback Work?Uses of Leverage BuybackImpact of Leverage Buybacks on Companies
What is a Leveraged Buyback?
Leveraged buyback is an instrument used in corporate finance to carry out a transaction where a firm uses debt to repurchase part of its shares from the open market. Another term for the leveraged buyback is to share repurchase. Note that there are a number of methods that a company can use to buy back its shares. A company can repurchase its share through tender or market offer. The move ensures that a company reduces the number of shares outstanding by increasing the remaining respective shares of owners.
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How Does a Leveraged Buyback Work?
Leveraged buybacks are similar to dividend recapitalizations and leveraged recapitalization in terms of impact, where companies make use of leverage to pay a one-time dividend. However, what makes them different is that there is no change in ownership structure when it comes to dividend recapitalization.
Uses of Leverage Buyback
Theoretically, leveraged paybacks have no immediate impact on the share price of the company, higher interest payments, and net of tax benefits from the new capital structure. However, additional debt may spur the management to improve its operational efficiency and discipline through downsizing and cost-cutting. This helps it to meet both larger principal and interest payments. Note that leveraged buyouts are usually a justification for the extreme levels. A company with excess cash may sometimes use leveraged buybacks to recapitalize its balance sheets. This way, it is able to avoid overcapitalization. Note that when a company increases the debt on the balance sheet, it provides what we call a shark repellant that protects it from possible hostile takeovers. Just like other share repurchases, leveraged buybacks can be used to increase return on equity earnings per share (EPS) and price-to-book-ratio. However, boosting EPS using this method, does not mean that there is an improvement as far as value or performance is concerned. To some extent, it can even cause damage to the business, especially where financial engineering comes at the expense of not producing capital investment. Financial markets have used buybacks to reward companies with a substitute whenever there is an improvement in their operational performance. It is the reason why buybacks are one of the favorite financial instruments after the worldwide financial crisis. Like between 2008 and 2018, companies in the United States spent more than $5 trillion, which is equivalent to more than half of their profits to repurchase their own shares from the market. In fact, they have been able to experience over 40% EPS growth as a result of repurchasing shares.
Impact of Leverage Buybacks on Companies
There has been a big comeback when it comes to leveraged buyback in the United States, where repurchasing shares have surpassed free cash flow since 2014. Companies can also use the leveraged buyback to pay U.S. taxes. By doing so, they have been able to avoid cash repatriate. Boom from leveraged payback has increased bondholders and shareholders risk. For instance, some companies with a good grade of investment have reduced their number of shares by sacrificing their good credit ratings. Note that when companies borrow heavily for the purpose of funding buybacks, there are high chances that their credit rating or score will go down. According to politicians, the rising interest rates are likely to choke off boom from the leveraged buybacks. They believe that recent tax reform is not benefiting the workers. That leverage buyback causes manipulation in the market, and so, regulating it will protect corporations from stock market manipulation charges. This is more especially if the buybacks on a certain day, happen to be above 25 percent of the average daily trading volume of the previous four weeks.