Leveraged Buyout Definition
Leverage buyout refers to the avenue used to purchase another firm by using funds gotten from outside such as loans and bonds instead of utilizing the earnings derived from the company. In some cases, the assets of the company being purchased serve as the security for the loans including those assets belonging to the firm doing the buying. This is usually achieved when a company is purchased by a collection of investors that engage in huge borrowing needed to facilitate the buying deal.
A Little More on What is a Leveraged Buyout
The following are examples of Leveraged Buyouts:
- The involvement of KKR in a $32,1 billion dollar acquisition of RJR Nabisco in 1989 which was one of the largest leveraged buyouts
- The 1988 Robert Campeau’s takeover of Federal Department Stores which made them be bankrupt in the long run.
Advantages of an LBO
Regardless of the risks linked to LBOs, they also have the following benefits:
- More control-After the acquisition deal has moved from public ownership to private, the current owners are free to change such things like the cost structure and the operations of the firm. This will make it possible for that venture to go through.
- Financial upside- Because LBOs entails the buying companies using very little of their capital, investors will be happy as far as the firm being acquired is in a position to produce enough money that can facilitate the buying deal.
- Continued operation- At some point, the firm may face the risk of being closed down because as a result of the poor financial situation. Because of this, when a party shows up as interested in the purchase, such a company may be open to such an acquisition deal.
Disadvantages of an LBO
Despite the advantages of LBOs, it has some of the following disadvantages:
- Poor morale-This may happen in instances where the firm engages in hostile buyouts where the firm has no interest in being bought. This may happen in cases of sabotage by unhappy employees that may stop or slow down the work which in return will prevent the company from achieving success.
- Bankruptcy a big risk-If the funds from the company being acquired is not in a position to take care of the loan amounts needed to purchase it, there is a possibility that the firm may end up being declared bankrupt as a result of the weak financial situation which is a risk itself.
- Deeper cuts-In an attempt to make the acquired company achieve profitability, the new management may engage in some measures such as cutting the operational cost. This may entail retrenchment of some employees leading to job losses, something which can have a negative influence on the society hence giving the firm a negative perception.
These days LBOs are not as common as they used to be at some point due to the fact that it has not been easy to get financing. This has been attributed to the tough and strict bank regulations that came into existence after the wild 1980s.
References for Leveraged Buyout
Academic Research on Leveraged Buyout
The determinants of leveraged buyout activity: Free cash flow vs. financial distress costs, Opler, T., & Titman, S. (1993). The Journal of Finance, 48(5), 1985-1999. The aim of this article is to find out the factors which influence Leverage buyout (LBO) practices by measuring companies that have engaged in LBOs and those ones that have never. The author reveals that those companies engaged in Leverage buyouts have a mixture of investment opportunities that are not friendly with high cash flow. In addition to this, these companies have a lot of diversification as opposed to non-LBO firms. The author concludes that companies may not involve themselves in LBOs if they have a lot of financial distress accompanied by high expenditures.
The private equity advantage: Leveraged buyout firms and relationship banking, Ivashina, V., & Kovner, A. (2011). The Review of Financial Studies, 24(7), 2462-2498. The author is trying to assess the bank relationship correlates with firms that engage in leveraged buyouts. The author finds out that bank relationships are key aspects in determining the difference in the rate of loan interest and the structure. These findings reveal that 2 channels encourage leverage buyouts funded by private equities to get friendly loan terms. The first one is that established bank relationships reduce information failure and that banks rate loans in order to cross-sell business fee.
The lock-in effect of capital gains taxes: Evidence from the RJR Nabisco leveraged buyout, Landsman, W. R., & Shackelford, D. A. (1995). National Tax Journal, 245-259. This article focuses on investigating the influence of capital gain achievements that were derived from the 1989 RJR Nabisco leveraged buyout. The author in this paper reveals an indirect relationship between the tax basis and price for the sold shares. This investor tax-rationality matches the lock-in effect claims that it increases the supply curve when buying equities.
Rehabilitating the leveraged buyout, Kester, W. C., & Luehrman, T. A. (1995). Harvard Business Review, 73(3), 119-130. The author in this article is concerned with how leveraged buyouts can be enhanced and improved. The paper suggests ways such as restoring the strong and constructive link between managers, owners, and other stakeholders. This was encouraged by the fact that LBOs started being perceived with some negativity. Some concerns like “paper entrepreneurs” and bankruptcies were raised in the early 1980s.In conclusion, the author is determined in finding out how value can be added to these leveraged buyouts.
Fraudulent Conveyance Concerns in Leveraged Buyout Lending, Kirby, M. T., McGuinness, K. G., & Kandel, C. N. (1987). The Business Lawyer, 27-49. The author here uses the lender’s perspective to review the risks linked with fraudulent conveyance regulations regarding leveraged buyouts. The article proposes ways that can be used to reduce those risks that come with Leveraged buyout lending.
Creditors’ Rights Against Participants in a Leveraged Buyout, Sherwin, E. L. (1987). Minn. L. Rev., 72, 449. This article highlights to us the rights enjoyed by those creditors who issue loans to the parties that are engaging in a leveraged buyout. The author informs us of the steps that creditors can take in case issues like defaults arise.
The crash of the Revco leveraged buyout: the hypothesis of inadequate capital, Bruner, R. F., & Eades, K. M. (1992). Financial Management, 35-49. This article focuses on the bankruptcy of Revco Drug Stores as one of the most leveraged transactions in the history of buyouts, which left it with very little capital which could not see it survive. The Monte Carlo simulation establishes that there was no chance of Revco surviving the high debt obligations in the first 3 years of the buyout.
Leveraged buyout bankruptcies, the problem of hindsight bias, and the credit default swap solution, Simkovic, M., & Kaminetzky, B. S. (2011). Colum. Bus. L. Rev., 118. The author in this article talks about the many bank bonds and loans that were issued during the credit boom of 2003 which peaked in 2007. A lot of leveraged transactions occurred during this period accompanied by eventualities like bankruptcies, defaults, and inter-creditor disputes. In addition to this, the paper talks about the newly introduced financial and legal innovations that may help bankruptcy courts in finding out fraudulent claims of transfer in extreme business bankruptcies. These innovations have led to economic stability by preventing inappropriate business decisions which resulted in inconsistencies, unpredictability and biased results. The author concludes by suggesting various methods that could be used to enhance credit decisions at banks so that stable transactions are realized. They include empirical analysis of how credit default swap prices correlate with equity. Another way is through the development of fraudulent transfer laws which can address those concerns once and for all.
Red and Blue: the relationship between the institutional context and the performance of leveraged buyout investments, Pe’Er, A., & Gottschalg, O. (2011). Strategic Management Journal, 32(12), 1356-1367. The article improves the conversation regarding the link between business and political conducts by analyzing the impact of institutional context on those investments of the leveraged buyout. Going by the institutional theory, there is a high possibility of buyout transactions in areas dominated by United State Republican Party than in the blue states occupied by the Democrats.The author concludes that there is a good correlation between institutions that are more aligned with the contributions of buyout investments.
The collapsed leveraged buyout and the trustee in bankruptcy, Queenan Jr, J. F. (1989). Cardozo L. Rev., 11, 1. The author in this article is concerned with how a fall in leveraged buyout correlates with the trustee in case there is a bankruptcy. The paper focuses on how bankruptcy has got negative impacts on the leveraged buyout.
Regulation of private equity-backed leveraged buyout activity in Europe, Ferran, E. (2007). This paper is concerned with major changes in European laws which have led to the rise of private-equity backed leveraged buyout. This has led to some economic benefits and various repercussions such as excessive leverage, market abuse, lack of transparency and conflict of interest. In an attempt to balance and curtail these competing concerns, there have been attempts to control them through introducing measures to the European Commission law. These measures are capable of controlling the excesses and abuses that come with Leverage Buyouts. In addition to this, the author informs of how article 23 of the second company law can be utilized in solving the agency challenges that come with LBOs.
The private equity-leveraged buyout form of finance capitalism: Ethical and social issues, and potential reforms, Nielsen, R. P. (2008). Business Ethics Quarterly, 18(3), 379-404. This paper narrates how private equity-leveraged buyout works as an aspect of finance capitalism.PE-LBO capitalism is normally defined and related to various types of capitalism namely: managerial capitalism, family business capitalism, and value capitalism. The analyses of social and ethical concerns that are structurally linked to PE-LBO are also considered with possible solutions and reforms.