Ask Mint | Leveraged buyouts work well for all sorts of corporate acquirers

Ask Mint | Leveraged buyouts work well for all sorts of corporate acquirers
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First Published: Mon, Jun 01 2009. 12 53 AM IST

Updated: Mon, Jun 01 2009. 11 41 AM IST
During the 1980s, leveraged buyouts (LBOs) worked like a machine gun firing bullets of junk bonds, hitting one company after another on Wall Street. At one time, it looked as if the whole world would soon become a playground for LBOs. But the collapse of junk bonds in the late 1980s silenced the machine guns.
It took some years before the second wave of LBOs started hitting the shores of the financial market. With the growth of private equity players in the mid-2000s, the US and the rest of the world saw the second boom in LBOs. But now, with the onset of the credit crisis in 2008, it seems LBOs may have to rediscover themselves.
Johnny:All of us at some point in our life rediscover something. I hope LBOs also maintain that spirit. But tell me, Jinny, how did LBOs start?
Jinny: Leveraged buyouts, or what you call LBOs in short, first emerged during the 1980s in the US, Canada and to some extent, the UK. The Journal of Economic Perspectives (Volume 23, No. 1) in one of its studies mentions that during 1985-89, when the process of LBOs was at its peak, these three countries accounted for 93% of the worldwide transaction value. The frantic growth in mergers and acquisitions on Wall Street during the 1980s fuelled LBO growth. At one point, it was thought LBOs would change the face of corporate finance forever. But during the 1990s, things didn’t turn out as expected; LBOs of public companies took a back seat.
Johnny: I am really curious to know why. But before that, it would be better if you could first explain how the process of LBOs actually works.
Jinny:The process of LBOs during the 1980s was most commonly used for converting a publicly listed company into a private company by buying back the shares from shareholders. The beauty of this process was that it appealed to both saints and sinners of high finance. While the management of a company or some friendly investment firm used the process to unlock the true potential of a company, corporate raiders used it as a deadly weapon in a hostile takeover. LBOs work perfectly well for all sorts of corporate acquirers. The process of LBOs, in its most basic form, involves the acquisition of a company by using a small portion of equity and a large portion of outside debt financing.
Johnny: So that’s the secret formula: a small portion of equity and a large portion of debt. That’s why I think the whole process is called leveraged buyout.
Illustration: Jayachandran / Mint
Jinny: That’s right. A typical LBO is financed with 60-90% debt. The acquirer himself has to put less of his own money in the acquisition. For instance, suppose you intend to convert a publicly listed company into a private company by buying shares from the existing shareholders. If the value of all the shares is currently Rs100 crore, you may just need to use Rs10 crore of your own for acquiring equity worth that much in the company. To raise the rest of the money for the buy-back, acquirers issue bonds to other institutional investors. At one point, LBOs of big companies with a thin layer of equity mostly relied on junk bonds to raise the required money for the buy-back. The junk bonds used to finance LBOs offered high returns to investors, albeit at a greater risk due to high leverage.
Johnny: Like a late night party, LBOs attract all sorts of characters, it seems.
Jinny: In any LBO you would find two classes of investors. One, the actual acquirers who invest some portion of their money to acquire the equity of the target company. Two, the lenders who invest their money in the bonds issued by the company, the proceeds of which are used by the company to buy back shares from the remaining shareholders. The company extinguishes the shares purchased through the buy-back.
In other words, the equity base of the target company decreases as a result of an LBO whereas its debt increases. Subsequently, the target company has to repay the bondholders out of its future income or by resale of its surplus assets. This requirement to compulsorily meet the obligation of bondholders has one obvious advantage. It forces the company to cut costs and make better use of its cash flows, which in turn helps in creating a lean and more efficient organization. But as actual experience shows, many companies fail to do that.
A large number of high-profile LBOs of Wall Street during the 1980s ultimately ended in default. As a result, LBOs of public companies virtually disappeared during the early 1990s. During lean times, LBOs of private companies were the only ray of hope. Things again picked up only in the mid-2000s, when LBOs of public companies made a comeback.
Johnny: Well, thanks for explaining all this, Jinny. I think, with the changing fortunes of the financial market, things would continue moving up and down.
What: The process of LBOs involves acquisition of a company by using a small portion of equity and a large portion of outside debt financing.
Who: LBOs are most commonly used by private equity players.
Where: LBOs first emerged during the 1980s in the US, Canada and UK.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Mon, Jun 01 2009. 12 53 AM IST