- Leveraged buyout
A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or "bootstrap" transaction) occurs when a
financial sponsoracquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage (borrowing). The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved. Many large buyouts in the 1980s produced insufficient cash flow to pay the interest of the borrowed capital, giving their bonds "junk" status.
Companies of all sizes and industries have been the target of leveraged buyout transactions, although because of the importance of debt and the ability of the acquired firm to make regular loan payments after the completion of a leveraged buyout, some features of potential target firms make for more attractive leverage buyout candidates, including:
* Low existing debt loads;
* A multi-year history of stable and recurring cash flows;
* Hard assets (
property, plant and equipment, inventory, receivables) that may be used as collateral for lower cost secured debt;
* The potential for new management to make operational or other improvements to the firm to boost cash flows;
* Market conditions and perceptions that depress the valuation or stock price.
Leveraged buyouts allow
financial sponsors or private equity firms to make large acquisitions without committing all the capital required for the acquisition. The use of debt also significantly increases the returns to a LBO's financial sponsor, as cash flows from the target company, rather than the financial sponsors, are used to pay down the debt used to purchase the company. This, in combination with the fact that financial sponsors pay only a portion of the original purchase price, means that a later sale of the company produces significant returns for the financial sponsor. As transaction sizes grow, the equity component of the purchase price can be provided by multiple financial sponsors "co-investing" to come up with the needed equity for a purchase. Likewise, multiple lenders may band together in a "syndicate" to jointly provide the debt required to fund the transaction. Today, larger transactions are dominated by dedicated private equityfirms and a limited number of large banks with "financial sponsors" groups.
As a percentage of the purchase price for a leverage buyout target, the amount of debt used to finance a transaction varies according the financial condition and history of the acquisition target, market conditions, the willingness of lenders to extend credit (both to the LBO's
financial sponsors and the company to be acquired) as well as the interest costs and the ability of the company to cover those costs. Typically the debt portion of a LBO ranges from 50%-85% of the purchase price, but in some cases debt may represent upwards of 95% of purchase price. Between 2000-2005 debt averaged between 59.4% and 67.9% of total purchase price for LBOs in the United States. [Trenwith Group "M&A Review," (Second Quarter, 2006)]
Origins of the leveraged buyouts
The first leveraged buyout may have been the purchase by McLean Industries, Inc. of
Pan-Atlantic Steamship Companyin January 1955 and Waterman Steamship Corporationin May 1955. [ On January 21, 1955, McLean Industries, Inc. purchased the capital stock of Pan Atlantic Steamship Corporation and Gulf Florida Terminal Company, Inc. from Waterman Steamship Corporation. In May McLean Industries, Inc. completed the acquisition of the common stock of Waterman Steamship Corporation from its founders and other stockholders.] Under the terms of that transaction, McLean borrowed $42 million and raised an additional $7 million through an issue of preferred stock. When the deal closed, $20 million of Waterman cash and assets were used to retire $20 million of the loan debt. [Marc Levinson, "The Box, How the Shipping Container Made the World Smaller and the World Economy Bigger", pp. 44-47 (Princeton Univ. Press 2006). The details of this transaction are set out in ICC Case No. MC-F-5976, "McLean Trucking Company and Pan-Atlantic American Steamship Corporation--Investigation of Control", July 8, 1957. ] Similar to the approach employed in the McLean transaction, the use of publicly tradedholding companies as investment vehicles to acquire portfolios of investments in corporate assets was a relatively new trend in the 1960s popularized by the likes of Warren Buffett( Berkshire Hathaway) and Victor Posner(DWG Corporation) and later adopted by Nelson Peltz( Triarc), Saul Steinberg (Reliance Insurance) and Gerry Schwartz( Onex Corporation). These investment vehicles would utilize a number of the same tactics and target the same type of companies as more traditional leveraged buyouts and in many ways could be considered a forerunner of the later private equity firms. In fact it is Posner who is often credited with coining the term " leveraged buyout" or "LBO" [Trehan, R. (2006). " [http://www.4hoteliers.com/4hots_fshw.php?mwi=1757 The History Of Leveraged Buyouts] ". December 4, 2006. Accessed May 22, 2008]
The leveraged buyout boom of the 1980s was conceived by a number of corporate financiers, most notably
Jerome Kohlberg, Jr.and later his protégé Henry Kravis. Working for Bear Stearnsat the time, Kohlberg and Kravis, along with Kravis' cousin George Roberts, began a series of what they described as "bootstrap" investments. Many of the target companies lacked a viable or attractive exit for their founders, as they were too small to be taken public and the founders were reluctant to sell out to competitors. Thus a sale to a financial buyer might prove attractive. Their acquisition of Orkin Exterminating Company in 1964 is among the first significant leveraged buyout transactions. [ [http://www.investmentu.com/research/private-equity-history.html The History of Private Equity] (Investment U, The Oxford Club)] Verify credibility|date=July 2008. In the following years the three Bear Stearnsbankers would complete a series of buyouts including Stern Metals (1965), Incom (a division of Rockwood International, 1971), Cobblers Industries (1971), and Boren Clay (1973) as well as Thompson Wire, Eagle Motors and Barrows through their investment in Stern Metals. [Burrough, Bryan. " Barbarians at the Gate." New York : Harper & Row, 1990, p. 133-136] By 1976, tensions had built up between Bear Stearns and Kohlberg, Kravis and Roberts leading to their departure and the formation of Kohlberg Kravis Robertsin that year.
Leveraged buyouts in the 1980s
In January 1982, former US
Secretary of the TreasuryWilliam Simon and a group of investors acquired Gibson Greetings, a producer of greeting cards, for $80 million, of which only $1 million was rumored to have been contributed by the investors. By mid-1983, just sixteen months after the original deal, Gibson completed a $290 million IPO and Simon made approximately $66 million. [Taylor, Alexander L. " [http://www.time.com/time/magazine/article/0,9171,951242,00.html Buyout Binge] ". TIME magazine, Jul. 16, 1984.] The success of the Gibson Greetings investment attracted the attention of the wider media to the nascent boom in leveraged buyouts. Between 1979 and 1989, it was estimated that there were over 2,000 leveraged buyouts valued in excess of $250 billion [Opler, T. and Titman, S. "The determinants of leveraged buyout activity: Free cash flow vs. financial distress costs." Journal of Finance, 1993.]
During the 1980s, constituencies within acquired companies and the media ascribed the "
corporate raid" label to many private equity investments, particularly those that featured a hostile takeoverof the company, perceived asset stripping, major layoffs or other significant corporate restructuring activities. Among the most notable investors to be labeled corporate raiders in the 1980s included Carl Icahn, Victor Posner, Nelson Peltz, Robert M. Bass, T. Boone Pickens, Harold Clark Simmons, Kirk Kerkorian, Sir James Goldsmith, Saul Steinberg and Asher Edelman. Carl Icahndeveloped a reputation as a ruthless corporate raider after his hostile takeoverof TWA in 1985. [http://www.time.com/time/magazine/article/0,9171,1590446,00.html 10 Questions for Carl Icahn] by Barbara Kiviat, TIME magazine, Feb. 15, 2007] [ [http://www.stlmag.com/media/St-Louis-Magazine/October-2005/TWA-Death-Of-A-Legend/ TWA - Death Of A Legend] by Elaine X. Grant, "St Louis Magazine", Oct 2005] Many of the corporate raiders were onetime clients of Michael Milken, whose investment banking firm, Drexel Burnham Lamberthelped raise blind pools of capital with which corporate raiders could make a legitimate attempt to takeovera company and provided high-yield debtfinancing of the buyouts.
One of the final major buyouts of the 1980s proved to be its most ambitious and marked both a high water mark and a sign of the beginning of the end of the boom that had begun nearly a decade earlier. In 1989, KKR closed in on a $31.1 billion dollar takeover of
RJR Nabisco. It was, at that time and for over 17 years, the largest leverage buyout in history. The event was chronicled in the book (and later the movie), " Barbarians at the Gate: The Fall of RJR Nabisco". KKR would eventually prevail in acquiring RJR Nabisco at $109 per share marking a dramatic increase from the original announcement that Shearson Lehman Hutton would take RJR Nabisco private at $75 per share. A fierce series of negotiations and horse-trading ensued which pitted KKR against Shearson Lehman Hutton and later Forstmann Little & Co.Many of the major banking players of the day, including Morgan Stanley, Goldman Sachs, Salomon Brothers, and Merrill Lynchwere actively involved in advising and financing the parties. After Shearson Lehman's original bid, KKR quickly introduced a tender offer to obtain RJR Nabisco for $90 per share—a price that enabled it to proceed without the approval of RJR Nabisco's management. RJR's management team, working with Shearson Lehman and Salomon Brothers, submitted a bid of $112, a figure they felt certain would enable them to outflank any response by Kravis's team. KKR's final bid of $109, while a lower dollar figure, was ultimately accepted by the board of directors of RJR Nabisco. [ [http://www.time.com/time/magazine/0,9263,7601881205,00.html Game of Greed] (TIME magazine, 1988)] At $31.1 billion of transaction value, RJR Nabisco was by far the largest leveraged buyouts in history. In 2006 and 2007, a number of leveraged buyout transactions were completed that for the first time surpassed the RJR Nabisco leveraged buyout in terms of nominal purchase price. However, adjusted for inflation, none of the leveraged buyouts of the 2006 – 2007 period would surpass RJR Nabisco.
By the end of the 1980s the excesses of the buyout market were beginning to show, with the
bankruptcyof several large buyouts including Robert Campeau's 1988 buyout of Federated Department Stores, the 1986 buyout of the Revcodrug stores, Walter Industries, FEB Trucking and Eaton Leonard. Additionally, the RJR Nabisco deal was showing signs of strain, leading to a recapitalization in 1990 that involved the contribution of $1.7 billion of new equity from KKR. [Wallace, Anise C. " [http://query.nytimes.com/gst/fullpage.html?res=9C0CE2D91E31F935A25754C0A966958260 Nabisco Refinance Plan Set] ." The New York Times, July 16, 1990.] Drexel Burnham Lambertwas the investment bankmost responsible for the boom in private equity during the 1980s due to its leadership in the issuance of high-yield debt.
Drexel reached an agreement with the government in which it pleaded "
nolo contendere" (no contest) to six felonies – three counts of stock parking and three counts of stock manipulation.cite book |last=Stone |first=Dan G. |title=April Fools: An Insider's Account of the Rise and Collapse of Drexel Burnham |year=1990 |publisher=Donald I. Fine |location=New York City |isbn= 1556112289] It also agreed to pay a fine of $650 million – at the time, the largest fine ever levied under securities laws. Milken left the firm after his own indictment in March 1989. [http://www.referenceforbusiness.com/history2/5/New-Street-Capital-Inc.html New Street Capital Inc.] - Company Profile, Information, Business Description, History, Background Information on New Street Capital Inc at ReferenceForBusiness.com] On February 13, 1990after being advised by Secretary of the Treasury Nicholas F. Brady, the SEC, the NYSEand the Federal Reserve, Drexel Burnham Lambertofficially filed for Chapter 11bankruptcy protection."Den of Thieves". Stewart, J. B. New York: Simon & Schuster, 1991. ISBN 0-671-63802-5.]
Age of the mega-buyout 2005-2007
The combination of decreasing interest rates, loosening lending standards and regulatory changes for publicly traded companies (specifically the
Sarbanes-Oxley Act) would set the stage for the largest boom private equity had seen. Marked by the buyout of Dex Mediain 2002, large multi-billion dollar U.S. buyouts could once again obtain significant high yield debt financing and larger transactions could be completed. By 2004 and 2005, major buyouts were once again becoming common, including the acquisitions of Toys "R" Us[SORKIN, ANDREW ROSS and ROZHON, TRACIE. " [http://www.nytimes.com/2005/03/17/business/17toys.html Three Firms Are Said to Buy Toys 'R' Us for $6 Billion ] ." New York Times, March 17, 2005.] , The Hertz Corporation[ANDREW ROSS SORKIN and DANNY HAKIM. " [http://www.nytimes.com/2005/09/08/business/08ford.html Ford Said to Be Ready to Pursue a Hertz Sale] ." New York Times, September 8, 2005] [PETERS, JEREMY W. " [http://www.nytimes.com/2005/09/13/business/13hertz.html Ford Completes Sale of Hertz to 3 Firms] ." New York Times, September 13, 2005] , Metro-Goldwyn-Mayer[SORKIN, ANDREW ROSS. " [http://www.nytimes.com/2004/09/14/business/media/14studio.html Sony-Led Group Makes a Late Bid to Wrest MGM From Time Warner] ." New York Times, September 14, 2004] and SunGard[" [http://www.nytimes.com/2005/03/29/business/29sungard.html Capital Firms Agree to Buy SunGard Data in Cash Deal] ." Bloomberg, March 29, 2005] in 2005. As 2005 ended and 2006 began, new "largest buyout" records were set and surpassed several times with nine of the top ten buyouts at the end of 2007 having been announced in an 18-month window from the beginning of 2006 through the middle of 2007. In 2006, private equity firms bought 654 U.S. companies for $375 billion, representing 18 times the level of transactions closed in 2003. [Samuelson, Robert J. " [http://www.washingtonpost.com/wp-dyn/content/article/2007/03/14/AR2007031402177.html The Private Equity Boom] ". The Washington Post, March 15, 2007.] Additionally, U.S. based private equity firms raised $215.4 billion in investor commitments to 322 funds, surpassing the previous record set in 2000 by 22% and 33% higher than the 2005 fundraising total [Dow Jones Private Equity Analyst as referenced in [http://www.boston.com/business/articles/2007/01/11/us_private_equity_funds_break_record/ U.S. private-equity funds break record] Associated Press, January 11, 2007.] The following year, despite the onset of turmoil in the credit markets in the summer, saw yet another record year of fundraising with $302 billion of investor commitments to 415 funds [DowJones Private Equity Analyst as referenced in [http://www.reuters.com/article/idUSBNG14655120080108 Private equity fund raising up in 2007: report] , Reuters, January 8, 2008.] Among the mega-buyouts completed during the 2006 to 2007 boom were: Equity Office Properties, HCA [SORKIN, ANDREW ROSS. " [http://www.nytimes.com/2006/07/25/business/25buyout.html HCA Buyout Highlights Era of Going Private] ." New York Times, July 25, 2006.] , Alliance Boots[WERDIGIER, JULIA. " [http://www.nytimes.com/2007/04/25/business/worldbusiness/25boots.html Equity Firm Wins Bidding for a Retailer, Alliance Boots] ." New York Times, April 25, 2007] and TXU[Lonkevich, Dan and Klump, Edward. [http://www.bloomberg.com/apps/news?pid=20601087&sid=ardubKH_t2ic&refer=home KKR, Texas Pacific Will Acquire TXU for $45 Billion] Bloomberg, February 26, 2007.] .
In July 2007, turmoil that had been affecting the mortgage markets, spilled over into the leveraged finance and
high-yield debtmarkets. [SORKIN, ANDREW ROSS and de la MERCED, MICHAEL J. " [http://www.nytimes.com/2007/06/26/business/26place.html Private Equity Investors Hint at Cool Down] ." New York Times, June 26, 2007] [SORKIN, ANDREW ROSS. " [http://www.nytimes.com/2007/08/12/business/yourmoney/12deal.html Sorting Through the Buyout Freezeout] ." New York Times, August 12, 2007.] The markets had been highly robust during the first six months of 2007, with highly issuer friendly developments including PIK and PIK Toggle (interest is "P"ayable "I"n "K"ind") and covenant light debt widely available to finance large leveraged buyouts. July and August saw a notable slowdown in issuance levels in the high yield and leveraged loan markets with only few issuers accessing the market. Uncertain market conditions led to a significant widening of yield spreads, which coupled with the typical summer slowdown led to many companies and investment banks to put their plans to issue debt on hold until the autumn. However, the expected rebound in the market after Labor Day2007 did not materialize and the lack of market confidence prevented deals from pricing. By the end of September, the full extent of the credit situation became obvious as major lenders including Citigroupand UBS AGannounced major writedowns due to credit losses. The leveraged finance markets came to a near standstill. [ [http://www. Economist.com/finance/displaystory.cfm?story_id=9566005 Turmoil in the markets] The EconomistJuly 27, 2007] As 2007 ended and 2008 began, it was clear that lending standards had tightened and the era of "mega-buyouts" had come to an end. Nevertheless, private equity continues to be a large and active asset class and the private equity firms, with hundreds of billions of dollars of committed capital from investors are looking to deploy capital in new and different transactions.
The purposes of debt financing for leveraged buyouts are two-fold:
# The use of debt increases (leverages) the financial return to the
private equity sponsor. Under the Modigliani-Miller theorem, [Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance, and theTheory of Investment," "American Economic Review", June 1958.] the total return of an asset to its owners, all else being equal and within strict restrictive assumptions, is unaffected by the structure of its financing. As the debt in an LBO has a relatively fixed, albeit high, cost of capital, any returns in excess of this cost of capital flow through to the equity.
tax shieldof the acquisition debt, according to the Modigliani-Miller theoremwith taxes, increases the value of the firm. This enables the private equity sponsor to pay a higher price than would otherwise be possible. Because income flowing through to equity is taxed, while interest payments to debt are not, the capitalized value of cash flowing to debt is greater than the same cash stream flowing to equity. Germanycurrently introduces new tax laws, taxing parts of the cash flow before debt interest deduction. The motivation for the change is to discourage leveraged buyouts by reducing the tax shield effectiveness.Fact|date=July 2008
Historically, many LBOs in the 1980s and 1990s focused on reducing wasteful expenditures by corporate managers whose interests were not aligned with shareholders. After a major corporate restructuring, which may involve selling off portions of the company and severe staff reductions, the entity would likely be producing a higher income stream. Because this type of management
arbitrageand easy restructuring has largely been accomplished, LBOs today focus more on growth and complicated financial engineering to achieve their returns. Most leveraged buyout firms look to achieve an internal rate of returnin excess of 20%.
A special case of such acquisition is a
management buyout(MBO), which occurs when a company's managers buy or acquire a large part of the company. The goal of an MBO may be to strengthen the managers' interest in the success of the company. In most cases, the management will then make the company private. MBOs have assumed an important role in corporate restructurings beside mergers and acquisitions. Key considerations in an MBO are fairness to shareholders, price, the future business plan, and legal and tax issues. One recent criticism of MBOs is that they create a conflict of interest—an incentive is created for managers to mismanage (or not manage as efficiently) a company, thereby depressing its stock price, and profiting handsomely by implementing effective management after the successful MBO.
Some LBOs in the 1980s and 1990s resulted in corporate
bankruptcy, such as Robert Campeau's 1988 buyout of Federated Department Storesand the 1986 buyout of the Revcodrug stores. The failure of the Federated buyout was a result of excessive debt financing, comprising about 97% of the total consideration, which led to large interest payments that exceeded the company's operating cash flow. In response to the threat of LBOs, certain companies adopted a number of techniques, such as the poison pill, to protect them against hostile takeovers by effectively self-destructing the company if it were to be taken over.
The inability to repay debt in an LBO can be caused by initial overpricing of the target firm and/or its assets. Because LBO funds often attempt to increase the value of an acquired company by liquidating certain assets or selling underperforming business units, the bought-out firm may face
insolvencyas depleted operating revenues become insufficient to repay the debt. Over-optimistic forecasts of the revenues of the target company may also lead to financial distressafter acquisition. The LBO debt may constitute a fraudulent transfer under U.S. insolvency law if it is determined to be the cause of the acquired firm's failure. [U.S. Bankruptcy Code, 11 U.S.C. § 548(2); Uniform Fraudulent Transfer Act, § 4. This is because the company usually gets no direct financial benefit from the transaction but incurs the debt for it nevertheless.]
Private equity firm
History of private equity and venture capital
List of private equity firms
* [http://www.http://www.ifrconferences.com/flb07/ European Leveraged Finance conference]
* [http://www.ifrconferences.com/lfa07/ Asian Leveraged Finance conference]
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