Leveraged Buyout Advantages And Disadvantages

A leveraged buyout relies on a combination of a large portion of debt financing and a small contribution of equity by a financial sponsor (a sponsor or a PE firm) to raise funds to purchase the intended target. The debt capital ranges between 70%-80% of the total capital . Because of this, it is known as Leveraged Buyout since the company leverages itself by way of borrowed funds. The assets of the target itself are used primarily as collateral for the loans in addition to the assets of the acquiring company. Once the control of a company is acquired, the firm ceases to be publicly traded. During this private period, new owners are able to reorganize a company’s corporate structure with the objective of making a substantial profitable return.

In addition, there should be significant improvements in profitability and operating efficiency after the LBO when corporate structure’s comprehensive changes are made, typically layoffs and employment redeployment or complete riddance of unnecessary company divisions.

• Tax advantages: A high level of debt provides the benefit of tax savings realized due to the tax deductibility from interest expense.

• Management incentives: Large interest and principal payments from the use of leverage can force changes in managerial behavior to improve performance and operating efficiency, specifically to focus on certain initiatives such as divesting non-core businesses, cost cutting or investing in technological upgrades. Also, through investment alongside management, PE firms can encourage top executives to commit a significant portion of their personal net worth to the deal in order to guarantee that management’s incentives will be aligned with their

A move from a publicly listed firm to private limited status “can provide greater control away from the need to meet the requirements of a multitude of other investors. The firm will also likely have less public scrutiny as less information is required to be divulged compared to that of a publicly listed company.”

However, how to spot a potential LBO target? Below are characteristics that deal professionals typically seek to define the ideal candidate for a LBO. Although it is very unlikely that any one company will meet all these criteria, some combination thereof is need to successfully perform an LBO.

• Strong and steady cash flows generation: helps the leveraged company service and pay down acquisition debt.

• Mature industry and/or company: whose stock price is trading at a lower multiple to free cash flow than new companies in high-growth industries. This enables the LBO purchaser to buy the company at a relatively low cost compared to the annual cash flow it produces.

• Well-established business and products and leading market position: to keep generating steady cash flows and keep position in its markets.

• Limited working capital requirements: Moderate or even low levels of capital expenditure required are better so that cash flows are not diverted from the principle goal of debt