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The A-Z of LBOs


wealthymatters.comWHAT IS AN LBO?
During mergers and acquisitions, when the buyer borrows money by keeping assets of the target company as collateral to fund the acquisition, it is known as a leveraged buyout (LBO). The borrowed funds could include junk bonds or traditional bank financing. Often a leveraged buyout does not involve much committed capital, as reflected by the high debt-to-equity ratio of the total purchase price (typically an average of 70% debt, 30% equity). In addition, any interest that accrues during the buyout tends to get compensated by the future cash flow of the acquired company. 
WHY DO LBOs GET A BAD NAME?
LBOs, especially,  of the 1980s vintage have had a notorious history when several prominent case studies led to the eventual bankruptcy of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100% and the interest payments were so large that the company’s operating cash flows were unable to meet such obligations. It is often ironic that a company’s success in the form of assets on its balance sheet can be used against it as collateral by a hostile company seeking to acquire it.
DO LBO TARGETS ALWAYS GET DELISTED AND BECOME PRIVATE COS?
Typically after the control of a company is achieved, the firm is  made private for at least some time with the intent of going public again. During this period, new buyout investors-cum-owners are able to reorganize a company’s corporate structure with the objective of making substantial profitable returns. Some comprehensive changes include downsizing departments, aggressive layoffs or completely chopping company divisions and sectors, which are considered non-core. The new investors also sell the company as a whole or in different parts in order to achieve a high rate of returns on their investments.
WHAT ARE THE ADVANTAGES OF LBOs?
In a leveraged buyout, since all depend on a high debt-to-equity ratio, companies can buy targets with very less capital. Further, large interest and principal payments can instill financial discipline in the managements of the companies and a balance sheet cleaning exercise like cost cutting, divestment of non core business can be undertaken to cut debt.
WHAT ARE THE DISADVANTAGES?
Unforeseen events like recession and other macro-economic issues can increase the financial stress in an LBO, where the acquirer is stuck with higher liabilities.
IS ACQUISITION FINANCING ALLOWED IN INDIA?
The RBI guidelines do not allow Indian companies to raise debt for domestic acquisitions. Hence, acquisition financing is not allowed. Indian companies have to either use their internal accruals and cash balances or have to swap equity while buying companies domestically. But for overseas deals, RBI restrictions do not apply.
THEN HAVE INDIAN COS EVER DONE LBOS?
Most of the Indian acquisitions overseas have had some element of LBO financing. These would include Tata Steel’s acquisition of Corus, Aditya Birla Group buying out Columbia Chemicals or even GMR acquiring Intergen.

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About Keerthika Singaravel
Engineer,Investor,Businessperson

2 Responses to The A-Z of LBOs

  1. sonika sharma says:

    Informative article.

    • Glad you found it useful.

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