With global M&A hitting records it pays for investors to understand what a leveraged buyout is and exactly why investment firms have been so keen to buy companies using this strategy.
A leveraged buyout occurs when one firm purchases/takes over another company utilising mainly debt and the acquired company's cash flows to finance repayments. The company performing the buyout usually only has to put a small amount of money down and makes a very large purchase relative to their equity invested. The objective of a leveraged buyout is that the return generated by the newly acquired firm will more than compensate for the interest which needs to be paid, allowing very high returns to be achieved while only outlying a small amount of money.
Leveraged buyouts are helped by the fact that the interest expense which is paid out can be deducted as a tax expense. Leveraged buyouts are often marketed as being beneficial to banks (who obtain higher interest margins) in addition to allowing the purchaser to achieve very high returns. Investment companies market them as "win-win" deals. Characteristics of ideal leveraged buyout transactions include:
- Stable & Secure cash flows: Leveraged buyouts are usually conducted in sectors where there is a high certainty that the acquired firm will be able to provide the required cash flows to service its debt. Firms which are cyclical or have cash flows that fluctuate dramatically between periods are generally not targets for leveraged buyouts simply because if the company cannot meet its interest repayments it will default.
- Long history/favourable economic environment: Firms who are bought in a leveraged buyout usually have a long record of producing free cash flow and operate in favourable sectors and under favourable economic conditions. This helps to give the creditors confidence that the firm conducting the leveraged buyout will be able to meet its debt obligations.
- Strong Management/Fair valuation: Having a management which is respected and has a long operating history gives creditors credibility that operations will be able to continue 'as normal' in the future. Similarly, should the firm be fairly valued by using justified metrics creditors are likely to feel more confident that the firm performing the buyout has not overpaid in the buyout.
- Balance between debt & equity: The nature of the transaction will affect how much debt is used relative to equity. Examples of highly leveraged transaction may involve only 10% equity and 90% debt financing, while around 40%-60% debt financing would be more typical. It is important to remember that a leveraged buyout adds a large amount of debt to the company's balance sheet and pressure to generate cash flows. Therefore acquiring a firm with few current obligations is generally favoured.
Takeaway for Investors
It pays to look out for firms which are candidates for leveraged buyouts. You can reap huge profits if they are bought-out at a premium. It also pays to understand exactly why investment firms are so keen to participate in leveraged buyouts. They get much more upside if things work out well than if they had simply decided to use equity.
