What is a buyout?

What is a buyout?

Although it can take many different forms, a buyout simply refers to the process by which a controlling interest in a company is acquired by an investor.

The controlling interest could be purchased by the company’s own management, a private equity firm, or – more commonly – by another company.

What is a buyout?

In order to have a controlling interest in a company, an investor – or group of investors – needs to own a majority (more than 50%) of the company’s shares. Because of the voting rights attached to their shareholding, this gives these shareholders significant influence over the future strategic direction of the company. In essence, they can effectively take over its operations. 

In most cases though, a buyout will entail the acquisition of the entirety of a company’s shares.

A potential acquirer will submit a proposal to the target company’s board of directors, who will then negotiate terms and provide a voting recommendation to their existing shareholders. The shareholders then vote on whether to accept or reject the buyout.   

Why do companies acquire other companies through a buyout?

There are many reasons why one company may choose to acquire another company through a buyout. Some of the key motivations are outlined below:

‘Tuck-in’ acquisition

Also called a ‘bolt-on acquisition’, a tuck-in acquisition refers to a company buying another business with the aim of merging it into one of its existing divisions.

Companies may pursue this buyout strategy when they wish to expand their product offering, but don’t currently have the infrastructure or technology to do so. In these situations, it may be more efficient and cost-effective for the company to simply acquire a smaller company that is already successfully offering that product or service.

A good example of this is the acquisition of social media company Instagram by Meta Platforms Inc (NASDAQ: FB) – the company formerly known as Facebook. Meta paid US$1 billion to acquire Instagram back in 2012, and it now contributes well over US$20 billion to Meta’s annual revenues.

Expansion into new markets

Companies might buy out similar companies because they operate in other markets. In many ways this is similar in concept to a tuck-in acquisition, but instead of expanding its product offering, the acquirer expands its geographic footprint. This is a quick and potentially less risky way for a company to access new markets, as the acquirer can leverage the acquired company’s existing brand and customer base.

Spanish bank Banco Santander provides a good example. Throughout its 160-odd year history, Santander has acquired banks and financial services companies in Argentina, Puerto Rico, Chile, Brazil, Mexico, and the United Kingdom, among others. Through these acquisitions, Santander Group has grown into 1 of the largest financial institutions in the world.

Large-scale strategic alignments

Companies will often acquire other companies that have similar strategies in order to boost revenues, realise cost synergies, and achieve their goals faster. For example, in 2005, Ramsay Health Care Limited (ASX: RHC) acquired Affinity Health, and became the largest private hospital operator in Australia. This acquisition quickly expanded Ramsay’s market share and made it the dominant player in its industry. 

Acquisitions like this can also help companies achieve faster economies of scale.  

Vertical integration

This is when companies acquire other companies along their value chain. This can give them greater control over the supply and distribution of their products and services. 

A good example is the acquisition of American grocery chain Whole Foods Market by tech giant Amazon.com, Inc. (NASDAQ: AMZN). In addition to diversifying its product offering, this acquisition gave Amazon a bricks-and-mortar retail distribution network where it could sell its products directly to consumers.

What are the different types of buyouts?

The way a buyout is classified generally depends on how the acquisition is settled, or which party instigates the buyout.

All-stock buyout

In an all-stock buyout, shares in the company being acquired are traded for a set amount of new shares of the acquiring company,  based on an agreed conversion ratio.

A good recent example of this is the acquisition of Afterpay Ltd (ASX: APT) by US digital payments company Block Inc (NYSE: SQ), formerly known as Square. Under the terms of the deal, eligible Afterpay shareholders will receive 0.375 shares in Block for every ordinary Afterpay share they own at the record date.

The advantage of this type of acquisition is that the acquiring company does not need to raise additional capital to finance the acquisition – it can simply issue new shares. The disadvantage is that taking this sort of action will lead to the dilution of the acquiring company’s share price. However, it is hoped that the business benefits stemming from the assets acquired through the buyout will more than offset those dilutive impacts over the longer term.

All-cash buyout

In an all-cash buyout, the acquiring company will purchase all shares in the target company using cash. Shareholders of the target company will not be issued any shares of the acquiring company. Instead, they will simply be offered an amount of cash in exchange for surrendering their shares. Often, the price offered by the acquirer will be higher than the market price of the shares to incentivise shareholders to accept the deal.

While this approach avoids diluting the acquiring company’s share price, it does require it to have a lot of funds available. This may mean it will need to borrow a significant amount of money in order to finance the deal, which can result in high interest payments further down the line.

Management buyout (MBO)

In this type of buyout, the company’s existing management will seek to acquire a controlling interest in the same company’s shares. Managers may want to take this action to secure greater potential rewards from the company’s success. It can also give them greater control over the direction of the company.

In 2018, John Humble, the CEO of ASX skincare company BWX Ltd (ASX: BWX) attempted to buy out the company (with the financial backing of a private equity firm). He was reportedly frustrated that the existing BWX shareholders weren’t allowing him to pursue as aggressive an M&A strategy as he would have liked. While the deal ultimately collapsed, this is still a good example of what might motivate a company’s management to execute an MBO.

Leveraged buyout (LBO)

In a leveraged buyout, a company will finance an acquisition by taking out a large loan, typically using the assets of the target firm as collateral. The advantage of this type of buyout is that companies can make large purchases without needing a lot of cash. However, like an all-cash buyout, because an LBO is financed by debt, it can pose financial risks if the interest payments are high.

Are buyouts good for shareholders?

Buyouts can be a bit of a mixed bag for shareholders. Typically, the share price of the acquiring company will drop on the buyout news, due to the fact that it may have to fork out a significant amount of money to seal the deal. However, over the longer term the benefits of the acquisition should see greater growth.

The share price of the target company, on the other hand, tends to rise in line with the premium offered by the potential acquirer. While this is good news for short-term investors who might realise a quick gain, longer-term shareholders may be disappointed that they are forced to give up their holdings in a company they had high hopes for – particularly in an all-cash deal.

In a worst-case scenario, a buyout may even result in a shareholder being forced to realise a loss on their holdings. For example, if you bought shares in Afterpay when it peaked at around $160, you may actually end up losing money under the terms of the Block acquisition.

What are the potential barriers to a buyout?

In order for a buyout to proceed, shareholders need to vote on it – hence the need for potential acquirers to offer them a juicy premium. If the shareholders don’t like the terms of the deal, they can vote it down and the acquisition will be blocked.

There are also regulations against companies gaining a monopoly in their industry. The Australian Competition and Consumer Commission (ACCC) reviews acquisition proposals to ensure they won’t substantially reduce competition in a particular market.

For example, the ACCC initially opposed the merger of TPG Telecom and Vodafone Hutchison Australia on the grounds that it would lessen competition in the mobile telecommunications market and disadvantage the consumer.

Ultimately, the Federal Court disagreed with the ACCC and allowed the merger to go ahead. However, this is still an example of some of the roadblocks that companies can come up against when trying to implement a buyout.

 

This article last updated on 19 January 2022. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool's board of directors. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Motley Fool contributor Rhys Brock owns Afterpay Limited and Ramsay Health Care Limited. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns and has recommended Afterpay Limited, Block, Inc., and Meta Platforms, Inc. The Motley Fool Australia owns and has recommended Afterpay Limited. The Motley Fool Australia has recommended Amazon, BWX Limited, Meta Platforms, Inc., and Ramsay Health Care Limited. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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