Leveraged Buyout (LBO)
A particularly popular mechanism for investment funds, Leverage Buyout (LBO) is the preferred financial package during a business buyout. This leveraged buyout method must be properly prepared to avoid any unpleasant surprises for both buyer and seller. How to set up an LBO? What types of LBOs are there? Who can claim it? What are the advantages and risks of a Leverage Buy-Out transaction? In this article, We will discuss LBO principles in detail.
What is LBO (Leverage Buy Out)?
A leveraged buyout, also known as an LBO, is a financial transaction in which a company is bought out with a combination of equity and debt. As part of an LBO, the acquisition of a company is made possible through the often large borrowing of cash (bonds or loans) to cover the cost of the acquisition. It is then said that the buyout is financed by debt.
One of the main arguments for carrying out such an operation lies in the low personal contribution by the purchaser (an individual, an investment fund or more rarely the employees) to take control of a company. Therefore:
- the assets of the acquired company are often used as collateral for loans, along with the assets of the acquiring company.
- the acquisition is largely financed by a bank loan, the cost of which is lower than the expected rate of return of the target.
In a leveraged buyout (LBO), the ratio is generally 90% debt to 10% equity. While a leveraged buyout can be complicated and time consuming, it can benefit both buyer and seller if done properly.
How the LBO works
The purpose of an LBO transaction is based on the acquisition of a total or majority stake in a target company, significantly limiting the initial contribution of the buyers. Thus, a buyer can buy a company valued at 100 with a contribution of only 40 or 50.
To carry out a Leverage Buy-Out arrangement, the buyer or the group of buyers create a holding company [a business entity usually a corporation or limited liability company (LLC)] whose share capital corresponds to the contribution that they can make or to their contribution plus that of financial partners. The constitution of a holding company has 3 objectives:
- buy out the target company;
- borrow funds to finance the buyout;
- repay the loan using the profits made a posteriori by the company.
1. The loan
Thanks to the loan taken out by the holding company and thanks to its share capital, the buyers can acquire 100% of the target company: the buyout is completed.
The company that acquires through an LBO, usually a private equity firm, uses its assets as financial leverage. The assets and cash flow of the company being bought out (called the target company or vendor) are also used as collateral and to pay the cost of financing.
2. The reimbursement
The main difficulty then lies in repaying the loan. It is therefore imperative to ensure upstream that the profitability of the target exceeds the cost of the loan. We are talking about positive leverage.
In order to be able to repay its loan, the holding company then carries out regular liquidity transactions (from the target’s profits and cash flow). Gradually, the holding company begins to reduce its debt, the process usually stretching over several years.
3. The merger holding company and target company
The operation will be successful when the holding company has repaid the loan in full and bought back the shares of the minority partners: the holding company can then merge with the target and form a single entity.
LBOs are carried out for three main reasons:
- to privatize a public enterprise;
- to part with an existing business by selling it;
- to transfer private ownership, such as when changing ownership of a small business.
The challenges of an LBO transaction
Depending on your position in an LBO transaction, you will be faced with different challenges:
As the leader of the target company
An LBO allows you to avoid mergers
You have the obligation to review a very precise business plan in order to respond to the expected leverage effects
You expose yourself to an often significant challenge which generally contains a significant potential for enrichment
As an employee
Management must respond to the challenges of profitability demanded by the new owners
The possibility of joining the “pool” of investors
Writing a new page in company history
As a seller
You are not necessarily forced to sell your company to your competitors (by turning to institutional investors for example)
You have the possibility of bequeathing to executives already present in your company
The LBO process can sometimes be long and tedious (although the terms of transactions tend to be easier and easier.
The different types of LBOs
It is important to examine the scenarios underlying LBOs to understand their possible effects. Here we’ll look at four examples: the repackaging plan, the split, the portfolio plan, and the bailout.
LMBO or MBO
In the case of an LMBO (Leverage Management Buy-out”), the current management team of the company buys the company. An LMBO generally takes place when a production unit is no longer the priority of an industrial group, for example. Instead of calling on outsiders, management then offers to sell it to its employees (executives and / or employees) to ensure its sustainability. In addition to the employees, external investors can join the operation and set up a holding company. This financial transaction is carried out on credit, with the aim of generating sufficient profits to repay the loan and the interest.
Business owners often prefer LMBOs if they are retiring or if a majority shareholder wishes to leave the business. MBOs have many advantages, including business continuity. When the management team does not change, the owner can expect a smoother transition as the business continues to operate profitably.
Note: in France, the LMBO is translated as RES for “company buyout by its employees”.
LMBI or MBI
The LMBI (Leverage Management Buy-In) or MBI is based on the same principles as the LMBO, with the difference that the company is bought by external investors. These then replace the management team, the board of directors and the other staff members with their own representatives. Executive buyouts occur especially when a company is undervalued or underperforming.
An LMBI does not come with the stability that characterizes an LMBO since sometimes entire teams are replaced by new ones. An LMBI can be a good exit strategy for homeowners who want to retire or who are overwhelmed by events.
OBO (Owner Buy Out)
The OBO (Owner Buy Out) is a relevant operation for business leaders and managers wishing to transform their professional assets into personal assets (i.e. cash). An owner sells his company to himself, which allows him to collect capital to be placed in one or more personal accounts (in life insurance for example).
Thanks to this judiciously invested money, he can then benefit from additional income at retirement while promoting the transmission of his wealth to his relatives.
The company is transferred in 2 stages in the case of an OBO:
- a partial contribution of the shares of the company to be transferred to the holding company, in exchange for which the founder of the company participates in the capital of the holding company. This participation allows him to maintain the qualification of professional goods with regard to the ISF (exemption). At the same time, the holding company borrows in order to buy the majority of the founder’s shares. The loan is reimbursed by dividends from the company thus gradually bought back;
- after a certain time, the founder sells his stake in the capital of the holding company. The last shares sold are of a higher value than those sold in the first stage because his company has, in the meantime, acquired value.
By having recourse to an OBO, the transferor gradually transfers his company while retaining management. The buyer, for his part, obtains facilities to buy back the shares sold to the holding company, as soon as he participates in the latter’s capital. It sometimes happens that the newly created holding (therefore the takeover holding) is sold to a third party: this operation is called a “double trigger sale”. The target company of an OBO transaction is ultimately valued by an accompanying financial investor.
Note: The setting up of an OBO must be the subject of a thorough legal, fiscal / taxes and asset analysis.
LBU (Leverage Build-Up)
By carrying out an LBU (Leverage Build-Up) arrangement, the investor generally seeks to establish his position in a sector of activity through the acquisition of a new company.
In this specific context, the LBU represents a bet on the future: the company raises even more debt to acquire companies in the same sector in order to strengthen strategic positions. The investor takes a risk when engaging in these type of transactions because there is no guarantee that the price of the shares will increase.
Ultimately, the buyer hopes to develop industrial synergies. The concentration of several companies operating in the same field can improve the weight of the company in this sector, and therefore its ability to negotiate with suppliers. Productivity can also be improved, especially in certain departments such as human resources.
The last LBO option is based on the so-called “BIMBO” (Buy-In Management Buy-Out) method. Here, the team of buyers is made up of both executives from the target company and outside executives. In this, BIMBO is a type of leveraged buyout combining the characteristics of LMBO and LMBI.
In practice, BIMBO associates a new external management team with the internal management team already in place in order to infuse new innovations and organizational methods into a company to facilitate its operation. External managers acquire the company, but do not get rid of directors who were already in the company. This strategy offers the benefits of both a buyback and a trade-in.
This transfer of functions and responsibilities usually takes place in an efficient and seamless manner, since part of the new management team already knows the company. This mix of management buy-in and management buyout positions leaders in the field in which they operate effectively, whether it is the development of a brand new product or service, finance, accounting or operations. .
The new management team will bring a breath of fresh air and innovative ideas, while the “historic” executives will ensure the continuity of the activity during the operation in particular. In this new hybrid management, decisions in principle revolve around the strategy to be adopted in order to maximize profits and repay the debts incurred (see below).
Statistics show that MBI processes often fail more than MBOs. This is why BIMBOs are becoming more and more common.
The main actors of Levereged Byout
The complexity of LBO transactions determines the need to involve multiple players, each of them playing a specific role. The main players in an LBO transaction are: financial sponsors, investment banks, banks, institutional lenders and target management.
To find your way around more easily:
L: Leverage, i.e. debt
O: Out, the buyer from the outside
I: In, the buyer is from the target company
M: Management (purchase by managers)
1. Management teams / leaders
Managers or business leaders are at the heart of a Leverage Buy-Out operation. They are the ones who present the activity and virtue of the target company to buyers and lenders. They deal with both potential investors and the main underwriter (vision, financial and marketing documents, etc.). A strong management team increases the value of the LBO target as it can generate favorable pricing and financing conditions.
Depending on their wishes and desires, it is common for existing management teams to acquire a significant stake in the post-LBO business, thereby aligning their interests with those of the acquirer.
2. Financial investors
The buyer (s) designate the financial investors in an LBO transaction. Most often, the investor transmits the raised capital to funds established in the form of limited partnerships. This could be a classic private equity fund, but also hedge funds, divisions of investment banks or venture capital funds.
The limited partnership usually takes the form of an investment vehicle in which the general partners manage the day-to-day operations and the limited partners (the acquirer (s)) play a passive role, providing capital when the general partners call upon them for specific investments. .
3. The banks
Banks mainly focus on the target business and credit profile, paying particular attention to cash flow.
The banks’ model is to ensure the ability of the target company to pay the full interest. They also pay attention to guarantees or restrictive clauses in order to protect themselves against possible disappointments.
In most cases, LBO stakeholders look to investment banks to play two specific roles:
- that of advisor in mergers and acquisitions;
- that of financing provider.
Investment banks provide advice on both the buy and sell side, bringing their network and expertise. On the buying side, investment banks look for deals and deliver expertise, relationships or even internal solutions. As far as the sale is concerned, investment banks take charge of the entire sale process, by finding future buyers, for example.
In particular, banks suggest the most suitable financing structure and set out the terms with which the acquirer must comply. After the approval of the credit committee, the investment bank can subscribe to the financing commitment which includes: a letter of commitment, a letter of engagement and a letter of fees:
The letter of commitment provides the commitment for the debt financing;
The commitment letter indicates the promoter’s decision to engage the investment bank to subscribe the bonds on behalf of the issuer;
The fee letter sets out the various fees that the promoter will pay to the investment bank, including the costs related to bridge financing.
4. Banks and institutional lenders
Institutional lenders, on the other hand, provide financing in the form of amortization loans. Their mission revolves around providing the amount necessary to complete the transaction following “credit analyzes”. These include pension funds, insurance companies or hegde funds.
5. Advice and intermediaries: advice on mergers and acquisitions
The last major player in an LBO transaction are mergers and acquisitions (M&A) consultancies. Their weight in the process can be considerable as they provide real know-how and can strongly influence the conditions of the operation. Among these actors, we find:
Their primary objective is to assess the value of the company to be acquired. Generally well established in the territories, they are also responsible for presenting and proposing the operation to the various stakeholders (in the information memorandum). Finally, they play the role of advisor at the time of valuation and negotiation, both with sellers and buyers.
Some law firms specialize in drafting deeds relating to the assignment (loan contracts, pledge agreements, etc.). Because an LBO transaction contains many sensitive legal documents, their support is essential.
their mission is organized around the verification of the information communicated. The audits cross-check, for example, the financial documents sent by the seller in order to confirm the validity of the valuation of the company. For a large-scale LBO transaction (costed in billions of euros), they are also called upon to give their opinion on the commercial aspects of the company, on the quality of managers, assess the information and management systems in position, the company’s positioning, market developments, environmental, legal, tax risks, etc. This is referred to as “due diligence”.
Leverage effects of LBOs
In the context of an LBO, there are 4 leverage effects: financial, fiscal/tax, legal and social.
1. The financial leverage effect
We talk about financial leverage in relation to the ability of the holding company to repay debt. The target company is the only one to bear the repayment of the loan. As a financial package, the LBO must make it possible to generate capital gains in the medium or long term. Ultimately, the profitability of the company must increase through debt. The greater the difference between the target’s internal rate of return and the holding’s borrowing rate, the greater the leverage effect.
In order for the target company to meet the costs of the operation, it will have to meet two criteria:
- have a sufficient yield to generate the distribution of dividends to the holding company;
- have a target company’s rate of return on investment (IRR) greater than the bank interest rate.
2. The tax leverage effect
A leveraged buyout is often part of a merger and acquisition (M&A) strategy. They are also sometimes used to acquire competition and to enter new markets to help a company diversify its portfolio. But the reason why a leveraged buyout interests many businessmen and private equity firms is still the tax aspect.
Indeed, a reduction in the taxable income of a company can result from an LBO. In this way, the future purchaser benefits from tax advantages which he did not previously have. These tax advantages are available:
- in the form of a __ tax deduction of loan interest __ at the level of the holding company;
- via the parent-daughter company regime: made possible from the moment a company holds more than 5% in the capital of another company (through the distribution of tax-free dividends between the target and the holding company). This opportunity is known as the “neutralization of double taxation”. When receiving dividends, the holding company is taxed only at 5% (representing costs and charges);
- by the tax consolidation regime: made possible from the moment a company holds more than 95% of the capital of another company. This mechanism makes it possible to declare only a single tax at the group level by adding up the results of each company. We speak in this case of “rapid fusion”. The losses recorded by some companies make it possible to balance the profits of other companies, thus reducing the burden of corporate tax (distribution of dividends without taxation, charging of deficits, etc.)
Note: these three effects cannot add up or be used simultaneously.
3. The legal leverage
Third lever in an LBO: legal lever. This consists of a takeover of the target company without owning the majority of the shares. To control the target company, it is sufficient to have 51% of the amount of the capital of the holding company through which the takeover is taking place (i.e. 26% of the target company). A direct acquisition would have required double that.
The greater the number of buyers in an LBO transaction, the less their shares (equity investment). Thus, the multiplication of intermediaries can make it possible to reduce the cost per buyer, unlike taking a direct stake in the target company. We therefore indirectly observe a reduction in the amount of capital required to maintain control of the company.
4. Social and human leverage
Finally, there is a last lever that is probably less obvious than the others that should be mentioned: the social lever. This notion underlines the importance of the role of the buyers in an LBO transaction. To cope with the strong financial constraints weighing on an LBO transaction, it is essential that the management team brings together experienced and motivated managers.
They are in fact the only ones who guarantee the success or failure of the assembly through their actions and their choices. This is why financial institutions and investors largely take the assessment of the team of buyers into account in their analysis (motivation, skills and complementarity).
Whether they are funders or not, they are committed to effectively managing the target company, during and after the transition. If they are providers of capital, they have an even greater incentive to act in an owner-rationale and are more involved in the operation.
How to finance a Leveraged Buyout (LBO)?
Remember: a leveraged buyout is based on the granting of a bank loan. But unlike a classic financing transaction, having recourse to an LBO offers the possibility of multiplying the sources of financing. It is therefore common to acquire a target company by contributing only 30 to 50% of the sale price.
However, the contraction of debts necessarily implies a hierarchy of repayment within the investors (we are not talking about equity investors here). It is very important to remember that senior debt always takes priority over subordinated debt.
Here are the different forms of financing to carry out an LBO transaction.
In an LBO transaction, it is customary for the liquidity contributed to equity capital to be between 30% and 50% (private equity). The remaining 50% to 70% of the amount is contracted in the form of debt (via bank loans). Note that these percentages do not apply to all assemblies; they fluctuate depending on the transaction and the market conditions at time “T”.
As the determination of the selling price can be a source of disagreement between the seller and the buyer, the parties have several means which represent real complementary levers.
Senior debt corresponds to a loan taken out by the holding company from one or more banks to acquire the target company. The bank loan is the main source of financing, which can be repaid within 5 to 9 years (depending on conditions). Senior debt generally has two repayment clauses:
- a depreciable portion, that is to say that it can be repaid as dividends are received;
- a repayable tranche, which must be repaid when the loan matures.
Through this mechanism, the holding company is not under too much pressure in terms of cash management in order to repay the debt. Unfortunately, it can happen that the dividend rises are not as high as expected. If so, the senior debt acts as collateral against the specific assets of the company. The lender will acquire the assets of the company if the company is unable to repay the debt.
Good to know: this debt is very secure, making it possible to obtain relatively low interest rates.
The financing of “second link”
This “second link” LBO financing corresponds to an intermediate product between senior debt and the senior mezzanine. Sometimes referred to as “subordinated debt”, it differs both in terms of its maturity and in terms of repayment. You can thus contract this debt for a period of 7 to 10 years but you are obliged to repay it in a single payment when due. This is referred to as a “bullet” type reimbursement.
In contractual terms, the second-link lenders are subordinate to the senior lenders in the rights to the proceeds from the realization of the collateral. As a result, the repayment of the second link financing can only take place if the senior loan has itself been repaid.
One of the downsides of this debt is the high interest rate set by lenders. Since it is not as secure as senior debt, the risk of default is generally higher.
In order to benefit from additional financing to that of banks to increase the effect of financial leverage, it is possible to resort to “junior” or “mezzanine” debt. Its duration ranges from 8 to 10 years but presents the most risk for lenders. Like second-link financing, mezzanine debt is subordinated to senior debt; it will only be possible for the company to make the repayment after repaying the senior debt. This financial leverage often takes the form of bonds with share purchase warrants (OBSA) or an issue of convertible bonds (COs).
Buyers In an LBO transaction, management teams are often stakeholders. Their functions imply that the buyers are responsible for the operational management of the target. Therefore, in most cases they join the financial package since they have the opportunity to bring their own capital.
Note: the buyers can equally well be teams already in place before the transaction, as well as executives or external managers recruited for the transaction.
Mezzanine financing and family SMEs In recent years, mezzanine financing has been used more by family SMEs thanks to the modalities available to them. In this case, the financing takes place in the form of a subordinated loan (in English “junior debt”). It is spread over an average term of 5 years and has the advantage of having a fixed interest rate over the entire term.
There are also some variations, including a conversion right or participation in the results. With this supplement, the acquirer can more easily obtain bank financing from lenders for senior debt. For family SMEs, mezzanine financing is therefore a major asset in the finalization of the operation.
Note: mezzanine financing being more risky, it costs on average 4% to 7% more than bank credit.
Revolving credit is a form of senior bank debt that works like a business credit card. In principle, it is used to help finance the working capital needs of a business. A business is said to “shoot” the gun to the credit limit when it needs cash. She then agrees to repay the gun once she has excess cash (without any repayment penalty).
The revolver gives companies flexibility in their capital needs, allowing them to access liquidity without having to seek additional debt or equity financing. There are two main costs associated with revolving lines of credit:
- the interest rate applied to the used balance of the gun;
- an unused commitment commission, used to remunerate the bank for having committed to lend up to the limit of the revolver.
High Yield Bonds
High yield debt or “high yield bonds”, is so called because of the high interest rate that characterizes it. It compensates investors for the risk they take by holding such debt.
This type of debt is often necessary to increase the level of indebtedness beyond what banks and other major investors are willing to provide. High yield debt can in principle be refinanced when the borrower raises new debt at lower cost. This subordinated debt is accompanied by a final repayment (payment in one go) and generally has a maturity of 8 to 10 years.
A business retains greater financial and operational flexibility with high yield debt through the existence of covenants. There are also early payment options (after 4 to 5 years for high yield securities). Like most subordinated debt, the interest rates on high yield bonds are higher than those on senior debt.
The Capex line
The line of Capex (for Capital Expenditure) as financing is akin to revolving credit. The Capex should allow the company to finance certain investments during the LBO transaction, such as the provision of certain means necessary for the operation.
The exceptional rise in dividends
As a working production tool, the target company undoubtedly has a cash fund. Depending on his financial health, the buyer is entitled to consider using this cash to finance the transaction, without impacting the business. In other words, it should not use the part of the cash that is used to finance the operating cycle. It is for this reason that it is possible to finance part of an LBO using distributable reserves, namely exceptional dividends.
Seller credit, also called deferred payment, allows the seller to accept a payment facility for the benefit of the purchaser, consisting of a partial or full deferred payment of the sale price. This granted claim is certain and is not subject to any conditions or contingencies. Thus, the risk of non-payment is covered by a deposit or bank guarantee on first demand.
This method is of particular interest to the buyer because it allows him to involve the seller in the repossession process. Indeed, if the transaction ends up failing, which would result in the inability of the company to repay the loans taken out, the buyer would no longer be able to repay the loan granted by the seller.
For the seller, deferred payment offers the advantage of setting a higher price since it gives the buyer financing facilities. The longer the term of the loan, the greater the risk the seller bears. This is one way to influence the price of the acquisition, just like the interest rate. Seasoned lenders generally want seller credit to be subordinated to senior debts.
In addition to these financing techniques well known by companies specializing in mergers and acquisitions, LBO transactions increasingly use hybrid financing. Securitization is the preferred method in the context of a Leverage Buy-Out arrangement. This technique is based on the transformation of illiquid assets into liquid securities.
Concretely, the company raises capital in the form of securities issues, based on the forecast financial flows generated by the assets. It is these issues of securities that will allow the company to repay part of the debts incurred.
Another trend in the financing of an LBO is to resort to portfolios of mortgages or rights linked to leasing transactions. This mixture of techniques is particularly appreciated by buyers because they make it possible to obtain a greater leverage effect while limiting the cost inherent in the transaction. Thus, the margins of securitization (between 0.8% and 1%) or mortgage loans (between 1% and 1.2%) are much lower than the margins of a revolving loan at 2% or the margins of senior debts.
The advantages of LBO
In the event of difficulties (financial or operational) for a company, its managers may be forced to make sometimes irreversible decisions, such as the sale of the company. However, reselling a business that may not be performing at peak performance can seem like a perilous mission. This is the point of an LBO. Not only is its position in the market improved, but this type of financial package also allows the preservation of bankruptcy that could impact shareholders and employees. As long as the company still has liquidity and growth potential, it should find a buyer ready to take up the challenge.
Jika terjadi kesulitan (keuangan atau operasional) bagi perusahaan, manajernya mungkin terpaksa membuat keputusan yang terkadang tidak dapat diubah, seperti penjualan perusahaan. Namun, menjual kembali bisnis yang mungkin tidak berkinerja pada kinerja puncak bisa tampak seperti misi yang berbahaya. Ini adalah poin dari LBO. Tidak hanya posisinya di pasar meningkat, tetapi jenis paket keuangan ini juga memungkinkan pelestarian kebangkrutan yang dapat berdampak pada pemegang saham dan karyawan. Selama perusahaan masih memiliki likuiditas dan potensi pertumbuhan, perusahaan harus mencari pembeli yang siap menerima tantangan.
Sebuah LBO bisa mendapatkan keuntungan sebagai berikut:
Dalam manajemen saat ini: direktur dan manajer lebih berkomitmen dan berkontribusi secara aktif untuk tujuan pengembangan;
Karyawan: mereka juga dapat berpartisipasi dalam operasi keuangan, tanda keterikatan mereka dengan perusahaan mereka;
Untuk penjual: dia dapat menetapkan harganya sambil memastikan untuk meninggalkan bisnis dengan rencana yang solid. Pembelian hutang adalah strategi keluar yang ideal bagi pemilik bisnis yang ingin menambah uang tunai di akhir karir mereka.
Kepada pembeli: mereka menegosiasikan pembelian kembali dengan memanfaatkan efek leverage.
Keuntungan pajak dari LBO
Seperti yang telah kita lihat, LBO memiliki 3 keuntungan pajak utama: dalam bentuk pengurangan pajak atas bunga pinjaman di tingkat holding;
melalui rezim perusahaan induk-anak;
oleh rezim integrasi fiskal.
Dengan mengelompokkan perusahaan yang berbeda bersama-sama di bawah rezim konsolidasi pajak grup, juga cerdas untuk mengatur prosedur lain seperti:
penyediaan real estat (merek, paten, dll.);
sentralisasi uang tunai;
partisipasi dalam manajemen akuntansi, administrasi, keuangan dan hukum.
- In the current management: directors and managers are more committed and actively contribute to development objectives;
- Employees: they too can participate in the financial operation, a sign of their attachment to their company;
- To the seller: he can set his price while making sure to leave the business with a solid plan in place. Debt buyout is an ideal exit strategy for business owners looking to top up on cash at the end of their careers.
- To buyers: they negotiate the repurchase by taking advantage of the leverage effects.
The tax advantages of LBO
As we have seen, the LBO has 3 main tax advantages:
- in the form of a tax deduction of loan interest at the holding level;
- via the parent-daughter company regime;
- by the fiscal/tax integration regime (may differ in some countries).
By grouping the different companies together under the group tax consolidation regime, it is also smart to set up other procedures such as:
- the provision of real estate (brands, patents, etc.);
- centralization of cash;
- participation in accounting, administrative, financial and legal management.
The limits of the LBO (Leveraged Buyout)
As we have seen, a leveraged buyout has many advantages, both operational and tax. Although it has been on the rise for the past fifteen years, it is nonetheless essential to stress certain limits to this technique of redemption.
1. Mandatory dividend escalations This is one of the main constraints of an LBO. Once acquired, the target company is obligated to raise a significant portion of its cash flow in the form of dividends.
2. The necessary bank approval It’s simple: without the agreement of a bank, the leveraged buyout operation cannot take place. To do this, bank lenders scrutinize the history and investment needs of all stakeholders. They validate or not the financial package. Banks can nevertheless show understanding in terms of repayment, if the holding company occasionally encounters a difficulty.
3. Repayment, absolute financial priority During the entire period of debt repayment, it is the financial results that will serve as liquidity. As a result, bonuses, training or investments are likely to take a back seat.
4. Limited short-term investments At the end of the repayment period, the holding company has in principle finished repaying the loan taken out to acquire the target company; the first therefore becomes the owner of the second. On the other hand, it is quite possible that the target company did not have enough inputs to invest in more modern production tools or in the training of employees. An upgrade work then begins.
5. A possible loss of competitiveness Limited in its investment capacity, the target company may suffer a relative loss of its competitiveness. In this case, only activities deemed sufficiently lucrative will continue to exist. The other entities may face a new buyback operation (LBO or not).
6. A very small margin of error In an LBO, the same leverage that allows for greater rewards also comes with greater risk. For the buyer, the margin of error is small, and if he is unable to repay the debt, he will not get any return. Depending on how the buyer defines risk and their tolerance for risk, this situation can be attractive or cause for anxiety. It is therefore necessary at all times to monitor its cash flow monitoring, as well as to measure and analyze the deviations: Agicap represents a solution adapted to this type of constraint:
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7. Bankruptcy as the sword of Damocles The risks of a debt takeover for the target company are also high. Interest rates on the debt she incurs are often high and can lower her credit rating. If it is unable to service the debt, the end result is bankruptcy. LBOs are particularly risky for companies operating in very competitive or volatile markets.
8. A turbulent handover A change in management sometimes leads to instability internally and externally. It is not uncommon to lose part of your clientele during a business takeover, hence the paramount importance of the profiles that will constitute the new management team.
9. Inability to pay deadlines Finally, the major risk of an LBO is linked to the subsidiary’s profits that are lower than those expected when it is bought out. This will create difficulties, or even make it impossible to pay the maturities of the loan taken out by the holding company as part of the takeover of the subsidiary.
Economic and social utility of the LBO
One of the criticisms leveled against LBO deals stems from the fact that the target company tends to cut costs once the takeover is complete. The goal: to pay off the debt as quickly as possible. However, this cost control is sometimes accompanied by downsizing or layoffs.
At the same time, spokespersons echoed the misuse of an LBO. Sometimes a management initiates a leveraged buyout and sells it back to the same management for personal short-term profits. These “predators” sometimes even target other troubled companies by privatizing them and then dismantling them. They can therefore sell the assets and file for bankruptcy while earning a high return.
In the majority of cases, however, LBO transactions are successful and beneficial to the target company.
Any good investor knows that establishing exit strategies is as important as when to invest. Indeed, the resale of participations largely determines the return on an investment. In France, an LBO transaction (from its formalization to the end of the repayment) lasts for 5 years on average. To exit following a leveraged buyout, it is necessary to take into account both endogenous and exogenous factors, such as:
- the specific characteristics of the target company;
- market conditions;
- the macroeconomic environment.
There are different possibilities for exiting an investment fund at the end of an LBO financing:
In addition to appearing as a successful takeover, the IPO is the most attractive option for the management team. Growth has been there, the bet has been won: the investor realizes his return with satisfaction. Of course, certain conditions must be favorable to allow a valuation of the company. Note: many new constraints (minimum size, communication of financial information, etc.) result from an IPO.
Secondary, tertiary and quaternary LBOs
A secondary LBO involves calling on shareholders other than the original ones to carry out a new LBO transaction. If this operation is repeated a third time, then we are talking about a tertiary LBO. The same goes for a fourth operation, called a quarter-year.
This solution can only be considered if the company is sufficiently profitable or has good prospects for growth. The first LBO having normally made it possible to clean up the finances, the secondary LBO should offer even more advantageous conditions to new investors. During this new LBO, the amount of the old senior debt is refinanced.
However, the growth in rates of return is not endless, and some believe that more LBO transactions lead to increased risk for investors.
Sale to an industrialist
Resale to a corporate represents a last exit alternative. This generally makes it possible to obtain a better selling price insofar as the potential synergies are valued and therefore integrated into the selling price. A strategic acquisition for the acquiring company, such a buyout ensures the sustainability of the company. Selling to a manufacturer is in principle the most profitable solution.
However, the management team is generally opposed to this type of operation. It loses control of the group and, ultimately, part of its independence.