Leveraged Buyouts
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A History of Leveraged Buyouts
Leveraged buyout (LBO) funds arose as an investment vehicle in the 1980’s as a result of several market condition factors. First, there was a high level of accessible capital in the markets. In addition, there were a large number of investors who were beginning to seek various alternative investments in the early stages of growth of various companies. At the same time, financial professionals were beginning to recognize that management was becoming haphazard in the operation of large companies and that in some cases, firms had been engaging in gross excess – wasting corporate assets for their own personal entertainment or benefit.
In such an environment, it was inevitable that the markets would react to help put companies back on track. At the same time, of course, these market participants hoped to put some money into their own pockets. However, what was unexpected was that in certain instances, the cure, that came in the form of LBO (then known as private equity) investors, was worse than the disease.
Given the then existing market conditions, small groups of investors began organizing pools of capital in much the same manner that was discussed previously in the section on venture capital funds. Pension funds, state benefits plans, insurance companies, high-net worth individuals, etc., began to invest in these first LBO funds that promised extremely high returns.
Initially, as funds began making investments – purchasing companies and taking them private – the results were strong. In several instances, LBO funds were able to take positions at such low valuations, and turn the companies around quickly for resale. In such cases, huge profits were made on investments that lasted for mere months. Throughout the 1980’s, as competition in the field began to increase, profits for the LBO industry began to decrease as more players entered the field and bid up prices for companies to levels that could not support a profitable model.
Ultimately, the 1990’s saw a decline in LBO activity, though many funds remain very active. In the modern economic climate, LBO funds have adjusted their operations, often entering into transactions that look more like venture capital investments or more standard corporate acquisitions. Whether the model will continue to operate into the future is a question that remains unanswered.
Operation of an LBO Fund
Like venture capital funds, LBO funds operate as Limited Liability Partnerships. The reasons for this are identical to the reasons why LLP’s were created in the first place. Namely, the LLP provides a vehicle whereby the LBO fund’s management may achieve their objectives without exposing their investors to heightened liability. Moreover, the management may operate the fund with the knowledge that the investors are not going to become overly involved in the operation of the fund because acting in such a manner would expose them to liability as “presumed” general partners.
EXAMPLE: Kaynor and Kaynor is an LBO fund that has raised a sizable capital pool with the goal of accomplishing several investment transactions. The fund has gotten itself together and is now beginning to make investments. Several of the fund’s investors have been known, in other investment forums in which they have invested, to be bothersome as investors because they like to maintain a high degree of control over their investments. However, Kaynor’s management team is not particularly worried in this case. Its belief is that the investors will maintain a low profile, only dealing with management when the need arises, because the investors would not want to have a court view them as implied general partners; as might happen if it exercises too much control over the fund’s activities.
Process of an LBO Transaction
LBO transactions are typically very complicated affairs. The method of the transaction – typically a purchase of a controlling share of the company’s stock, or on occasion, a proxy contest – is straight forward. However, it is the size of the transaction that an LBO fund undertakes that makes such deals exceedingly complicated.
Essentially, the process of an LBO investment is as follows. First, the investment fund identifies a target for acquisition. Typically, LBO funds look for companies that have weak management or management that has allowed the company’s assets to dwindle at the shareholders’ expense. Additionally, LBO managers look for situations where a company has a large cash account, readily saleable assets, and a large public float.
After identifying a target company, the LBO fund will typically begin acquiring the company’s stock up to near the level requiring a 13-D disclosure or up to near the level that would trigger the company’s poison pill (if there is one). Once that point is reached, it is inevitable that the fund’s goal to acquire the company will become public knowledge. As such, the fund typically will want to be in a situation where it can approach management (if it has not already done so – most funds usually try negotiations first) and discuss the nature of the transaction.
If management is not amenable to the transaction, then the standard rules of engagement for a hostile takeover, which were discussed previously, are triggered, and the firm will begin maneuvering to avoid being taken over. However, if management is agreeable, and many LBO funds will only work with a firm where management agrees to go along with the takeover, then the fund and the firm will begin structuring a deal.
An alternative name for a textbook LBO transaction is a “going private” transaction. This name may help to clarify the actual LBO process. The LBO fund will acquire shares of the company by borrowing extensively against the company’s assets. With those borrowed funds, the fund and the company begin purchasing the company’s shares from other shareholders. Ultimately, the goal of the transaction is to acquire a controlling stake in the company and then make a distribution to the shareholders of the LBO fund that allows the fund to purchase all remaining outstanding shares and give the fund complete control over the firm.
Once the fund has control over the firm, two things happen. First, the remaining shareholders are bought out of the company; turning the once public company into a private, closely held firm. Finally, the firm, now controlled by elements of the management and members of the LBO fund, begins to reorganize. The reorganization is accomplished by the new management team’s selling off corporate assets to pay down the debt – the leverage money – as quickly as possible. In addition, the team will also begin streamlining the company’s operating procedures and overhead by reducing the number of employees and/or making other alterations to the company by redeploying personnel and by generally improving the firm’s operations.
However, the ultimate goal of an LBO transaction is not to keep the company in a private, stand-alone condition. While such a situation may produce strong operating cash flows, the return would not be great enough to justify the risk that the fund took in making the investment. In the end, what the fund will attempt to do is to get the firm to a point where it is either able to sell the firm at a rate much higher than its original investment, or to retake the firm public at a raised valuation after it has improved the firm’s economic state.