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What Is a Leveraged Buyout: How It Works and Examples
Leveraged buyouts offer an excellent purchase method for organizations and people without enough cash on hand to buy a ...
Leveraged buyouts offer an excellent purchase method for organizations and people without enough cash on hand to buy a company directly. Even the wealthiest people often need to leverage private equity to purchase businesses and other high-capital assets. Elon Musk's takeover of Twitter is one such leveraged buyout example. What is a leveraged buyout, and how can your company use it for expansion? As a type of merger or acquisition, is it risky?
What Is a Leveraged Buyout?
A solid leveraged buyout definition is the financial transaction where a person or organization acquires a company using significant debt. The purpose of an LBO is to enable the completion of an acquisition without committing a large amount of cash. In fact, companies may choose this route even when they have sufficient cash on hand.
For a leveraged buyout explained in simpler terms, think of it like buying a house. You don't usually pay the total price upfront; instead, you take out a mortgage, make a down payment, and pay off the balance over time. Similarly, an LBO uses debt — like a mortgage — to cover most of the acquisition cost.
How Do Leveraged Buyouts Work?
Along with understanding the leveraged buyout meaning, you also need an appreciation for the process. LBOs have three key players: the acquiring company or buyer, the target company, and the lenders. The process begins when one entity identifies the other as a good buy and signals an interest in buying. The basic process ends with acquisition and loan repayment.
Here is a detailed look at how the process unfolds:
- Identification of Target: The acquiring company or person identifies a potential target company. The target often has a stable cash flow, substantial assets, and potential for improved performance. In the case of Twitter, Musk saw value in the platform as the world's digital town square.
- Financing: The buyer approaches lenders to secure debt financing. This could involve a combination of loans from financial institutions and high-yield bonds or mezzanine financing. NPR estimates that Musk used $13 billion of borrowed money to pay for the buyout.
- Acquisition: The acquiring company uses the borrowed funds and some of its own equity to purchase the target company. Twitter is a public company, so Musk took over Twitter by buying shares.
- Repayment: Post-acquisition, the target company's cash flows or assets are used to repay the debt. This is the case for Twitter as well. Even though Musk took on the debt, he did so on behalf of the company, so Twitter (later rebranded as X) must repay the loan. However, if the company fails, Musk will take a financial hit when the share values plummet.
The legal and regulatory considerations in LBOs can be complex, involving compliance with securities laws, antitrust regulations, and lender requirements. Companies should work with experienced legal counsel to navigate these complexities.
What Are the Main Types of Financing Options for Leveraged Buyouts?
No one knows all the sources Musk used to finance the Twitter deal. However, several banks, equity investors, and even a Saudi Prince reportedly played a role. The agreement is an excellent example of the level of creativity companies can exercise when securing funding.
Equity partnerships are a form of shared ownership where partners contribute capital in return for a share of the profits. Owners can form partnerships with wealthy friends, private equity firms, and even other corporations. Joining forces reduces the acquirer's financial burden and spreads the risk among partners.
In Twitter’s case, the Saudi Prince and equity investors were Musk’s equity partners. They helped cover the financial gap in hopes of reaping some of the rewards.
The definition of mezzanine financing is a hybrid debt and equity financing option. Equity investors can provide mezzanine loan capital in exchange for owning some equity in the target company. This makes it an attractive choice for firms looking to leverage buyouts. Mezzanine financing also often comes with lower interest rates, making it a more affordable option. It is often used to “top off” the balance.
For example, Company A wants to buy Company B for $20 million. It uses $5 million of its own cash and takes out a $10 million business loan. It then gets a mezzanine loan from Bank C for an additional $5 million. Company A uses the $20 million to acquire Company B. If it defaults on the mezzanine loan, Bank C will own the unpaid amount in company shares.
High-yield bonds are corporate debt offerings with a high interest rate because they are riskier than investment-grade bonds. They provide an alternative to traditional bank loans and can offer higher yields over time. High-yield bonds also have fewer restrictions, meaning companies can use them to finance the buyout without sacrificing assets.
For example, Company D wants to buy Company E. Company D acquires Company E by issuing high-yield bonds to investors. The newly formed Company DE pays interest on those bonds until they mature. If Company DE defaults, then the unpaid investors own a stake in the company.
What Are the Main Advantages of Leveraged Buyouts?
Leveraged buyouts create more opportunities for mergers and acquisitions. There are several reasons why so many businesspersons choose this over other options.
Preserves Cash in Hand
Cash is king in the business world. Companies need liquid assets to pay their bills, such as utilities, mortgages, and payroll. Cash is also necessary to cushion the company against market downturns and keep it afloat. An LBO allows businesses to maintain cash reserves while expanding operations. This can be especially useful for small or medium-sized enterprises with limited capital.
Increases Debt Capacity
Debt capacity refers to the amount of debt a company can incur without compromising its financial well-being. An LBO allows companies to leverage the target's assets, balance sheet, and cash flows for loans. Additionally, private equity lenders may be willing to take on more risk than traditional financial institutions.
Increases Purchase Capacity
Leveraged buyouts allow companies to make more significant acquisitions than they otherwise would. By taking on debt, companies can acquire assets that may be financially out of reach with cash alone. It allows for the quick expansion of a business or portfolio and can lead to increased earnings.
Receives Favorable Tax Treatment
Another advantage of leveraged buyouts is that the interest on debt used to finance the acquisition is tax-deductible. This can significantly reduce a company's tax liability, freeing up funds for other purposes. Compare this to paying dividends to equity shareholders. Companies cannot write these off as business expenses.
What Are the Risks and Challenges of Leveraged Buyouts?
Without a doubt, taking on debt has its risks. Companies must weigh the pros and cons before choosing this purchase method. Taking a proactive approach reduces the likelihood of expenses surprises.
Cash Flow Pressure
Debt repayment can be a significant challenge for companies, especially when the economy takes a downturn. A recession can lead to reduced cash flows, which affect the company's ability to pay. Even in strong markets, the company must set aside significant portions to repay the loan, which can stifle opportunities. Companies must have contingency plans in place.
Lower Credit Rating
Taking on too much debt can adversely affect a company's credit rating. Creditors may see a highly leveraged company as risky, making it challenging to secure new debt. This will affect the company's ability to take on other projects or expand its portfolio. Reduced borrowing opportunities will also negatively impact a company's expansion abilities.
Potential for High-Interest Payments
Companies must consider the interest payments when calculating whether an LBO is cost-effective. Lenders demand higher rates with high-yield debt and mezzanine financing because they assume more risk. Companies must ensure that the extra profits expected from an acquisition outweigh these costs. The target company needs strong cash flow and profitability to justify high-interest loans.
What Is a Good Leveraged Buyout Example?
Private equity firms often acquire other corporations and then sell them at a profit. This covers the cost of the initial loan and puts extra money into the pockets of investors. Blackstone's purchase and reselling of Hiltons Worldwide is an excellent leveraged buyout example.
Blackstone bought Hilton Hotel Corporation via an LBO for $26 billion in 2007. Of this total, Blackstone financed a whopping $20.5 billion. It then took the hotel chain private and focused on growth. Despite the hardships of the 2008 Great Recession, the hotel chain bounced back.
Blackstone took the company public again in 2013. Over the next five years, Blackstone gradually offloaded its shares of Hilton. When it sold the final share in 2018, the company gained almost $14 billion in profits.
What Is a Leveraged Buyout Partner for the Cloud and How Can We Help Lower Buyout Costs?
After a leveraged buyout, companies must carefully review budgets and cut costs. Elon Musk hit the ground running on this task after buying out Twitter. He laid off workers en masse, shut down servers, and removed some Twitter services. However, this approach led to early departures of key personnel, bad publicity for Twitter, and users leaving in droves for competitors.
Sometimes layoffs are unavoidable, but looking for effective ways to reduce infrastructure costs is often more successful. Shutting down servers or skipping out on bills can have devastating consequences that are difficult to bounce back from. They can tarnish vendor trust and negatively impact employee morale.
Instead, companies should consider modernizing the infrastructure through cloud computing, data migration, and other technological options. Our experienced professionals can survey your existing infrastructure, recommend migration plans, and suggest tools that boost productivity. Schedule your consultation today to get started.
With unmatched next generation migration technology, Cloudficient is revolutionizing the way businesses retire legacy systems and transform their organization into the cloud. Our business constantly remains focused on client needs and creating product offerings that match them. We provide affordable services that are scalable, fast and seamless.