6 MASTERING TRANSACTIONS / LEVERAGED BUYOUTS
The balance between
Colin Blaydon is the William
and Josephine Buchanan
Professor of Management at
the Tuck School of Business,
Dartmouth College.
colin.blaydon@
tuck.dartmouth.edu
Fred Wainwright is adjunct
associate professor of
business administration at
the Tuck School of Business,
Dartmouth College.
fred.wainwright@
tuck.dartmouth.edu
The authors are principals at
the Center for Private Equity
and Entrepreneurship at Tuck.
For more information go to
www.tuck.dartmouth.edu/
pecenter
debt and added value
Leveraged buyouts, whereby purchasers use significant debt to fund transactions, are growing
in size and influence. Colin Blaydon and Fred Wainwright explore the rise of private equity
T
he leveraged buyout (LBO)
model has evolved into a
powerful mechanism for
corporate transformation.
Multibillion-dollar buyout
funds are busy purchasing
private companies and tak-
ing public companies private. Nine of
the top ten largest buyouts in history
have been completed in the past 18
months by private equity houses, and
with these record amounts of capital,
both in terms of debt and equity, avail-
able, megadeals are almost common-
place.
This article will survey the basics of
buyout transactions, discuss how
value is created and describe current
industry issues. Recent developments
include club deals, technology buy-
outs, the high levels of credit currently
available and the institutionalisation
of the industry.
What is an LBO?
An LBO is the purchase of a company
or division of a company using signifi-
cant debt, whereby the target com-
pany’s cash flows are used to support
the loan payments. Integral to the
alignment of incentives is manage-
ment participation in the equity of the
new company, usually a combination
of personal cash investment and stock
option compensation. Debt can be in
the form of traditional bank financ-
ing, bond offerings, seller financing
and loans from specialised funds.
According to data collected by
Thomson Financial and the National
Venture Capital Association, in the
US, the buyout industry is expected
to raise over $100bn in 2006 and top
quartile buyout funds have generated
net annual returns in excess of 40 per
cent returns in the past 20 years. The
average net annual returns of the
industry have been 13.3 per cent,
according to Thomson, and the S&P
500 index has returned just 12.1 per
cent per year.
In strategic terms, there are three
ways that a buyout transaction can
build value:
● buying low and selling high (value
arbitrage or multiple expansion);
● structuring an improved combina-
tion of equity and debt (restructur-
ing the balance sheet or recapital-
ising to add value);
● improving operations to increase
cash flow (restructuring the
income statement).
Of course, there are many combina-
tions of these three strategic objectives
and the timing and application of any
of them is part of the challenge for
management and buyout investors.
These objectives correspond to the his-
toric evolution of the modern buyout
industry. At the start of this era, in the
early 1980s, it was the age of the hostile
takeover, acquisition and breaking up
of inefficient conglomerates. At that
time, buyouts were examples of value
arbitrage and/or balance sheet engi-
neering. In the early 1990s, buyout
value creation focused on improving
operating margins and bottom line cash
flows. In the mid-1990s, the “growth
LBO” emerged with an emphasis on
expanding sales and increasing scale.
By contrast, today, most buyouts are
relatively friendly among buyers and
sellers and buyout houses use all four
methods to add value.
A common misperception
Some people mistakenly believe that
the key to capturing value in a LBO is
to use an aggressive amount of debt to
buy a company and then pay down
that debt over time with the com-
pany’s cash flows. According to this
logic, paying off debt allows the com-
pany to use cash flow to build the
value of the equity. In reality, reducing
Andy Martin/Inkshed
acquisition debt has often been a
requirement of senior lenders. They
see the aggressive amount of debt used
in the acquisition as unsustainable or
too risky in the long term. Thus, they
often require a rapid pay down of the
debt. In contrast, the company’s man-
agement and investors make every
effort to eliminate or at least minimise
loan principal payments in the early
years of ownership.
A few quarters of good post-deal
financial performance will present
management with the opportunity to
approach lenders to renegotiate terms
and perhaps even increase the level of
debt in a “leveraged recapitalisation”.
In today’s generous debt markets, sen-
ior acquisition debt has had much less
stringent repayment requirements
than has historically been the case.
This is important – clearly, the com-
pany would be better off reinvesting
any excess cash, after paying loan
interest, back into the core business.
The rate of return on internal projects
or growth through acquisitions is often
higher than the cost of capital. If this is
not the case, a company’s investors
will prefer to have excess cash returned
to them in the form of a dividend.
Value arbitrage
The new reality of public markets is
that many good companies are ignored
by the relatively slimmed down analyst
groups of major financial institutions.
Even before a series of recent corporate
scandals spawned a wave of new cor-
porate regulation that affected invest-
ment banks, there were many publicly
traded companies that were poor at
marketing themselves to investors.
By contrast, buyout funds are
experts at knowing when and how to
communicate with various constituen-
cies of a business, from employees and
shareholders to potential lenders and
buyers. This is not just window dress-
ing – often, adjustments need to be
made to the management team or new
markets found for a product. What is
surprising is how often the changes
are minimal but the resulting increase
in valuation, whether through an IPO
after taking a company private or
through a sale to a strategic buyer, is
substantial. In addition, sectors suffer
from the cyclical nature of supply com-
modity prices or other macroeconomic
trends as well as investor fads. Good
companies can be caught in these
downdrafts of investor sentiment,
which create opportunities for buyout
funds to help management make
adjustments to the company in private
and then relaunch with an IPO when
the sector is in better favour.
Major corporations periodically
expand their range of products and
operating divisions then slim down and
sell off non-core assets. Buyout groups
stand ready to sell their fund’s portfolio
companies when major corporations are
buying. Conversely, when corporations
are selling divisions, the buyout funds
are willing to take the risk of helping
the divisions develop their own internal
operating structures and external mar-
ket positioning.
Today, sophisticated sellers and
their advisers are aware of the value
increase that private equity acquirers
are anticipating. Therefore, sales are
frequently achieved through auctions
or multiple bilateral negotiations, and
relatively few are unilateral propri-
etary acquisitions. The result is that
the seller anticipates and generally
receives a premium over any current
market valuation and, thus, partici-
pates in the anticipated value increase.
Recapitalising to add value
The earliest LBOs were based on the
idea that some companies with hard
assets and/or steady cash flows could
be financed in a manner similar to
real estate. Real estate transactions
8 MASTERING TRANSACTIONS / LEVERAGED BUYOUTS
have long been financed with sub-
stantial amounts of debt because
lenders rely on the physical assets and
relatively steady rents.
The first LBO practitioners realised
that many companies could be lever-
aged but had historically carried little
debt. The companies were valued
based on an expectation that they
would continue to use low amounts of
debt, so buyout houses could pay a
premium for two reasons: they were
only using relatively small amounts
of cash to make equity investments
(the rest of the purchase price was
paid via debt); and the interest pay-
ments on the debt were tax deductible.
In fact, the latter point enables the
creation of tax shields that add value
to the enterprise. This is well known to
financial economists who understand
that the value of a company can be
expressed as the value of the company
financed with equity only plus the
value of any future interest tax shields
created by adding debt to the capital
structure. Of course, there is a limit to
this value adder because the introduc-
tion of financial risk due to signifi-
cantly higher debt can result in
increased debt and equity costs that
offset the value of the tax shields.
Today, sophisticated restructuring
of the balance sheet is commonly prac-
tised by large private equity houses
and investment banking advisers.
Some claim that such restructuring
capability has become a commodity
available to all qualified companies
that seek it and balance sheet restruc-
turing is no longer an approach that is
available exclusively to private equity
groups. However, there is no doubt
that the private equity investors have
extensive deal structure experience
that can result in favourable arrange-
ments that add value to an enterprise.
But this value alone is no longer of a
sufficient magnitude to achieve the
returns required by buyout investors.
Capital structure
The capital structure of a typical LBO
consists largely of four types of capital:
bank debt, which usually accounts for
about 50 per cent; high-yield debt at
about 10 per cent; mezzanine debt at
about 10 per cent; and private equity,
which represents the remaining 30 per
cent. Other forms of debt may also be
utilised, such as asset-based loans and
securitisations, second-lien loans,
equipment leases and seller financing,
but these are less common.
■ Bank debt consists of a revolving
credit facility that can be paid back
and drawn down as needed by the
company, as well as several tranches
or categories of term loans differing in
seniority, maturity and cost.
■ High-yield debt is used to increase
leverage beyond levels that banks are
willing to provide. Companies will
make offerings to either the public
bond market or the private institu-
tional market (for example, insurance
companies and pension plans) of debt
with a relatively high interest rate (or
large discount to par) reflecting the
risks involved in being in a subordi-
nate position to bank debt.
■ Mezzanine debt is in an even lower
position, so buyout funds, hedge funds
and other lenders will provide this cap-
ital with a high interest rate and
require warrants (options to purchase
stock) as additional compensation.
■ Private equity is the riskiest form of
capital. If a company goes bankrupt,
debt holders control the bankruptcy
process and, in the case of liquidation,
have priority in receiving the proceeds
from the sale of any assets such as
real estate and equipment. Equity
investors, being last in line, lose con-
trol of the company and usually lose
their entire investment.
Increasing cash flow
There are three ways to improve
the cash flow of a company: reduce
the costs of making products or pro-
viding services; reduce the costs of
operating the company; and increase
sale profitably.
In the early 1990s, private equity
investors realised that they could no
longer rely on finding acquisitions at
attractive prices and aggressively
adding debt to achieve their invest-
ment objectives. They were going to
have to actively encourage or even
intervene to achieve improved operat-
ing performance of their acquired com-
panies. Thus, the era of re-engineering
of operations was born. In addition to
working with management and often
bringing in consultants, other tech-
niques were used to enhance financial
statements and increase cash flow.
In the abstract, improving opera-
tions, cutting costs and increasing effi-
ciency can sound benign. But many of
the specific actions undertaken to
improve profitability are the reasons
that LBOs are sometimes criticised and
perceived negatively. These can
include reducing R&D and capital
expenditures, extending accounts
payable, lowering accounts receivable,
selling real estate and other assets,
modifying compensation to reduce base
salaries and increase performance
bonuses, and restructuring health and
retirement benefits.
Some communities in the US, and
some European and Asian govern-
ments have reacted critically to buyout
funds that purchase companies, reduce
work forces and then sell the compa-
nies for large profits. These reactions
have raised concerns among the inter-
national private equity funds that gov-
ernments might act to restrict investor
access, alter tax or regulatory prac-
tices or place constraints on capital
movement.
The growth LBO
After the emphasis in the 1980s on
acquiring undervalued and undercapi-
talised stable companies and, in the
early 1990s, on operations improve-
ments, private equity investors began
to look for acquisitions that had the
potential for significant expansion in
the market. This was the beginning of
the era of the growth LBO.
After purchasing a company with
strong products and services, some
buyout funds will invest the com-
pany’s cash into expanding regionally,
nationally or internationally as well
as developing derivative products and
services. If the core business model is
proven to produce decent financial
results, growing sales will often give
the company the necessary clout to
secure volume discounts from suppli-
ers, negotiate advantageous alliances
and buy smaller competitors. Scale can
be a powerful tool.
For buyout funds, however, the risks
are significant. They have to depend
on company management to execute
expansion or acquisition strategies
without letting the company lose
momentum or cost control. Many
acquisitions do not work, often due to
cultural differences or a lack of syner-
gies at the operations or marketing lev-
els. If management does not perform as
it promised it would to its board, buyout
funds will not hesitate to replace the
CEO and/or the senior leadership team.
The new world of LBOs
The last two years have seen a dra-
matic transformation in the world of
LBO transactions. These changes have
included an unprecedented influx of
funding resulting in the first $10bn-plus
LBO funds, the first equity syndica-
tions, called “club deals”, the first buy-
outs of large technology companies, a
greatly expanded reliance on leveraged
recapitalisations or sales to other finan-
cial buyers for investment exits and a
dramatic increase in the reliance on
debt and a corresponding relaxation in
the stringency of debt covenants. In
addition, new institutional structures
are evolving, including multiproduct
companies accessing public markets
and, for the first time, the formation of
an industry association.
Club deals
An important characteristic of the ven-
ture capital industry is the ability of
multiple companies to operate effec-
tively as board members of startup and
growth companies. The challenge of
these risky investments and the
amount of co-ordination or negotiation
among venture capital companies is
substantial.
In contrast, buyout groups have
been accustomed to operating as “lone
rangers”. They find companies in
which to invest, provide most of the
risk equity themselves and form rela-
tively small boards of portfolio com-
panies to work with management to
resolve issues.
In the past two years, buyout funds
have begun to invest together as syndi-
cates of three to seven players. This
equity syndication enables them to
diversify risk, buy bigger companies
and reduce the level of competition in
an acquisition auction.
So far, this new type of arrangement
has not been fully tested. A single buy-
out investor can act quickly and unilat-
erally to fix problems and seize
opportunities, and this has often been
viewed as the advantage of the private
equity governance model over public
company governance. So, it remains to
be seen if a multibusiness private equity
governance structure will be as effective
as the lone ranger model that has
served the industry so well.
Technology buyouts
As many technologies have become
mainstream, banks and other lenders
have become more comfortable with
helping buyout groups who target
established technology companies.
Until recently, such a buyout was
viewed as a contradiction in terms:
buyout funds assumed they could not
take a technology risk and convince
lenders to provide capital in highly
volatile industries.
But a few technology investors
realised that a number of technology
companies had developed stable recur-
ring revenue streams that were also
diversified. Buyout funds have targeted
healthcare data providers, electronic
commerce systems, software compa-
nies, disc drive manufacturers and chip
manufacturers. Furthermore, it is
entirely possible that larger technol-
ogy companies, whose performance has
been sideways at best, will be candi-
dates for buyout transactions.
The credit bubble
Buyout veterans are not shy about
admitting that the amount of leverage
and the number of lenders in the mar-
ketplace is at levels not seen since the
1980s. Banks and other lenders are
aggressively competing with each
other for deals to generate fees and
interest income in the midst of a rela-
tively low interest rate environment.
The result has been a steady expansion
of the amount of debt available for
leveraged acquisitions and a relaxation
of lenders’ terms and conditions.
This expansion of debt availability
has permitted investors to quickly
recapitalise their acquired companies
and make large dividend payments to
themselves and other equity owners.
This debt expansion has also encour-
aged the sale of companies from one
buyout fund to another. These early
and significant returns on investment
have led to a strong performance by
the LBO sector in the past couple of
years. Endowments, pension plans,
insurance companies and other insti-
tutional investors in buyout funds have
committed greater amounts of capital
to the sector.
It is not anticipated that the debt
markets will continue to expand as
they have in the past few years. This
means that the emphasis on creating
value in the future will have to focus
on operations improvement and prof-
itable growth.
Moreover, if the debt markets
tighten, the hurdle to achieving suc-
cessful exits will be raised even higher.
Still more challenging would be an eco-
nomic slowdown. In that event, com-
panies with significant debt on their
balance sheets could have difficulty
meeting their debt obligations. This
could lead to a cycle of distress where
opportunities for buyout funds could
lie in restructuring companies with
over-leveraged balance sheets. A few
buyout houses have actually developed
funds specifically for such distressed
investing.
New institutional
arrangements
As the buyout sector of the interna-
tional economy reaches unprecedented
levels, several new institutional struc-
tures are emerging. First, a small
number of private equity groups, such
as Carlyle and Blackstone, have
become large multiproduct enterprises
spanning buyout, venture capital,
hedge funds, specialty lending, energy
and real estate. Second, other houses,
such as Apollo and Kohlberg Kravis
Roberts, are turning to public capital
markets for funds that will provide a
base of permanent capital to supple-
ment the traditional ten-year term fund
structure upon which they previously
relied. Finally, concerns about possible
adverse reactions to expanded and vis-
ible buyout investment activity world-
wide has led to the formation of a
buyout industry association.
Conclusion
The leveraged buyout model of incen-
tives, financing and governance has
been shown to generate significant
value. It has evolved over the past 25
years and holds promise as a new stan-
dard for corporate transformation
worldwide.
Today, there does not appear to be a
limit on the size of these buyout trans-
actions. The amount of capital avail-
able and the willingness among
buyout funds to collaborate with each
other gives them significant power in
global capital markets. However, the
continuation of this trend will rely on
the health of the debt markets, global
economic growth and lack of a political
backlash worldwide.