!!!Introduction
Hilton Hotel chains, PetSmart, Inc., Georgia-Pacific LLC, and First Data Corp. are some of target companies of the leveraged buyouts from the 1980s through 2000s. The American private equity firm called Kohlberg Kravis Roberts & Co. pulled off the most famous leveraged buyout (LBO) of all time in 1989, the RJR Nabisco deal. The Blackstone Group picked the worst timing when it bought Hilton in a leveraged buyout in 2007 right before the financial crisis. These deals purport to maximize shareholder values, but are usually considered as hostile takeovers since the current management of the targets do not want the deal in the first place.
!!!Definition of a leveraged buyout
When the management of a company and or a financial buyer, such as a private equity fund wants to buy a company or a part of it but does not want to commit too much of their own equity capital, a financing structure called a __leveraged buyout__ is utilized. The bonds issued in the process are usually ”junk” bonds since the bonds are not backed by much cushion called equity. The cash flow of the company being acquired and/or the assets of the acquiring company are often used as collateral for the loans, given the scant amount of equity investment of the acquiring company.
As we saw in the MM Proposition I & II, the use of debt, which has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition, thus the name of ”leveraged” buyout.
!!!Types of leveraged buyouts
There are variants of leveraged buyouts such as __highly leveraged transactions (HLTs), __management buyout__ (MBO) by the current management, __management buy-in__ (MBI) of outside management, __secondary leveraged buyouts__ of a company that was acquired through an original leveraged buyout, etc. But, they are typically categorized for the following three purposes:
*Converting a public company into a private one
*Leveraged buyouts in spin-offs
*Financing private property sell-off
!!Public-to-Private
When a financing buyer purchases all of the outstanding stock of a public company and turns the company into a privately one, this particular leveraged buyout is called a __public-to-private deal__. Depending on the management’s point-of-view, these deals could be either friendly or hostile. In a friendly deal, the current management buys the company out for itself with plans to run it. On the other hand, when an outside financing group buys to reorganize and to resell the company, it is called a hostile deal.
!!Spin-Offs
Companies sometimes need to sell off a segment of their business to pay the investors back. In some cases, the seller may itself have been bought in a leveraged buyout. In these situations, the management of the spun-off segment may initiate the management buyout or may be passive in the transaction. Regardless, the fundamental financial logic of such leveraged buyouts, however, are the same.
!!Private Deals
__Private deals__ are the case where a privately held operation is bought by an investor group. This oftentimes happens when a small company owner wants to retire. The owner resorts to this private deal leveraged buyout when he wants to sell the company and cannot find an outside buyer. The eventual buying group tends to be the company’s employees or managers who are familiar with the operation already.
!!!Summary
A __leveraged buyout__ is usually structured to form a new company for the purpose of acquiring the target company. The financial buyers or management of the target company, depending on the case, invest a small amount of capital with the majority of debt provided by investment banks.
Subsequently, the target company either becomes a subsidiary of a new company or they merge with each other later on. As financial buyers increase their returns by employing a very high leverage, they have an incentive to employ as much debt as possible to finance an acquisition. This has in many cases; however, led to situations in which companies were ‘~’over-leveraged’~’. They did not generate sufficient cash flows to service their debt, which in turn led to the equity owners losing control of the company to the investment banks.