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Leveraged buyouts for Financial Management and Policy Mcom sem 2 Delhi University

Leveraged buyouts for Financial Management and Policy MCOM sem 2 Delhi University:- we will provide complete details of Leveraged buyouts for Financial Management and Policy MCOM sem 2 Delhi University in this article.

Leveraged buyouts for Financial Management and Policy MCOM sem 2 Delhi University

Leveraged buyouts for Financial Management and Policy MCOM sem 2 Delhi University

Leveraged buyouts for Financial Management and Policy Mcom sem 2 Delhi University

A leveraged buyout (LBO) is a financial transaction in which a company is purchased with a combination of equity and debt, such that the company’s cash flow is the collateral used to secure and repay the borrowed money. The use of debt, which has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition. This reduced cost of financing allows greater gains to accrue to the equity, and, as a result, the debt serves as a lever to increase the returns to the equity.

The term LBO is usually employed when a financial sponsor acquires a company. However, many corporate transactions are partially funded by bank debt, thus effectively also representing an LBO. LBOs can have many different forms such as management buyout (MBO), management buy-in (MBI), secondary buyout and tertiary buyout, among others, and can occur in growth situations, restructuring situations, and insolvencies. LBOs mostly occur in private companies, but can also be employed with public companies (in a so-called PtP transaction – Public to Private).

As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition. This has, in many cases, led to situations in which companies were “over-leveraged”, meaning that they did not generate sufficient cash flows to service their debt, which in turn led to insolvency or to debt-to-equity swaps in which the equity owners lose control over the business to the lenders.

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Leveraged buyouts for Financial Management and Policy Mcom sem 2 Delhi University:-Characteristics

LBOs have become attractive as they usually represent a win-win situation for the financial sponsor and the banks: the financial sponsor can increase the rate of returns on his equity by employing the leverage; banks can make substantially higher margins when supporting the financing of LBOs as compared to usual corporate lending, because the interest chargeable is that much higher.

The amount of debt banks are willing to provide to support an LBO varies greatly and depends, among other things, on:

  • The quality of the asset to be acquired (stability of cash flows, history, growth prospects, hard assets, etc.)
  • The amount of equity supplied by the financial sponsor
  • The history and experience of the financial sponsor
  • The overall economic environment

Leveraged buyouts for Financial Management and Policy Mcom sem 2 Delhi University

For companies with very stable and secured cash flows (e.g., real estate portfolios with rental income secured with long-term rental agreements), debt volumes of up to 100% of the purchase price have been provided. In situations of “normal” companies with normal business risks, debt of 40–60% of the purchase price are usual figures. The possible debt ratios vary significantly among the regions and the target industries.

Depending on the size and purchase price of the acquisition, the debt is provided in different tranches.

  • Senior debt: This debt is secured with the assets of the target company and has the lowest interest margins
  • Junior debt (usually mezzanine): this debt usually has no securities and thus bears higher interest margins

In larger transactions, sometimes all or part of these two debt types is replaced by high yield bonds. Depending on the size of the acquisition, debt as well as equity can be provided by more than one party. In larger transactions, debt is often syndicated, meaning that the bank who arranges the credit sells all or part of the debt in pieces to other banks in an attempt to diversify and hence reduce its risk. Another form of debt that is used in LBOs are seller notes (or vendor loans) in which the seller effectively uses parts of the proceeds of the sale to grant a loan to the purchaser. Such seller notes are often employed in management buyouts or in situations with very restrictive bank financing environments. Note that in close to all cases of LBOs, the only collateralization available for the debt are the assets and cash flows of the company. The financial sponsor can treat their investment as common equity or preferred equity among other types of securities. Preferred equity can pay a dividend and has payment preferences to common equity.

As a rule of thumb, senior debt usually has interest margins of 3–5% (on top of Libor or Euribor) and needs to be paid back over a period of 5 to 7 years; junior debt has margins of 7–16%, and needs to be paid back in one payment (as bullet) after 7 to 10 years. Junior debt often additionally has warrants and its interest is often all or partly of PIK nature.

In addition to the amount of debt that can be used to fund leveraged buyouts, it is also important to understand the types of companies that private equity firms look for when considering leveraged buyouts.

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Leveraged buyouts for Financial Management and Policy Mcom sem 2 Delhi University

While different firms pursue different strategies, there are some characteristics that hold true across many types of leveraged buyouts:

  • Stable cash flows – The company being acquired in a leveraged buyout must have sufficiently stable cash flows to pay its interest expense and repay debt principal over time. So mature companies with long-term customer contracts and/or relatively predictable cost structures are commonly acquired in LBOs.
  • Relatively low fixed costs – Fixed costs create substantial risk for Private Equity firms because companies still have to pay them even if their revenues decline.
  • Relatively little existing debt – The “math” in an LBO works because the private equity firm adds more debt to a company’s capital structure, and then the company repays it over time, resulting in a lower effective purchase price; it’s tougher to make a deal work when a company already has a high debt balance.
  • Valuation – Private equity firms prefer companies that are moderately undervalued to appropriately valued; they prefer not to acquire companies trading at extremely high valuation multiples (relative to the sector) because of the risk that valuations could decline.
  • Strong management team – Ideally, the C-level executives will have worked together for a long time and will also have some “skin in the game” by participating in the LBO by rolling over their shares when the deal takes place.

Leveraged buyouts for Financial Management and Policy Mcom sem 2 Delhi University

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