Sunday, February 12, 2017

Private Equity and the Leveraged Buyout, pt. 2

The other day I took a stab at giving you a little primer on private equity.  Today I'm going to try to shed on private equity's most famed tool, the leveraged buyout.

Not every leveraged buyout (or "LBO") is a hostile takeover.  There are plenty of instances of a target company being the willing "victim" of an LBO.  With that said, LBOs frequently are predatory in nature and feared for that very reason.

First, let's talk "leverage".  The leverage refers to the amount of debt taken on by the entity doing the buying out.  When a private equity firm announces an LBO of this or that company, most of the money in the buyout attempt does not come from the private equity firm itself - it is borrowed.  Often the private equity firm will put up 10% of the total equity, while borrowing 90% of the funds needed for the buyout.  This amount of leverage means that the debts are usually not "investment-grade" - they are "junk bonds" (a term that, I think, speaks for itself, but basically - highly risky debt).

The upside of this arrangement is that the private equity firm stands to make a hefty profit for a minimal investment.  The downside of the arrangement is all that debt, which is not necessarily easy to repay and - here's the critical point - will be repaid by the acquired company, not by the company doing the acquiring!

That's right: a successful LBO attempt raises a ton of debt and that debt is not taken on by the private equity firm - it is taken on by the targeted company.  Furthermore, in an LBO the assets of the targeted company are used as collateral for the debt incurred.  (For a refresher on the meaning of "collateral", from Investopedia: "Collateral is a property or other asset that a borrower offers as a way for a lender to secure the loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup its losses."  In other words, should the targeted company be unable to pay down this LBO debt, it is the assets - machinery, you name it - of the targeted company that will be sold off to attempt to meet these debt obligations.)

So the LBO that is not mutually agreed to by all parties is intensely predatory, because the "victim" is on the hook for all the debt incurred by the "predator". 

Now - quite often the private equity firm or other entity doing the buying out will re-shape the targeted company in a way that improves that company's profitability, allowing it to repay all the incurred debt and turn a profit!  However, that is often not the case.  Frequently the private equity firm, after making its changes to the bought-out company (which often involve "spinning off" inefficient branches of the target company and firing the employees who work in these branches) will attempt to sell off the company before all the debt from the LBO has been repaid.  Sometimes new shares will be sold to the public, in an attempt to raise cash to retire the LBO debt.  This is called a reverse LBO, and if that sounds a little bit like taking someone to the hospital after you've jumped them and beaten the hell out of them, that's because it's not a terrible analogy.

Target companies typically have a low share price but high cash flow.  You've got to have high cash flow if you want to pay back all that debt!  That's why many LBO targets have historically been older, not very "sexy," but stable companies.  The classic example is the 1989 takeover of RJR Nabisco by KKR.  Old manufacturing firms are prime targets.

If your sole concern is that companies be renovated and improved from a profitability perspective, older workers in particular be damned, the LBO seems an appealing tool - vicious, but rational.  And indeed, if LBOs generally resulted in leaner, meaner and more competitive target companies (once sold for a profit, which is the end game of the LBO), then you'd have to say you had a capitalistic success story on your hands.  However, many LBOs simply leave companies with too much debt to cope.  While the private equity firms or other businesses tend to sell their stake for a profit, they often leave target companies underwater, drowning in debt.  Ergo, once again, the predatory reputation of the LBO.

Whether or not the target company makes it out the other side in fighting shape or burdened with debt, the likelihood of mass layoffs during the process is quite high.  You can't afford to pay a huge staff while servicing all that debt, after all.  Whether you care if these workers live or die depends in part on your view of the free market, I suppose.  It is not rational to retain unprofitable workers when you're coping with debt repayments.


Not all private equity firms are and not every LBO attempt is vampiric or predatory.  However, the reputation of the LBO as a predatory process that leaves ruin in its wake (mass layoffs and companies choking to death on debt) is not undeserved.  The 1980s were the heyday of the LBO but its practitioners are still with us, and they are chummy-chummy with the President, so private equity bears watching.

Let me close by quoting Doug Henwood's Wall St., a book I urge you all to read and a bit of a Bible of mine (and available for free as a PDF!), on the 1980s LBO craze, words which are still quite pertinent today.  Emphases added mine:

Deals became more overpriced and riskier at the same time the commitments of managers and financiers to the deals were weakening. High up-front fees encourage irresponsible deal making — book the deal now, the hell with long-term prospects. Tighter repayment schedules meant that asset sales — selling off pieces of a company — rather than improvements in profitability were central to the financing strategy — the very definition of Minsky’s Ponzi financial structure. The inferior performance of the public junk bond market suggests that bank lenders are better judges of credit than are mutual fund managers and other portfolio jugglers.

The whole picture of bigger, dumber deals as the buyout binge matured is a severe blow to notions of efficient markets; the whole affair with leverage looks in retrospect like one of the great financial bubbles of all time. But it was a bubble with a flossy intellectual pedigree, deep support from the government (both the elected one and the Federal Reserve) and financial establishment, and with damaging consequences to the real U.S. economy. None of the perpetrators — investment bankers, finance academics, or central bankers — have suffered any blow to their prestige. And none of the governance issues ... have been solved; we know now that the LBO association hasn’t become the new model of business organization, but shareholders are still conniving to get a bigger share of corporate cash flow.

Don't snooze on private equity.

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