Understanding Leveraged Buyout Scenarios

Leveraged buyouts (LBOs) have probably had more bad publicity than good because they make great stories for the press. However, not all LBOs are regarded as predatory. They can have both positive and negative effects, depending on which side of the deal you're on.

A leveraged buyout is a generic term for the use of leverage to buy out a company. The buyer can be the current management, the employees, or a private equity firm. It's important to examine the scenarios that drive LBOs to understand their possible effects. Here, we look at four examples: the repackaging plan, the split-up, the portfolio plan, and the savior plan.

The Repackaging Plan

The repackaging plan usually involves a private equity company using leveraged loans from the outside to take a currently public company private by buying all of its outstanding stock. The buying firm's goal is to repackage the company and return it to the marketplace in an initial public offering (IPO).

The acquiring firm usually holds the company for a few years to avoid the watchful eyes of shareholders. This allows the acquiring company to make adjustments to repackage the acquired company behind closed doors. Then, it offers the repackaged company back to the market as an IPO with some fanfare. When this is done on a larger scale, private firms buy many companies at once in an attempt to diversify their risk among various industries.

Those who stand to benefit from a deal like this are the original shareholders (if the offer price is greater than the market price), the company's employees (if the deal saves the company from failure), and the private equity firm that generates fees from the day the buyout process starts and holds a portion of the stock until it goes public again. Unfortunately, if no major changes are made to the company, it can be a zero-sum game, and the new shareholders get the same financials the older version of the company had.

The Split-Up

The split-up is considered to be predatory by many and goes by several names, including "slash and burn" and "cut and run." The underlying premise in this plan is that the company, as it stands, is worth more when broken up or with its parts valued separately.

This scenario is fairly common with conglomerates that have acquired various businesses in relatively unrelated industries over many years. The buyer is considered an outsider and may use aggressive tactics. Often in this scenario, the firm dismantles the acquired company after purchasing it and sells its parts to the highest bidder. These deals usually involve massive layoffs as part of the restructuring process.

It may seem like the equity firm is the only party to benefit from this type of deal. However, the pieces of the company that are sold off have the potential to grow on their own and may have been stymied before by the chains of the corporate structure.

The Portfolio Plan

The portfolio plan has the potential to benefit all participants, including the buyer, the management, and the employees. Another name for this method is the leveraged build-up, and the concept is both defensive and aggressive in nature.

In a competitive marketplace, a company may use leverage to acquire one of its competitors (or any company where it could achieve synergies from the acquisition). The plan is risky: The company needs to make sure the return on its invested capital exceeds its cost to acquire, or the plan can backfire. If successful, then the shareholders may receive a good price on their stock, current management can be retained, and the company may prosper in its new, larger form.

The Savior Plan

The savior plan is often drawn up with good intentions but frequently arrives too late. This scenario typically includes a plan involving management and employees borrowing money to save a failing company. The term "employee-owned" often comes to mind after one of these deals goes through.

While the concept is commendable, the likelihood of success is low if the same management team and tactics stay in place. Another risk is that the company may not be able to pay back the borrowed money quickly enough to offset high borrowing costs and see a return on the investment. On the other hand, if the company turns around after the buyout, then everyone benefits.

The Bottom Line

While there are forms of LBOs that lead to massive layoffs and asset selloffs, some LBOs can be part of a long-term plan to save a company through leveraged acquisitions. Regardless of what they are called or how they are portrayed, they will always be a part of an economy as long as there are companies, potential buyers, and money to lend.