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Leveraged Buyout

Leveraged Buyout

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Published by: carlosdondada on Mar 05, 2010
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Leveraged buyout
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leveraged buyout
, or highly-leveraged transaction (HLT), or "bootstrap"transaction) occurs when afinancial sponsor acquires acontrolling interestin a company'sequityand where a significant percentage of the purchase price is financedthroughleverage( borrowing). The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. The bonds or other paper issued for leveraged buyouts are commonly considered not to beinvestmentgradebecause of the significant risks involved.
Companies of all sizes and industries have been the target of leveraged buyouttransactions, although because of the importance of debt and the ability of the acquiredfirm to make regular loan payments after the completion of a leveraged buyout, somefeatures of potential target firms make for more attractive leverage buyout candidates,including:
Low existing debt loads;
A multi-year history of stable and recurring cash flows;
Hard assets ( property, plant and equipment,inventory,receivables) that may be used as collateral for lower costsecured debt;
The potential for new management to make operational or other improvements tothe firm to boost cash flows;
Market conditions and perceptions that depress the valuation or stock price.
Diagram of the basic structure of a generic leveraged buyout transactionLeveraged buyouts involve
making largeacquisitions without committing all the capital required for the acquisition. To do this, afinancial sponsor will raise acquisition debt which is ultimately secured upon theacquisition target and also looks to the cash flows of the acquisition target to makeinterest and principal payments. Acquisition debt in an LBO is therefore usually non-recourseto the financial sponsor and to the equity fund that the financial sponsor manages. Furthermore, unlike in a hedge fund, where debt raised to purchase certainsecurities is also collateralized by the fund's other securities, the acquisition debt in anLBO is recourse only to the company purchased in a particular LBO transaction.Therefore, an LBO transaction's financial structure is particularly attractive to a fund'slimited partners, allowing them the benefits of leverage but greatly limiting the degree of recourse of that leverage.This kind of acquisition brings leverage benefits to an LBO's financial sponsor in twoways: (1) the investor itself only needs to provide a fraction of the capital for theacquisition, and (2) assuming the economic internal rate of return on the investment(taking into account expected exit proceeds) exceeds the weighted average interest rateon the acquisition debt, returns to the financial sponsor will be significantly enhanced.As transaction sizes grow, the equity component of the purchase price can be provided bymultiple financial sponsors "co-investing" to come up with the needed equity for a purchase. Likewise, multiple lenders may band together in a "syndicate" to jointly provide the debt required to fund the transaction. Today, larger transactions aredominated by dedicated  private equityfirms and a limited number of large banks with "financial sponsors" groups.As a percentage of the purchase price for a leverage buyout target, the amount of debtused to finance a transaction varies according the financial condition and history of theacquisition target, market conditions, the willingness of  lenders to extend credit (both to the LBO's financial sponsorsand the company to be acquired) as well as the interest costs
and the ability of the company to cover  those costs. Typically the debt portion of a LBO ranges from 50%-85% of the purchase price, but in some cases debt may representupwards of 95% of purchase price. Between 2000-2005 debt averaged between 59.4%and 67.9% of total purchase price for LBOs in the United States.
To finance LBO's, private-equity firms usually issue some combination of syndicatedloansandhigh-yield bonds. Smaller transactions may also be financed with mezzanine debt from insurance companies or specialty lenders. Syndicated loans are typicallyarranged by investment banks and financed by commercial banks and loan fundmanagers, such as mutual funds, hedge funds, credit opportunity investors and structuredfinance vehicles. The commercial banks typically provide revolving credits that provideissuers with liquidity and cash flow while fund managers generally provided funded termloans that are used to finance the LBO. These loans tend to be senior secured, floating-rate instruments pegged to the London Interbank Offer Rate(LIBOR). They are typically  pre-payable at the option of the issuer, though in some cases modest prepayment feesapply.
High-yield bonds, meanwhile, are also underwritten by investment banks but arefinanced by a combination of retail and institutional credit investors, including high-yieldmutual funds, hedge funds, credit opportunities and other institutional accounts. High-yield bonds tend to be fixed-rate instruments. Most are unsecured, though in some casesissuers will sell senior secured notes. The bonds usually have no-call periods of 3-5 yearsand then high prepayment fees thereafter. Issuers, however, will in many cases have a"claw-back option" that allows them to repay some percentage during the no-call period(usually 35%) with equity proceeds.Another source of financing for LBO's is seller's notes, which are provided in some cases by the entity as a way to facilitate the transaction.The acquisition of another company using a significant amount of borrowed money(bonds or loans) to meet the cost of acquisition. Often, the assets of the company beingacquired are used as collateral for the loans in addition to the assets of the acquiringcompany. The purpose of leveraged buyouts is to allow companies to make largeacquisitions without having to commit a lot of capital.
Investopedia Says
:In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this highdebt/equity ratio, the bonds usually are not investment grade and are referred to as junk  bonds. Leveraged buyouts have had a notorious history, especially in the 1980s whenseveral prominent buyouts led to the eventual bankruptcy of the acquired companies.This was mainly due to the fact that the leverage ratio was nearly 100% and the interest payments were so large that the company's operating cash flows were unable to meet theobligation.

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