Corporate restructuring through LBO

Going Private refers to the transformation of a public

corporation into a privately held firm and in this
connection LBO can be defined as the acquisition,
financed largely by borrowings of all the stocks or
assets of a higher to public company by a small
group of investors.

The LBO differs from the ordinary acquisition in

two ways: Firstly, a large fraction of the purchase
price is debt financed through junk bonds and
secondly, the shares of LBOs are not traded in the
open market.

In a LBO programme, the acquiring group consists

of a small number of persons or organizations
sponsored by buyout specialists’ investment bankers.
The group with the help of certain financial
instruments like high yield high risk debt instrument
(Junk bond) deferred payment instruments, private
placement instruments, loan from venture capitalists,
merchant bankers etc., takes the target firm
privately. The buyout may or may not include
current management of the target firm. If so does,
the buyout may be regarded as Management Buyout,
MBO.

Stages of LBO operations:

1st stage: Arrangement of Finance: The first stage of

the operation consists of raising the cash required for
the buyout and work out a management incentive
system. The equity base of the new firm consists of
around 10% of the cash put up by the top
management or buyout specialist. Outside investors
like merchant bankers, venture capitalist and
commercial banks then arrange remaining equity.
Usually 50% of cash is raised by borrowing against
company’s assets in secured bank acquisition loan
from commercial banks. Rest of cash is obtained by
issuing certain debt in a private placement usually
with pension funds, insurance companies, venture
capital firm or public offering through junk bonds.

IInd stage: In the second stage the organizing or

sponsoring group purchases all the outstanding
shares of the target company and take it privately
through stock purchase format or purchase all assets
through asset purchasing format.

IIIrd Stage: In this stage, the new management

would try to enhance the generation of profit and
cashflows by reducing certain operating costs and
changing the marketing strategy. For this purpose,
the organization may adopt any or all of the below
given policies:
 1.Consolidation and re organization of existing
production facilities.
2.Changing the product mix(thereby changing the
quality of the product) and changing the policy
relating to customer service and pricing.
3.Trimming employment through attrition
4.Phasing out employees in turn and reduction in
spending on research & development, new
plants and equipment etc., so long as there is a
need to redeem the fresh acquired debts, and
5.Extraction & implementation of better terms
from various suppliers.

IVth Stage: Reverse LBO

Under this stage, the investor group may take the

company to public again, if the already restructured
company emerges stronger and the goals set up by
the LBO group have already achieved. This is
known as reverse LBO or the process of going
public. The purpose of this exercise is to create
liquidity for existing shareholders. This type of
exercise is mostly executed by ex post successful
LBO companies.

Candidate for LBO exercise: The typical target

includes any of the following:

• If the company does not have share holding

more than 51%
• If the company is over leveraged with debt
components nearing to maturity.
• If the company has diversified into unrelated
areas and thus facing problems.
• If the company is earning low operating profit
• If the company is having an asset structure
which is grossly underutilized.
Value Generation through LBO

Every restructuring programme must generate some

additional value for the business, owners and
shareholders

 Reduction in agency cost is the most important

source of value in an LBO

Efficiency

Tax benefits

Management or investors in an LBO deal have

more information on the value of the firm.
Criticisms of LBO

 Because of heavy deployment of debts in

financial restructuring, the cost of debt capital
increases in the capital market, making difficult
for other firms to raise debts for their needs.

 Many old and experienced employees of the

target firms are threatened of losing their jobs
because of streamlining of the new management in
the post buyout scenario.

 Since the new management in the post buyout

scenario concentrates on short term goals like
reduction of debt burden at the cost of research
and development expenditure, the long term
growth of the restructured firm is disrupted.
 In case of incapability of the restructured
firm to redeem the debt, the firm is exposed to
bankruptcy.