Leveraged Buyouts (Private Equity Only)

PRIVATE EQUITYS GOLDEN EGG

The basic definition

A leveraged buyout (LBO) employs financial leverage to acquire a company. Often,
the assets of the acquired company are used as collateral for the debt; then the
bought-out business generates cash flows, which are used to pay down the debt.
LBOs allow private equity firms to make large acquisitions without having to commit
a lot of capital (equity).

The most popular type of LBO buys a public company, which then is quoted as a
company going private. The rationale is that a company can be more valuable as
a private company. Perhaps the public markets are undervaluing it, or management
can be more effective without the scrutiny of quarterly earnings reports to public
shareholders. Moreover, the burden of governance, like Sarbanes-Oxley, is removed,
which frees up time and resources.

When successful, LBOs generate high return because, as the equity holder, the
sponsor receives all the benefits of any capital gains (while debt holders have a fixed
return). Leverage magnifies these gains, allowing private equity firms to make
outsized returns on investments in boom cycles.

Today, the current credit freeze and economic decline have significantly decreased
LBO prospects. Additionally, the changing political climate will affect the way private
equity is defined.

THE BEGINNING
The history of private equity can be traced back to 1901, when J.P. Morganthe
man, not the institutionpurchased Carnegie Steel Co. from Andrew Carnegie and
Henry Phipps for $480 million. Phipps took his share and created, in essence, a
private equity fund called the Bessemer Trust. Today the Bessemer Trust is more
private bank than private equity firm, but Phipps and his children started a trend of
buying exclusive rights to up-and-coming companiesor buying them outright.

Yet, although there were pools of private money in existence between the turn of the
century and through the 1950s, these were primarily invested in startups, much like
todays venture capital firms. The notion of a private buyout of an established public
company remained foreign to most investors until 1958, when President Dwight D.
Eisenhower signed the Small Business Act of 1958. That provided government loans
to private venture capital firms, allowing them to leverage their own holdings to make
bigger loans to startupsthe first real leveraged purchases.

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