“One of the main advantages for investors is the limited losses that accompany buying a company mainly with debt secured by the assets of that same company.”
Reduced taxes
Depending on where on the globe you transact, interest expense may be tax deductible. So, while it would be great if money could be borrowed for free and used for LBOs, the consolation is that the tax burden can be reduced based on realized interest expense.
Risks of Leverage
For all of its advantages, leverage comes with risk. While it is possible to breakdown the various advantages of leverage into different descriptions the risk of leverage is singular in nature. The risk of leverage is greater default risk.
When times are good and a company is producing earnings to pay its suppliers, employees and officers, leverage is a beautiful thing. However, in times of trouble, when the company is not generating profits, leverage can be a death blow that does not allow a company to get itself back on its feet. Even in times of trouble, interest payments are still required on top of the regular operating expenses that come with operating a company.
“For all of its advantages, leverage comes with risk. The risk of leverage is greater default risk.”
The creditors have prepared for the day of failure since before the original credit agreements were signed. In the case of a failing business (or bankruptcy), the creditors stand in line ahead of the equity partners to get their money back. Only after all the creditors get their money back is there any chance of equity investors recouping their investment capital and usually by that time there is nothing left to recoup.
If a company were to not have any debt, but were to fall on tough financial times, the outcome would be somewhat different. The biggest difference would be that there would be less chance of bankruptcy. (We are presuming that there are no unsecured creditors like employees or vendors that have supplied goods or services without being paid.) The company could sell any assets it has on its balance sheet. From the proceeds of the asset sale, the equity partners of the company could keep all the money and help stave off bankruptcy.
Leverage comes with the risk not being able to meet the interest expense obligation. In good times, leverage seems like a wonderful idea. It allows a company to get the most out of the assets on its balance sheet and assists the growth of the company. However, in bad times, the interest burden can weigh on the company so greatly that it becomes a weight around the company’s proverbial neck and sinks the company in an ocean of debt.
Outcomes
Given what we now know about the advantages and risk associated with leveraged buyouts, let’s take a look at a simple example on how a transaction can potentially unfold, for better and then for worse.
In our example we have an investor that has identified a target company for a leveraged takeover. The target company produces essential engine parts for trains and has been doing so, profitably, for nearly 90 years. The target company has very little debt on its balance sheet and strong, steady cash flows. The company has been family owned since its inception and the family is looking to sell 100% of the company.
After conducting his due diligence and analysis the investor calculates a value range for the target company. The analysis, which we will cover in detail later, includes: 1) the market pricing for similar companies as a multiple of EBITDA (Earnings Before Interest Depreciation and Amortization), 2) purchase pricing in previous acquisitions of similar companies, as well as, 3) a discounted cash flow analysis – which also relies on multiples of earnings to derive the implied enterprise value of the company.
The investor carefully analyzes the impact of the target company taking on additional debt and its ability meet the interest payments over a decided time period. From this analysis the investor gains a measure of comfort in the target company’s ability to continue to generate earnings, service the debt, and eventually provide a satisfactory return on investment.
Based on his analysis and research, the investor decides to put forth an offer to the current owners of the company. The bid is accepted and the purchase transaction closes successfully at a price of $100 million.
Positive outcome
Now that the leveraged buyout transaction has been completed the hard work begins for those tasked with the job of running the business and ultimately generating earnings. Business managers will focus on operating efficiency and try to identify areas within the company where unnecessary costs can be reduced. They will also try to identify additional revenue-generating opportunities.
The economy continues to grow and businesses are shipping goods by train as much as ever. The company experiences growth in demand for its train engine parts by 5% every year for the next five years. Under these circumstances, the company is able to meet is regular interest payments and realize a return on equity.
As time goes on, the company continues its profitable ways, steadily paying down debt and using its profits to expand operations, which will result in greater revenues and ultimately profits down the road. The company also increases the dividends paid out to owners.
Five years after the original acquisition of the company, our investor decides that he is ready to sell the company. At this point, significant value has been created within the company. Business operations have expanded, and with it, revenue and earnings have also increased. The firm has generated significant positive cash flows that have been used to expand the business and pay the owners, in the form of dividends.
Using the same methodology that was used to value the purchase of the company, the investor is now selling the company at a price that will result in a handsome return on investment. With a large portion of the debt now paid down and turned into equity, our investor is selling a considerably larger portion of the company as equity than he actually bought on the day of purchase. That coupled with the fact that earnings have also grown over the past five years contributes to the returns that the investor expects to realize.
“Five years later, if a large portion of the debt is paid down and turned into equity, an investor can sell a considerably larger portion of the company as equity than he actually bought on the day of purchase.”
In the end, our investor identifies a buyer that is willing to purchase the company at the same multiple of EBITDA he purchased the company at. It doesn’t sound very exciting at first, but the key facts are that the company’s EBITDA has grown 30% over the past five years and while our investor only put up 10% of the purchase price in the form of an initial equity investment, his equity share now accounts for 40% of the company’s capital structure. The short summary of this positive outcome is that our investor has made a lot of money on this deal by increasing the company’s earnings (EBITDA), paying down debt and amassing a larger portion of shareholders’ equity in the firm over time.
Negative outcome
Now that the leveraged buyout transaction has been completed the hard work begins for those tasked with the job of running the business and ultimately generating earnings. Business managers will focus on operating efficiency and try to identify areas within the company where unnecessary costs can be reduced. They will also try to identify additional revenue-generating opportunities.
“Faced with a bleak economic horizon, and all of its available cash paying down large interest expenses, a company can find itself in serious trouble.”
The greater economy stalls and businesses are not shipping as many goods as they do under normal economic circumstances. The weakening demand for new trains and less expensive alternatives from overseas result in significantly weaker demand for the company’s engine parts. Revenues decrease on average by 5%, annually, over the next five years.
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