In the corporate world, there are plenty of techniques you can use as a part of your merger and acquisition tactic. One of the most well-known financing techniques is a Leveraged Buyout of an LBO.
So, what exactly is a leveraged buyout? This refers to a financing technique that a variety of entities uses. Many, including corporations, individuals, investment groups, management of corporations, partnerships, and so on use LBOs as a tactic.
About Leveraged Buyouts
Leveraged Buyout is the process of using debt to purchase the stock of a corporation. Most of the time, this involves taking a public company private. The level of interest rates and the availability of debt financing are some of the few factors that affect an LBO’s popularity.
In the years between 2004 and 2007, there were plenty of low-interest rates that prevailed. These helped explain why there are a lot of large LBOs that happened in that same period.
Additionally, from 2008 to 2009, we have seen a lack when it comes to debt financing at a time when interest rates were low. These occurrences help explain the big falloff in numerous deals during those years.
When the economy recovered from 2010 to 2017, there was an increase in debt financing availability. This was mainly due to the fact that there were large amounts of liquidity that were provided by expansionary monetary policy. However, lenders were also cautious at this time. So they weren’t ready nor willing to fund all types of deals that they did before the subprime crisis happened.
Leveraged Buyout Terminologies
Usually, there is a lot of overlap when it comes to LBOs and going-private transactions. What does a going-private deal mean? This refers to a public company that goes private. There are also times where it is referred to as a public-to-private transaction or PTP.
Transactions like PTP are financed with some equity and some debt. It is also important to remember that a debt-financed buyout can be done of a non-listed, that is, not-public firm.
LBO Deal
Now, this deal can also be called an LBO when, and only when, the bulk of the financing comes from debt. These deals are also referred to as bootstrap transactions back in the 1960s and 1970s.
Additionally, there are also deals that are called institutional buyouts. Institutional buyouts are when the owner of the formerly public company is a private firm or other financial institution.
On the other hand, there are also deals that are referred to as management buyout or MBO. MBO happens when a company sells a business unit, or sometimes even the entirety of a company to a management group.
The majority of these transactions involve a public company divesting a division. In doing so, the public company sells it to the unit’s management as opposed to an outside party. These types of deals are usually referred to as unit management buyouts.
Lastly, deals may also be referred to as a leveraged buyout when managers rely heavily on borrowed capital to finance the deal. You see, this is where the significant overlap in the terms come in. There are so many gray areas between the terminologies used to describe these transactions.
Leveraged Buyouts Early Origins
So, how did leveraged buyouts came to be? Well, this terminology became popular in the 1980s. However, long before that, the concept of a debt-financed transaction where a public company goes private was already around.
Take the Ford Motor Company as a great example of an LBO. In 1919, Henry Ford and his son Edsel grew tired of having to answer to shareholders. The main reason was that the founder of the auto company and the shareholders have different opinions regarding important matters such as dividends policy.
Henry Ford’s solution was to borrow what was considered to be an astronomical sum of money at the time to take the company private. Keep in mind that this is the world’s largest automobile company. Henry and Edsel purchased the company’s shares from the shareholders for $106 million. This roughly converts to $1.76 billion dollars today.
$75 million of those $106 million was borrowed from a collection of East Coast banks including Old Colony Trust, Bond & Goodwin, and Chase Securities of New York. Additionally, Ford also wanted to be free to manufacture and sell their Model Ts ever-decreasing prices.
This means that they would have to reinvest the profits they make back to the company instead of distributing them to shareholders. The shareholders have a mixed reaction to this.
Ford Strategic Plan
Some shareholders, such as the Dodge brothers were happy to cash out their shares. They were planning on using their capital to expand their own auto company that will clash with Ford later.
There were also some investors who wanted higher profits. But of course, this means that Ford needed to sell their automobiles at higher price points. That wasn’t part of Henry Ford’s plans at the time.
He was focused on making Ford automobiles that were affordable and attainable for the average American. To do this, he needed to continually lower his prices. Hence, he decided to take his public company private.
Ford Downhill Solutions
Interestingly enough, there were also problems that befell the LBOs of the fourth merger wave (which we will discuss in the next article) that affected Ford. Years after Ford went private, the United States economy experienced a downhill which affected Ford.
During 1920-1921, the automobile company incurred a cash crunch. This worried a lot of people that the company may no longer be able to service the huge debt load it had taken on in the buyout.
However, Henry Ford responded with a smart strategy by temporarily halting production. This was followed by layoffs and measures to cut their costs.
Not only that, but Ford also had other alternatives at his disposal. He exercised his rights in his agreements with Ford dealers and sent them the mounting inventory of cars, even though they didn’t necessarily have a need for them.
In return, this required the dealers to pay for the cars and dealers from all over the United States headed out for financing. At the end of the day, this gave Ford Motor Company the cash infusion it needed to resume production.
© Image credits to Evie Shaffer