Leveraged buyout, a term for a financing technique where a company goes private, has been around since the early ’80s. Despite this, the activity itself has been done for a longer period. Such as in 1919, when the Ford Motor company wanted to be free from public regulations. This is true in terms of manufacturing and selling their Model Ts. It is also significant to note that Ford was affected by some problems that befell the LBOs. For instance, they incurred a cash crunch when the US economy was declining. They thought the company wouldn’t be able to service the huge debt load obtained from the buyout. Their strategic responses were a halt in production, layoffs, and cost-cutting actions.
Henry Ford exercised rights in his agreements with Ford dealers and shipped them the mounting inventory of cars. Even though they did not necessarily need them. The dealers were required to pay and Ford Motor Company was able to cope with the cash infusion it needed. This strategy was done instead of seeking distressed financing.
Start of Deconglomeration
As mentioned earlier, LBOs became prominent in the 1980s than they did in the ‘70s. High stock prices of ‘60s motivated private corporations to go public and allow entrepreneurs to enjoy the profit. Even firms that are not of high quality had their stocks absorbed rapidly by the bull market. But when the stock lowered between 1972 and 1974, so did the low-quality companies and their prices. As a result, managers of some of the companies that went public in the 1960s chose to take their companies private in the 1970s and 1980s. There was a so-called de-conglomeration.
Those that had been built through large-scale acquisitions dissembled through sell-offs. It took place through the sale of divisions of conglomerates through LBOs, ongoing through the 1980s and is partially responsible for the rising trend in divestitures that occurred during that period. The LBOs formed during this decade were Kohlberg Kravis & Roberts, Thomas Lee Partners, and Frostmann Little who created investment pools to benefit from finding undervalued assets and firms, as well as using debt capital to finance their profitable acquisitions. Later on, these became known as LBO firms, and many other firms joined them in the activity.
Peak of LBOs
The 80s were the peak for LBOs, especially during the end of the decade, reaching up to 200, 000 in terms of value worldwide. Larger companies were the target of LBOs, and the average transaction went from $39.42 million in 1981 to $137.45 million in 1987. Despite this, there were still very few LBOs and their value was deemed low. For instance, there were 3701 mergers in 1987 but only 259 LBOs, hence the latter accounts for only 7% of the total number of transactions. You can learn about types of merger in this article “Type of mergers:short-form Mergers”.
It was in 1987 when LBOs made up 21.3% of the total value of transactions. It shows that the typical LBO tends to have a larger dollar value than the typical merger. LBOs were too efficient that many thought it would replace the usual public corporation, but they thought wrong. The fourth merger wave experienced a more limited number of sponsors or LBO dealmakers and also providers of debts. The sponsor was able to pursue deals using high leverage percentages.
The high returns during the ‘80s and the minor barriers attracted many competitors. The barriers to entry were really the access to capital, which proved not that challenging. Given the very large number of pension funds and endowments aggressively seeking diverse investments in the hopes of achieving higher returns. These provided the equity capital, and the access to bank financing and public debt markets provided the rest. As theorized by microeconomics, growth in competition precedes a fall in return.
90’s Drama
The start of the ‘90s was also the start of their dramatic fall. The decrease coincided with the decline in the junk bond market that started in late 1988 and the 1990–1991 recession that followed a few years later. This is proven by Cao and Lerner’s study which reported that the established funds between 1986 and 1999 earned less than 10%. Despite the average buyout firm formed that generated 47% internal rate of return.
The value and the number of worldwide LBOs still increased during the fifth wave of mergers. By 1998, the number reached its highest until 2000. The number of deals in 2000 was approximately double the 1980 level even though the total value was only half. The deals of the fifth merger wave were not the mega-LBOs of the fourth wave but smaller and more numerous.
Decade of Recovery
During the new decade, the number of LBOs fell along with the value. 2001 and 2002 coincided with a recession and an initially weak recovery, so the event was predictable. But by 2004, the LBO volume rose along with mergers and acquisitions until 2007, making it the most robust of all. The growth was strengthened by readily available capital at somewhat modest rates through the collateral debt obligations markets.
Aside from the LBOs increasing, the average size of deals also grew, with 7 out of 10 deals taking place during this period (2006-2007). The instant growth happened because of a combination of a very robust economy, with a rising stock market and a housing-market bubble. The low-interest rates made the cost of debt financing for debt-laden LBOs unusually inexpensive. There were readily available equity and capital, and there were even more of the latter than there were good deals to pursue. This all came to a rapid halt when the subprime crisis took hold and the global economy entered a recession in 2008. This also resulted in low-interest-rate due to the stimulative monetary policy. Whereas pursued by most central banks, credit availability dramatically shrank.
The dealmaking of LBOs fell to a near term low during 2009 and remained below the heady levels of 2004-2007 despite making a rebound in the years that followed. One company affected was RJR Nabisco, which used to be the largest LBO until 2006.
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