What are Leveraged Acquisitions?

Saptaswara Chakraborty| North Eastern Hill University| 12th June 2020 

Introduction

After the advent of the globalisation, the domestic, as well as the global market, saw an increase in the number of acquisitions predominantly by the private equity firms. Leveraged acquisitions or commonly known as the leveraged buyout has become the favoured vehicle for the business acquisitions by the private equity firms, management buyout groups, etc. Investors or the private equity firms over the years have resorted to the means of the buyout because of the new innovation or technique through which they can invest on a large corporation or a company even though they might not have a vast amount of equity for such an acquisition. The basic strategy behind such an investment is to acquire the target company and its target management through a minimum equity share.

Understanding what a leveraged buyout is

A leveraged buyout is essentially a strategical process through which a company is acquired by a specialised investment firm through the process of using a small portion of debt financing. Under a leveraged acquisition, the leveraged buyout firms or what they are most commonly referred to as nowadays buys a majority or invests considerably thereby gaining majority control over the mature firm with a minimum share of the equity. The private equity firm then uses the cash inflow from the acquired firm to pay off the debt. This can be taken as a distinguishing feature from the venture firm, which mainly gains control over only a minimal amount of the firm which is young or individual emerging companies. The concept of the leveraged buyout became increasingly common in the year 1980 and also substantially increased in size. Jensen had predicted that the leveraged buyout organisation would eventually become the dominant corporate organisational form because of its high powered incentives for the private equity professionals with minimal overhead costs. Under such a buyout there is the existence of a ration of 70% debt and 30% equity. The assets of the company after having acquired are then used as collateral for the loans in addition to the assets that the acquiring company would also possess. The very purpose of a leveraged company is to allow companies to make significant acquisitions without having to commit much capital. A good example of it would be when anyone invests in a house after having taken loans. This house after having been bought is then given under rent; hence the amount which is received as rent is now used for the repayment of the loan.

Types of leveraged buyouts or acquisitions

• Management buyouts: According to the Hindu Business line, a management buyout or refers to the acquisition of the divested or a subsidiary company or of a privately owned firm in which the existing company also takes up a substantial portion of the firm or of the equity. Under such a situation, the owner may desire to sell the firm, but the management may think or envision for future growth potential and therefore are ready to take or acquire a considerable share of it. It is often found that the managers of the company may not possess the required capital for such an acquisition they are often compelled to seeking financial or even a strategic partnership for this purpose. In such a case, therefore it is found that the MBO is much more helpful than the LBO.
• Management buy-ins: A management buy-in is simply an MBO with the only difference being that the management teams are outsiders. Although similar to the MBOs, MBIs carry a higher risk as the incoming management are not much aware to the knowledge or the various details of the operation of the business similarly, they might also not know about the inner working of the company that is to be acquired. The advantage of such an MBI is that it has a broader chance for the others who possess a better knowledge than the existing management team. Similarly, such a team may provide for the company and also have a good reputation.
• Institutional buyouts– Institutional or the investor-led buyouts refer to the acquisition of a whole company or a division of a large group. The private equity firm may retain the existing management to run the company or even may hire a new team for its management. Such management may also run as a cumulative effort of both the internal as well as the external management.

Advantages and Disadvantages of the leveraged buyouts

Advantages

• This sort of buyout helps in getting rid of any areas or services for the product duplication. It can also reduce the operational expenses, which in turn can lead to an increase in profits.
•  This sort of buyout helps in increasing the buyouts as it helps in reducing the competition.
• A private equity firm would want to buy a smaller company with the objective in developing new technologies which may be beneficial for both of them.

Disadvantages

The most significant disadvantage of such a buyout is the increase in debts. A leveraged buyout is only successful if the debt is paid timely. Increase in the number of debt results in affecting the debt structure of the acquirer and may lead to an increase in the loan finally being bankrupt.

Conclusion

A leveraged buyout is, therefore, a very beneficial way of accessing the market, thus reducing the competition. It is the new vehicle as has earlier been mentioned, which has resulted in the investors in gaining control over mature firms with a minimum equity share. However, this buyout comes with a risk that is of an increase in debt. Hence it is essential for any investor to understand the risks before venturing into it thoroughly.