A. INTRODUCTION:
A Leverage Buyout (“LBOs’), simplistically stated, implies the acquisition of controlling interest in a company, where the purchase price (or a majority of it) is financed through leverage, i.e. borrowing. The borrowing is often done using the target company’s assets as collateral. LBOs were a rage in the 1980s when promoters indulged in large-scale buyouts using this route. A classic example of this was Minnesota-based RJR Nabisco’s takeover by private equity giant Kohlberg Kravis Roberts & Co. Lp (KKR) in 1988. Among Indian firms, the Tata group has used this route. In 2000, Tata Tea Ltd became one of the first Indian firms to undertake an LBO while acquiring Tetley in the United Kingdom. Management Buyouts also referred to as MBO, refer to a situation when the Promoter/management of a company purchase a controlling interest in the business from existing shareholders. In most cases, the management will buy out all the outstanding shareholders because it feels it has the expertise to grow the business better if it controls the ownership.
B. STRUCTURING THE DEAL FOR LBO OR MBO:
In a classical leveraged structure, the acquirers (being the managers) will acquire the entire stake of the target (or at least a large portion of it), for which they will obtain debt financing from lenders or financiers. Promoters / Management may also have to commit some capital, but that is relatively minor compared to the large finance obtained through leverage. Here, unlike in the case of private equity-type transactions, the Promoters / Management do not have to cede shareholding to an outside entity such as the private equity players. However, as security for the repayment of the financing obtain, they would offer as security the assets of the target company. It may be noted that the new Companies Act, 2013 does not allow a public company to provide security for the acquisition of its own shares and consequently restricts the ability to undertake a typical leverage buyout.
C. CHARACTERISTICS OF A GOOD LBO CANDIDATE:
The following characteristics define the ideal candidate for a leveraged buyout. While is it very unlikely that any one company will meet all these criteria, some combination thereof is in need to successfully execute an LBO:
- Strong, predictable operating cash flows with which the leveraged company can service and pay down acquisition debt.
- Well-established business and products and leading industry position.
- Moderate CapEx and product development (R&D) requirements so that cash flows are not diverted from the principal goal of debt repayment.
- Limited working capital requirements.
- Strong tangible asset coverage.
- Undervalued or out-of-favour.
- Strong management team.
- Viable exit strategy.
The returns in an LBO are driven by three factors which are as follows:
- De-levering (paying down debt);
- Operational improvement (e.g. margin expansion, revenue growth);
- Multiple expansion (buying low and selling high).
D. POTENTIAL EXITS:
All LBO acquisitions are made with the goal in mind of improving the company, paying down debt and selling the company for a handsome profit. Thus, it is important, when evaluating a potential LBO, to consider the exit opportunities that may be available for the company when the time is right, and an appropriate exit strategy should be developed
- Sale: Can sell the company to another private equity firm or a strategic investor.
- IPO: This is usually not a sale of the company; however it offers an opportunity to realize a significant return on your investment.
- Recapitalization: The equity shareholders may recapitalize by borrowing new funds to re-leverage the company.
E. RISK:
- For the Promoter / Management who has levered: In addition to the operating risk, assumed risk arises due to significant financial leverage. Interest costs resulting from substantial amounts of debt are “fixed costs” that can force a default if not paid. Furthermore, small changes in the enterprise value of a company can have a magnified effect on the equity value when the company is highly levered, and the value of the debt remains constant.
- Debt holders: The debt holders bear the risk of default equated with higher leverage as well, but since they have the most senior claims on the assets of the company, they are likely to realize a partial, if not full, return on their investments, even in bankruptcy.
F. SUMMARY OF LBO CONSIDERATIONS:
1. Parameters
a. Range
- Equity Returns – Typically range between 20% – 30% IRR.
- Capital Structure (Leverage)- Typically, 1 Loan to value.
- Time Horizon to Exit – Typically, 3-5 years.
G.OTHER ISSUES:
- LBOs can also go bad and the management may lose company as the “funder” would be ruthless in case of defaults. Expansion may also go for a toss as the investor may not allow for an increase in exposure of debt into the business. It’s good to do LBOs but getting out of it successfully is the biggest challenge. The business being IPO able / gateway for smooth exit is the biggest requirement for LBOs. Lot of “special situation funds” are operating in India which are ready to take the risk of funding if the promoter is dynamic, the industry outlook is positive, EBITDA is up and growing and the company’s exit route is certain. During the due diligence process, the financial sponsor evaluates the characteristics of an LBO candidate (including its strengths and risks). The target becomes an LBO opportunity only if it can be acquired at a price and using a financing structure that generates acceptable returns with a viable exit strategy.
- Overall, LBO / MBO transactions do provide interesting possibilities for buyouts, but there are existing challenges under Indian law which need to be overcome before leveraged structures can be used to give effect to these transactions.
Author: Prashant Jain, Co-Founder & Partner.
Disclaimer: The content of this article is intended to provide a general guide on the subject matter. Specialist advice should be sought about your specific circumstances. For any queries, the author can be reached at prashant@samistilegal.in.
Updated as on July 20, 2018
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