I watched the movie Barbarians at the Gate (1993) yesterday and was interested in understanding one of its central themes, the concept of leverage buyouts (LBOs).
The movie is based on a book written by the investigative journalists Bryan Burrough and John Helyar about the leveraged buyout of RJR Nabisco, a company that primarily sold tobacco and food products. The book in turn was essentially a compilation of a series of articles that the authors wrote for the Wall Street Journal.
The leveraged buyout of RJR Nabisco in 1988 was carried out in an environment that was critical of corporate and executive excesses. There was a bidding war for the buyout of the company.
RJR’s management team (whose President and CEO was Ross Johnson) worked with Shearson Lehman Hutton and Saloman Brothers, to submit a final bid of 112 USD per share. They were confident that their bid would beat any potential offer made be their primary opponent in the bidding war, Kohlberg Kravis Roberts & Co (KKR) whose managing partner is Henry Kravis. KKR’s final bid was 109 USD per share. RJR Nabisco’s board of directors chose to accept KKR’s bid despite KKR’s offer having a lower USD value. This was because KKR’s offer was considered to be guaranteed as opposed to RJR’s management team’s offer. This means that there was a risk of the actual share sale price being lower than the proposed 112 USD with RJR’s offer. A significant number of members on the board of RJR Nabisco were also supposed to have been very displeased with disclosures about Ross Johnson’s golden parachute deal in the proposed takeover. A golden parachute is a contract between a company and an employee that guarantees substantial financial benefits to the employee in the event of the employee losing his job as a consequence of the company being sold or merged.
A leveraged buyout is the acquisition of a company financed with a substantial portion of borrowed funds. In a leveraged buyout the acquisition of a target company is thereby carried out through financial leverage. The financial leverage of a company is directly proportional to the amount of debt financing that a company uses.
While every leveraged buyout is unique with respect to its specific capital structure, the one common element of a leveraged buyout is the use of financial leverage to complete the acquisition of a target company. In an LBO, the private equity firm acquiring the target
company will finance the acquisition with a combination of debt and equity, much like an individual buying a house with a mortgage. Just as a mortgage is secured by the value of the house being purchased, some portion of the debt incurred in an LBO is secured by the assets of the acquired business. Unlike a house, however, the bought-out business generates cash flows which are used to service the debt incurred in its buyout – in essence, the acquired company helps pay for itself (hence the term “bootstrap” acquisition). (Note on Leveraged Buyouts, Center for Private Equity and Entrepreneurship, Tuck School of Business at Dartmouth)
Risks of a Primarily Debt Financed Company Acquisition
- Financial distress due to unforeseen developments like a recession, litigation, negative trends in the regulatory environment. These developments could serve as impediments to servicing the regular interest payments and could even result in a default or liquidation.
- Bad management at the target company.
- Lack of alignment between the incentives of the shareholders in the company and the management of the company.
Advantages of a Primarily Debt Financed Company Acquisition
- Significant interest and principal payments will drive the company’s management to optimize performance and operating efficiency due to the “discipline of debt”. It thereby forces changes in managerial behavior.
- A private equity firm can acquire the company at a fraction of the target company’s total purchasing price as the debt ratio of the acquisition financing gets larger.
- The top management of the target company typically invest significantly in the target company as a part of the deal which ensures the alignment of the shareholders and managements interests.
This brief and informative “Note on Leveraged Buyouts” released by the Center for Private Equity and Entrepreneurship of the Tuck School of Business at Dartmouth is a must read to develop a reasonably comprehensive understanding of the history, theory, mechanics, and structure of LBOs.