Denice R. Preston
The fully leveraged buyouts have become among Wall Street’s more popular and well-publicized deals. However, their success depends on the ability to comprehend a company’s potential and its capability to bargain the best conditions for a purchase.
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Revenue Growth
Strategies based on revenue growth involve buying a company and increasing its revenue with a similar expense ratio, which results in a rise in the company’s earnings before interest, taxes, depreciation, and amortization, or EBITDA–and later refinancing it or selling it for the exact price (but on a more excellent EBITDA basis).
Expense Reduction
These strategies depend on the implementation of cost-cutting plans. Like the revenue growth model, the modifications are designed to increase EBITDA and ultimately lead to a sale or refinance at the same price (but on a more excellent EBITDA starting point).
Financial Engineering
In a way, the primary aspect that defines the term LBO is modifying the company’s capital cost by implementing a new financial structure, regardless of whether the company’s business operations (revenue and expenses) alter. Three examples of the strategies used in financial engineering include:
Reduce the business’s estimated cost of capital by acquiring a greater quantity of credit (or other money more efficient) that was in place before the acquisition, resulting in a more significant equity yieldRe-calculate a company’s assets to reduce capital expenditures through fraudulent financing transactions, for instance, by leasing real property or capital assets, selling and licensing crucial intellectual property or other assets that the company might manage, or developing more aggressive plans for working capital.
Combine an entity with other companies or assets owned by the investor and increase its size to the point that the market will accept a more excellent price for the combined business, also known as a roll-up method and is a standard method in the retail industry for instance, one could typically purchase franchises at less than the cost of single stores, and sell them at a higher value when a certain amount of critical mass is achieved in terms of the number of stores operated by the business.
Market Timing
A company is purchased with the belief the value of equity at which it’s priced will rise and give the possibility of a refinance/sale with better terms than those available in the present market.
While this strategy must be mentioned, and ultimately, the expectations of market prices affect the investment process of all kinds, My experience is that I’ve yet to meet an investor who can consistently forecast price fluctuations for long periods. (If you’re one of those, please contact me. I want to invest.)
Market Beta
Market beta is comparable to market timing in that the investor using the strategy relies on market forces rather than changes in the asset market to generate returns. However, the difference lies in that a market beta investor is not concerned about a company’s future growth prospects and the changes in market prices; however, they believe that exposure to markets for prolonged durations has historically produced results. The market beta investor takes the mindset of an index-fund investor seeking to diversify their investments and relying on the expansion of assets generally to generate earnings.
An LBO transaction might involve an assortment of all or all of these elements in various amounts, and it’s beneficial to ask yourself when looking at the possibility of investing, “Which of these things am I relying on for my returns?” Although this is a rumor, from my experience, the first three factors are much more easily controlled than the last two, and plans that involve trading the market or simply being in the game never yield alpha.
Tax Shields and Loan Covenants
Although most strategies for a successful LBO acquisition are pretty simple (at most conceptually, though they aren’t practical), few aspects aren’t as straightforward. According to me, the unintentionally titled tax shield is the more crucial of the latter. Although I am not a fan of the name, I will refer to it in the remainder of this post because it’s widely used in LBOs. I would much prefer the more descriptively titled tax transfer or tax reallocation, which will better reflect the fundamental nature of this element.
The principle behind tax shields lies in the fact that, in the majority of instances, the corporation has to pay tax on its earnings (which are ultimately the equity holders of the company), not on interest that is paid to lenders, which are thought to be an expense for the business. The term”tax shield” comes from the idea that when a company is in more outstanding debt and consequently uses a more significant portion of its operating profit to pay interest, the gains are protected from taxation.
Problems with Tax Shields
First, having a situation in which the business you manage has a lower profit and declaring it a shield would be somewhat sloppy. Furthermore, even though companies may not be required to be taxed on interest, a lender will. The interest income earned will be taxed and typically at a higher rate. In essence, what happens is that the obligation of taxing a percentage of a company’s earnings is shifted to the lender (a transfer, not as a shield). It is also possible to ask what a lender would like to receive compensation for this transfer.
This is a great time to change the lender’s view and the importance of this in the context of an LBO deal. As you might have guessed, the initial word in LBO is leveraged, which is basically what the game is about. Although lenders come in a variety of kinds as well as sizes, the market overall is responsible for pricing credit risk. This is why low-risk loans usually being offered with a minimal spread over the market’s risk-free rate, with high-risk loans coming with a more expensive rate and possibly having the equity-related component or a convertibility feature, which allows the debt to receive similar returns to equity.
In conjunction with the risk-based pricing are the terms based on risk. What I refer to when a lender offers an unsecured loan, they likely have a few restrictions that are not guaranteed, few reports, as well as a large amount of freedom to the borrower. A lender providing loans with higher risk may need various types of covenants, guarantees, and reports. This is understandable because the higher-risk lender will require additional assurances and alignment of incentives from a company’s owners and affiliates. They’ll be looking to limit the types of actions a company can do and timely information regarding the business’s financial health.
