A leveraged buyout occurs when a firm is bought by a group of investors who borrow a large proportion of the money needed to buy a target firm.
Often the investors will use the assets of the target firm as collateral for borrowing money.
Leveraged Buyouts are often highly aggressive methods of taking over an existing firm. By borrowing against the assets of the target firm, private financiers can take over the firm with a minimal down payment.
Examples of Leveraged Buyouts
- In 1989, KKR were involved in a $31.1 billion dollar takeover of RJR Nabisco. – Adjusted for inflation, the biggest leveraged buyout
- Robert Campeau’s 1988 buyout of Federated Department Stores, this led to their bankruptcy.
- Hedge fund managers buy Toys R Us – in 2005. Led to a sharp rise in debt of company and bankruptcy in 2017.
Reasons for Leveraged Buyouts
- A private investment firm may feel it can run the target firm more efficiently. By gaining control they can make the firm more efficient and more profitable.
- Buying a firm with borrowed money helps reduce tax bill. Firms don’t pay tax on interest payments, they do if they transfer equity directly.
- By borrowing money, private equity firms have the potential to gain a greater rate of return on their investment.
Problems of Leveraged Buyouts
- The private equity firm involved could easily go bankrupt if the debt interest payments exceed the profit of a firm. For example, a recession may knock profitability or higher interest rates could unexpectedly increase the cost of borrowing money.
- Firms subject to leveraged buyouts see a large increase in corporate debt. Private equity firms who buy the companies may become more interested in short term gains from selling assets and charging interest to the target company. Many US retail giants like Sears, Toys R Us – were targets of leveraged buyouts, they saw rising debt levels which became a burden to profitability leading to their demise.
- It is unfair a private equity firm can use assets of the target firm to borrow money.
- It encourages ‘asset-stripping’
- Assessments of how profitable the target firm is (or how much scope for increasing profit) could easily be over-estimated.
- Managers and workers may react negatively to the hostile takeover.