A Primer on Leveraged Buyouts

A common expansion strategy for businesses and private equity firms alike is to make acquisitions. Businesses gain control of another company by purchasing a majority of the company’s shares. 

However, acquirer companies often might not have the money to execute such expansion plans, especially for more mature companies. This is where leveraged financing comes in. Companies can use leveraged financing for several reasons, including funding business development, investing in a project, and implementing expansion plans or acquisitions. 

Leveraged buyouts (LBOs) is a common acquisition strategy that entails using debt to finance an acquisition. LBOs allow companies to make large acquisitions through borrowed money and without much capital investment. 

LBOs emerged in the early 1980s as an essential financial instrument for funding acquisitions. However, LBOs were seen as a highly risky acquisition strategy for several years because excessive speculation and loosely drafted agreements caused the companies undertaking LBOs to suffer a series of losses. 

The fear around using LBOs lessened when LBOs were modified to include balanced equity and debt amounts. While traditional LBOs had a 30:70 equity to debt ratio, revised LBOs came with a 50:50 equity to debt ratio. This alteration, along with reduced regulatory costs and increased stakeholder scrutiny, resulted in a mega-boom of LBOs in the 2000s. Although the ubiquity of this instrument was short-lived due to the 2008 financial crisis, the subsequent healing of the US economy made LBOs popular once again. Today, leveraged buyouts are a well-known acquisition strategy worldwide.

This article will highlight what LBOs are and discuss the five biggest LBOs in history.

 

Understanding LBOs

Today, LBOs are undertaken for three main purposes: to convert a public company into a private one, to transfer private property, and to spin out a subsidiary as a new, separate company by selling it. A leveraged buyout aims to combine two companies into a single stronger one without much capital investment. 

A typical LBO has a 90:10 debt to equity ratio. Given the high debt to equity ratio, bonds issued under LBOs are deemed extremely risky and called ‘junk bonds,’ which carry higher default risk than other bonds. Historically speaking, several LBOs have led to companies going bankrupt primarily because the debt to equity ratio was 100 to 0. Companies that undertook LBOs had such large interest payments that those businesses failed to meet their debt obligations with existing cash flow.

In an ideal scenario, the acquiring company, its investment partners, or another private equity company injects some equity into the LBO transaction. The company being acquired (target company/seller) can also use its assets as collateral for seller financing, Small Business Administration (SBA) backed loans, and other conventional bank loans). 

Now that we have understood the nuts and bolts of LBOs, let’s look at the biggest LBOs in history and how they turned out.

 

  • Energy Future Holdings (2007): $45 billion 

Formerly known as Texas Utility Company (TXU), Energy Future Holdings went private in October 2007 through a leveraged buyout scheme led by Kohlberg Kravis Roberts & Co. (KKR), Texas Pacific Group (TPG), and Goldman Sachs Capital Partners. These private equity firms acquired TXU and its affiliated companies, Oncor and Luminant Energy, for $32 billion-plus $13 billion in assumed debt. The deal was based on the speculation that electricity rates in Texas that were pegged to natural gas prices would increase as these prices rose, while TXU could manage its costs by generating electricity through less costly coal and uranium. However, no one foretold the decline in natural gas prices, and in 2014, Energy Future Holdings filed for Chapter 11 bankruptcy, proposing to split up its power generation and retail businesses. 

 

  • HCA Healthcare (2006): $33 billion

In 2006, Kohlberg Kravis Roberts & Co. (KKR), Bain Capital, and Merrill Lynch acquired most of HCA Healthcare, leaving just a 4.4% stake for the target company’s founders, the Frist family. Although HCA remained under private equity ownership until 2010, the new owners took the company public in 2011. In the public offering, HCA’s mounting profits earned Bain Capital a whopping $1.2 billion off an equity investment of just $64 million. 

HCA hospitals’ cash-flow-margin ratio was significantly higher than its local competitors before and after the LBO scheme. While other LBOs in history are a cautionary tale of bankrupt companies, HCA’s subsequent success after 2006 proved that LBOs could succeed with effective management strategies and wise decisions. 

 

  • Hilton Hotels (2007): $26 billion 

In 2007, the Blackstone Group, Bear Stearns, and Lehman Brothers purchased Hilton Hotels for $26 billion in a leveraged buyout deal. However, when the real estate bubble burst in 2007, the Hilton deal suffered as Blackstone’s partners, Bear Stearns and Lehman Brothers, fell apart. 

When Blackstone took Hilton public in 2013, things started turning around. In 2017, Hilton’s shares increased by 36%, and in 2018, Blackstone sold 15.8 million Hilton shares, generating a whopping $1.32 billion. The Hilton deal became one of the most profitable private equity deals in US history and a successful example of a leveraged buyout. 


  • JR Nabisco (1989): $31.4 billion

In November 1988, Kohlberg Kravis Roberts & Co. (KKR) acquired RJR Nabisco for $31.4 billion. When RJR’s competitor, Marlboro, cut the price of its cigarettes by 40 cents in April 1993 in a bid to out-compete low-cost brands, RJR had to follow through, slashing its cigarette price by half. While Marlboro had enough longevity to continue promoting its products despite suffering a loss, RJR Nabisco did not enjoy the same advantage due to its high debt. Eventually, RJR Nabisco gave in, selling its international tobacco business to Japan Tobacco for just $8 billion in 1999. This deal is one of the most well-known LBOs of all time, with a book and a movie - Barbarians at the Gate - based on its spectacular failure. 


  • Alltel (2007): $27 billion 

In 2007, Texas Pacific Group and Goldman Sachs purchased Alltel telecommunications corporation for $27.5 billion, with the equity investors contributing $4.6 billion and banks funding the rest of the transaction. In 2008, with corporate loans at record lows, the banks sold their debt at higher discounts. In the same year, Goldman Sachs and TPG were able to sell Alltel to Verizon for $28.1 billion, with $5.9 billion in equity and $22.2 billion in debt. According to the Wall Street Journal, the equity investors made a 28% return on their original equity investment while banks incurred losses by selling a $5 billion bridge loan to Verizon at a discount.

 

Is a leveraged buyout a good idea?

Leveraged buyouts have historically produced mixed outcomes. Some analysts contend that successful returns on LBOs are only possible in theory because companies bear debt obligations long after acquisitions. Others argue that striking a good balance between debt and equity can reduce the high risk associated with LBOs, making them an accessible and profitable financing strategy. 

Wherever LBOs stand in public opinion, one thing is certain. Companies that qualify for LBOs need reliable cash flows, effective management teams, and viable exit strategies. Otherwise, LBOs can become tremendously costly failures for even the most successful private equity firms, companies, and banks. 

 

Topics: funding, raising

Akshat Biyani

Written by Akshat Biyani