Buying a business is a massive purchase for almost anyone. For this reason, purchases of whole businesses are often financed with debt. In a leveraged buyout, not only is the purchase financed with debt, but the business itself becomes collateral for that debt.
The practice of leveraged buyouts is controversial for many reasons. If it happens to your business or a business you invest in, what does that mean for you?
How a Leveraged Buyout Works
We’re all familiar with financing a large purchase with debt. The commonest one most people deal with is a mortgage. You put down only a small amount, maybe ten or twenty percent, and the rest comes from a loan. After that, the house you purchased is collateral for that loan—the bank will take it back if you don’t pay.
The leveraged buyout of a business happens in a similar way. The buyer, usually a private equity firm, puts down about 10% and borrows the other 90% of the purchase price, financing it with bonds. These bonds come with a high interest rate because of the high risk of default. The assets of the company are used as collateral for the loan, which means the purchased company becomes burdened with debt right at the beginning.
After the purchase, the purchased company has to service the debt taken on in its acquisition. This can be a significant drag on the business, making it harder for it to turn a profit. For this reason, only strong, profitable companies tend to be purchased this way. A struggling company would quickly go under after a leveraged buyout, leaving the buyers out their original down payment.
Why It’s Controversial
When you buy a house with a mortgage, your success relies on two factors. First, can you afford the mortgage payments? Second, will the house keep its value while you own it? Buyers regularly make a profit from their homes in the end. However, if you can’t keep up with the payments or the house loses value, the debt you took on to finance it will very quickly become a problem.
The same is true with a leveraged buyout. With such a high debt ratio, the company needs to stay profitable and expand. No matter how good the buyer’s plan to improve the business, an economic downturn or a crisis in the industry can decimate its profits. Without high profits, it can’t service the debt, so it has to start selling off assets. This can spell the end for a formerly thriving business.
Research shows that a leveraged buyout increases a company’s risk of bankruptcy tenfold: from 2% to 20%. Yet the private equity firm that carried out the buyout bears much less risk. Since the debt is on the purchased company’s books, it bears the brunt of the loss in case of bankruptcy. All the buyer loses is their initial equity stake—which might be 10% or less of the purchase price. Because they have so much less skin in the game, they might not be as motivated to avoid bankruptcy as the original owners.
Remember Toys R Us, Chuck E. Cheese, Neiman Marcus, and Hertz? All went bankrupt after leveraged buyouts. The buyouts saddled them with so much debt that they couldn’t weather market problems.
Reasons for a Leveraged Buyout
Despite the risks, leveraged buyouts continue to happen. They lost popularity some after the 2008 housing crisis, but they are once again on the rise. Why are they so popular, and why do sellers agree to them?
Mainly, sellers accept a leveraged buyout because it allows them to exit their business with the cash they want. They may also walk away with shares in the company, even though they’ve surrendered control.
Here are a few situations when leveraged buyouts are popular:
To take a company private
It takes a lot of cash to buy up all the public shares of a company and take it private again. A leveraged buyout can fund this move. Then, after reorganization of the company, a fresh IPO can allow it to re-enter the market.
To split a business into smaller companies
Sometimes a large conglomerate becomes inefficient. At that point, a leveraged buyout can make it possible to break up the company into smaller brands. Selling these smaller companies can recoup the initial cost of the purchase and pay off the debt.
To buy out the competition
Alternatively, businesses may want to consolidate in order to reduce competition and increase their market share. They make a bet that, once they aren’t competing with each other anymore, both businesses will do much better and pay off the debt.
What This Means for You
If you’re selling a business, it’s vital to think hard about all offers you receive. Should you take a lower offer in cash over a leveraged buyout? Is it better to sell to a partner than a large firm? It depends greatly on what your goals are. Do you want cash in your pocket now or the knowledge that you’ve given your company its best chance to thrive for years?The circumstances of every purchase are different, so you’ll need an expert, unbiased guide to go over your options with you. We can connect you with a business financial advisor with experience in buyouts and transitions. Contact us today and we will match you with the best advisor for your situation.