Leveraged Buyout - The new move

CA Maneet Pal

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http://www.capasricha.com/

Any technique to multiply gains and losses in finance is known as leverage. Buyout means when a firm purchases the controlling interest of another firm to takeover assets or its business operation or both.  Therefore, leveraged buyouts mean when and investor acquires a controlling interest in company’s equity, where a considerable amount of purchase value is financed through leverage. The assets are used as collateral security to the borrowed amount. These investments carry high amount of risk and therefore are not term as safe and menace-free. The purpose of Leveraged buyouts is to permit organizations to make large acquisitions without having to obligate a lot of capital.

Who made the first move?

Back in time as far back as January 1955 that’s when the first leveraged buyout took place. Mclean Industries acquired Pan-Atlantic steamship company, the transaction that took place was $7 million stock and $42 million borrowed by Mclean Industries. The cash and assets received from the deal were used to pay the debt by the company.

Characteristic   

• Strong cash flow

Since it has to raise a significant amount of capital through debt the company must ensure that it has a steady and predictable cash flow. This will make it easier for the firm to get hold of a loan and the cash flow will make sure that the regular interest payments on the borrowed capital will be met in time without any problem.

• Cut the unnecessary areas

The management is very skilled in the cases of LBO and has immense experience on hand, after acquiring the desired company they can cut a few areas and generate some cash by the means of may be closing down an unproductive department or reducing unnecessary expenses. This in turn can help a great deal in repayment of the debt.

• Set tangible assets against collateral loan

Assets will help get low interest financing loans which mean less cash to repay the loans in the future. The tangible assets include factories, property, cash inventory etc.

• Capital requirements

The acquiring party will need not worry about the capital requirements as the existing company will already have it. The extra expenditure on this area will not be needed. The focus would only lie on running the business into profits and simultaneously paying the debts off.

• Exit Strategy

The main focus of making this big risky investment is to gain handsome returns on equity and the after a few years of good returns sell off the company after LBO goes through. Without a good strategy the LBO can’t really take place.

Why choose Leverage Buyout?

• Cost savings

A public company has an obligation to produce annual reports with the numerous regulations required by the security and exchange commission. Its management must meet with the security analysts who follow the firm’s stock and deal wit h investor concerns. All these costs do not have to meet in LBO.

• Number of shareholders are less

Since the investors buy the existing shares of the company the number of absolute shareholders becomes less. Lack of public accountability leads to less time wasted in petty issues. And major part of the shareholders is the management itself so the progress and dedication put up in the overall business would be greater than having equity shareholders who simply receive returns on their investment and are not associated with the firm in any other productive way.  

• No shareholder intervention

Since the maximum number of stake holders in the company is the management itself there will no unnecessary shareholder meddling. The company wouldn’t have to deal with the issues of the shareholders they’d be able to concentrate more on the work targets and goals set for the near future.

• Tax benefits

A huge amount of capital is raised through debt and interest on the debt is deductible from the taxable profit. A significant amount of tax can be saved this way; the profit can be enjoyed by all or reinvested in the business. LBOs have this great advantage where their debt to equity proportion is more, the more the debt the greater the tax benefits.

Starting of a new age of LBO’s in INDIA

Leverage Buyouts are relatively a newer term in India. LBOs came into existence in the 1950s and 1960s where their business was limited to medium sized organizations. The real phase of LBOs started from 1970 and gradually emerged as a strong entity.  In India LBO works different from the rest of the world. Due to liberalization the general tradition followed in India is, companies acquires other companies and invest capital in it and then after some years subsequently move out with a high rate on return on their investments.

The very first buyout that took place in India was when Tata Tea acquired Tetley (US based) in March 2000. The transaction took place for 271million pounds. Vijay Mallya's UB Group's acquisition of Glasgow-based whiskey maker Whyte & Mackay is just another example.

LBOs operate in India in 3 Steps:-

Stage 1 is made up of raising the cash required for the buyout. The Investor Company funds about 10% of it and about 50-60% of the cash is raised by debt backed by the company’s assets.

Stage 2 consists of the organizing company buying the outstanding shares of the company and forming a new company. Or a private company purchases the assets of the company.

Stage 3 the funding aspects of the company being taken care of. The management works towards increasing profits and cash flows by reducing operating costs and altering marketing strategies to meet the set targets.

Root of LBOs - Private Equity firms 

The role of private equity firms in mergers and acquisitions has been more than significant. This investment of private equity firms in various business structures started as early as in the late 1970s. It started from just one firm learning, progressing and then guiding other firms in the same path. In today’s time lower interest rates, change in policies and regulations has facilitated private equity firms in acquiring and investing in businesses all over the globe. Largely these acquisitions are aggravated due to inflation, deregulation, commodity shortages, and demographic changes and so on.

Private equity firms are more active in LBOs than in any other segment. The favorable banking schemes and changing regulatory rules have facilitated their involvement in market. Although the risk factor in private equity mergers and acquisitions is high the success of reputed firms makes it very tempting and a viable solution when the firm is not working up to its efficiency or there may be several other reasons as well.

Kohlberg Kravis Roberts and company- Successful PE firm Specializing in LBO -KKR’s Indian Impact

The Aricent Group - Founded in 1991 as Hughes Software Systems, it’s among the largest privately held companies in the Silicon Valley, USA being the headquarters. The company is widely known for developing software and providing technology services to application, infrastructure and service providers with functioning in about 19 countries worldwide.

The private equity firm KKR who expertise’s in Leverage Buyout started its active operations in India since 2006. Their investments exceeded $1.1 billion in various companies in India. KKR acquired the India –US based company Aricent for $900 million which is said to be largest buyout in the history of India. Although Aricent is a California founded company majority of its employees are based in India (about 6500 out of 8000). A further $60 million has been raised by Aricent from KKR in the last round. KKR India is centered on providing Indian businesses with a steady capital structure. KKR has put forth tremendous support for Indian companies to grow by executing a variety a deals buyouts.

Other companies where KKR has actively invested are Bharti Infratel (2008), Max India Group (2009), Coffee Day Resorts (2010), Dalmia Cement/Avnija (2010) and JSW Group (2010).

LBO Analysis

An analysis is prepared to estimate the current value of the company to a financial buyer. This analysis will forecast the debt repaid by the by the company during the relevant period and make assumptions about the multiple earnings after which the business will be sold off after a period ranging from about 3 to 7 years. Constant returns along side with the firm’s historical results will result in LBO analysis providing an estimate of what purchase value a buyer will be willing to pay in accordance with the analysis.