Why distressed companies are becoming takeover targets – Taamara de Silva

The recent resurgence of leveraged buyouts (LBOs) can be attributed to a combination of low interest rates and extensive quantitative easing while a multitude of opportunities to acquire assets at more reasonable valuations has also opened up.

Many companies have seen substantial growth in industries that specialise in healthcare related goods and services, with personal protective equipment (PPE) taking the lead while online sales and delivery business models have thrived. Others have been less fortunate as COVID-19 has spurred many corporates to start new businesses to stay relevant in the ‘new normal.’

Distressed companies – especially in sectors directly impacted by lockdowns – are at seemingly low valuations and as a result, become takeover targets for investors and private equity funds with access to low-cost funding.

While these deals are exciting, the gains (and losses) can be enormous; and the transactions involved can seem quite complicated to the untrained eye. But at a high level, the concept of an LBO is quite simple.

An LBO is a transaction where a corporate is acquired using debt as the main source of consideration. These transactions typically occur when a private equity (PE) company borrows as much as it can from a variety of lenders (up to 70-80 percent of the purchase price) and funds the balance with its own equity. While leverage increases equity returns, the drawback is that it also increases risk.

Matt Levine of Bloomberg defines an LBO quite simply: “You borrow a lot of money to buy a company; and then you try to operate the company in a way that makes enough money to pay back the debt and get rich. Sometimes this works and everyone is happy. Sometimes it doesn’t work and at least some people are sad.”

The first LBO wave began in the early 1980s with high-yield bonds (also known as junk bonds) invented by Michael Milken being an essential source of financing. Towards the early ’90s, leveraged financing was seen as a highly risky acquisition strategy, leaving little scope for liquidity issues in case the business became distressed.

However, in the early 2000s, the age of the mega buyouts surfaced amid a combination of decreasing interest rates, loosening lending standards and regulatory changes for publicly traded companies. The financial crisis in 2007/08 impacted mortgage markets and spilled over to leveraged finance.

Despite the lack of market confidence, the rebound gave birth to a whole new control mechanism, and private equity continues to be a large and active asset class. In fact, private equity companies with hundreds of billions of dollars of committed capital from investors are looking to deploy capital in new and different transactions.

From The Blackstone Group to KKR & Co., businesses have been pivoting from repairing the balance sheets of companies they own to hunting for new investments; and realising gains on businesses that have performed well during the pandemic.

So what would be an ideal candidate for an LBO?

In general terms, companies that are mature, stable, noncyclical and predictable are good candidates for a lever-aged buyout.

There are four main LBO scenarios – viz. repackaging, split up, portfolio and saviour plans. The repackaging plan means buying a public company through leveraged loans, making it private, repackaging it and selling its shares through an IPO.

A split up plan entails acquiring a company and selling its different units for an eventual dismantling of the enterprise.

Under the portfolio plan, there’s the acquisition of a competitor in the hope that the new entity becomes better through synergies.

And the saviour plan is about the acquisition of a failing business by its management and employees.

Given the amount of debt that will be strapped onto the business, it’s important that cash flows are predictable with high margins and a relatively low requirement of capital expenditure. This steady cash flow is what enables the business to service its debt with ease.

In today’s context, most small businesses are on the hunt for additional funds – and who can blame them? It’s only possible to remain competitive in the modern marketplace if there’s constant investment. This may mean selling the company or large swaths of its shares to a third party in order to capture much needed financing.

Leveraged buyouts are a fantastic option that can help many small businesses on the road to success. However, only a few entrepreneurs and potential financiers truly understand the concept.

Hilton Hotels & Resorts was famously acquired through a leveraged buyout that exceeded US$ 20.5 billion in debt financing, illustrating that even historically renowned mega corporations can also be purchased through LBOs.

Regardless of how leveraged buyouts are viewed, they will always be a strong option for the smart investor and savvy private equity firm – provided there are funds to be lent.