Company Succession: Leveraged Buyout
The well-publicized success of the Gibson Greetings acquisition in 1982 marked the beginning of the first boom period in leveraged buyouts (LBOs). Based in Westlake, Ohio, Gibson Greetings is the world’s second-largest greeting card company, right after Hallmark Cards. The company specializes in paper greeting cards, electronic greeting cards, party products and favors, and other electronic content like ringtones.
Founded in 1850, Gibson Greeting Cards became a corporation in 1895; it was acquired first by CIT Financial Corporation in 1964, then by RCA in 1980. By 1984, Gibson Greeting had sales of $304 million, making it the third-largest greeting card company. RCA decided to sell Gibson Greeting Cards to Wesray Corporation; its price was $81 million.
The Deal Details
Twenty percent of the company remained with Gibson Management. Wesray and Gibson stockholders invested $1 million. Other funds came as loans from GE Credit Corporation ($40 million) and Barclays American Business Credit ($13 million). Gibson Greeting raised the rest of the money by selling and leasing its manufacturing and distribution centers, making the actual price $54 million. GE Credit Corporation purchased 2.3 million shares for 14 cents per share in addition to interest and dividends.
Just 18 months after the deal, Gibson cashed in a $290 million IPO, taking its share price to $27.50. The colossal success of Gibson Greeting initiated the boom in leveraged buyouts.
The Basics of Leveraged Buyout
When a buying company doesn’t have the working capital to pay for an acquisition, it sometimes uses a leveraged buyout to complete the transaction. Borrowed money finances the buyout to pay for the investment. The contract usually has a high debt-to-equity ratio for which a high share of the purchase price is paid by borrowing against what is paid outright. The usual ratio is 90 percent debt and 10 percent equity. The high-risk bonds issued for the buyout are known as junk bonds.
The buying company usually finances the deal by taking loans against its assets and uses the target company’s future expected cash flow as collateral for the loans. Using this proven acquisition strategy, the buyer purchases another company without committing a lot from its funds.
Top Reasons Behind LBOs
To make a public company privately owned.
According to data published by Dealogic in Institutional Investor, “Deals involving public companies being taken private by private equity sponsors in 2019 were valued at $69.6 billion, compared to $54.3 billion total in 2018. Dealogic also noted that if the volume of deals continues, 2019 will be the most active year for privatization in the US since 2007, before the financial crisis.”
Privatization offers several advantages since it’s challenging to take care of day-to-day business activities and plan for long-term success while managing the demands of the volatile market conditions. Many companies face numerous issues due to uncertain markets that affect overall sustainability and business governance. Moreover, privatization offers more freedom to execute long-term strategies toward value and growth. Companies also free themselves from numerous administrative, financial reporting, regulatory, administrative, and corporate governance laws to which public corporations must comply. These mandatory activities tend to shift the management focus away from critical operational activities.
For example, the Sarbanes-Oxley Act (SOX) of 2002 imposes several compliance rules on public companies. SOX mandates that all levels of publicly traded companies apply internal controls. The most tedious part of SOX is Section 404, which requires one to implement, document, and test internal controls at all company levels over and above financial reporting.
To form a new company by selling a portion of an existing business.
Sometimes a parent company spins off a part of its business when it’s profitable to do so. The new company receives a separate management structure; however, it retains its parent company’s assets, human resources, and intellectual property rights. The newly formed company has a more significant focus on specific products and services, increasing returns for its shareholders.
Critical reasons for distributing/selling the company include:
- Increased focus on resources
- Efficiently manage business divisions with long-term potential
- Restructure a part of the business that is headed in a different direction and has other strategic priorities
- Get acquired by a buyer who is keen to buy only a segment of the business
Sara Lee & Coach Inc. Spinoff
The US’s largest maker of frozen baked goods, The Sara Lee Corporation, filed to spin-off from leather manufacturer Coach Inc. The total value of the stock sale was $140 million.
Coach Inc. was a renowned manufacturer of designer handbags, outerwear, gloves, and scarves with stocks trading in NYSE. The spin-off resulted from Sara Lee’s strategy to trim down businesses acquired in the last quarter of the century. The company sold approximately 7.38 million shares to public investors at $14 to $16 per share and raised almost $99 million after paying the parent company.
After the IPO, Sara Lee refocused on smaller consumer products like baked goods, coffee, Playtex, and Hanes undergarments. Coach used the proceeds from the IPO to pay off the $190 million debt it owed to Sara Lee due to the spinoff.
To transfer private property, especially in the case of small business ownership.
Upon having reached their retirement age, small business owners may wish to relieve themselves of their businesses. Still, they cannot find a corporate buyer or might not want to sell their business to another company. The buyers can then either be the company’s employees or business associates who have a longstanding relationship with the business owners. In such an instance, the business buyers rely on a leveraged buyout since they have limited equity to self-finance the whole business deal. This also applies when an investor group buys a privately held business.
Kinder Morgan Takeover Consortium
Houston-based Kinder Morgan Inc. (KMI), a pipeline operating company, was bought out by investors led by its co-founder Richard Kinder. The investor group included KMI co-founder Bill Morgan, Goldman Sachs Group, Carlie Group, Riverstone Holdings LLC, and American International Group (AIG).
The company made history in 2011 when it went public as the largest American, private-equity-backed IPO.
Planning a Leveraged Buyout
Once the buyer has identified a potential purchase target, it’s time to do some serious calculations. Ask yourself these questions to understand the complexity of the acquisition.
- Is the target company stable? What are the chances of the business tanking a few years down the road? This is the most crucial question, as it can seriously wreak havoc on your debt payback timeline.
- What are the target company’s financial forecasts? If the company does not have one, you must hire an expert in the specific field of business to draw one up.
- Is the business’ current cash flow steady and predictable? The acquisition should be able to pay off the borrowed debt.
- How much debt can you realistically afford? Overestimation can lead to profound financial implications.
- What is the interest rate against all borrowed capital? A higher rate of interest will slowly erode profit margins.
Look at all the scenarios of LBO by running a sensitivity analysis to uncover variables that can impact your financial projections.
Pros and Cons of Leveraged Buyouts
Pros: Leveraged buyout model offers numerous benefits
- The most promising aspect of an LBO is that debt does all the work for you. Even though you have to invest your capital, it is significantly less than what you invest in a traditional buyout.
- If the business acquisition does not yield promising results and you cannot pay off the debt, your finances and company are safe.
- Since the acquisition is financed by debt, your company receives numerous tax benefits.
- Buyers usually get an excellent ROI on the equity they put in the business.
Cons: There are several disadvantages of an LBO to consider:
- The most significant burden of an LBO is the massive debt acquired along with the company. If the company profits do not fulfill projections, paying off the debt could be a problem.
- Most of the acquired business’ cash flow is used to make debt payments, reducing its ability to replace and maintain assets.
- Sometimes, the target company implements cost-cutting measures to keep up with debt payments, e.g., curtailing the R&D budget.
- When the leveraged company has to downsize its operations, that may put many employees out of work.
The leveraged buyout is a viable business exit strategy in several situations. It’s best to weigh all the pros and cons before making a final decision. If all the right conditions are met, then LBOs lead to significant financial rewards in the long run.