Private Equity And Leveraged Buyouts

By M. Isi Eromosele

A leveraged buyout (LBO), which is a subset of Mergers & Acquisitions (M & A) activity, is a strategy involving the acquisition of a company, using a significant amount of debt financing.

LBO deals are dominated by private equity transactions, and the share of debt in such deals can be as high as 90 percent, but a share of 65–70 percent is more common.

Private equity, in broad terms, refers to the holding of stock in unlisted companies. Categories of private equity investment include venture capital, buyouts and restructuring.

Venture capital provides equity funding to younger, small and relatively high risk companies with strong growth potential. Leveraged buyouts and restructuring deals, on the other hand, are usually targeted towards more mature firms where substantial gains in operational efficiency are likely to materialize.

Buyout deals are structured by using a significant amount of debt financing to acquire the target company, with the assets of the acquired firm serving as collateral. The equity capital invested in the acquired firm by deal sponsors is generally recouped after three to seven years using one or more of the following options.

Dividend Recapitalization | Selling the firm to corporate buyers | Selling the firm to private equity firms | Holding an Initial Public Offering

Private equity also have a role in providing “charge capital” through restructuring or refocusing an existing business.

Private equity is now categorized as an alternative investment, an asset class that is often thought to offer improved risk-return trade-offs and diversification benefits relative to investments in publicly traded equity.

Public vs. Private Equity

Focus has been on the advantages that private equity controlled businesses offer over public ownership. One potential advantage is that private ownership of a firm may mitigate some agency problems in corporate governance.

A private equity investor with a controlling interest in a firm may be able to provide a high level of management oversight and put in place an effective corporate governance structure.

In contrast, some large investors in public companies are restricted under securities commission regulations from active management participation or board representation as these would make them insiders.

Some techniques for improving firm performance include direct oversight of managers by investors, well designed pay-for-performance packages for managers and preventing the cross-subsidization of weak business units by strong ones.

Private equity firms also seek to limit inefficient use of free cash flows. Managers of public companies that produce large operating profits but lack good investment instincts may have strong incentives to hold on to the excess cash and invest it in low-return projects rather than returning it to shareholders.

In firms acquired through a Leveraged Buyout (LBO), a larger share of operating cash flows is used to service debt payments. The private equity model may promote long-term decision making as the requirement to meet short-term earnings expectations is avoided.

The ability to realize substantial profits on buyout deals early through dividend recapitalization also creates incentives for General Partners to act in a manner that is detrimental to the interest of the debt holders.

Recapitalization also reduce the size of the equity stake, diminishing the incentives to monitor the acquired firm. The view that private equity can resolve conflicts in corporate governance and foster greater efficiency of firms has come under increased scrutiny lately.

Particularly, it has been observed that private equity firms have recently sought an early exit strategy, much like activist funds, and that higher returns have been obtained essentially through increased leverage.

As companies controlled by private equity firms escape market surveillance, there is also some concern that capital markets’ efficiency may be adversely affected when large corporations are taken private.

This, in turn, might reduce investment opportunities to retail investors or even pension funds that do not have the expertise or mandate to invest in private equity.

However, considering that the market capitalization of LBO deals has been less than 2 percent of public stock market capitalization, this concern seems exaggerated.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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