Causes and consequences of leveraged buyout
Leveraged buyout is way or method of a small company buying a large company, using fund that is borrowed based on the value of this larger company. The principle behind it is to increase the size of leveraged buyout company, market size, competitive strategy and increase profit through tax incentive. There are a number of implications for leveraged buyout company since it does not have sufficient cash to pay the debt it can lead to the collapse of leveraged buyout company it is forced to strain to pay debt, and due to the increase of interest employee can go without their salaries. Unless leveraged buyout is well planned and managed, for the company to fail is inevitable. According to Jennifer Lindsey, the entrepreneur’s cruise to capital “the deal to succeed, it should be taken when interest are low and the inflation rate is high, which make assets more valuable” Leveraged buyout company should use experts to transact the transaction so that to avoid frustration since the expert will provide necessary skills and knowledge, since the loan is repaid through the company’s future cash flow or the sale of the company assets. Timing when the purchase of the large company is very vital to the leveraged buyout company, before purchase is done the cash flow of small company should be monitored to ascertain whether it will be able to service the loan which attracts high interest due to time changes.
Mostly leveraged buyout is seen as short term strategy then long term, because using the loan or debt to buy a large company has to affect future cash flows of the leveraged buyout company in the long run but in the short run can be seen as importing and increasing the market share of purchasing company and due to increase of the business size the employee productivity will increase and employee commitment to the company’s goals since they know that increase productivity and increase of the company size will lead to high pay. It is advisable before purchase (leveraged buyout company) the company should have at least twice as much cash flow as will be required for payment om the proposed loan. The leveraged buyouts loan should be reduced to 50% of overall capitalization within one year and should be completely repaid within four or five years.
Comparison should be made between leveraged buyout company that which has implemented LBOS to those that have not . The analysis should be based on sources of gains from leveraged buyout as well as the cost that can arise from the large amount of debt included in their financial structure consistent with the free cash flow. Theory states that firms that initiate LBOS can be characterized as having a combination of unfavorable investment opportunity and relatively high cash flow.
Companies which have high cost of financial distress are less likely to succeed to do leveraged buyout since most of cash flow will be used to pay debt and there will be no funds to run the firm. The firm will be seen at all times as geared and investors will be running away from it to avoid losing of their funds in case of the company collapse. For a company to succeed in business it should have well balanced financial structure. There are complaints from employee’s who argue that leveraged buyouts affect the employees’ salary but according to Michael’s theory ‘managements that fail to pay out excess cash, instead investing it in diversifying acquisitions or in low pay-off projects, will cause the stock price of their companies to be below their optimal value, creating a value gap”.Which mean that Leveraged buyouts can not be used as excuse for employees to go unpaid,since the value of the leveraged buyout firm does not go down but it increase, so the leveraged buyouts firms should even pay high prices. These force efficiencies eliminate the value gap and create net economic gains for shareholders”. Although this is a severe solution that exposes the firm to financial distress in the few years after the leveraged buyout, the evidence is that the leveraged buyouts and leveraged restructuring of the created large net gains for shareholders. In market for corporate control unprecedented activity and change during the eighties as the largest public companies became frequent targets of hostile takeovers.
Leveraged buyout is seen to have some advantages and disadvantages. Some of the advantages include after post leveraged buyout the shareholders can increase abnormally due to increase of business, the productivity will increase and the leveraged buyout company has advantage of acquiring big company, this will provide confidence on those who want to invest in that company hence increase of the market share which leads to high return on investors, there is wealth transfers from old public shareholders to the buyout group, this will occur after the post leveraged buyouts since the larger company will be bought by small company all the wealth that is all asset of the acquired company will go to the smaller company that purchases company once the transaction is completed.
All wealth of the acquired company will move to the leverage buyout company hence increasing it whether by transacting with from large company, this will boost the asset and profitability of the leveraged company and restoring confidence on the interests, there is also wealthy transfers from public shareholder to he investing group. Once the transaction of the purchasing is complete the company which had public shareholder will end up on the investor group hence increasing investor profitability which has been acquired.
Wealth creation from improved incentives for managed decision making, management and employee will be committed to he company since they earn their living that is salary from the company due to the increase of the company the management will whisk extra to provide necessary skills and experience in decision making so that the company will grow hence increase of their salary and benefits. Management, try to come up with brilliant ideas on how the company should be run so that to increase wealth which will lead to increase of their salaries also the employees get committed to increased productivity for the pay rise in return. Lastly leveraged buyout company get wealth from the government due to fix shield which come as result of debt of the company. The increased level of debt that the new company supports after the leveraged buyouts decreases taxable income, leading to lower tax payment, therefore the interest tax shield resulting from the higher levels of debt should enhance the value of the company. This does not mean that every small company to go for leverage buyout so that it can get all the above advantages, if there are not managed properly there are likely to fail terribly from the onset of the new formation of the company that post leveraged buyout.
Any company wants to purchase a large company should consider its market share , its cash flow and the level of financing that new company that is the amount of loan to be paid and the period the loan will be paid.
Some of disadvantages of leveraged buyout include cash flow problem, if the company’s cash flow and the sale of assets are insufficient to meet the interest payment arising from its high level of debt, the leveraged buyout is likely to collapse and the company may go bankrupt. Cash flow of any company is very important before leveraging buyout is done because cash flow will determine whether it will be enough to service the loan (debt) and the company run without interruption of funds. Insufficient cash flow will lead any company to collapse if not managed properly, management can purpose a leveraged buyout only for short term personal benefit or profit. This occurs when the management wants to meet short term benefits and forget about long term benefit.
Management can be advisable on short term benefit so that their benefit to be met and not advise on the long run of the company which will mean that on the short term the leveraged buyout will work but fail to work on the long term hence leading to collapse of the company.
Managers or managerial should look long term for leveraged buyout to succeed, another disadvantage is that paying high interest rates on leveraged buyout debt can damage a company’s credit rating due to high interest rates by leveraged buyout other companies will fear granting or extending credit terms to the leveraged buyout company because it has high loan or debt it is paying and the debt in attracting high interest, the other companies will fear that their debt will not be paid making the leveraged buyout company to be liquidated since it can not be able to pay its debts.A leveraged buyout can be dangerous for companies that are vulnerable to industry competition or volatility in the overall economy. If the company does fail following a leveraged buyout, this can cause significant problems for employees, as lenders are usually in a better position to collect their money. If the leveraged buyout is done in systematic manner employee and management will lose their jobs which will lead to the problems in the society in general since employees will be left without jobs hence lack daily meals.
There should be proper forging or close partnership between management of leveraged buyout, investor lends who finance its acquisition for leveraged to succeed, since management are required to give proper skills, knowledge and expertise not forgetting proper decision making. Investors play vital role since they provide funds which management invest in the company which is required to be managed properly.
Two sides argue about leveraged buyout, one group argues for another against. Those argue against, they say leveraged buyouts transaction harm the long term competitiveness of the firm involved. The firm is unlikely to have to replace operating asset since its cash flow must be devoted to servicing the leveraged buyout related debt, hence the equipment plant and property of leveraged firm is likely to have aged considerably during the time when the firm is privately held, expenditure for repair and maintenance may be stopped as well and possibly development expenditures have also been minimized hence the future growth prospects of this firm may be significantly reduced.
Others argue that leveraged buyout transactions have a negative impact on the share holders of the firm. They argue that in most cases leveraged buyout leads to down sizing of operations and employee end up losing their job, this occur when the acquired company ceases to operate most of its employees are deployed so that the leveraged company to have a few employees which it can manage to pay and control and it is seen as strategy to be better placed, that is to reduce unnecessary expenses like paying salary. For any company to increase profit it must reduce expenses which are unnecessary. Some of the leveraged buyout have negative effects in the communities in where the firm is located.
Finally argue that short price gains ignore the economic loses that the overall and leveraged buyouts imposed on other groups connected with the target firm.
For leveraged buyout to be done well analysis and preparation should be done. Critical issue of public policy, long term strategies must be put in place to avoid difficulties or break up soon after initiation. Also successful operation should be looked at, before leverage is done thorough analysis should be made on purchaser (leveraged buyout) company cash flow which is very vital and the employees should be given jobs elsewhere other than being send home ,which will frustrating to the family and community in generality is advisable for any firm or company which want to leverage to do consultation before taking such crucial investment ,which can totally affect the business of the leveraged buyout.
1) CFO Magazine 1, 2002
3) Michael,J. Theory in Management (2001)
4) Jennifer Lindsey, the Entrepreneur’s Guide to Capital (2002)