A leveraged buyout, or LBO, is when a group of investors attempts to take over control of a company using the company's assets as collateral for borrowing. The borrowed money is then used to buy stock from existing shareholders. It only works if enough stock is transferred to give voting control to the investor group. If the LBO is successful, the company's debt burden is substantially increased, but most LBO candidates are relatively free of debt.
When an investor group announces an offer for the outstanding stock of its targeted company, the price to be paid is higher than the current market price -- sometimes twice the market price. This causes the market price of the stock to rise as investors buy the stock on the assumption that the tender price will rise further, as is often the case. This benefits the shareholders who sell their stock in the market prior to the tender offer. If the LBO fails, as they sometimes do, those shareholders who did not sell are stuck with stock that has declined in value to its previous price, or lower.
One of the goals of an LBO is to sell assets of the company that are underperforming or otherwise blocking the efficient operations and growth of the company. An ideal takeover candidate has large cash reserves, little or no debt, and holdings of underutilized assets such as patents, trademarks, real estate and product lines. Revenues from the sale of these assets are used to pay down the debt incurred in the LBO, so the new company is more efficient and, theoretically, produces greater profits. Increased profitability can help raise a company's stock price.
Original Bond Holders
While original shareholders experience a potential profit, the value of any existing bonds in the company declines because of the additional debt incurred in the LBO process. It affects the credit rating of the company by increasing the debt-to-equity ratio, which is a prime factor in the credit rating process. Original bondholders experience a decline in the market price of their bonds, which is a problem if they want to sell before maturity.
The investor group behind an LBO is often comprised of dissident managers of the company, in addition to corporate raiders. The assumption is that the new management will be better and more productive than the old management, but this is not always the case. Whether the LBO fails or is successful, there is sometimes a post-LBO let down, which can cause the stock to trade lower in the marketplace. In making the company more efficient, employees are offered early retirement packages or other incentives to voluntarily terminate their employment, but lawsuits do arise and can be very expensive. Additionally, the sale of assets may not produce the revenues expected.
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