Leveraged Buyouts in Investment Banking

Anyone working in the investment banking industry for a few years has definitely come across the term “leveraged buyouts.” It creates huge risks, as well as investment opportunities. Over the years, many investment banks have been involved in financing several big-ticket leveraged buyouts.

In this article, we will explain in detail what a leveraged buyout is, and the role played by investment banks in enabling leveraged buyouts.

What is a Leveraged Buyout?

In simple words, a leveraged buyout is a company buying another company (which may be several times bigger than itself) using a lot of borrowed money. We know the meaning of the word “buyout.” The usage of the word leveraged hints at the use of other people’s money. In simple words, if a company worth $10 million is purchasing a company worth $40 million using a lot of debt, then it can be called a leveraged buyout.

Now, the question arises about how can a company worth $10 million ever raise the $40 million required to buy the bigger company! This is where the investment bankers come in. They have created a different kind of business model for leveraged buyouts in which the money lent to the buyer is secured by the assets of the target company. Therefore, once the acquisition goes through, the assets of the $40 million company will be held as collateral until the debt is repaid.

It is easy to see why many companies like leveraged buyouts. If they do well, they earn a handsome return on their investment. However, if they don’t do well, then the loss is borne by the acquired company since its assets have been used as collateral.

Role of an Investment Banker in a Leveraged Buyout

Investment bankers are the experts in raising capital, and a leveraged buyout involves the usage of large amounts of capital. Hence, they have a very important role to play. The details of the role have been mentioned below:

• Investment bankers are generally engaged by both buy and sell sides during a leveraged buyout bid. On the buy-side, investment bankers help raise capital and also select the company to be acquired, whereas, on the sell side, investment bankers help at coming at the correct valuation and also finding the highest bidder for the company.

• Investment bankers deal with mergers and acquisitions on a daily basis. Hence, they are well versed in the methods used in valuing other companies. These investment banks have the resources required to perform a thorough credit check of the target company. A lot of times, companies have debt hidden off their balance sheet. Investment bankers are aware of the existence of these structures and help in giving the acquirer a true picture. They also carefully evaluate the business plan of the target company. They try to see whether there are opportunities for cost-cutting present, which can be used to support the increased debt burden, which will result from the leveraged buyout.

• Investment bankers often have to deal with the existing creditors of the target firm. This often includes bondholders as well as commercial banks. Sometimes existing holders decide to stay on, whereas other times, they want their money back since the risks become too much for them. Investment bankers have to negotiate with such lenders and, if need be, have to arrange funds for them to be paid back. In such cases, the negotiations are done to reduce costs, such as pre-payment fees.

• Investment bankers play a key role in deciding the financing structure of the new company. The role of the investment bankers is to ensure the usage of as much debt as possible. However, they have to keep in mind that the company does not turn cash flow negative because of increased interest costs because that would make it difficult for the investors to sell the company at a later stage. Investment bankers ensure the minimal use of equity so that the investors have minimum skin in the game.

• Lastly, after taking approval of the financing committee of the target company, investment bankers secure the financing. This is called “underwritten financing” because the job of obtaining the financing belongs to the investment bank. However, the target company has to maintain certain levels of cash as per the commitment given to the investment banks. The investment banks also provide bridge finance to companies undertaking a leveraged buyout. The details of bridge financing have been discussed in a separate article. It is important to understand that the services of investment banks are extensively used during the process. Hence, they are able to generate a lot of earnings in the form of advisory and underwriting fees during a leveraged buyout.

Every investment banker cannot pull off a leveraged buyout deal. It requires a certain amount of skill as well as expertise to do so. This is because most of the bonds issued as a result of leveraged buyouts are junk-rated. This means that the investors will not be easily willing to purchase them and may also ask for a higher interest rate. Seasoned investment bankers have deeply entrenched distribution networks which they leverage to sell these bonds.

To sum it up, leveraged buyouts are a specialized field in investment banking. Over the years, such transactions have turned out to be money-spinners for investment banks. However, investment bankers are required to have an excellent network to pull it off.