Andrew Greta's Business Development Blog

A recent article in The Economist did a post mortem on the 10-largest leveraged buyouts (or LBOs) of the year and found many were in trouble almost from the start. Lenders and companies both pushed the very limits to the point where businesses now walk a razor thin line where the tiniest misstep or earnings hiccup could plunge them into default.

To understand why deals like the giant TXU transaction (done by a consortium of brand name investors like Goldman Sachs and KKR), or Blackstone’s buyout of Hilton Hotels could now face the danger of bankruptcy, you first have to dissect the typical LBO to understand its anatomy.

A leveraged buyout is simply a method of financing the purchase of a company or asset using a significant portion of debt financing which is typically serviced by the operating cash flows of the business itself. A classic real-world example of an LBO occurs when a landlord purchases a rental property as an investment. The investor puts up a portion of the purchase price as equity in the form of a down payment, and the bank lends the rest. If the deal is done at the right price, the monthly lease income from the tenant more than covers the investor’s after-tax interest, principal, and maintenance costs with maybe a tickle of cash flow left over for cushion.

But that hardly sounds like a great way to get rich. Real estate (and other hard-asset businesses like heavy equipment, and utilities) generally grow with the overall economy at or around the gross domestic product (or GDP). Why would I look at an investment in a staid old asset growing at a steady but boring 3-5%, when I could sink my cash into the stock market or next high-growth VC-funded biotech company and perhaps make much more?

The secret is in the “L” part of LBO – or leverage. By using the bank’s money as a fulcrum, I can dramatically increase the power of my equity stake and reap huge gains (or losses) on my investment. To see how, remember that leveraged financing is typically in the form of a loan from bond buyers who are guaranteed a stated interest rate no matter how the company performs. As long as I pay my interest, the bondholders don’t get any upside (or face any downside) based on company performance.

So, if I buy my $1mm rental property (or oil rig, or fleet of leased railcars), with say 10% equity that means I ante up $100,000 and the bank (or bondholders) front the rest. If the investment rises in value just 10%, I’ve doubled my money (and this is ignoring any pay-down of debt you might choose to fund out of operating cash flows). The more leverage (i.e. debt) I can pile on, the more I stand to make on my equity investment so I have an incentive to push the limits – and banks are only too happy to lend in booming times awash with liquidity.

Unfortunately, if those initial cash flow projections aren’t right, the property bought at too high of a price, or if market conditions later impact asset values or revenue streams, the bondholders can be left holding the bag. This is what seems to be brewing for companies like TXU as their cash flow now looks insufficient to make their interest payments.

But, at the end of the day, the companies may still not be out of business. Most bondholders don’t have any experience actually running the companies they loan to (witness GE Capital’s ill-fated takeover of Montgomery Ward after a bond default as a classic example). So, when push comes to shove, most are likely to restructure the loans and give the company a chance at survival. And even in the event of an outright liquidation, hard assets tend to retain some value so it’s unlikely the lenders will suffer 100% losses.

While often overlooked in the glamorous world of growth investing, LBO specialists (often termed private equity), can quietly continue to do extremely profitable deals of 20% ROEs or greater based on fundamental cash-flows, and hard assets by focusing on areas and industries others might consider boring. But just like any deal, they aren’t foolproof money makers if over-enthusiastic bidders pay too much or are too optimistic in their assumptions.

Labels: Structuring

posted by Andrew Greta  # 9:46 AM