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Accounting for Rising Leveraged Buyout Activity

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Accounting for Rising Leveraged Buyout Activity E ACCOUNTING FOR RISING LEVERAGED relative to their capital buffers. However, some BUYOUT ACTIVITY vulnerabilities were found such as the fact that some banks might be materially exposed to The value of global corporate leveraged buyout underwriting risk in LBO deals.2 In addition, (LBO) transactions has expanded substantially some operational risks may arise from the fact over the past couple of years. Many of the deals that the functioning of the LBO market is rather have been characterised by high debt-to-equity dependent on recently developed techniques for ratios, which have reached levels comparable credit risk transfer. to those seen in the US LBO boom of the 1980s. Putting recent developments into historical The purpose of this Special Feature is to perspective, this Special Feature recalls the highlight specific financial stability issues implications of theories of optimal capital related to the debt financing of corporate structure for recent developments and it takeovers, an area in which banks have been explains how recent LBO activity has been playing a particularly important role. facilitated by recently developed techniques for credit risk transfer. From a financial stability SEQUENCES IN LEVERAGED BUYOUT perspective, there are some concerns as it TRANSACTIONS cannot be excluded that intense competition to win new deals in the pursuit of fee income, In broad terms, an LBO can be defined as an together with the strength of the bargaining operation involving the acquisition, friendly or power of private equity firms in negotiating hostile, of a firm using a significant amount of terms for LBO transactions, may have led to an borrowed funds (bonds or loans) to meet the inadequate pricing of risks by investors in cost of the takeover. LBO deals often involve various forms of LBO debt. To mitigate these private equity sponsors and where such a risks, banks will need to ensure the adequacy of sponsor is involved, the assets of the acquired stress-testing of their direct exposures and company, in addition to the assets of the exercise vigilance in the monitoring of acquiring private equity sponsor, are generally counterparty risks. used as collateral for these loans. The debt usually appears on the acquired company’s INTRODUCTION balance sheet and its free cash flow is used to repay the debt. Overall, LBOs allow private In recent years, rapid growth in LBOs involving equity sponsors to make large acquisitions private equity sponsors has attracted without having to commit a material amount of considerable attention from market observers, their own capital. central banks and prudential regulators alike. Private equity sponsors manage funds devoted The financing of LBO projects tend to follow a to the acquisition of companies with the aim of particular model where equity and debt funding improving their operational efficiency and are raised sequentially (see Figure E.1). At the financial structure. While originally the vast start, the general partners (GPs) – that is the majority of target companies were not quoted in managers of the LBO fund (or sponsor) – create public equity markets, over the last couple of years, investments in listed companies, which 1 See ECB (2007), “Large Banks and Private Equity-Sponsored are then taken private, have become increasingly Leveraged Buyouts in the EU”, April. common. In April 2007 the BSC, in cooperation 2 This risk arises from the large LBO debt concentrations which with the ECB, published a report on large banks’ banks are exposed to from the day they agree to finance an LBO transaction until its completion, and throughout the debt 1 exposures to LBO activity in the EU. Based on distribution process by means of syndication or credit risk a survey comprising more than 40 banks, the transfer (also called “warehousing” risk). This time frame, within which banks are vulnerable to changes in market report found inter alia that debt exposures of sentiment and early defaults of acquired firms, has proven banks to the EU LBO market are not large rather lengthy. ECB Financial Stability Review 172 June 2007 IV SPECIAL FEATURES Figure E.1 Timeline of a leveraged buyout it is optimal for the LPs (equity investors) to commit only a part of their funds and to induce the GPs into seeking additional deal-specific Debt debt financing, as this increases the GPs’ distribution is finalised incentives to pick the most profitable projects. Debt capital is raised and Possible On the other hand, the research has also shown the deal is recapitalisation or secondary buy-out Target finalised that the initial raising of equity funds deprives firm is Possible re- LBO identified recapitalisation or the debt providers (banks) of full decision sponsor tertiary buy-out Exit/ raises equity divestment capital by IPO rights on each individual LBO project, and increases the expected quality of the investments that are undertaken by the GPs. Investment time span: 3-10 years Source: ECB. DEBT VERSUS EQUITY AS A MEANS OF FINANCING CORPORATE TAKEOVERS a pool of capital by investing their own funds Although the sequenced LBO financing model and raising equity capital from institutional can be justified from the point of view of investors (limited partners, LPs). The GPs may informational asymmetries, it is not that clear draw down these funds while companies why the share of debt in LBO transactions tends targeted for acquisition are being searched for, to be much higher than the share of equity. but generally the funds need to be invested in From the point of view of standard corporate target companies within a given time frame. finance theory, the well-known Modigliani and Once target companies have been identified, Miller (MM) theorem states that under certain debt financing is raised, typically from banks conditions the value of the firm – measured as which subsequently distribute their credit the sum of the values of all financial claims on exposures to the wider investor community. the firm’s future income – should be independent of whether the firms’ financial structure is During the corporate turnaround process, the dominated by equity or debt.4 Put another way, LBO sponsors may either recapitalise the deal a decision by a firm to substitute debt for equity or sell the acquired company to another sponsor (e.g. to finance an LBO or to buy back its own who will assume the remaining debt stock) should not change the weighted average commitments. However, the most common exit cost of capital that the firm has to pay to the by LBO investors – after the debt has been investors who have claims on it. This is because repaid – is by means of an initial public offering a firm that increases its leverage by taking on (IPO), where the acquired firm is floated on the more debt has to pay correspondingly higher stock market. After the exit, the proceeds of the returns to its equity holders, whose claims have operation are distributed among the general and become more risky because dividends are only the limited partners of the LBO fund. distributed after interest is paid. Based on this argument, Modigliani and Miller conclude that Recent academic studies have suggested that decisions concerning a firm’s financial structure the “sequenced” financing model used by LBO can only affect the distribution of the total value sponsors, which involves first general raising of the firm (as measured by its future stream of of equity capital followed by deal-specific debt cash flows or earnings) among its stakeholders, financing, can be rationalised from the point of view of optimal contracting in the presence of 3 See, for instance, U. Axelson, P. Stromberg and M. S. Weisbach 3 informational asymmetries. In particular, it (2007), “Why Are Buyouts Leveraged? The Financial Structure can be argued that although the GPs are expected of Private Equity Funds”, NBER Working Paper, No. 12826. 4 See F. Modigliani and M. Miller (1958), “The Cost of Capital, to dedicate their skills to gathering information Corporation Finance and the Theory of Investment”, American about the quality of the potential LBO targets, Economic Review, June. ECB Financial Stability Review June 2007 173 but not the magnitude of that value. Rather, the Figure E.2 The impact of debt financing on value of a firm should purely depend on “real” the value of a firm factors, such as cash flow and investment. All in all, given that the objective of an LBO Value of firm under Value of firm (V) Present value of tax MM with corporate sponsor is to maximise the resale value of the shield on debt taxes and debt acquired companies, the MM theorem suggests VL = VU +TCB that the nature of the claims (debt or equity) Maximum Present value of firm value financial distress costs used to finance the acquisition should be V = Actual value of firm V = Value of firm with no debt irrelevant from the point of view of future value U creation objectives. In reality, however, institutional factors often 0 Debt (B) play a role in determining the optimal financing B* Optimal amount of debt structure of a corporate takeover. From this Source: ECB. perspective, additional leverage may have both positive and negative impacts on the prospects of enhancing the expected future profits of the concentrated, unlike publicly listed firms. LBO acquired firm. On the positive side, the Consequently, the LBO general partners, as tax treatment of debt and equity typically representatives of the owners, may be in a better differs, with a shift to debt financing often position to focus the attention of the acquired resulting in tax relief that positively affects the company’s managers on maximising cash flow firm’s future cash flows.5 On the negative side, and profits. Governance structures can include the existence of bankruptcy costs means that a contractual constraints and covenants that higher debt burden, by increasing the firm’s limit managers’ actions, as well as managerial probability of default, will depress the expected incentives such as salary structures that value of the firm’s expected future cash flows are connected to profits.
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