LBO = Definition

 Buyout: The purchase of a company or a

controlling interest of a company's shares.

 Leverage buyout: The acquisition of a company

using debt and equity finance. As the word
leverage implies, more debt than equity is used
to finance the purchase, e.g. 90% debt to 10%
equity. Normally, the assets of the company being
acquired are put up as collateral to secure the debt.
Example of LBO in Daily life

 Mortgaging a Home.

 Buying a Car/Taxi, financed by bank.

Special purpose Vehicle
Whose operations are limited to the acquisition and
financing of specific assets. The SPV is usually a
subsidiary company with an asset/liability structure
and legal status that makes its obligations secure
even if the parent company goes bankrupt.
Tata tea-Tetley
The first major LBO by an Indian company was
acquisition of Tetley by Tata in early 2000.In this
case, Tata Tea set up a SPV in the UK in the form of
Tata Tea (GB) Limited. This SPV had equity capital
of GBP 71 million contributed by Tata Tea Limited.
The SPV, in turn mobilized GBP 235 million by way
of long-term debt on the security of the assets and
cash flows of Tetley and acquired 100 percent of
Tetley at the cost of GBP 271 million, taking it
private.
Corus-Tata Steel
 Acquisition of Corus by Tata steel ltd is also a case
of Leveraged buyout. In case of Tetly, Tatas used
only one SPV, i.e, Tata Tea (GB) Limited. In case
of Corus they used a chain of SPVs-Tata Steel Asia
Pt was set up as a wholly owned Singapore based
subsidiary of Tata Steel limited and Tata Steel UK
Limited was set up as wholly owned subsidiary of
TATA steel Asia Pt.
 Debt mobilization was also done by both the SPVs.
$5.6bn through a LBO ($3.05bn through senior
term loan, $2.6bn through high yield loan)
Essential characteristics of an Ideal LBO

 Efficient and experienced management team:

In order to motivate the lenders as well as investors for
providing borrowed or loan capital to a considerable extent
and with a view to make the LBO programme successful, a
strong management body comprising of experienced as well
as professionally highly qualified chief financial services,
CEO’s, directors, senior managers, etc. is quite a essential.
The management should have long track record in the history
and also should have long track record in the industry and also
should have desirable experience of handling large projections
effectively and efficiently.
 Assurance of sufficient and stable cash flow:
With a view to service the debt borrowed for the
acquisition and in order to ensure the smooth
ongoing operations of the firm, the existence of
sufficient, strong and secure cash flow is considered
indispensable for a successful LBO programme. A
LBO candidate having strong and stable cash flow
can easily impress the lenders to provide huge
amount loan capital required for the purpose of
acquisition under the LBO programme and also to
produce highest borrowing capacity of the firm.
 Lower degree of operating risk: in a LBO programme,
the financial risk is very high since it is mostly based
on leveraged capital or debt capital. Thus, in order to
sustain in the market, the degree of operating risk
arising out of normal business activities should be as
less as possible. Companies with strong market
positions, diversified products portfolio, strong
customer base and new innovative power to cope with
the changing business world, etc.
 Limited amount of debt
There should have been limited amount of debt in the firm’s
balance sheet compared to the value of the tangible assets of
the firm that can be used as collateral securities for raising the
loan capital required to finance the LBO programme. The
lower the amount of existing debt relative to the collateral
value of such assets, the greater will be the borrowing
capacity of the firm. On the other side, if the balance sheet of
the acquiring company is already over-burdened by debt
capital, the acquiring firm may have to face difficulties in
financing the acquisition through the option of LBO.
 Other factors:
Apart from the above mentioned factors, lenders or investors
may look for some other important factors depending upon
the nature of the business of the LBO candidate. For instance
the existence of strong asset base in the balance sheet of the
company is one of the most important tangible factors
because, such assets are used as collateral for financing the
LBO programme. A LBO candidate having strong asset base
can easily raise capital to finance the LBO. On the other hand
timing is another important factor to make a LBO programme
successful. Proper timing is very much important to maximize
the probability of making the LBO transaction successful.
Sources of LBO financing
There are a number of types of financing which can be used
in an LBO. These include:
Senior Debt: This is the debt which ranks ahead of all other
debt and equity capital in the business. The debt is usually
secured on specific assets of the company, which means the
lender can automatically acquired these assets if the
company breaches its obligations under the relevant loan
agreement, therefore it has the lowest cost of debt.
Typically, the terms of senior debt in an LBO will require
repayment of the debt in equal annual installments over a
period of app. 7 years.
Senior debt is prepayable and has a floating rate of
interest. From the lender’s perspective, this is the
most secured form of financing. A financial buyer
will usually want the LBO to be financed by as
much senior debt as possible as it provides the
platform for the debt financing, since it is the lowest
cost form of financing.
-However, the providers of senior debt will be
reluctant to accept very high levels of senior debt or
may impose conditions which are unacceptable to
the equity investor. As a result senior debt will often
only from about 50% of the total financing.
Subordinated debt
This debt is less secured as compared to senior debt
and repayment is usually required in one bullet
payment at the end of the term. A high yield, or
"junk", bond is a bond issued by a company that is
considered to be a higher credit risk. The credit rating
of a high yield bond is considered "speculative" grade
. This means that the chance of default with high yield
bonds is higher than for other bonds.
 Cash-pay bonds – The high-yield market’s “plain
vanilla” bonds, they offer investors a fixed coupon
rate of interest, paid in cash, until maturity or an
earlier stated redemption date.
 Step-coupon bonds – Offer one interest (coupon) rate
in the early years of the bond’s
life, followed by a second, higher interest rate at a
specified time (the step-up date) in later years. Most
of these bonds are callable at a premium on the step-
up date.
Mezzanine Financing

 A hybrid of debt and equity financing that is  typically used

to finance the expansion of existing companies. Mezzanine
financing is basically debt capital that gives the lender the
rights to convert to an ownership or equity interest in the
company if the loan is not paid back in time and in full.
 Since mezzanine financing is usually provided to the
borrower very quickly on the part of the lender and little or
no collateral on the part of the borrower, this type of
financing is aggressively priced with the lender.
. 
Preference Shares
This forms of a company’s share capital and
usually gives preference shareholders a fixed
dividend.
Advantages of LBO
 With the help of LBO , the acquiring company can
expand its business network in the international
market based on leveraged capital i.e. without
occurring huge amount of outlay from the internal
resources of the firm.
 Benefit of SPV:
Since in the LBO system, a new company is
created to procure the debt capital as well as other
sources of finance required for the acquisition, the
volatility of earnings of that new created company,
does not affect the business of the acquiring
company.
 Tax benefits:
The newly created company can enjoy tax benefits in
operating the business for a considerable time period
of five to six years. Due to the existence of high
amount of leveraged or debt capital, in the capital
structure of the company, tax benefits can be achieved
in respect of payment of interests. Moreover, higher
amount of assets setup will provide greater amount of
tax savings in the form of depreciation expense.
 Discipline on management
High payments in the form of interests tends to be a
discipline on management, since a company’s cash
flow is usually quite tight due to the necessary pay-
down of interest and debt.
Limitations
 High degree of financial risk:
The LBO programme is subject to high degree of
financial risk since, it is mostly based of borrowed
capital. On he other hand, if the degree of operating
risk of the LBO candidate is also high, it may be
difficult for the firm to service the debt properly
which, in turn, may lead to the firm into bankruptcy
in near future. In addition to that, the fluctuation in
interest rate is another important point to be
considered here. The rise in interest rate may create
genuine problem for firm that has more variable debt
rate.
 In case of Less assets:
A LBO candidate should have strong asset base
that can be used as collateral for financing the
acquisition. Moreover, an experienced as well as
efficient team of management is also important.
Financing of Merger
 Equity
 Debt
Equity
(a) Internal Accruals:
For most of the domestic acquisition, the primary source of
funding is internal accruals. Acquisition is a game that is
normally played by the cash-rich companies who are
looking at growth opportunities through acquisitions using
surplus cash.
 In october 2002, when Hindalco made an open offer for
acquisition of 25.5 percent of the voting capital of Indal, the
entire cost of Rs. 218.19 cr was funded purely through
internal accruals.
 Dec 2008, Dabur india ltd acquired Fem Care Pharma ltd at
the total cost of over Rs. 250 crore which was funded
entirely through internal accruals.
(b)IPO/FPO
 IPO (Initial public offering): Funds can be raised
by IPO or FPO. But it has some limitations:
-Its not suitable for companies whose performance
in the market is not good.
-Time consuming and expensive process
-Market perceives acquisitions as risky investments
and would not have much appetite for such issues.
(c) Right Issue
 Right Issue is an effective post-acquisition route to
mobilize funds for repayment of loans taken from the
banks and financial institutions for acquisition. In oct
2008, Tata Motors came out with a right issue of Rs
4145 cr for prepayment of part of the short-term loan
availed by jaguar Land Rover Ltd., a subsidiary of
Tata Motors, to partially fund the purchase
consideration for the the acquisition of Jaguar Land
Rover from Ford.
(d) Private Placements/PE funds
 The sale of securities to a relatively small number
of select investors as a way of raising capital.
Investors involved in private placements are
usually large banks, mutual funds, insurance
companies and pension funds. Private placement is
the opposite of a public issue, in which securities
are made available for sale on the open market.
(e) ADRs/GDRs
 Use of funds mobilized through American
Depository receipts and Global Depository
Receipts is not permitted for acquiring a company
or a part thereof in India except that the
ADRs/GDRs proceeds can be utilized for the
acquisition of shares in the disinvestment process
of public sector undertakings.
Borrowed funds
 (a) Banks and FIs
When in May-june 2007, Kingfisher acquired Deccan
Airways, the transaction consisted of Air Deccan first
making a preferential allotment of 26%. The funding
of the Preferential allotment was done through two
medium-term loans-400 cr term loan of 3 year tenure
from IDFC and Rs 100 cr term loan of 3 year tenure
from HDFC.
 A management buyout (MBO) is a form of acquisition
where a company's existing managers acquire a large part or
all of the company.
 Management buyouts are similar in all major legal aspects
to any other acquisition of a company. The particular nature
of the MBO lies in the position of the buyers as managers
of the company, and the practical consequences that follow
from that. In particular, the due diligence process is likely to
be limited as the buyers already have full knowledge of the
company available to them.
The Purpose of an MBO
The purpose of such a buyout from the managers'
point of view may be to save their jobs, either if the
business has been scheduled for closure or if an
outside purchaser would bring in its own management
team. They may also want to maximize the financial
benefits they receive from the success they bring to
the company by taking the profits for themselves.
This is often a way to ward off aggressive buyers.
Financing a Management
Buyout
 Debt Financing
The management of a company will not usually
have the money available to buy the company
outright themselves. They would first seek to
borrow from a bank, provided the bank was willing
to accept the risk. Management buyouts are
frequently seen as too risky for a bank to finance
the purchase through a loan.
Private Equity Financing
 If a bank is unwilling to lend, the management will commonly look to
private equity investors to fund the majority of buyout. A high proportion
of management buyouts are financed in this way. The private equity
investors will invest money in return for a proportion of the shares in the
company, though they may also grant a loan to the management.
 Seller Financing
 In certain circumstances it may be possible for the management and the
original owner of the company to agree a deal whereby the seller finances the
buyout. The price paid at the time of sale will be nominal, with the real price
being paid over the following years out of the profits of the company. The
timescale for the payment is typically 3–7 years.
 This represents a disadvantage for the selling party, which must wait to receive
its money after it has lost control of the company. It is also dependent on the
returned profits being increased significantly following the acquisition, in
order for the deal to represent a gain to the seller in comparison to the situation
pre-sale. This will usually only happen in very particular circumstances.
 The vendor may nevertheless agree to vendor financing for tax reasons, as the
consideration will be classified as capital gain rather than as income. It may
also receive some other benefit such as a higher overall purchase price than
would be obtained by a normal purchase.
 The advantage for the management is that they do not need to become involved
with private equity or a bank and will be left in control of the company once
the consideration has been paid.
 Examples of MBOs
 A classic example of an MBO involved Springfield Remanufacturing Corporation,
a former plant in Springfield, Missouri owned by Navistar (at that time,
International Harvester) which was in danger of being closed or sold to outside
parties until its managers purchased the company.
 In the UK, New Look was the subject of a management buyout in 2004 by
Tom Singh, the founder of the company who had floated it in 1998.
 An earlier example of this in the UK was the management buyout of Virgin
Interactive from Viacom which was led by Mark Dyne
 The Virgin Group has undergone several management buyouts in recent years. On
September 17, 2007, announced that the UK arm of Virgin Megastores was to be
sold off as part of a management buyout, and from November 2007, will be known
by a new name, Zavvi. On September 24, 2008, another part of the Virgin group,
Virgin Comics underwent a management buyout and changed its name to
Liquid Comics. In the UK and Ireland, Virgin Radio also underwent a similar
process and became Absolute Radio