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Could someone explain to a total finance noob how a "leveraged buyout" transaction actually works? I think I understand how hostile takeovers work for public c

by xg15 3y ago

Could someone explain to a total finance noob how a "leveraged buyout" transaction actually works? I think I understand how hostile takeovers work for public companies (thanks to Elon's helpful demonstration of the concept) : Basically, a buyer can "acquire" the company against the wishes of the company's management because the company doesn't "own" itself in the first place. The real "owners" are the shareholders and so the two parties of the transaction are really the buyer and the shareholders, not the company that is being bought. Consequently, the buying price goes to the shareholders, not the company. However, here we're talking about acquisition of private companies - so there are no shareholders. Then who exactly is the "seller" party in the transaction? It could be that the hospice was owned by itself and the board members just got greedy. However, tge article implies that the bulk of hospices before consolidation were small, local businesses. I have a hard time believing that the owners of all those shops suddenly decided to throw the wellbeing of their employees and patrons in the wind for some personal riches. On the other hand, if the hospices were not owned by themselves then there already must have been some sort of corporate structure before that the PEFs latched on to. But then, what was that. In short, the "leveraged buyout" is an acquisition where it seems completely clear even beforehand that the acquired company will be strictly worse off afterwards. So why would a private company agree to that or, if not, who can make them agree? And who is the buy price paid to anyway?

notacoward 3y ago
Not an expert by any means, but I see nobody else has answered so I'll give it a shot. In the less extreme case, the seller has no choice but to sell or go under, so they'll take the best offer they can get. In the more extreme case, there is no choice because the seller has already taken on some debt under conditions that give the creditors first claim on assets. Then it's easy for the rentiers to buy up the debt and then wait - usually not long - for the company to run out of operating funds and trigger their own effective acquisition. I once worked at a startup that suffered a similar fate. They had taken on some debt - a small amount really - during desperate times. Later, before the debt was paid off, they ran out of operating funds. Boom. Game over. The company shut down, most employees were immediately let go except for a few charged with liquidating the assets and wrapping up all the IP which went into storage somewhere never to be used again. It sucked. That creditor probably made a tiny bit more than they had loaned originally, while everyone else lost. And the only way their own business model worked was to do the same thing over and over and over again, destroying enough aggregate value that even the residue they skimmed off the top could pay for their yachts or third vacation homes.
- fallingknife 3y ago
  What you are describing has nothing to do with an LBO. You are just describing debt and bankruptcy. In an LBO the debt is part of a transaction to buy the company and the seller is rarely desperate. Banks wouldn't lend into an LBO of a company that is on its last legs. Also, the probability that a lender gets out of a liquidation whole is slim. The probability in a case where the main asset is IP is basically zero.
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SilverBirch 3y ago
To give an illustrative example, you have a company that runs a care home. It owns the care home and employs the workers etc. So that company has a set of assets, and a set of cash flows, let's say the care home it owns is worth $10m, and it makes a profit of $1m a year (totally made up numbers). It might be privately owned or public - that's not important. This has nothing to do with hostile takeovers - the sellers of the business are willing sellers. A buyer comes in and says "I'll buy this business for $15m". But the buyer doesn't have $15m, Let's say they have $5m. So they go to the bank and they agree to borrow $10m. But the bank won't just lend you $10m, they need collateral. So what the buyer does is they say "We'll borrow the $10m from you to buy the company, and the collateral we'll provide to the bank is the assets of the company, which we'll own once we've completed the acquisition". In a weird way it feels like buying the company with it's own money. So now, the private equity firm own the $15m business, but the business now has $10m in debt. The reason this is good for the private equity firm is that if they can increase the value of the business 10%, the business is now worth $16.5m and the PE firm reaps all the reward - they make $1.5m profit from a $5m investment, instead of making $1.5m from a $15m investment. It's a way of them making efficient use of their limited capital. Now, here's the bad side: That business that had $10m worth of assets, and made $1m profits? Well now it has $0m of net assets and it's got to make interest payments on the debt. So the Private Equity firm has to move quickly to squeeze more profits out of the business. It's like when Elon Musk bought twitter- he claimed he had to make a tonne of cuts because the business was hemorrhaging money, but the truth is it wasn't losing money until he saddled it with a huge amount of incredibly expensive debt.
JPws_Prntr_Fngr 3y ago
A company always has shareholders. A privately-held share simply changed hands in private transactions, rather than in the public stock markets. So an LBO happens when a PE buyer makes a sufficiently attractive offer (privately) to the shareholders. If they offer you 50% over what you think your own business is worth, you probably would take it, right? That’s the BO in LBO. This large amount of money is typically acquired through debt - “leverage” - which is the L in LBO. The classic coup de grace is to then load the giant loan onto the books of the acquiree and let them sink.
aesh2Xa1 3y ago
I think you are asking two questions: * (1) How is a private seller different from a public seller? * (2) What is the incentive for a private seller to sell, especially in this hospice case where, presumably, the seller cares about the people they employ and serve? Whereas a public seller has shareholders to pay out, a private seller is simply getting paid to transfer the ownership of their business. In both cases there is a pay out. The amount to be paid out is a large number – the buyer invests only a fraction of the purchase, whereas a bank finances the rest of the transcation. A large payout is enticing to sellers. A private seller has the incentive of "a large payout" to sell their business. Even in the case where the seller is plausibly ethical and knowledgeable of the outcome of the buyout, their ethics are in contest with the financial incentive. People make personal compromises in exchange for money all of the time. Lastly, you didn't ask, but I think there is an important part of "how it actually works;" The buyer owes the bank the rest of the transaction. In order to make good on that debt they will need a competent "exit strategy." It seems typical that the buyer will attempt to slash costs up front in order to make a quick, initial gain (e.g., fire employees to avoid paying salaries). After the short-term squeeze realizes gains, the buyer needs to sell off the company to dump the rest of the debt (e.g., spin off some of the business area/assets and sell to yet another buyer at a mark-up; having attractive short-term growth figures probably helps with this part).
s1artibartfast 3y ago
There's a lot of loaded language around Leverage buyouts but it is just taking out a loan to make a purchase. In practice they work almost exactly like a mortgage. You get a lender to take most of the cost.
jdasdf 3y ago
> Could someone explain to a total finance noob how a "leveraged buyout" transaction actually works? Have you ever bought a house using a mortgage? What you've done was a leveraged buyout of that house. When you do a leveraged buyout of a business, it's the exact same thing! You borrow money from someone, and use that money to purchase the asset (whether its a house, a car or a business), and you use the asset you're purchasing to "back" the loan, essentially saying "If I don't make the payments, you can auction off the house/car/business to pay off the debt". >However, here we're talking about acquisition of private companies - so there are no shareholders. Then who exactly is the "seller" party in the transaction? Shareholders is just the name for "Partial Owner", and every company has one (or more) owners. The owners of the business sell it to the one who is buying. A company being "Private" just means that the company's shares (ie: the partial ownership) is not being traded on any stock exchange. It doesn't mean the ownership of the business can't be sold, any more than the fact that your house not being listed on a stock exchange prevents you from selling it to whoever will buy. >It could be that the hospice was owned by itself There is no such thing as something being "owned by itself". There is always one final owner.
fallingknife 3y ago
The Twitter transaction was not a hostile takeover. In fact it was exactly the opposite. The board ended up suing him to make him buy Twitter.

by xg15 3y ago

notacoward 3y ago

Not an expert by any means, but I see nobody else has answered so I'll give it a shot. In the less extreme case, the seller has no choice but to sell or go under, so they'll take the best offer they can get. In the more extreme case, there is no choice because the seller has already taken on some debt under conditions that give the creditors first claim on assets. Then it's easy for the rentiers to buy up the debt and then wait - usually not long - for the company to run out of operating funds and trigger their own effective acquisition. I once worked at a startup that suffered a similar fate. They had taken on some debt - a small amount really - during desperate times. Later, before the debt was paid off, they ran out of operating funds. Boom. Game over. The company shut down, most employees were immediately let go except for a few charged with liquidating the assets and wrapping up all the IP which went into storage somewhere never to be used again. It sucked. That creditor probably made a tiny bit more than they had loaned originally, while everyone else lost. And the only way their own business model worked was to do the same thing over and over and over again, destroying enough aggregate value that even the residue they skimmed off the top could pay for their yachts or third vacation homes.

fallingknife 3y ago
What you are describing has nothing to do with an LBO. You are just describing debt and bankruptcy. In an LBO the debt is part of a transaction to buy the company and the seller is rarely desperate. Banks wouldn't lend into an LBO of a company that is on its last legs. Also, the probability that a lender gets out of a liquidation whole is slim. The probability in a case where the main asset is IP is basically zero.
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SilverBirch 3y ago

To give an illustrative example, you have a company that runs a care home. It owns the care home and employs the workers etc. So that company has a set of assets, and a set of cash flows, let's say the care home it owns is worth $10m, and it makes a profit of $1m a year (totally made up numbers). It might be privately owned or public - that's not important. This has nothing to do with hostile takeovers - the sellers of the business are willing sellers. A buyer comes in and says "I'll buy this business for $15m". But the buyer doesn't have $15m, Let's say they have $5m. So they go to the bank and they agree to borrow $10m. But the bank won't just lend you $10m, they need collateral. So what the buyer does is they say "We'll borrow the $10m from you to buy the company, and the collateral we'll provide to the bank is the assets of the company, which we'll own once we've completed the acquisition". In a weird way it feels like buying the company with it's own money. So now, the private equity firm own the $15m business, but the business now has $10m in debt. The reason this is good for the private equity firm is that if they can increase the value of the business 10%, the business is now worth $16.5m and the PE firm reaps all the reward - they make $1.5m profit from a $5m investment, instead of making $1.5m from a $15m investment. It's a way of them making efficient use of their limited capital. Now, here's the bad side: That business that had $10m worth of assets, and made $1m profits? Well now it has $0m of net assets and it's got to make interest payments on the debt. So the Private Equity firm has to move quickly to squeeze more profits out of the business. It's like when Elon Musk bought twitter- he claimed he had to make a tonne of cuts because the business was hemorrhaging money, but the truth is it wasn't losing money until he saddled it with a huge amount of incredibly expensive debt.

JPws_Prntr_Fngr 3y ago

A company always has shareholders. A privately-held share simply changed hands in private transactions, rather than in the public stock markets. So an LBO happens when a PE buyer makes a sufficiently attractive offer (privately) to the shareholders. If they offer you 50% over what you think your own business is worth, you probably would take it, right? That’s the BO in LBO. This large amount of money is typically acquired through debt - “leverage” - which is the L in LBO. The classic coup de grace is to then load the giant loan onto the books of the acquiree and let them sink.

aesh2Xa1 3y ago

I think you are asking two questions: * (1) How is a private seller different from a public seller? * (2) What is the incentive for a private seller to sell, especially in this hospice case where, presumably, the seller cares about the people they employ and serve? Whereas a public seller has shareholders to pay out, a private seller is simply getting paid to transfer the ownership of their business. In both cases there is a pay out. The amount to be paid out is a large number – the buyer invests only a fraction of the purchase, whereas a bank finances the rest of the transcation. A large payout is enticing to sellers. A private seller has the incentive of "a large payout" to sell their business. Even in the case where the seller is plausibly ethical and knowledgeable of the outcome of the buyout, their ethics are in contest with the financial incentive. People make personal compromises in exchange for money all of the time. Lastly, you didn't ask, but I think there is an important part of "how it actually works;" The buyer owes the bank the rest of the transaction. In order to make good on that debt they will need a competent "exit strategy." It seems typical that the buyer will attempt to slash costs up front in order to make a quick, initial gain (e.g., fire employees to avoid paying salaries). After the short-term squeeze realizes gains, the buyer needs to sell off the company to dump the rest of the debt (e.g., spin off some of the business area/assets and sell to yet another buyer at a mark-up; having attractive short-term growth figures probably helps with this part).

s1artibartfast 3y ago

There's a lot of loaded language around Leverage buyouts but it is just taking out a loan to make a purchase. In practice they work almost exactly like a mortgage. You get a lender to take most of the cost.

jdasdf 3y ago

> Could someone explain to a total finance noob how a "leveraged buyout" transaction actually works? Have you ever bought a house using a mortgage? What you've done was a leveraged buyout of that house. When you do a leveraged buyout of a business, it's the exact same thing! You borrow money from someone, and use that money to purchase the asset (whether its a house, a car or a business), and you use the asset you're purchasing to "back" the loan, essentially saying "If I don't make the payments, you can auction off the house/car/business to pay off the debt". >However, here we're talking about acquisition of private companies - so there are no shareholders. Then who exactly is the "seller" party in the transaction? Shareholders is just the name for "Partial Owner", and every company has one (or more) owners. The owners of the business sell it to the one who is buying. A company being "Private" just means that the company's shares (ie: the partial ownership) is not being traded on any stock exchange. It doesn't mean the ownership of the business can't be sold, any more than the fact that your house not being listed on a stock exchange prevents you from selling it to whoever will buy. >It could be that the hospice was owned by itself There is no such thing as something being "owned by itself". There is always one final owner.

fallingknife 3y ago

The Twitter transaction was not a hostile takeover. In fact it was exactly the opposite. The board ended up suing him to make him buy Twitter.