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Home / Finance & markets / Banking / Leveraged Buyout & Financial Assistance

Leveraged Buyout & Financial Assistance

Leveraged Buyout

Leveraged Buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition.[1] The SPV[2] obtains debt financing under the expectation that the acquired company will repay it. As a result, the target pays the economic price of its own acquisition.

LBO is considered as one of the most fascinating examples of financial ‘alchemy’. Its’ magic comes from the fact that, if the acquisition debt is fully repaid, the acquirer will eventually enjoy ownership of the target that has essentially been bought with the target’s own resources.

Corporate finance has basically two methods. You can raise either equity or debt.

1) The term ‘leverage’ is used, because the debt amplifies the returns the equity invested, much as a lever amplifies the effect of a physical force.[3] This happens because debt has a fixed return (interest rate), whereas equity owns the rest. If you increase the amount that has a fixed return, you amplify the returns on the balancing equity, that has no ceiling.

2) Debt has other advantages relative to equity in terms of i) providing tax savings, ii) working as a disciplining factor on companies’ management and iii) permitting lenders (banks) to closely monitor and actively take part in the governance of the companies, if need be.

3) However, the less equity that a company has, the smaller the cushion against default and insolvency risks. Thus, if you do not have a solid business plan, you cannot create enough profit by operating the target company, and lose all your equity.

 The Prohibition of Financial Assistance

This kind of LBOs caused great social costs in the 1920s in the UK and 1980s in the US. That’s the main reason it was called as ‘asset-stripping takeovers’, which led to an outright ban on providing financial assistance by a company to purchase its own shares. This prohibition is seen as ‘a ban on the LBOs’ by many writers.

The prohibition of financial assistance can be traced back to the UK Companies Act 1928. It expanded to all European economies through its adoption by the Second Company Law Directive[4]. Yet, today, there is a reverse trend of relaxing the ban in order to benefit from the momentum created by LBO’s in the private equity-backed M&A market.

In the next article I will explain the ban, the current trends in European countries (including Turkey) and the techniques used to avoid the rule.


[1] www.investopedia.com

[2] Special purpose vehicle is a newly founded company having the sole purpose of acquiring the target company.

[3] Private Equity Demystified: 2012 Update. (www.icaew.com)

[4] 77/91/EU.

 

Image source: Flickr

Cem Veziroğlu

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