LBO (Leveraged Buyout): Definition, Threat

This Financial Trick Could Trigger the Next Financial Crisis

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LBOs are like too much credit card debt for companies. Photo: Daryl Solomon/Getty Images

Definition: LBOs, or leveraged buyouts, is when one company borrows a lot of money to buy out another one. A typical buyer borrows the money by issuing bonds to investors, hedge funds, and banks. Like any other bond, the buyer will put up its own assets as collateral. But an LBO allows it to put up the assets of the company it wishes to buy as collateral, as well.

That leverage allows a small company to borrow funds to buy a much bigger company without much risk to itself.

All the risk is carried by the bigger target company. That's because the debt is put on its books. If there's trouble paying the debt, its assets will be sold off first and it will go bankrupt. The smaller, acquiring company goes scot-free.

These deals usually done by private equity companies that purchase a public company to take it private. That gives the purchaser time to make the changes needed to make the target company more profitable. It will then sell the acquired company later on at a profit, often by taking it public again in an IPO. It's like a flipper for companies instead of houses. 

The debt must offer high yields to offset the risk. The high interest payments alone can often be enough to cause the bankruptcy of the purchased company. That's why, despite their attractive yield, leveraged buyouts issue what's known as junk bonds. They're called junk because often the assets alone aren't enough to pay off the debt, and so the lenders get hurt as well.

Is There Any Protection From LBOs?

The Federal Reserve and other banking regulators issued guidance in 2013 to their banks to control LBO risk. They urged banks to to avoid financing LBOs that allowed the debt to be more than six times annual earnings of the targeted company. The regulators told banks to avoid LBOs that stretched out payment timelines or didn't contain lender protection covenants.

Regulators can fine banks up to $1 million a day if they don't comply.

But enforcement of the guidelines isn't straightforward. Many bankers complain that the guidelines aren't clear enough. There are different ways to calculate earnings. Some deals may follow most, but not all, guidelines. Banks want to make sure they are all judged the same. 

Banks have reason to be concerned. The Fed has allowed some banks to exceed the recommended level in certain cases. The Fed only oversees foreign banks, Goldman Sachs, and Morgan Stanley. The Office of the Comptroller of the Currency (OCC) oversees national banks. That includes Bank of America, Citigroup, JP Morgan Chase and Wells Fargo.

The Looming LBO Threat

Too many banks have ignored the regulations. As a result, an alarming 40% of U.S. private equity deals exceeded the recommended debt levels. That's the highest since the 2008 financial crisis. In 2007, 52% of loans were above the recommended levels. (Source WSJ, Debt Rises in Deals Despite Warnings, May 21, 2014)

Regulators are concerned that, if there is any kind of a downturn, banks will once again be stuck with too much bad debt on their books. Only this time it will be junk bonds instead of subprime mortgages.

In fact, it looks like that's already started. In April 2014, the largest LBO in history became the eighth largest bankruptcy ever. Energy Future Holdings was destroyed by the $43 billion debt it was saddled to pay for its buyout. The three who brokered the deal, KKR, TPG and Goldman Sachs bought the company for $31.8 billion in 2007 and took on $13 billion in debt the company already had.

The company they bought, TXU Corp, was a Texas utility with strong cash flow. The dealmakers didn't realize that energy prices were about to drop thanks to discoveries of shale oil and gas. They paid top dollar to shareholders to take the company private, thinking that gas prices would rise instead. The company lost 400,000 customers, since Texas utilities were deregulated. The other creditors have had to agree to forgive a whopping $23 billion in debt, in addition to the $8 billion the dealmakers put up.

LBOs Hurt Job Growth and Economic Growth

The next four largest LBOs were also flailing:

  1. First Data ($26.5 billion) just hired a new CEO to turn it around.
  2. Alltel ($25.7 billion) was just sold to Verizon for $5.9 billion, plus $22.2 billion in remaining debt. Usually after a merger like this, jobs are lost as the companies try to find more efficient operations.
  3. H.J.Heinz ($23.6 billion) closed plants to generate more cash flow.
  4. Equity Office Properties ($22.9 billion) sold off more than half of its 543 commercial buildings.

These are great examples of how LBOs hurt the economy. The new owners must find ways to increase profits to pay off the debt. The best way to do this is to sell buildings, consolidate operations and reduce headcount. All these steps reduce jobs, or at least stop job growth. (Source: WSJ, Biggest Leveraged Buyout Goes Bust, How Shale Boom Killed TXU, April 30, 2014.)