Investing in Leveraged Buyouts: Know the Risks

Leveraged buyouts were wildly popular in the 1980s, when huge deals such as the takeover of RJR Nabisco grabbed headlines and led to a best-selling book and movie.

Though the heyday of LBOs is over, investors can still participate in deals--as long as they're aware of the risks.

A leveraged buyout is when investors buy a company with a small amount of equity and a significant amount of debt. The strategy allows for large acquisitions without committing a lot of capital.

In most cases, leveraged buyouts are handled by private equity firms that raise capital from institutions and wealthy individual investors. If you have deep pockets, you can join the group providing the equity stake. This requires that you are categorized as a “qualified” investor, which means that you have at least $5 million of investments in your portfolio. The cash the private equity firm puts up gives it an equity stake, or ownership, in the target firm. This equity stake is generally 40% or less of the target’s value. The rest of the purchase price is funded by debt.

Several types of credit can be used in the buyout: bank loans, bonds and mezzanine debt.

Bank loans involve money the acquirer borrows from a bank. Bonds involve debt issued by the acquirer in order to help fund the transaction. The bonds are often backed by the assets and cash flows of the company being acquired. These bonds are often what is referred to as “junk” bonds or high-yield debt because they have a higher chance of default that other bonds and therefore are forced to offer higher interest rates.

Other types of financing such as mezzanine debt may be used. These complex instruments are a hybrid between stocks and bonds, offering attractive returns to investors in exchange for taking notable risks. Once the purchase is complete, the debt must be serviced. That is to say, principle and interest must be repaid to the bank, the bondholders and the holders of the mezzanine debt. Repayment can be made using cash flows from the acquired business or from profits made by breaking up the business and selling its components.

As an individual investor, you can buy the bonds issued to back the buyout. In many cases, this means you are willing to take a chance on junk bonds.

Another option is to buy the stock in the target company once you hear news about a possible acquisition. Generally, the stock tends to rise in reaction to the news, but there is always a risk that the deal collapses and the stock falls back down.

The easiest - and probably safest - method is to invest in mutual funds that specialize in buyout opportunities. These funds are managed by professional investors who have access to research tools and analysts responsible for evaluating investment candidates. The funds also hold multiple securities, thereby reducing the risk of making a single bad choice. The CPG Carlyle Private Equity Fund offered by Carlyle Group is an example of a buyout fund.

LBOs often make headlines because the buyers are taking big risks and looking to make serious money. In the 1980s, deals with target returns of 25% to 30% were not unusual. These returns were often achieved by taking on extraordinary, and sometimes unsustainable, levels of debt.

Deals were sometimes financed with 90% debt to 10% equity. This high debt/equity ratio is one of the reasons that the bonds issued to support the acquisitions are often rated as less than investment grade, and are commonly referred to as junk bonds. With such high leverage ratios, the interest payments can be so large that the company's operating cash flows are insufficient to pay the debt.

More recently, LBOs have been initiated by acquirers looking to run the acquired businesses at a profit, with a planned exit based on a five-to-seven-year timeframe. These deals are seeing equity of closer to 40%. The buyers want to add value and build a business that can sustain itself.

Evaluating an LBO from an investor’s perspective is similar to conducting fundamental analysis on a stock. This involves traditional analysis designed to determine what the company is worth and whether or not it can pay its bills and be run at a profit.

In 2013, the $24.9 billion takeover of Dell by Silver Lake Management was a large transaction and certainly a notable chapter in the computer maker’s history, but it pales in comparison to history’s largest LBOs.

The top half dozen, which include RJR Nabisco ($55+ billion), Energy Future Holdings ($47+ billion), Equity Office Properties ($41+ billion), Hospitality Corp of America ($35+ billion), First Data ($30+ billion) and Harrah’s Entertainment ($30+ billion), were all significantly larger. Many of these events were hostile takeovers, meaning that the purchase was made against the wishes of the existing management teams.

In such scenarios, it is particularly ironic that a company's success (in the form of assets on the balance sheet) can be used against it as collateral by a hostile company that acquires it. This tactic was employed by corporate raiders who used private equity firms to help finance the acquisitions in transactions that were viewed as particularly ruthless and predatory. This characterization is something LBO practitioners once embraced.

Michael Milken and Ivan Boesky are two of the best-known players from the private equity side in from the early days of LBOs. Milken worked for private equity firm Drexel Burnham Lambert, a company that hosted an annual Predators’ Ball gathering that brought together various LBO participants. Milken’s exploits helped inspire the movie Wall Street. A best-selling book, Barbarians at the Gate, chronicled the takeover of RJR Nabisco, which was also made into a film.

Milken’s name is forever linked with that of Ivan Boesky, another inspiration for Wall Street. Boesky colluded with Milken, using inside information Milken provided about pending deals to conduct lucrative stock trades. Both men went to jail and paid hefty fines for their misdeeds. Their spectacular downfall revealed the fraud that was taking place and fueling spectacular profits behind the LBO frenzy.

While LBOs do present opportunities to make money, greed can work against you. Deals don’t always go through, and even when they do, the results aren’t always favorable for investors. If you are interested in investing in LBOs, either learn to do the fundamental analysis and invest the time to do it properly or else leave the work to the experts.