Take the L out of LBO

August 31, 2009

In a perfect world, we would simply ban leveraged buyouts. The vast majority of these debt-laden corporate takeovers are no less predatory and value-destroying to a company than a loan shark who charges usurious rates of interest.

Realistically, a prohibition on private equity deals will never happen, given the big dollars involved in these transactions and the sizeable campaign contributions that private equity chieftains shower on politicians from both parties.

So here’s another way to prevent private equity firms from again saddling their corporate prey with too much debt: Prohibit banks from committing financing to any LBO where the private equity buyers are not willing to pony up at least 50 percent of the purchase price.

A 50 percent equity threshold would stop banks from giving in to their worst impulses, which are to do whatever they can to win favor with the private equity firms, in the hopes of rich fees and the promise of lucrative stock and bond underwriting deals down the road.

And it will force banks going forward to make more loans to companies looking to expand their operations and create jobs — not destroy jobs, as is often the end result of an LBO.

Requiring a private equity firm to put up a dollar for every dollar in a financing that a deal needs to get done is not as extreme as it may sound.

In fact, at the end of the two most recent LBO booms, it was not uncommon for the small number of deals that did get consummated to involve equity commitments in excess of 40 percent, according to data compiled by Standard & Poor’s Leveraged Commentary & Data.

Even in a dismal year for private equity deals like 2008, there were still more than 600 leveraged buyouts in the United States with a total value of $61 billion.

But with the credit markets sealed tight, the private equity players who orchestrated these takeovers had to dig deeper into their own pockets — coming up with the funds to cover some 42.6 percent of the average purchase price, according to Standard & Poor’s LCD.

By contrast, during the peak of the most recent LBO boom, the average equity contribution from private equity buyers was 33.6 percent in 2006. But there were some mega-deals — Clear Channel Communications — in which the private equity firms were able to put down as little cash as a subprime home buyer.

Now Clear Channel is struggling mightily with the mountain of debt the private equity firms loaded up on the company to complete the $19 billion deal. Overall, companies taken private by buyout firms are sitting on some $400 billion in debt, much of which needs to be repaid in the next five years.

Of course, the private equity firms will complain that a minimum 50 percent equity commitment will stymie deal-making and impact returns for buyout funds. That’s no doubt true. It’s a good thing, too.




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I am a simple minded uncomplicit no nonsense kind of guy. The work I do creates value. My creativity guides my work and that helps me get equity. If I ever get to the point of an IPO it would be awful to find myself working for some lame group bent on my demise because thier position in my competition is threatened.
BO ok LBO no good.

Posted by DanO | Report as abusive

LBO are really ponzi schemes in which today’s investors will make out okay but tomorrow’s investors run the risk of failure. Th LBO overloads the company with debt and uses the money pulled out to pay off the investors. LBOs work to the detriment of the long term benfit of the public and the original business. So why does this coutnry admire equity groups so much?

I can only agree with the general statement about the outcome for companies overladen with debts. However a ban or a limitation to the amount of debt with which the LBO firm will laden the company is highly unlikely to happen. It all comes back to the banker’s responsibility who has to make a sound and informed decision on the amount of the loan he is ready to give out.
I strongly believe that if top CEOs and Managers at large banks and other private equity houses were indefinitely and jointly responsible for their bad investment decisions, things would be quite different. It is the model used by the unjustly criticised Swiss Private Bankers, were the partners are liable for their bank’s liabilities jointly on all their private assets. What would have the big bosses of UBS, Citi and other banks done if they had been in the same situation.
I guess we wouldn’t be in such a bad situation.
We can argue about regulation, restrictions, you name it for the years to come, but I strongly believe that without changing the way managers are responsible for the behaviour in managing other people’s assets, things will not change but only come back on a regular basis in a different way.
Antoine Praz, Geneva, Switzerland

LBO’s will be regulated only if the hedge funds and other havens of dirty(ill-begotten and generated)money by the nexus of business leaders and politicians,could be accounted for and regulated.

Posted by cosmicinsight | Report as abusive

Having sold a couple of businesses I always had to remind the buyers that a business could not buy itself. Some money has to be put in otherwise the new enterprise will be saddled with too much debt. I do think that 50% is a good minimum amount that must be invested and that investment must be real money(not paper) We can ill afford any more houses of cards in our economy. Also if the new owner does not have any risk they can gut the company and everyone loses.

Posted by f belz | Report as abusive

Anne, you obviously don’t know what you are talking about. I read classics, like Plato and Kant, all the time. So I know how the world works. LBOs are very important for general business.

So we are being said that there are idiot investors out there, borrowing money with the purpose of buying an entity, only to burden it with debt and destroy it.
Bad investments happen all the time. Does it matter if the money is borrowed? I don’t think so. If you manage to identify a good investment, it will make little difference if the funds needed are borrowed or not.

Posted by Michael | Report as abusive

[...] Matthew Goldstein on taking the L out of LBO, too much debt on these deals.  (Reuters) [...]

[...] The problem with LBOs is leverage.  (Matthew Goldstein) [...]

Having been in the business of selling companies for the past 17 years, I can only agree with the comment that a business cannot buy itself……… However for the past 2 decades that’s what an increasing number of financial investors have tried to do to increase their ROE.. Greed is of the essence here, and bankers as well as investors were blindsided buy the prospect of huge returns. They forgot that in all businesses, in all industries, there are cycles with sometimes significant ups and downs, and that a company has to rely on its internal resources to overcome difficult times….. Instead, They relied on hockey stick financial projections and borrowed huge amount of money to be repaid by their victims while they walked away with their pockets full with their hefty management fees and bonuses.
When you’re in finance or banking you can always shut down your computer, the light in your office and go back home with your bank account replenished. This can be done in a matter of seconds. Try do that when you are in hi tech, manufacturing complex products, with hundreds of engineers working hard to get the best product to their customers !!!
Again, it all comes back to responsibility. With an unlimited and joint responsibility of the managers and board members of these financial institutions entrusted with other people’s money, this would not have happened. And it’s quite unethical, unfair and whatever you want to qualify it, since very often, if not always, bankers ask for a joint solidarity of entrepreneur as a pledge to the loans made to their company. Why not the reciprocal to financial investors, bankers, LBO funds, etc. in fact everybody entrusted with someone else money ? Since I remind you that all this money comes from OUR pocket, meaning the money gathered without effort by the pension funds, life and other insurance companies…..
I really do not believe in a complicated and probably impossible or very difficult to enforce regulation on private equity, hedge funds, etc. especially when this regulation will not be equally implemented throughout the world. You cannot move your plant in a matter of days, but computers and bank accounts can, as well as people operating them.
I believe we should change the liability rules for Top Managers and Board Members to make sure that they also suffer the losses their clients suffer and are jointly liable for the losses. I don’t care if they make billions of dollars when things go the right direction, but I want to make sure that this wealth is at the same level of risk as their clients’ money.
Why should we continue to privatise the profits and collectivise the losses ? This cannot go on forever and not only the governments but private individuals and other responsible investors should stand up for a fair and equal treatment and vote with their feets when they are not satisfied with what they are told about the security of their investments and the fairness and ethical behaviour of their banker or asset manager.
Antoine Praz, Geneva, Switzerland

One solution for any cases. what a simplistic view…
Leveraged should be appreciated with the corporate risk.
Example : a toll-road company (I am french so excuse my bad english) is a low risk busines (EBIT >80% of the turnover) with almost constant cash flow can be acquired with a leveraged of 90% and still be a low-risk LBO.
Example 2 : a fresh food distribution company with EBIT circa 1-2% of the turnover have a high risk profile. If you buy 10 times its EBIT with only a senior debt of 5x EBIT (50ù) that’s a very risky investment.

Posted by oo | Report as abusive

I fully agree with “oo”. It is a business decision to find the proper leverage, but those making that decision should also take full responsibility for it. You cannot reap huge profits when things work out properly and let the investors and/or the company bear all the losses and burden when things go wrong and you have made a big mistake in assessing the level of debts which the company can support.
I still believe that any funds have a role to play in the global economy, mainly to support the sound developement of the companies they invest in. There are also many positive examples.
I’m stubborn, so again, it’s all about being responsible for what you do. That’s quite simplistic, I agree, but responsibility and confidence are key ingredients to any business relationship aren’t they ?
Antoine Praz, Geneva, Switzerland

[...] Take The L Out of LBO – Reuters [...]

I can’t believe people link to this idiotic article. Using this logic, we should reduce defaults and bankruptcies even further by prohibiting any purchase requiring more than 50% debt financing. Surely if people put down 50% equity to buy homes, cars, and companies we would not be in current mess.

It’s convenient to blame plenty of the current, global state of overleverage on LBO practitioners, but consumer overleverage from credit is a much greater problem.

Posted by Tom | Report as abusive

Great idea. In fact, no institution should be able to buy another w/o committing 50% of the price as equity invested into the deal. That’s the only way to prevent these over-leveraged LBOs. And by institution, I mean bank, hedge fund, PE firm, govt entity, AND (probably most importantly) each person. Every potential home-owner should be capped at a mortgage equal to 50% of the purchase price of the home. Every credit card transaction should be capped at 50% of the cost of the transaction. Students should not be able to borrow more than half the cost of their education. Cars 50% down, etc.

The only way to save ourselves is to have the government impose disciplines. Clearly that has worked so well so far with Fannie Mae, Freddie Mac, consumer debt, and now the Cars for Clunkers program.

But how do we stop Congress and government from over-leveraging the country?

Posted by Timm | Report as abusive

My name is Chris Gergen and I did not write the comment listed above under my name on September 2nd. Please remove that post immediately. Thank you.