A leveraged buyout is the acquisition of a company using significant amounts of borrowed money to meet the cost of acquisition. Often, the assets of the acquired companies are used as collateral for the debt. Leveraged buyouts, as a means to acquire companies came into prominence in the 60s and 70s. Kohlberg Kravis Roberts set up by Jerome Kohlberg Jr., Henry Kravis and George Roberts, better known as KKR was primarily responsible for this.
Leveraged buyouts have come into prominence in India in recent times, mainly due to India Inc. going global to quench its thirst for growth by acquiring companies larger than itself. Leveraged buyouts empower smaller firms in India to acquire larger firms abroad by helping to raise major portions of the necessary capital through debt.
In this edition of Delphique, we attempt to address questions raised about the pros and cons of Leveraged Buyouts (LBO). Does the increased debt in firms acquired through the LBO route increase their efficiency or make them merely a riskier proposition? We also hope to address the reason LBOs are at such a nascent stage in India. What does the government need to do to empower India Inc. to address its global ambitions? Is it safe for the regulatory authorities to allow banks to contribute towards the debt funding of an LBO or is it better to maintain status quo? On a more holistic perspective, is it beneficial to the society as a whole or detrimental as viewed by stalwarts like Warren Buffet?

We shall begin this discussion by studying the impact that an LBO has on the various stakeholders that are involved in it.

Acquirers:
Acquirers could either have strategic or a financial perspective for executing an LBO. In case of strategic LBOs, the acquirers are looking for synergies with their current operations. This ensures that they invest in the acquired company’s future and don’t sacrifice long term potential for short term gains. This leads to better performance and a secure future.
On the other hand for LBOs carried out for financial gains, the acquirers have a smaller time frame in mind. Value is created by hiving off non core businesses and reducing wasteful expenditures.
However, to maximize returns they might sacrifice long term investments, which might have been undertaken otherwise. This could be detrimental to the health of the company in the long run. For instance expenditures like capex and R&D which are essential to ensure competitive advantage, might not be undertaken once the company is taken over by using an LBO.
In addition, in the Indian scenario, acquirers face challenges in raising capital. This can be attributed to the under developed debt market in India, which is not suitable for developing such complex instruments of financing as required in an LBO. Also certain existing government regulations prevent banks from taking an active role in financing of such deals.
What could be the measures taken for creating liquid and mature debt markets in India?

Old Shareholders:
The impact of LBOs on old shareholders of the acquired company is a point of contention. On the one hand, while they receive a premium on the existing stock price at the point of exit; it could also be argued that they, especially minority shareholders, are deprived of the value that may be realized once the LBO is completed and successful in the long run.

Old debt holders: Due to the inherent risk involved in an LBO, the credit worthiness of the company as a whole is reduced. This impacts the existing bond holders by increasing the yields required, thus devaluing the bonds they hold.
Another aspect is that if existing bond holders are not covered by suitable covenants, their debt could be subordinated to the new debt raised for the LBO.
Thus credit rating agencies play a crucial role in assessing risk associated with an LBO. Is it necessary for these agencies to develop a new framework to assess companies which have been taken over by a LBO and if so, what are these changes?

Management: An LBO carried out at the initiative of the management, (management buys part of the stake) is known as Management buyout. When the management feels that the current owners are not investing enough into the business or when they are of the opinion that the market is undervaluing the business, they could take the company private to make better use of the existing opportunities to realize the value of the firm.
The negative aspect of this could be that the management may be using insider information for its own benefit, thus depriving the existing shareholders. On the other hand it could be argued that since the management knows the business the best, they are in a position to achieve best results. Also since the management takes a stake in the company, this ensures greater commitment and better performance from them.

Employees:
Presence of debt ensures greater control over spending and reduces wastage. This leads to leaner and more efficient organizations. Also employees are set stiffer targets, leading to a general improvement in their performance.
However one of the methods employed to develop lean organizations involves laying off people. This is major concern for not only the employees of the company but to the society as a whole. This is one of the reasons that LBOs developed a bad reputation in the United States during the 80s.

Investment Bank:
Investment banks play a very important role in structuring and executing such complex deals. They act as mediators between various stake holders.
But concerns have been raised about their role in LBOs. Investment banks usually earn a fixed percentage from the deal. Since they have no stake in it, they have been accused of pushing deals through without view of the consequences, thus creating riskier firms in the process. Is this criticism justified?

Wealth creation vs. Wealth Transfer:
An important point of contention is that whether LBOs help in wealth creation or are just a means of wealth transfer. For instance it could be argued that the leveraged buyout of Manchester United, the prestigious football club in England, led only to transfer of wealth from the past owners to the Malcolm Glazer, the buyer and did not benefit the club in any way. In fact the club, which was initially debt free, had a huge amount of debt in its books.
The proponents of the wealth transfer theory of LBOs, describe them as a zero sum game, where wealth has been transferred from the old owners to the new owners, creating no new value.
A counter example is the Tata-Corus deal. This deal could be expected to create wealth for both the stake holders of Tata and Corus due to the existing synergies between them and achieving consolidation in the steel industry.

Impact of LBOs on society:
Proponents of LBO point out to the fact that an LBO enables the creation of a market which acts as an able substitute to the share market for realization of a firm’s value. When a company that has gone private through the means of an LBO is listed after its value is realized, this process enhances the efficiency of capital markets.
However, LBOs also increase the credit risk present in the society as a whole. The latest report by IMF states that the increased trend of LBOs being done with a higher percentage of debt coupled with the fact that target companies in LBOs are shifting from cash rich companies to sick companies means that the credit risk in the financial system has increased tremendously.
Also, the primary benefit of LBOs comes from the tax benefits that such a system enjoys. This is also seen as detrimental to the society as the tax perks enjoyed by the firm imply lesser resources available to be spent for the society.

Warren Buffet v/s KKR
We believe PE firms are an alternative to capital markets which help undervalued firms realize their true valuations. However, in the world of investment we see 2 very different approaches being followed to derive this value. On the one hand, we have Warren Buffet, who views leveraged buyouts as harmful to the society. He describes the process of LBOs as driving a car with a dagger facing the driver. One would drive the car better but a small bump and one could end up with a deadly and unnecessary accident.
At the other end of the spectrum is the private equity firm, Kohlberg Kravis Roberts. This firm has made many firms efficient by burdening them with debt and providing managers incentives by making them buy a stake in the company to solve the agency problem.
Thus, to conclude we wish to answer questions like what impact LBOs have on individual stakeholders and what benefit do they bring to the society as a whole and taking it forward from here we would like to explore and question the two different investment philosophies followed by two very successful investors -- Kohlberg Kravis Roberts and Warren Buffet.