Discover why companies choose the leverage buyout strategy and take debt to acquire other businesses.
You might have often heard that – An intelligent businessman makes profits from others’ money. That’s the reason why businesses prefer borrowing money. Companies then deploy the borrowed funds in their operations and generate profits. Meanwhile, they must repay the principal amount and interest to the lender.
That’s precisely how debt works, right? But debt is risky. Companies like Suzlon Energy and Reliance Capital have lost their crown jewels to massive debt. Hence, managing debt is essential for every company.
But why are we suddenly talking about debt? Because today we will tell you about a type of deal which is majorly funded by debt. Here a company acquires or merges with another company, and the majority of the deal is financed through debt.
The deal we are talking about is called Leveraged Buyout.
While it was once a widespread practice in the US, it remains relatively unknown in India.
What is Leveraged Buyout?
Leveraged buyout is indeed a risky merger, and let us tell you how.
A leveraged buyout is a merger in which the acquiring company uses borrowed funds to buy another company. This means that they take on a significant amount of debt to finance the purchase.
Do they actually keep their assets as mortgages and take such a huge loan to acquire the new company? No, that’s not the case. The acquiring company borrows money by keeping the target company’s assets as collateral for the loan. If the debt is not repaid, the target company’s assets may be used to cover the outstanding debt.
But, you may wonder how a company can mortgage the assets of another company when they don’t own it in the first place. To understand this, you must understand how the leveraged buyout deal takes place.
How Does a Leveraged Buyout Deal Take Place?
When an acquiring company wants to purchase a target company but lacks sufficient funds, they invest a relatively small amount of money upfront compared to the total purchase price of the target company. They turn to leverage to cover the remaining cost, which involves securing debt or issuing bonds as a funding source.
To take the process further, the acquiring company establishes a new corporation. The target company then becomes a subsidiary of this newly formed corporation.
To secure the necessary funding, an institutional investor or financial sponsor issues bonds or obtains a loan. Here, the target company’s assets are kept as collateral for the loan.
The loan is then repaid using the target company’s cash flows.
Leveraged Buyouts in India
The first ever successful leveraged buyout in India occurred in 2000 between the Indian company Tata Tea and the UK-based company Tetley Tea.
After the leveraged buyout deal of £271 million, Tata Tea became the world’s second-largest tea company, transforming it from a plantation company into an international consumer products company.
As a leveraged buyout deal, Tata Tea minimised its cash outlay for the purchase and relied on debt. Later, they repaid the debt using Tetley’s cash flows.
Apart from this, there were a few more leveraged buyout deals like the Indian spirits behemoth; the United Breweries Group acquired select brands of Whyte & Mackay (W&M) through leveraged buyouts where ICICI Bank and Citi Bank funded the buyout.
Following the path of the Tata-Tetley deal, Tata Steel acquired the UK-based steel-making company Corus Steel. Today it is known as Tata Steel Europe Ltd.
Similarly, in 2006, Suzlon Energy, an Indian company, acquired Hansen Transmission, a Belgium-based company renowned as the world’s second-largest manufacturer of wind turbine gearboxes. But, the irony is that they had to sell off the company to help repair its overstretched balance sheet.
Advantages of Leveraged Buyout
Higher Return on Investment
A leveraged buyout is an attractive option for acquiring companies because it allows them to invest a smaller upfront amount while still earning a high return on investment.
For example, Company A wants to acquire Company B for Rs 100 crore but lacks sufficient capital, so they pay only 10% upfront and borrow the remaining 90%. The borrowed amount incurs an annual interest of 10% (Rs 9 crore).
Company B already generates Rs 15 crore in revenue annually. After deducting the interest payment and taxes, let’s assume they have a net income of Rs 4 crore. If Company A opts for the leveraged buyout, they will earn Rs 4 crore on their investment of Rs 10 crore, resulting in a 40% yield.
In contrast, if Company A had used its own funds and invested Rs 100 crore, it would earn a revenue of Rs 15 crore, translating to a 15% yield. Moreover, after accounting for taxes, the yield percentage would decrease further.
This example illustrates how a leveraged buyout can be viewed as a profitable deal.
Access to Better Deals
After the merger, the merged entity benefits from increased capacity, enabling it to handle larger production volumes and fulfil big orders. For example, in the case of the Tata-Tetley deal, the company became the second-largest tea company in the world. With these enhanced capabilities, the entity must have attracted bigger deals, benefited from economies of scale, and gained a competitive edge in pricing.
Challenges of Leveraged Buyout
Rising Cost of Capital
In a leveraged buyout, the acquiring company’s goal is to repay the loan, including interest, using the target company’s cash flows. This approach is profitable when borrowing cost is low, and the target company generates healthy cash flows.
However, if interest rates rise, the debt may be repriced, resulting in higher interest expenses. If the company cannot generate sufficient cash flows to cover the increased costs, it may face financial challenges or even default on its loan payments.
To conclude, leveraged buyouts can be a lucrative strategy for companies, but it requires careful debt and cash flow management to ensure long-term success.
*The article is for information purposes only. This is not an investment advice.
Note: This article was originally written by Teji Mandi for ET Markets.