Leveraged Buyouts and Private Equity - Essay Example

? Leveraged Buyouts and Private Equity Contents Introduction 3 Thesis ment 3 Emergence 3 Theory of leveraged buyout 4 Private equity firms 4 Private equity funds 6 Private equity transactions 8 Private equity fund returns 9 Boom and Bust Cycles in Private Equity 11 Current Events of Private Equity 12 Conclusion 13 Reference 15 Introduction An organization is often taken over by a particular firm involved in investment activities. These firms use a comparatively tiny portion of equity and a comparatively large portion of outside debt financing. This type of activity is known as leverage buyout. These leveraged buyout firms are generally referred as private equity firms who buy a major proportion of control of existing firm. There is a difference with venture capital firms as they do not obtain the major proportion of control by investing in young and dynamic firms. Thesis statement Leveraged Buyouts and Private Equity- A summary and current events Emergence Leveraged buyout first came into the picture as an important phenomenon in 1980s. It was predicted that these types of organizations would form the major portion of organization which will eventually become the dominant one. These types of private equity firms involved themselves in various measures like providing incentives based on managerial abilities, and introduced the concept of active governance. They relied upon the possibility of junk bond financing. A few years later the junk bond market crashed resulting in bankruptcy of several leveraged buyouts and the leveraged buyouts of public to private transactions vanished in the starting phases of 1990s. But the market of leveraged buyout was also suffering a gloomy phase as the private equity firms continued their operation by acquiring private companies. The US experienced the boom in market of leveraged buyout in the mid 2000s. The evidences supported by various researches on some selected companies reveals that private equity investors took the advantages of time factor between the debt and equity markets. Theory of leveraged buyout The importance of leveraged buyout lies in the usage of financial leverage in order to strengthen the acquisition of the company that has been targeted. The generated cash flow from the bought out business is used to cover he debt incurred in the acquisition. The debt holders are usually expected to earn affixed return while the equity holders seem to grasp all the benefits in a successful buyout. The factors that influence a good leverage buyout includes strong consumer base, small amount of debt on balance sheet, the management team consisting of dependable hands and continuous cash flow (Tuck School of Business at Dartmouth , 2003, p.p. 7-8). Private equity firms Private equity firms are characterized by firms where general partners take the initiative to manage funds while the other partners take the responsibility to provide capital. The limited partners comprise of pension funds, wealthy individuals, and companies operating in the insurance sector. It is important for a partner to contribute to at least 1 percent of the wealth of the firm. The private equity firms has the opportunity to invest the committed capital for at least five years but the period can be extended to ten to thirteen years to return the capital. Again the fund has the life of ten fixed years but can have the extension to thirteen. The limited has little liability in the working of the capital as long as the initial agreements are met. The agreements include restrictions on the amount of capital that can be invested in a company, the particular form of securities in which to invest, and on the level of debt. There are three ways to compensate a general partner. With an annual management fee which is usually a portion of the committed capital and then as a portion of capital employed when the investments are realized. The general partners also earn a share of the profits and they can also charge fees for deal and monitoring to the companies where they put their money in. Portfolio companies often pay fees to the general partners and the ranges of these fees are sometimes the benchmark in the negotiations of fund raising. In a private equity transaction agreement the acquiring firm pays a premium of 15 to 50 percent above the current stock price if the company is public. The term leveraged buyout arises from the buyout financed with 60 to 90 percent debt. A loan portion is included in the debt which is arranged by investment banks. Presently institutional investors including hedge fund investors and managers purchase a major proportion of secured loan. The debt also includes a portion financed by high yielding bonds or bonds subordinated to the senior debt. In the last few years the economy has witnessed the unprecedented growth of private equity partnerships. The business had the investment of less than 10 billion dollars in 1990 while in 2006 the total amount of investment raised to 432 billion dollars with more than 680 firms. The private equity revolution witnesses a change in capitalism. This change works because of the interests between two sets of parties namely the investors with corporate managers and investment managers. (Haarmeyer, 2008, p.247) Private equity funds The private equity firms invest equity with the funds of the investors as a cover the 10 to 40 percent of the cost price. The management of the acquired company can also contribute in funding the new equity but the amount is usually small percentage of the contributed equity dollars. After the emergence of private equity funds in 1980 there has been an exponential increase in committed nominal dollars each year to the private equity funds of U.S. It will be more appropriate to measure the committed capital as a proportion of the total value of the U.S. stock market. Source: Kaplan and Stromberg, 2009, p.125 Source: Kaplan and Stromberg, 2009, p.126 The first figure provides the evidence to comment that there are cyclical fluctuations in equity commitments. Although data is unavailable in comparing the information of commitments of capital with non U.S. funds but it can be said that there has been substantial growth. The number and the value of leveraged transactions across the globe by a private equity fund sponsor are shown in the second figure. Not computed transaction is taken as functions of various deals. The patterns of private equity fundraising are shown in buyout transactions. Transactions characteristics evolved with the growth of private equity market. In the period of 1985 to 1989 the business of buyout leverage accounted by large transactions in the industries of manufacturing and retail. The ratio of operating income to sales accelerated by 10 to 20 percent according to Kaplan and Smith while according to Lichtenberg and Siegel there was significant increase in total factor productivity post buyout. Kaplan showed that employment increases after the buyout operation in 1980s and it was supported by Lichtenberg and Siegel 1990 (Berg, n.d. p.18). This was also supported by Davis, Haltiwanger, Jarmin in 2008 but the important point to note is that they found that the growth of employment has been smaller before the buyout transaction in the study of large sample of U.S leveraged buyout (Boucly, Sraer, and Thesmar, 2010, p. 432). However studies of Amess and Wright in 2007 have shown that firms experiencing leveraged buyouts in United Kingdom from 1994 to 2004 had similar employment growth but the wage rate has increased slowly (Hall, 2007). The findings were similar to that of Kaplan in the study of 59 large buyouts from 1997 to 2003 as studied by Acharya and Kehoe in 2008. The percentages of ownership management remained greater in leveraged buyouts. One of the concerns includes the finding that an increase in cash flow can take place because of leveraged buyout but this may hurt the future cash flow. Kaplan advised to study the performance of the leveraged buyout organization after they have gone through an initial public offering. A study finds a non-negative stock performance adjusted for the industry after such public offering (Cao and Lerner, 2007). Private equity transactions These types of transactions paved the way to form the conception of private equity. But there was a drop in public to private transaction to less than 10 percent of the total value of transaction following the fall in junk bonds. On the other hand significant growth took place in middle market buyouts. The buyout activity spread its shadows in information technology and financial services while retail and manufacturing firms triggered away from being targets. The markets continued to evolve as the private equity experience steady growth from 1995 to 2004. There was an emergence of secondary buyouts where the funds of private equity comprise of existing investments and the funds from the sale of portfolios to other private equity firms. The western European private equity market accounted to 48.9 percent of world wide leverage which surpasses that of U.S from 2000 to 2004. There occurred a equity boom from 2000 to mid 2007. Rapid increase in numbers and size of secondary buyouts and public to private buyouts constituted to more than 60 percent of the total amount of leveraged buyout during this period. Private equity activity speeded to new portions of the globe and buyouts in non manufacturing industries showed its progress. Private equity fund returns The leverage buyouts can create value but this does not support the fact that private equity funds are able to earn a superior returns accruing to their limited type of partner. Sellers are likely to take over a meaningful portion of the value as private equity firms are engaged in acquisition of firms through competitive auctions. The credit market activities can have an impact on the commitments patterns of private equity firms. The private equity investors can hold upon the advantages of systematic mispricing. It will be possible to benefit for the private equity firms when the cost of debt is low relative to equity cost. It depends highly on the presence of frictions in the market that acts to segment the debt and equity markets. In order to examine the impact debt mispricing it is required to assume an unlevered public company that is being run in optimal fashion. The private equity firm can create value by borrowing if it can borrow at a rate which is low relative to the given risk. The mispricing theory reveals that there will be more undertaken deals when there are unusual favourable debt markets. The turmoil in credit market in the later part of 2007 interprets that the buyout wave was fuelled by the favourable terms from debt investors. Calculating the enterprise value is necessary to measure the cost of the deals. The cash flow of the firm is calculated using the standard measure of performance relating to the firm during the time of the buyout. The firm level performance is measured by EBITDA, which is referred as earnings before interest and taxes, accrued depreciation and amortization. The multiples of valuation exceeded that of 1980s although more research can be put to get into this interpretation. The last decade showed higher ratios in corporate values to flow of cash. To look at the fluctuations in leverage buyout it is required to compare the ratio of equity in each period of time and take into account that share of equity that was comparatively constant in the both wave ranging from 10 to 15 percent in the first wave and at around 30 percent in the second wave. The significant increase in equity percentages between the eras is of the prediction and arguments that was offered by debt investors in 1980s for large leverage and on favourable terms. Lower interest coverage ratio indicates more fragility of buyout as the firms has limited options for not enabling to meet the payments due on interest. It was found out that deals were subjected to more fragility in the recent wave as ratios of interest coverage were higher. The second wave remained to follow the cyclical pattern. For a private equity boom to take place the earning yields must be greater than the rates on interest mainly on the bonds that are high yielding. The tendency of private equity activity is on the lower side the yielding of operational earnings are less than rates of interest. Leverages are found to be uncorrelated to similar size, leverages within similar industry and public firms. Leverages are also uncorrelated to factors that are specified to firms and explain leverage in public firms. There seems to be rise in interest rates as the leverage in the leveraged buyouts decrease. The availability of leverage affects the payment that a private equity firm makes to acquire a firm. Studies have shown that the transaction of public to private experienced increase in performance of the firm but of modest type and are able to generate financial returns to private equity funds in the post 19080s. These findings are consistent with the statement that private equity firms targets the undervalued industries (Guo et al. 2007). Boom and Bust Cycles in Private Equity In the recent decades the private equity transactions and the commitments have showed that the conditions of the credit market may affect the activities. The interest rate in the junk bonds is very high as these securities are not so secured. Therefore, this type of bonds affects the credit market conditions. There is one hypothesis about this type of bonds that the investors used to take the advantages of the mispricing of debt and the equity markets. Most recently the repayment schedule has become more flexible for the leveraged buyouts. As the collateral assets are from the acquired company, and the debt size is large; as a result it is tough for the investing companies to repay the loans. In some cases the investing companies get bankrupted. Because of this the repayment schedule by the creditor companies has been liberal recently. The boom period of the private equity period comes when the earning yields cross the interest rates on the bonds which are of high yields. The private equity period was at its pick in the year 2005-06 and in the late 1980s. On the other side when the interest rates from the high yields are of low rate than the earnings from the operating earnings then that is a bad sign for investing in the leveraged buyouts. It can be said, if the sufficient debt finance is available to the company which wants to invest in other companies, only relying on loans; then it is fine for them to go with the strategy. Sufficient debt market brings the boom period in the private equity market. Current Events of Private Equity The largest leveraged buyout (Texas energy giant TXU) has become a painful incident for the investors. The bonds of the company are now named as ‘a big mistake’. A loss of 1.9 billion dollars was reported and loss of market power to 17 percent because of cheaper rivals. The debt burden of 35 billion dollars was put into the balance sheet to finance the buyout (Lattman, 2012). Advent International Corp. and Goldman Sachs Group Inc’s private equity signed up a deal to buy the company from Madison Dearborn Partners and the Pritzker family, which will the largest buyout deal for the year. According to the statement from TransUnion, the deal is expected to get complete by the early phases of the second quarter and values the company at more than 3 billion dollars (Crabill, Baumgaertel and Friedman, 2012). A private equity consortium was composed of Goldman Sachs, KKR and TPG. This was known as one of the healthiest consortium of private equity. At the time of boom of buyout, which is in the year 2007, the consortium has planned to buy the largest Texas Power Generator. But the private equity deal was not successful at last. The leverage buyout was of $45 billion. But the consortium invested money as they thought that the price of Gas will go up and they will make profit from that, instead they have incurred loss from that as the price of gas has went down. The private equity firms have targeted the companies which are in the industry of supplying the natural gas, as it is one of the most profitable businesses of the future (McCrum and Bullock, 2012). Conclusion Leverage buyout is a strategy through which a company acquires any other company without investing much equity of them. Instead they prefer to finance the transaction through borrowing. The assets of the acquired company is there as a collateral of the bond. These types of bonds are known as very risky and also known as junk bonds. The reason behind such acquisition is that the companies can acquire other companies without much investment in the equity. In a leveraged buyout generally the debt equity ratio is 9:1, which means there is 90% debt financing and 10% equity financing. This debt equity ratio makes the financing and the acquisition very risky. The acquiring companies take loan from the banks with the collateral of the assets of the acquired companies. As the debt equity structure of the company is like this, as a result, the debt of the company become risky. Mainly the investment firms buy the companies with the small portion of equity and the large portion of the debt. The strong empirical evidence witnesses the fact that economic value is created on average due to the activity of private equity. The result will get cemented in the future as private equity firms are increasing investments in operational engineering. The activity is believed to have a substantial permanent component. But empirical results also support the fact that boom and bust cycles cannot be eliminated from private equity activity. The boom and bust cycles are subjected to returns and interest rates relative to the values in stock market as well as earnings. Larger public to private transactions provides further evidence supporting the empirical results. Unfavorable debt markets will pressurize the firms to invest the committed capital and commitments of private investors towards private equity funds will remain stable. It cannot be expected that private equity firms will return the money because of the structure of fees of private equity funds but structure of deals in private equity will evolve as suggested by the patterns. Private equity commitments are likely to decline with the decline in returns of private equity. Reference Kaplan S and Stromberg P, 2009, Leveraged Buyouts and Private Equity. [Pdf]. Available at: http://faculty.chicagobooth.edu/steven.kaplan/research/ksjep.pdf. [Accessed March 9, 2012]. Tuck School of Business at Dartmouth, 2003, Centre For Private Equity and Entrepreneurship, [Pdf]. Available at: http://mba.tuck.dartmouth.edu/pecenter/research/pdfs/LBO_Note.pdf. [Accessed March 12, 2012]. Berg, A. Understanding Value Generations in Buyout., no date. [Pdf]. Available at: http://www.hec.fr/var/fre/storage/original/application/2fb5663dd12520435a66a7033a1f2c2a.pdf [Accessed March 12, 2012]. European Finance Association, 2009, Are Buyout Sponsors Market Timers in RLBOs?.[Pdf]. Available at: http://www.efa2009.org/papers/SSRN-id1031690.pdf. [Accessed March 12, 2012]. Boucly, Q., Sraer, D., Thesmar, D., Growth LBOs. [Pdf]. Available at: http://www.princeton.edu/~dsraer/bouclysraerthesmar.pdf [Accessed March 12, 2012]. Haarmeyer, D., 2008. Capitalism’s Misunderstood Entrepreneurs and Catalysts for Value Creation. [Pdf]. Available at: http://www.independent.org/pdf/tir/tir_13_02_5_haarmeyer.pdf. [Accessed March 12, 2012]. Hall, D., 2007. Methodological issues in estimating the impact of private equity buyouts on employment. Available at: [online]. http://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cts=1331540077167&ved=0CCUQFjAA&url=http%3A%2F%2Fwww.psiru.org%2Freports%2F2007-05-PE-emp.doc&ei=lK9dT7e7FcrOrQeqktmRDA&usg=AFQjCNHVM3tkz8p8_UZISZA5yE-HvngFKg. [Accessed March 12, 2012]. Lattman, P., 2012. A Record Buyout Turns Sour for Investors. Available at: http://dealbook.nytimes.com/2012/02/28/a-record-buyout-turns-sour-for-investors/ [online]. [Accessed March 12, 2012]. Crabill, S., Baumgaertel, C., Friedman, J,. 2012. Goldman Sachs, Advent to Acquire TransUnion for $3 Billion. Available at: http://news.businessweek.com/article.asp?documentKey=1376-LZJJJC0D9L3501-0PDFG7KJL4AM008N [online]. [Accessed March 12, 2012]. McCrum, D. and Bullock, N., 2012. Utility Buyout Loses Power in Shale Gas Revolution. [Online]. Available at: http://www.ft.com/cms/s/0/79b81e42-648f-11e1-9aa1-00144feabdc0.html#axzz1oiPfBH3n. [Accessed March 10, 2012]. Read More