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Leveraged buyout (LBO) is very interesting way of acquiring new businesses and assets.
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You may have already heard about this word: “LBO” or “Leveraged Buyout” (if not then you are in the right place). And if you did, there is a high probability that you did not understand a single thing about it. Classic… Because financial engineers behind every LBO try as hard as they can to make it unreadable to you. They do it because of two reasons: they don’t want to disclose useful information and because they are not pedagogic at all (less than your German teacher… I imagine)
You might ask yourself “Why should I bother about LBO during my free time?” It is true that it is not the most common subject in financial news and least in your dinner with your crush. Actually the truth is: understanding a LBO gives you valuable strategic and financial knowledge. Valuable because you will develop a capability to anticipate some market moves, and because saying “I’m analysing a LBO” is ten times better than “I’m reading Donald Duck”. More seriously, if you understand a LBO, you are able to understand any corporate finance concepts and you have a true advantage compare to an average finance reader.
Hence, I have decided to make you a notice, a guide for LBOs. Then you won’t say “I didn’t know”. Let me tell you the story of LBO with Harley Davidson case.
A Leveraged Buyout is simply the purchase of an asset (often a firm) by a buyer. This purchase has the particularity to be done with the help of the buyer’s indebtedness. This is a technique which appeared in 80s and which is part of the family of “Structured Finance” (A fancy word that you can say if your GF or BF asks you too much about what you’re reading and you don’t want to explain).
“LBO” is the big name. Actually there are several categories of LBO (MBO, MBI, BIMBO…) but it is not a requirement to know exactly all of their meanings. You just have to know that depending on who is the buyer in the LBO, the category changes accordingly.
To understand a LBO you have to understand who the parties are. There are basically three parties involved in the process: the targeted asset, the buyer and the sponsor bank.
They all have their personal interest in a LBO.
a) The targeted asset:
The targeted asset is the essential thing in a LBO because it gives importance or not to the LBO. A targeted asset in a LBO has no more utility for its owner. Then, they try to get rid of this undesirable asset in their books. The asset’s owners can sell an entire company, a little subsidiary, a complete activity... However, the size of an asset does not affect the way you have to analyse it. According to Charles-Henri Larreur (who wrote an excellent book about structured finance), the perfect asset in a LBO is an asset with:
The aspect 1 has an aleatory aspect. At the LBO date the targeted firm can answer well to the financial requirement, nothing can give us a 100% probability that tomorrow will be the same.
The aspect 2 is subjective. The appreciation of a given perspective of growth depends from one to another.
Then, the perfect asset for an LBO is not a company which answers perfectly to all of these criterias (because if it does exist, it surely won’t be sold). It is the one who tends to get the closest to these requirements.
With this information, you can already make your own opinion on the asset sold in a LBO.
The buyer of a company with a LBO is the leader of the process. He has the initiative and also puts money on the table to acquire the targeted asset (30% of the whole sum for instance). The buyer can be a Private Equity Fund, an individual or another company. Depending on who is the buyer, the objectives behind a LBO change.
A fund would seek to make a profit with an asset by buying it, restructuring it and eventually selling it to another fund or other party. The horizon of the LBO is very short.
An individual would seek to use the targeted asset to realise an entrepreneurial project. Individual tend to think over the long term. The individual can be an executive from the bought out company as we will see with Harley Davidson. A company would use a LBO to eliminate a competitor or to strengthen its competitiveness on its market.
Looking at the buyer gives you strategic indications on the LBO’s future. What does the purchaser aim with an asset? Is it a long term purchase? Why a buyer is focused especially on one subsidiary in the company?
The sponsor bank:
The bank (or the banks, it depends) concerned by the LBO does one thing in the deal: they lend money to purchaser. The bank has one concern: the ability of the buyer to pay back its interest.
As this capacity depends on the targeted assets and its dividends’ streams. The bank is actually concerned by everything in a LBO (Like your gran mother when preparing the Christmas dinner). The bank checks both the buyer and the targeted asset. During the first one, they check his indebtedness, money management historic and his financial past (his financial successes or defeats by the past).
During the second one, they check the nature of the targeted asset and how it could be a successful purchase. They check if the targeted asset will provide enough cash to the buyer for the loan reimbursement.
Depending on its appreciation of the buyer and of the targeted asset, the bank can rise its interest rate on the loan and affects the whole deal.
Eventually, they organize the deal with a SPV. What is a SPV? A pot where the buyer and the bank deposit all the money for the acquisition (the actual name is Special Purpose Vehicle). The SPV will use the dividends from the targeted asset to pay back the bank first, then the purchaser. The last sentence refers to debt’ structure.
Looking at the bank's decision on the LBO gives you financial indications about the nature of the LBO. Why the interest rate is high? Why a bank prefers not to lend the whole sum? Investigate reasons and statements.
You all know the great motorcycle brand. Born in 1903 in Milwaukee, the firm has built its success on the reputation of its model. James Dean, Marlon Brando, even the US army is equipped with Harley Davidson motorcycles.
Difficulties appeared when Asian brands came in the US by the West Coast during the late 50s. Harley Davidson produced heavy, big and powerful models while Honda and other Asian brands were focused on little models with high efficiency in mind. Harley Davidson didn’t see the threat and lost its leader position on the market very quickly.
Harley Davidson’s owners decided to sell the firm in the 1970s. The problem was that there were not many interested buyers at this time. Harley Davidson did not inspire a lot for investors. The firm was closed to being bankrupt. Goldman Sachs was the institution in charge of finding the LBO parties and eventually found that the management of Harley Davidson was interested to acquire the firm.
Hence, Harley Davidson is bought by an intern LBO of 81.5 millions of dollars in 1981. The purchaser are led by Vaughn Beals (CEO) and backed by CitiBank (sponsor bank) which provided 87% of the requested amount.
The post-LBO era is managed by the old management team of Harley Davidson. They had not many resources as they were already indebted for $71 millions. They had to make Harley Davidson successful again within short period of time and without expensive improvements.
They decided to make complete modifications on the operations of the firm by getting inspirations from Asian competitors. The “just in time” process (a production concept created in Asia) is excellent because it makes the production process more efficient and less costly. Harley Davidson invented a new motor which is more reliable and more efficient.
Also, they've decided to redesign motorcycles…Unfortunately, Harley Davidson had to fire 50% of the workforce at every level to reduce production costs.
Thanks to this strategy led by courageous managers, Harley Davidson changed its market position. In five years the sales increased by 135%. Harley Davidson came back to its leader position and eventually made its IPO in 1986. A true success in the LBO industry.
Now you're a bit smarter than 20 minutes ago. You can say “My opinion on Harley Davidson LBO is…” We hope this article has brought plenty of satisfaction to you and if not please let us know why :)
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Written by Samuel Chaineau│Co-founder of HNFC
Edited and Corrected
by Vee Venski
This article is not a promotion of financial investment. Investing money in financial instruments is risk-reward process. Losses and gains are part of financial investment process. Only invest money you can afford to lose.