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An LBO involves buying a controlling interest in a company using leveraged finance, with loans secured against the company’s assets. The amount of leverage used is typically high, with debt making up around 60% of the purchase price. LBOs became popular in the 1980s, with hostile takeovers used to strip companies of assets for immediate profit. The biggest LBO ever was KKR’s acquisition of RJR Nabisco.
An LBO, or leveraged buyout, is where someone buys a controlling interest in a company’s stock using leveraged finance. The LBO is used when an acquiring interest is unwilling to invest or does not have the amount of capital needed to effectively purchase a controlling interest in a target company. To finance the purchase, they take out massive loans, using the company’s assets they acquire as collateral against their debt. They usually liquidate the company they bought, pay off the loans and pocket the profit.
Generally, the amount of leverage used in an LBO is high, but not excessively so. The average percentage of the total purchase price made up of debt is usually around 60%, but in some cases it can be as high as 95%. Such cases tend to occur only when the expectation of profit is almost guaranteed, when the borrowing group is highly reliable, and when the profit to be made is quite high.
The first LBO likely took place in 1955 when McLean Industries borrowed $7 million USD to purchase Waterman Steamship Corporation for $49 million. After the company was acquired, $20 million of Waterman Steamship Corporation assets were sold to pay back the borrowed money. Small-scale examples of LBO continued into the 1950s and 1960s, when they began to grow a bit. Since the inception of the LBO, the use of publicly traded holding companies has grown as a way to acquire investments in other assets, a tactic used to great effect by the big financiers of the 1960s, including Victor Posner and Warren Buffett.
In the 1980s, the LBO grew in popularity, with over $250 billion in purchases taking place in that decade. It was largely brought about by a 1982 purchase by William Simon of Gibson Greetings for $80 million, of which something in excess of 95% of the investment capital was leveraged. Just over a year later, the company had an initial public offering (IPO) worth over $290 million, generating a profit of over $65 million.
It was during this period that the so-called corporate attack on the LBO came to the fore. This type of LBO often used a hostile takeover to buy the target company, rather than negotiating a sale willingly. After the sale, the acquiring group used to strip the company of its assets or break it up into its constituent parts and sell each part at a profit. This was also called scorched earth investing, as buyers would swarm in, take a relatively healthy or somewhat ailing company, and break it up into pieces for immediate profit.
The biggest LBO of the 1980s, and the biggest ever adjusted for inflation, was KKR’s acquisition of RJR Nabisco. After submitting a final bid of $109 per share, well above the initial bid of $75 for Shearson Lehman Hutton, KKR won a fierce bidding war to acquire Nabisco. This LBO was recorded in the seminal book on the LBO and hostile takeover, Barbarians at the Gate.
Asset Smart.
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