What is a leveraged buyout?
A leveraged buyout, also known as a leveraged share buyback, is a business financing transaction that allows a company to buy back some of its shares using debt. By reducing the number of shares in circulation, it increases the respective shares of the remaining owners.
Leveraged buyouts have similar impacts to leveraged recapitalizations and dividend recapitalizations, in which companies use leverage to pay a single dividend. The difference is that dividend recapitalizations do not change the ownership structure.
Key points to remember
- A leveraged buyout is a financial transaction that allows a company to buy back some of its shares using debt.
- The process increases the actions of the remaining owners by limiting the number of shares outstanding.
- Companies sometimes use leveraged buyouts to protect themselves from hostile takeovers by having additional debt on their balance sheets.
- Most often, this type of buy-back is intended to increase earnings per share and improve other financial parameters.
How a leveraged buyout works
Leveraged buyouts should, in theory, have no immediate impact on a company’s share price, less the tax benefits of the new capital structure and higher interest payments. But the additional debt encourages management to be more disciplined and to improve operational efficiency through cost reduction and downsizing, in order to cope with higher interest and principal payments – a justification for the extreme debt levels in debt buyouts.
Leveraged buyouts are sometimes used by companies with excess cash to decapitalize their balance sheets to avoid overcapitalization. By increasing debt on the balance sheet, this can provide repulsive protection to sharks against hostile takeovers.
But more often than not, leveraged buyouts, like other share buybacks, are simply used to increase earnings per share (EPS), return on equity and the price-to-book ratio.
The use of leveraged buyouts, particularly to improve EPS and other financial metrics, increased significantly in the aftermath of the 2008 financial crisis.
Leveraged buyouts and EPS
Boosting EPS through leveraged buyouts can be an effective tool for businesses, but that doesn’t mean improved performance or underlying value. It can even hurt the business if financial engineering is done at the expense of long-term capital investment. Leaders say there are not enough investment opportunities. But there is clearly a big conflict of interest, since executive compensation is tied to EPS in most American companies.
The financial markets have rewarded companies using buyouts to replace improved operational performance. It is therefore not surprising that takeovers have become one of Wall Streets’ favorite tools since the global financial crisis. Between 2008 and 2020, companies in the United States spent more than $ 5 trillion to buy back their own stocks, more than half their profits. As a result, more than 40% of total EPS growth comes from share buybacks.
Redemptions are a mixed bag, they can increase earnings per share and improve other financial parameters, but also jeopardize a company’s credit ratings.
Leveraged buyouts have made a big comeback in the United States, where share buybacks have exceeded free cash flow since 2020. They can also be used to avoid having to repatriate money and pay US taxes.
The buyout boom has increased the risk for both bondholders and shareholders. Even premium companies have been willing to sacrifice their credit ratings to reduce the number of shares. For example, McDonald’s, whose executives depend on BPA measures for 80% of their salary, borrowed so heavily to finance the buyouts that their credit rating went from A to BBB between 2020 and 2020.
Rising interest rates could stifle this boom in leveraged buyouts. But so are the politicians. Senate Democrats have strongly criticized the takeover boom, arguing that Trump’s tax reform is not just about workers. They want to regulate buyouts, which were seen as a form of market manipulation before the Securities Exchange Commission gave them the green light in 1982 when it adopted rule 10b-18. This protects companies from the manipulation costs of the stock markets if the redemptions on a given day do not exceed 25% of the average daily trading volume of the previous four weeks.