Leveraged buyouts to create waves

The VIR-organised Vietnam M&A Forum 2013 drew attention from many investors and economists,Photo: Le Toan

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A “leveraged buyout,” or LBO, is a term to describe the acquisition of a target company for a majority or its entire stake and the purchase price is financed mainly by loans from financial institutions. These assets are provided as collateral either by the target company’s operating cashflow or its assets, or by issuing high-yield bonds which usually have more relaxed covenant terms compared to loans from financial institutions or by a mixture of loans and high-yield bonds.

To complete an LBO transaction, the investor usually sets up an entity and uses that entity to raise funds, in which the debt/equity structure is determined by the detailed plan for that LBO transaction. This entity will use the entire capital raised to acquire the target company’s shares or equity capital and make loans to the target company to repay its existing loans and debts. After the LBO transaction, the new entity will control the target company and use its operating cashflow - in some cases through dividends paid by the target company - to repay the loans and debts used for financing the LBO transaction. If the investor wants to exit the investment, it can sell the entity or make the entity public through an IPO. By setting up such a structure, the investor has indirectly changed the target company’s capital structure  - usually increasing the loans and debts portion significantly. During the LBO transaction, financial advisors usually participate to assist the investor in analysing the appropriate LBO financing structure, valuing target companies and raising funds from the capital market.

LBO transactions create value in two specific ways.

The first way is that the cost of debt is usually lower than cost of equity. Therefore, using leverage can decrease the weighted average cost of capital of the company, increasing the intrinsic value of the target company.

The second way is for the investor, after the transaction, to perform operation and business restructuring for the target company, helping to boost growth and the target company’s value.

Because of the high risk involved with the high leverage capital structure used, the success of an LBO transaction depends on numerous factors.

 The first factor is the target company usually has valuable and liquid assets which can be used as collateral for loans financing the LBO transaction. Its debt portion of capital is low, its operating cashflow is stable and has a high ratio over its revenue. Its business is less susceptible to business cycles, its working capital and future capital expenditure is minimal and there is sufficient cashflow for repaying loans and debts.

If the target company, after the LBO transaction, is managed and operated in the most efficient way by a capable management team that has experience with the company and industry it will achieve business targets estimated by the valuation performed during the LBO transaction.

Meanwhile, if the capital market as a whole is liquid, the cost of debts will remain stable at a low level.

Macro factors of the economy, business environment and a stable legal environment are also factors to support the company’s growth.

The history of LBO transactions in the US showed that the number, the size and the success of such transactions are related to the level of interest rate as well as macro economic situation. In the 1980s, the US economy recovered and grew by several stimulus policies leading to an  increased demand for investment. The Tax Reform Act of 1986 excluded some provision items excluding the interest expenses as tax-deductible, the normal income tax including interest income was at the same level with capital gains tax. These two factors led to a booming high-yield bond market, with new issues increasing significantly from $1.5 billion in 1982 to $15 billion in 1984, with demand from insurance companies, mutual funds and other financial investors. A recovering economy, optimistic sentiment, liquid bond market with many participants in this period fueled the boom in LBO transactions in the US during this period, which was initiated by many large private equity companies. The most well-know transaction was the leveraged buy-out of RJR Nabisco by KKR in 1988, with a $25 billion transaction size.

There are conflicting opinions regarding the pros and cons of the LBO transactions to the target company as well as the economy.

On the positive side, the investor will restructure the target company’s business, operations, finance and manage the company more efficiently to achieve the expected return on the investment. The LBO transactions, especially where the target company is a listed company, will add a lot of value to the existing shareholders because the offer price is usually much higher than the market price. The LBO transactions, however, also negatively affect the company as well as the economy. After an LBO transaction, the target company is usually highly leveraged, increasing credit risk and market risk. In some LBO transactions, the investor focuses only on reducing costs and repaying debts over a short period, not considering the company’s long-term growth, by laying off employees as well as breaking up and selling the target company’s assets piece by piece. The use of operating cashflows is mainly down to pay large amounts of debt and leaves the company with less capital to reinvest into the business.

As a result, it can lose its competitiveness compared to other companies. The over-heated booming of LBO transactions can also create asset price bubbles - especially when private equity funds chase few large target companies, boosting up the valuations - as well as credit bubbles with increased debt over GDP ratio.

This increases the risk of a collapse in the financial system, including those financial institutions and other investors who finance those LBO transactions.

In Vietnam, although not officially labelled LBOs, there are some M&A transactions in which the purchase price was financed by loans or in exchange for existing loans based on the target company’s assets acting as collateral. However,  the details are usually not publicised. As an M&A advisor, VCSC advises its clients to restructure the target company’s debt capital structure by decreasing interest rates, revising repayment schedules, and adjusting the collateral’s value to ensure the success of the transaction. Although LBO transactions have certain positive values as discussed above, we believe that LBO transactions will take a while to gain traction in Vietnam, due to the small size of corporate bond market, the economic situation and the target to stabilise the financial system and reducing non-performing loans.

Firstly, the corporate bond market in Vietnam is still small in size, very low liquidity and not attractive to investors apart from some large commercial banks. According to some statistics, the corporate bond market size in Vietnam is only 1.4 per cent of GDP, while it is 15.5 per cent, 40.9 and 58.0 per cent in Thailand, Malaysia and the US, respectively. With a small sized corporate bond market which remains unattractive to many investors, raising capital through issuing corporate bonds for LBO transactions in Vietnam is difficult.

Secondly, although showing signs of improvement, the economy still has certain risks which can negatively affect the target company’s performance. Such risks can leave  the target company unable to achieve the business plan used to evaluate the LBO transaction. This will lead to bad investment returns or, in the worst case, make the target company bankrupt due to the highly leveraged capital structure.

Thirdly, with LBO transactions, highly leveraged capital structures do not add much value to the banking system’s effort to restructure assets, decrease non-performing loans, increase capability to value and manage risks. Due to these reasons, investors should be careful during the due diligence period in setting a valuation of the target company, analysing an appropriate capital structure for the transaction and especially valuate the business plan of the target company with all the possible scenarios together with relevant business, industrial and legal risks, executed by a capable, experienced management team.