In this post, I'll describe buyouts.
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A buyout is a transaction where an investor (typically a private equity fund) acquires control of a mature operating company (which may be public or private) and where a significant portion of the purchase price consists of debt (which is why they are often called "leveraged buyouts").
Elements of Buyouts
- Mature operating companies. For the buyout model to work, the target company (which may be a division of a larger company) must have a real business, with a stable and growing market, meaningful revenues, positive cash flow (or negative cash flow that the private equity fund manager believes can become positive with some operational improvements), and (in many cases) significant assets.
- Examples include Hilton Hotels, Hertz (car rental), Albertson's (supermarkets), Harrah's (hotels and casinos), Equity Office Properties (commercial real estate), Neiman Marcus (luxury department stores), Heinz (food) and Dell Computers.
- Public or private target companies. The target companies are often publicly-traded on a major exchange, but not always. Buyouts often occur with target companies that are privately-held.
- Control investment. The vast majority of buyouts are control transactions. A control transaction means that the investor acquires enough equity to control the company (often called the target company). In most cases, the private equity fund will acquire 100% of the outstanding equity of the target company. In many cases, the existing management of a company will work with a private equity firm to acquire the firm (in these cases, the transaction is known as a "management buyout." By having control, the private equity fund manager can make rapid changes to the strategy, operations and personnel at the target company in order to enable the company to grow rapidly and become more efficient.
- Use of leverage. In buyouts, bank debt comprises a significant portion of the purchase price. This debt is usually secured by the assets of the target company (meaning the assets of the target company are used as collateral for the loan).
- Compare to Venture Capital. Venture capital targets startup companies, which by definition often don't have revenue, cash flow or substantial assets. Because of this, most banks won't lend to early-stage startup companies. There's no collateral for the banks to foreclose on if there's a problem. In buyouts, the companies are mature, have revenues, cash flows and an asset base that can serve as collateral for bank loans.
- Lower-risk investments with potentially strong returns on investment. Compared to investments in early-stage companies, buyout transactions are generally lower risk investments. This is because the companies targeted for buyouts operate in established markets, have proven products/services and have revenues and cash flows. One risk that exists with leveraged buyouts that doesn't exist with venture investments is the risk of leverage. The high debt burden that exists with buyouts means that target companies could go bankrupt if they don't meet their debt burden. While early-stage investors are looking to make 10x on their investments, buyout investors look for 4-5x return on their investments due to the lower risk profile.
- Medium-term holding period. Whereas venture investors must be very patient with investment periods of 5 to 7 to 9 years (or more), buyout transactions typically have shorter investment periods.
- Exits. After a private equity fund has acquired the target company, the private equity fund manager will make operational improvements to the company and will later look to sell the company to a strategic buyer, another financial buyer or take the company public. Also, an alternative way to obtain partial liquidity is called a recapitalization - a refinancing of the bank debt on the target company so that the company may obtain cash, which is paid as a dividend to the private equity fund investor.
- Investors. Some of the largest and better known buyout firms include The Blackstone Group, KKR (Kohlberg Kravis Roberts), The Carlyle Group, Apollo Global Management and TPG (Texas Pacific Group).
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