Time to Take the 'L' Out of LBO

In a perfect world, we would simply ban leveraged buyouts. The vast majority of these debt-laden corporate takeovers are no less predatory and value-destroying to a company than a loan shark who charges usurious rates of interest.

Realistically, a prohibition on private equity deals will never happen, given the big dollars involved in these transactions and the sizeable campaign contributions that private equity chieftains shower on politicians from both parties.

So here’s another way to prevent private equity firms from again saddling their corporate prey with too much debt: Prohibit banks from committing financing to any LBO where the private equity buyers are not willing to pony up at least 50 percent of the purchase price.

A 50 percent equity threshold would stop banks from giving in to their worst impulses, which are to do whatever they can to win favor with the private equity firms, in the hopes of rich fees and the promise of lucrative stock and bond underwriting deals down the road.

And it will force banks going forward to make more loans to companies looking to expand their operations and create jobs — not destroy jobs, as is often the end result of an LBO.

Requiring a private equity firm to put up a dollar for every dollar in financing that a deal needs to get done is not as extreme as it may sound.

In fact, at the end of the two most recent LBO booms, it was not uncommon for the small number of deals that did get consummated to involve equity commitments in excess of 40 percent, according to data compiled by Standard & Poor’s Leveraged Commentary & Data.

Even in a dismal year for private equity deals like 2008, there were still more than 600 leveraged buyouts in the United States with a total value of $61 billion.

But with the credit markets sealed tight, the private equity players who orchestrated these takeovers had to dig deeper into their own pockets — coming up with the funds to cover some 42.6 percent of the average purchase price, according to Standard & Poor’s LCD.

By contrast, during the peak of the most recent LBO boom, the average equity contribution from private equity buyers was 33.6 percent in 2006. But there were some mega-deals — Clear Channel Communications — in which the private equity firms were able to put down as little cash as a subprime home buyer.

Now Clear Channel is struggling mightily with the mountain of debt the private equity firms loaded up on the company to complete the $19 billion deal. Overall, companies taken private by buyout firms are sitting on some $400 billion in debt, much of which needs to be repaid in the next five years.

Of course, the private equity firms will complain that a minimum 50 percent equity commitment will stymie deal-making and impact returns for buyout funds. That’s no doubt true. It’s a good thing, too (click to enlarge).

Apture™

Comments

[Walter Kurtz]

You mean to say if I have a family business, I'd be unable to sell it because the buyer is prohibited from getting bank loan?

If I manage a business that I'd like to own, I can't take out a loan to buy the bisiness from the owner?

Most buyers just don't have the resources to buy a business for cash and need loans to complete their purchase.

Where do you stop before we have a socialist system?

2009 Sep 01 08:38 AM

[john s. gordon]

'subprime private equity'.
a new category of sleazy financing?
> jack

2009 Sep 01 08:44 AM

[dertre]

About LBO deals, there is a fiscal aspect too. LBO usually Creates a holding which take all profit out to repay the loans used to buy the firm. Both employees and State are suffering from these schemes : no more income taxes and no bonuses.
On the very long term, you end up whith a firm that was paid with tax avoidance and a few mispriced assets of the firm (real estate for instance).

I think the LBO industry could be controlled at the source. I mean financement : the banks should have really tighter rules on capital which would prevent them from excessive lending or excessive trading as their capital is rare and expensive.
(These conclusions are the same than for the trading debate...)

The cost of the loan would be higher and the banks would be highly aware of the viability of the projected investment (it used to be their main work...).

2009 Sep 01 12:25 PM

[sticktoitiveness]

"Time to Take the 'L' Out of LBO"

Then you just have BO, and that stinks.

I'm agreeing with Walter Kurtz on this. It may be a good idea for these huge firms, but small businesses use a lot of leverage on some of their transactions.

2009 Sep 01 01:06 PM

[Pj568]

An attention grabbing headline but what's being advocated is already happening in the market place. The entire world is now aware of the down side of leverage and the markets are adjusting.

Today capital requirements are being revised for banks, tougher covenants issued, revised loan standards, non consolidated SPE's being brought back onto the balance sheet, downward adjusted market valuations for high leveraged firms, liquidity concerns, fair market adjustments, and attention to ROI's and ROA's as opposed to gross earnings are all having their effect on the ability of lenders to issue loans and entities to use a high degree of leverage.

2009 Sep 02 10:06 AM

[Kinabalu]

This is one area in which market discipline is much more effective than regulatory discipline. LBOs fill a neccessary need as pointed out by Walter Kurtz. If a buyer pays too much for a profitable operating company because he and/or the lender doesn't do its homework, both buyer and lender will lose their return.

But the company, if it's profitable on a non-leveraged basis, shouldn't go out of business. It will be restructured with a new owner and lender at a lower price and a lower leverage. Everyone will benefit including the employees, who don't lose their jobs. It will just take a little more time. This process is happening, very effeciently, every day, all over the country.

2009 Sep 02 01:50 PM