Keurig Green Mountain was acquired in December of 2016 for $13.9B dollars by JAB Holding Company and was taken private. There is a lot of fanfare around companies that finally make it into the public markets through an IPO but often the reversal of this action, going private, can be much more interesting. Buyouts are a complex process that often are aided by leverage and strategy that lead to companies growing or getting cut up and sold. Today we’ll talk about what this means for investors, the companies that are acquired, and the process behind it.
We’re going to refer to the company purchasing another company as the acquiring firm, and the company being purchased as the acquisition target. Usually acquiring firms take advantage of leverage to purchase an acquisition target because purchasing a public company can be one of the most expensive purchases around (unless you’re competing with the F-35 program). Leverage is a fancy term for using loans to purchase something else. The goal is to make sure that whatever you’re purchasing gives you a higher interest rate than the interest rate that you must pay on the loans. This is called capturing the spread. In a leveraged buyout, both companies are typically profitable because the loaner of the funds wants to make sure they have a high probability of being repaid. These loans are massive so it’s important that they get repaid.
The interesting thing about this transaction is that the assets of the acquisition target can be used as collateral for the loan. Imagine this from the acquisition target’s point of view. Your company becomes easier to purchase simply because of the number of assets that it has. Acquisition targets view this as using their own balance sheet against them. It makes sense when you compare this to a car loan though. When you purchase the car using debt and can’t pay the bank back, the bank can repossess your car, the same way that the bank can kind of repossess the company you just acquired. The reason these loans are provided is because banks want to make it possible to purchase companies without committing a massive amount of capital. The acquisition target does not typically welcome leveraged buyouts. This is one reason LBOs are viewed as a predatory tactic.
The common use of an LBO is to take a public firm private. Most of the time, private equity firms are the ones buying. There is value in this process because a private equity firm can purchase a failing company that is public, spin-off parts of the business that are wasting resources, sell assets, and make the company profitable again. Corporate strategy plays a key role in the thought process of the acquiring firm. The three things that drive a profitable LBO are:
- The ability to pay down the loan
- The ability to improve the operations of the acquisition target
- Something called “multiple expansion” which means buying at a low price and selling at a higher price, hopefully many multiples above your buying price
Private equity firms typically try to exit their investment sometime after three to seven years. Therefore, investors in private equity firms are often forced to keep their money locked up for a long period. The ratio of debt to equity in an LBO is usually around 9:1. The equity portion is synonymous with the down payment on a home when someone takes out a mortgage. LBOs are usually incredibly profitable and are measured using slightly different metrics than the common ones. Cash on Cash (CoC) is the measurement of success here. CoC is defined as the final value of the investment at exit divided by the initial investment. CoC is expressed as a multiple and LBO deals usually return a CoC multiple somewhere between two and five (A CoC of two means that you doubled your money).
LBOs became pretty common in the 1980’s and have taken a lot of household names private. Hertz was acquired by Merrill Lynch and two other investors in 2005. Kinder Morgan is the second largest oil producer in Texas and they experienced a similar fate in 2006 when they were taken private by Goldman Sachs, Carlyle, and Riverstone.
LBOs are often used in hostile takeovers which get a lot of media attention. A hostile takeover is when the acquisition target does not agree to or want to be acquired. Friendly takeovers do exist, but this is usually a poorer deal for the acquiring firm. The activist hedge funds that you hear about in the news are typically the ones that engage in hostile takeovers (usually through LBOs). Hostile takeovers can only be performed on publicly traded companies and the premise is that the acquiring firm must obtain +50% of all outstanding shares. Other reasons for hostile takeovers are that competitors want to control other parts of their supply chain that are dominated by other firms. Hostile takeovers can occur through two methods.
This is a public bid for a large amount of the acquisition target’s stock. Usually the offer is at a premium over the current stock price so shareholders are incentivized to sell. Tender offers traditionally have time limits and sometimes before a tender offer, the acquiring firm will slowly buy up shares of the acquisition target to make the tender offer more likely to succeed and capture that +50% of total shares.
Proxy fights occur when the acquiring firm doesn’t try to purchase stock, but instead tries to convince other shareholders to vote out the current board of directors and replace them with a board that is friendly to a takeover. Proxy refers to the ability of someone to make decisions on behalf of someone else.
LBOs are an interesting tool that can be used to make failing companies more profitable. Public perception often clouds this fact and prefers to focus on the predatory nature of the process. LBOs often result in cheaper prices for consumers, more cost-effective firms, and more productive companies. I like to think of LBOs as a way of cleaning house after things get a little messy. Private equity firms can be thought of as the maids of the public equity markets. Maybe you’ll take a second look at investing in a private equity firm, or maybe you’ll hope the company you’re invested in gets a tender offer.
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