In 2007, at the peak of the real estate bubble, Blackstone Group invested $6.5bn equity in Hilton Worldwide. Soon after the transaction, the economy plummeted, and it seemed as the group could not have chosen worse time, especially when Lehman Brothers and Bear Stearns – Blackstone’s partners – fell apart. The story took a significant u-turn as the Hilton re-listed in 2013, transforming doomed-to-spectacularly-fail into one of the most profitable private equity deals ever. After 11-years of relationship, Blackstone finally „checked out” from Hilton realising $14 billion of profit.
Even though the Blackstone Group managed to triple its initial investment, the very same period brought losses to others. In the era of mega-buyouts (2005-2007), a consortium led by Kohlberg Kravis Roberts & Co. (KKR), Texas Pacific Group (TPG Capital), and Goldman Sachs acquired the largest electricity utility in Texas, then known as TXU for $48bn. In 2007, the investors were betting on rising natural gas prices giving its coal-fired plants a significant advantage. What happened soon after the acquisition, was the exact opposite – U.S. shale gas revolution tumbled the natural gas prices. Today known as Energy Future Holdings, the company filed for Chapter 11 in 2014. The biggest deal in history, left Energy Future Holdings with $40bn debt, and even Warren Buffet himself ended up losing nearly $900mln throughout the investment.
What these two deals have in common, is the form of their financing: leveraged buyout.
What is an LBO?
A Leveraged Buy-Out (or LBO) is a form of acquisition that implies a significant amount of debt as a mean of financing. The sole purpose is to increase the financial leverage by reducing the equity capital in an acquisition. In order to do so, a holding company is created with one aim: holding financial securities. The holding company borrows money to buy a company, generally called “target”. The holding company has to pay interest on the debt and also pay back the principal with the cash flows generated by the target.
The following figure depicts the framework of an LBO:
There are two main strategies in order to maximize the Internal Rate of Return (IRR):
1) Buy and Hold (B&H): Before the subprime crisis, investors were investing in companies without really looking to be involved in their growth rate. It is a form of passive investing, where PE funds are building a diversified portfolio where they only have to wait on their returns.
2) Buy and Build (B&B): After the crisis, financial sponsors have adapted their strategies, particularly developing an interest for having a goal of going public with their target companies. Buy and Build is strategy-related with a long-term vision, thus involving a closer relationship between target management and sponsors, creating real synergies.
Why do some of them fail?
As simple as it may look, the leveraged buyout is a transaction that requires specialized knowledge and involves technicalities, that cannot assure positive outcomes. There exists a number of reasons for LBO failures, which differ due to transactions’ diverse nature. The following are characteristics that accompanied the greatest failures in LBO transactions:
- financial distress of a company;
- the obligation to refinance debts in order to avoid a company going bankrupt;
- breach of an agreement;
- the capital loss exceeding the initial investment from financial sponsors;
- unexpected departure of top management;
- the size of a target company.
For the purpose of this article, we have decided to discuss how the size of a company can influence the success of an LBO transaction, focusing on the situation in France.
Recently, the SME market has constituted a main target for LBO transactions, as it involves smaller investments and lower risk. The main threat comes from the lack of knowledge of LBO transactions, potentially leading to the failure of the buy-out (by not following the business plan or by confronting different visions). According to BPIFrance, mid-caps are constituting an ideal target for LBO activity, through realizing the best financial performances (having a margin rate of 25% vs 20% for SMEs), being more established internationally (with an average of 5 subsidiaries abroad), and more diversified (31% of mid-cap firms are acquiring holdings in other companies), but they are not infallible. However, failure in this market exists as well. According to Souissi (2013), breaches of covenants are more present in Midcaps than SMEs, the former having an average of 46% breaches. But Midcaps are more targeted by covenants than SMEs. So regarding large corporations we can wonder if they are too powerful for LBOs.
The real issue with large corporations is refinancing, which means reporting the debt, and the risk. Risk is strongly linked to the banks, and considered more important nowadays, even if the “too big to fail” effect still exists, and can give some ways of pressure. Moreover, banks tend to issue loans more quickly for a significant amount, which implies a bigger leverage effect, and an increase of loans for larger corporations (8.1% in June 2019 YTD. Source: Banque de France).
|Number of companies in 06/2019||Amount issuing for loans (in €bn) in 06/2019||Variation (in %) 06/2018 vs. 06/2019|
Following this pattern, the “Haut Conseil de Stabilité Financière” (HCSF) decided to set (in July 2018 and for a minimum of 2 years) a limit of 5% of the equity capital for any loan exceeding 300 million of euros issued by a large corporation in France. This preventive measure is established in order to avoid a large and risky concentration on systemic banks such as BNP Paribas, Societe Generale, Credit Agricole, that are covering 95% of the credit outstanding.
From the perspective of a financial structure, things have drastically evolved. Not only has the debt ratio decreased, the financial structure has also changed, leading banks to refuse the financing of Term Loan B (or “in fine”) and its limit of 30%. Now the tendency for them is to focus on the first main amortized Term Loan A:
Example of a Balance Sheet of a target in an LBO transaction (after the subprime crisis)
|Assets||Liabilities & Equity|
|Value of titles |
|·Equity Capital (minimum 50%) |
·Senior debt (maximum 50%)
– Term loan A (70%) on 6 years
– Term Loan B (30%) on 7 years Debt Mezzanine (0 to 10%)
Debt Mezzanine (0 to 10%)
LBO transactions now require more equity into the financial consolidation in order to satisfy the financial sponsors.
The European Central Banks, being aware of this tendency, did not hesitate to act and established the “ECB Guidance on leveraged transactions”. In this set of new rules, it is stated that banks issuing loans to companies with a ratio Debt/EBITDA above 4x should improve their risk management and surveillance system. It is therefore of great importance that the selected target company in an LBO is capable of generating strong cash flows along with having a solid business model.
Can we really understand the failure of LBOs?
It is not clearly possible to identify and say how to avoid the failure of LBO transactions, but some key factors can be identified. The financial structure of the debt plays an important role in a buy-out. Finding the right amount between debt and equity in order to decrease the risks for the actors is essential, especially by respecting the covenant set into the LBO. As explained, banks are changing their financing model following the crisis, by limiting the amount of debt issued at the amount of the Equity capital, focusing on the first term loan amortized.
Private Equity firms are using their resources, their connections with other firms, their risk management and their network to be involved in the growth of the target company. However, all those resources are limited, and according to Steveno (2005), top managers are themselves deciding alone on which pieces of information are given to financial sponsors.
Nowadays, financial sponsors tend to hold LBO targets for a longer amount of time, but as the last phase approaches, the visions from sponsors and top managers are less innovative and centered mainly around the maximization of the IRR rather than realizing the strategy of the company.
Authors: Qitong Sun, Joanna Przadka, Nicolas Chedeville, Erik Steineger and Nikolas Schmitte
QUIRY, Pascal; LE FUR, Yann.Pierre Vernimmen Finance d’entreprise 2016, Chapitre 50 -Les LBO, en ligne, Edition Dalloz, 2016, p1015-1032