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Home > Mergers and Acquisitions Best Practice > Going Private: Public-to-Private Leveraged Buyouts

Mergers and Acquisitions Best Practice

Going Private: Public-to-Private Leveraged Buyouts

by Luc Renneboog

Executive Summary

  • Listed firms go private through a leveraged buyout (LBO)—for example, a management buyout or an institutional buyout).

  • Reasons for going private are the value of the tax shield, increased incentives for management through equity ownership, to reduce cash flows, to avoid the direct and indirect costs of maintaining a listing, or as an anti-takeover device.

  • At announcement of the LBO of a listed firm, the premium (the offer price relative to the pre-buyout share price) amounts to about 40% and abnormal returns to about 25%.

  • Good candidates for LBOs have stable cash flows, low and predictable capital investment needs, a liquid balance sheet with collateralizable assets, an established market position, and are in a recession-proof industry.

Introduction

When a listed company is acquired and subsequently delisted, the transaction is referred to as a public-to-private or going-private transaction. As most such transactions are financed by substantial borrowing, which is used to repurchase most of the outstanding equity, they are called leveraged buyouts (LBOs). An overview of the different types of LBO is given in Table 1. Four categories are generally recognized: management buyouts (MBOs), management buyins (MBIs), buyin management buyouts (BIMBOs), and institutional buyouts (IBOs).

Table 1. Summary definitions of types of public-to-private transaction

Term Definition
LBO Leveraged buyout. Acquisition in which a nonstrategic bidder acquires a listed or non-listed company utilizing funds containing a proportion of debt that is substantially above the industry average. If the acquired company is listed, it is subsequently delisted (in a going-private or public-to-private transaction)
MBO Management buyout. An LBO in which the target firm’s management bids for control of the firm, often supported by a third-party private equity investor
MBI Management buyin. An LBO in which an outside management team (often backed by a third-party private equity investor) acquires a company and replaces the incumbent management team
BIMBO Buyin management buyout. An LBO in which the bidding team comprises members of the incumbent management team and externally hired managers, often alongside a third-party private equity investor
IBO Institutional buyin. An LBO in which an institutional investor or private equity house acquires a company. Incumbent management can be retained and may be rewarded with equity participation
Reverse LBO A transaction in which a firm that was previously taken private reobtains public status through a secondary initial public offering (SIPO)

Why Do Listed Firms Go Private?

Reduction of Stockholder-Related Agency Costs

The central dilemma of principal-agent models is how to get the manager (the agent) to act in the best interests of the stockholders (the principals) when the agent has interests that diverge from those of the principals and an informational advantage.

  • The incentive realignment hypothesis states that the gains in stockholder wealth that arise from going private are a result of providing more rewards for managers (through an increased ownership stake) that induce them to act in line with the interests of investors. Furthermore, in the case of an institutional buyout, the concentration of ownership leads to improved monitoring of management.

  • The free cash flow hypothesis suggests that the expected stock returns follow from debt-induced mechanisms that force managers to pay out free cash flows. Free cash flow is the cash flow in excess of that required to fund all projects that have positive net present value (NPV) when discounted at the appropriate cost of capital. The high leverage does not allow managers to grow the firm beyond its optimal size (so-called “empire building”) and at the expense of value creation.

Tax Benefits

The substantial increase in cash flow creates a major tax shield, which increases the pre-transaction (or pre-recapitalization) value. After the buyout, firms pay almost no tax for a period of at least five years. Consequently, the (new) stockholders gain, but the government loses out.

Reduction of Transaction Costs

The cost of maintaining a stock exchange listing is very high. Although the direct costs (fees paid to the stock exchange) are relatively small, the indirect costs of being listed are substantial (for example the cost of complying with corporate governance/transparency regulations, which requires larger accounting/legal departments, the cost of investor relations managers, and the cost of management time in general, etc.). For a medium-sized listed company these indirect costs are estimated at US$750,000–1,500,000 annually. The going-private transaction eliminates many of the transaction costs.

Wealth Transfers from Bondholders to Stockholders

Gains in stockholder wealth that arise from going private result from the expropriation of value belonging to pre-transaction bondholders. There are three mechanisms through which a firm can transfer wealth from bondholders to stockholders: an unexpected increase in the asset risk (the asset substitution risk); large increases in dividends; or an unexpected issue of debt of higher or equal seniority, or of shorter maturity. In a going-private transaction, the last mechanism in particular can lead to substantial expropriation of bondholder wealth if protective covenants are not in place.

Defense Against Takeover

Afraid of losing their jobs if a hostile suitor takes control, the management may decide to take the company private. Thus, an MBO is the ultimate defensive measure against a hostile stockholder or tender offer.

Undervaluation

As a firm is a portfolio of projects, there may be asymmetric information between the management and outsiders concerning the maximum value that can be realized with the assets in place. If management believes that the share price is undervalued in relation to the firm’s true potential, they may privatize the firm through an MBO. Alternatively, if an external party believes that it is able to generate more value with the assets of the firm, the firm may be taken over by means of an IBO or MBI.

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Further reading

Books:

  • Amihud, Yakov (ed). Leveraged Management Buyouts: Causes and Consequences. Washington, DC: Beard Books, 2002.
  • Wright, Mike, and Hans Bruining (eds). Private Equity and Management Buy-Outs. Cheltenham, UK: Edward Elgar, 2008.

Articles:

  • Denis, David J. “Organizational form and the consequences of highly leveraged transactions: Kroger’s recapitalization and Safeway’s LBO.” Journal of Financial Economics 36:2 (October 1994): 193–224. Online at: dx.doi.org/10.1016/0304-405X(94)90024-8
  • Renneboog, Luc, Tomas Simons, and Mike Wright. “Why do public firms go private in the UK? The impact of private equity investors, incentive realignment and undervaluation.” Journal of Corporate Finance 13:4 (September 2007): 591–628. Online at: dx.doi.org/10.1016/j.jcorpfin.2007.04.005
  • Simons, Tomas, and Luc Renneboog. “Public-to-private transactions: LBOs, MBOs, MBIs and IBOs.” Working paper no. 94/2005, European Corporate Governance Institute, August 2005. Online at: ssrn.com/abstract=796047
  • Wright, Mike, Luc Renneboog, Tomas Simons, and Louise Scholes. “Leveraged buyouts in the UK and continental Europe: Retrospect and prospect.” Journal of Applied Corporate Finance 18:3 (Summer 2006): 38–55. Online at: dx.doi.org/10.1111/j.1745-6622.2006.00097.x

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