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Leveraged Buyouts

May 29, 2012

Leveraged buyouts (“LBO”) seem to have become a current political issue.  Supporters of President Obama claim LBOs are a cause of our financial destruction and Romney supporters are claiming they are a major job creation device.  Neither is right.  LBOs are a long used financial tool and like any tool can be used properly or not, based on the motive and skill of the artisan.

 

I know Marty Edelston from the Bottom Line/Personal publications for about 36 years and he is a good friend and advisor.  The first article I ever wrote for him appeared in the August 15, 1976 issue of Boardroom Reports and was titled “Business Acquisitions Via Bootstrapping.”  It explained how LBOs worked.  I called it “bootstrapping” since LBO wasn’t used until an investment banking firm devised the term sometime in 1978.  They thought they came up with a secret weapon, when in reality, LBOs were a long, widely used technique in M&A.  In fact, one firm I worked with had ownership positions in over 600 companies they had acquired using bootstrapping.  They maintained a no publicity and notoriety profile but had a power far greater than almost all of the best known investment bankers combined.

 

LBOs are a method of buying a business by using the assets of the business as collateral for the loan obtained to pay for the business. 

 

A simple illustration is to compare an LBO to a typical home mortgage.  Don’t we all buy houses putting up a small down payment and then borrow the bulk of the purchase price using the house as collateral.  That is an LBO.  Not so terrible is it?  There have been many abuses – overpriced and overvalued houses; too little or negligible down payments; and/or the owners lacking cash flow to make the payments.  Other factors contributed to failure… such as a lack of care and maintenance of the house or suddenly adverse economic conditions shrinking values and cash flow.  Well, business LBOs work the same way – but to blame or condemn the tool is irresponsible.  For the user to claim the universal goodness of the tool is a false humility.  LBO is a borrowing technique and nothing else.

 

My 1976 article ended with caution for the seller to probe the buyer’s character, past history, source of upfront funds, and to the extent there is a commitment to manage the business as well as possible.  Still the same advice today!

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