Leverage Buyouts: A Brief History

MCC Partners examines the inception and evolution of the leveraged buyout (LBO) business in the United States and analyzes future trends. The factors contributing to the rises and falls of the LBO market in the last two decades are reviewed. We compare the characteristics of the LBO business in the 80's and 90's. The LBO market in the 90's was more mature and challenging than in the 80's, resulting in a lower mean industry return. The current low public stock valuations and strong investor capital inflows suggest many good opportunities for the buyout funds. However, the skills required for success are different from those in the 80's as the LBO transactions are likely to target companies at earlier stages, require more operational expertise, and expand globally...

I. Introduction

Financial dictionaries define a leveraged buyout (LBO) as a debt-financed transaction, typically via bank loans and bonds, aimed at taking a public corporation private. Because of the large amount of debt relative to equity in the new corporation, these bonds are typically rated below investment-grade, and are properly referred to as high-yield or junk bonds.

Investors can participate in an LBO through either the purchase of the debt (i.e., the purchase of the bonds or participation in the bank loan) or the purchase of equity through an LBO fund that specializes in such investments. Heavy reliance on debt to finance the acquisition magnifies the risk of the transaction; consequently, the potential return to the buyer upon subsequent exit is increased. Possible exit strategies for LBOs include (i) initial public offering, which allows investors to liquidate ownership interest, (ii) re-capitalization which allows equity holders to realize a return by taking a sizable dividend, and (iii) outright or partial sale to another strategic or financial buyer.

The LBO market comprises three major types of transactions: (i) those in which a public company is taken private (this is usually the takeover segment of the LBO market), (ii) divestitures that result from selling off divisions of a public corporation, and (iii) private market transactions involving companies whose stocks are not publicly traded. Exhibit 3 sets forth a breakdown of transaction value in each segment from 1981 to 1997 (Source: M&A Database, Mergers and Acquisitions, 1997)

The LBO market has gone through several cycles: it started quietly in the 1970's and in less than ten years LBO became a topic of heated discussion in Congress and in the news media. The leveraged buyout boom of the late 1980's gave way to the buyout bust of the early 1990's. Beginning in 1991, LBOs began to make a comeback, reaching $24.2 billion in 1996. Then, in the aftermath of the high yield market shutdown in the late 1998 (Exhibit 1), the new LBO wave was pronounced dead. The pronouncement was echoed through 1999 and 2000 when acquisition multiples remained at historic highs in the so-called New Economy and leveraged lenders became increasingly cautious about risk.

However, in the wake of the current dot-com breakdown and stock market corrections, many wonder if LBO markets will resurge yet again. The reasoning is that acquisition multiples have started to decline and sellers finally are willing to realistically accept the resulting lower valuations. The high yield market has not recovered to its 1998 level, but leveraged loan makers are seeing ample liquidity among institutional investors, and several recent transactions suggest that the market is quite receptive to LBO activities.

How does one make sense of the spectacular rise and abrupt fall of the LBO in the 1980's? How has the business changed from its origins in the 80's? What is the outlook for the business? This paper attempts to answer these questions by providing a brief overview of the LBO market and exploring future trends by examining the changes in financial structure and contributing factors over time. As a general theme, the LBO market is a demonstration of the works of the invisible hand of the market trying to eliminate inefficiencies through exploiting arbitrage opportunities. Profitability comes from the financial inefficiency in the 1980s, and shifted more towards operation inefficiency in recent times. The flow of funds into the LBO market is determined by the relative profitability of this market compared to alternative markets, and is therefore affected by the business cycles.