Clearly, that means that you have heavy debt financing.
Well, if you go private,
you can not buy the stock from the existing shareholders for anything but cash.
So, these people get out of this company only in exchange for cash.
That's why you have to take on a lot of them.
Sometimes, the leverage can go as high as 90 or 95 percent.
Well, that limits the number of companies and the industries in which they operate,
and it depends upon the time period.
The explosive growth of LBOs and MBOs again occurred in the 80s of the last century,
and that was due to many reasons.
But basically, that happens in an industry that has
predictable cash flows and in which if you borrow a lot,
the people who participate in this buyout,
they have a good probability of sharply reducing this debt burden.
So, here is a sharp reduction
of debt burden.
And then hopefully, that will result in much higher value.
So, let's talk about
these sources of value increases.
So, what can happen to this company?
Why is it more likely that under new management it's going to do better?
Well, first of all,
most often in these cases,
there is a certain turnaround element.
So the company was doing maybe not very poorly,
but sort of slowly and then it was sort of restarted.
So, here we talk about efficiency.
Well, one very simple example is that when the company is taken private,
when the new measurement has more freedom in their decisions,
let's say they take the company private,
and then fire a lot of people that they
believe are not producing that much value for the company, well,
that's much more difficult to do in a public company,
but it's easier to do in a private company.
Well, still this is a significant conflict,
but sometimes it may reduce costs significantly and raise efficiency.
Well, I would point out sort of even the more important thing.
This is managerial incentives,
and I would put agency here.
If this is an MBO,
the management buyout, now the managers become the owners of the company.
So, basically, the conflict disappears.
The people who before could be tempted to behave,
expose harmful for their principles,
now they are principles themselves.
So they would not behave in a way that would be detrimental to themselves and therefore,
that if not completely eliminates,
but at least reduces this conflict of interest,
that might be very helpful.
Then, some people also say that this is
a tax component because if you have a lot of debt,
then clearly you have interest tax shields.
But it has been shown that actually, at first possibility,
these companies tried to reduce this debt burden and therefore,
they sort of forefeet these tax shields.
So that seems to be a motive here, but in reality,
it's definitely not the most important one and in some cases,
it's not a motive at all.
And then, another thing that is also important,
this is the famous information asymmetry that we talked a lot in our other courses.
But here, what it means is that it is the management,
or in some cases,
the outsiders who know this industry and all these companies,
who know much better the potential of this company,
and they know how much to pay for that,
and that is why again,
when the company is taken private,
there is no issue of any kind inside the trading here.
If we know how much to pay,
then we are more likely to succeed.
Now, there is also some idea of
wealth transfer that we already mentioned sort of because,
for example, taxes is wealth transfer from the government.
If you fire people,
this is wealth transfer from the employees.
So, there are quite a few sources of value increases.
Now, why are people doing this?
In the next episode,
we will go deeper into the core of an LBO on an example.
But here, I would just provide some numbers and some ideas.
Well, first of all,
it was in the 1980s when LBOs and
MBOs were up to 20 percent of all M&As.
Well, later, it had gone down significantly,
then and now, it's about 45 percent no more,
and there is a correlation.
So, when there is growth or when companies are doing fine in general,
that sort of provides an incentive for an MBO
because the future of the company's cash flows is,
I'm not saying, better seen,
but it seems to be less risky,
which is extremely important for a successful LBO transaction.
Now, and the overall chain of events here is,
first of all, this is, let's say, an LBO,
then you reduce that,
and then there is a secondary IPO when you go public back again.
Now, the premium at this page to
the target shareholders was studied to be about 35 percent.
So, that is about these people know how much to pay.
In some most famous cases,
it was even much higher.
We will talk about that in just a few minutes.
And on top of that,
as a result of this,
the annual return from an LBO after having paid this premium to the secondary IPO,
the annual compounded return
was a spectacular 37 percent.
So, this is quite a deal.
And the question arises,
if this is such a deal,
why don't we see many more LBOs and MBOs?
And indeed here, we saw a significant jump in that,
but then, this is only a small fraction of all M&As.
Now, to provide some support to these fancy numbers,
in the next detailed episode,
I will analyze the mechanics of an MBO transaction.
I will use the example from the Western book,
which is in detailed covered in our candles and then the book itself.
But sometimes, when you read that,
you can really miss out on some core ideas,
and that is why I reproduce some numbers,
and we'll specifically see what actually goes.
Konstantin KontorDirector and Professor of Finance and Strategy
