This article is an excerpt from the Shortform book guide to "Barbarians at the Gate" by Bryan Burrough and John Helyar. Shortform has the world's best summaries and analyses of books you should be reading.
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What is an LBO? Are LBOs considered hostile in the business industry?
A leveraged buyout (LBO) is when a group of executives makes a company private by buying all of the company’s stock. There’s still much debate on whether a leveraged buy-out is considered a hostile takeover of a company.
Read more about LBOs, according to Barbarians at the Gate by Bryan Burrough and John Helyar.
The Basics: Leveraged Buyouts
What is an LBO? Burrough and Helyar focus more on the drama of the RJR Nabisco buyout than on the mechanics of it, but they do explain LBOs in passing. In a typical leveraged buyout, a team of executives takes the company private, usually in order to gain a greater share of company profits, as we’ll elaborate on shortly.
| Shortform Background: Key Business Terms There are some key business terms that are helpful to understand before we dive into the explanation of the LBO process: The Stockholders: Publicly traded companies are owned by stockholders, with shares of stock equating to shares of ownership. Sometimes stockholders have the opportunity to vote on key issues affecting the company, but usually they have no direct say in how the company is run, even though they own part of it. The Board of Directors: A company’s board of directors acts as representatives of the stockholders. They govern the company at the highest level but generally are not involved in its day-to-day operations. The Management Team: A team of corporate executives, typically led by a CEO, actively runs the company, directing day-to-day business operations. They report to the board of directors. |
The LBO Process
In an LBO, the management team arranges to buy all the company’s stock at a price agreed upon by the company’s board of directors. They purchase the stock using primarily borrowed money and use the company (and its assets) as collateral for the loan.
Thus, an LBO removes a company’s stock from the stock market and replaces its board of directors with a new board representing the company’s new owners. In principle, the new board could just be the management team, who would then be their own bosses. But in practice, the management team almost always partners with a financial consulting company, which usually acquires a controlling share of ownership in the company.
In addition to coordinating the transaction, the consulting company brings its own financial resources to the table. In most cases, partnering with a financial company is the only way the management team can acquire sufficient credit to borrow enough money for the LBO.
Finally, as the authors point out, LBOs are not a hostile business maneuver: The management team and its financial partners make an offer to the company’s board of directors. The LBO only happens if the board of directors agrees to sell the company to them on behalf of the shareholders.
| Are LBOs Hostile or Not? There are differences of opinion about whether LBOs should be classified as a hostile takeover mechanism. In the form that Burrough and Helyar describe, LBOs aren’t hostile because a group internal to the company organizes the LBO and the board of directors approves it. Other sources that describe LBOs similarly tend to draw the same conclusion, even arguing that LBOs are often used as a tactic to avoid a hostile takeover. This works because a hostile takeover often involves one company buying up more than 50% of the target company’s stock, giving them a controlling interest. LBOs eliminate the risk of this happening because they pull the company’s stock off the market. But others identify LBOs as a hostile takeover method and describe LBOs more broadly as any buyout in which the assets of the company are put up as collateral to borrow the money to purchase it. So someone outside the company approaching the board with an LBO offer without the support of the company’s management would still meet the more general definition of an LBO, while also following the normal pattern of a hostile takeover. It’s worth noting that hostile LBOs tend to be riskier because they lack the partnership between the management team and the financial backers who are buying the company. Without the management team on board, the transition to new ownership (and potentially new management) will likely be more disruptive to company operations. And without the management team’s inside knowledge of the company’s financial situation, there’s more uncertainty about how much the company is really worth. |
Motives for LBOs
Why would a company’s executives prefer to share ownership of the company with a financial consulting firm and have a huge loan to pay off instead of having publicly traded stock? Burrough and Helyar give two reasons, both of which revolve around making more money.
First and foremost, they say LBOs became popular in the 1980s because they allowed executives to dramatically increase their own income from corporate dividends—the share of corporate profits that a company pays to its shareholders.
Second, interest payments on bank loans are deductible from corporate taxes, while dividends paid to stockholders are not. Depending on interest rates and tax rates, this sometimes produces substantial savings for the company after the LBO, increasing profits.
Burrough and Helyar also recount how the financial consulting firms that facilitate LBOs actively try to sell CEOs on these advantages. They do this because they profit from up-front fees for their financial services, as well as dividends on their share of ownership in the company once the LBO is completed.
Junk Bonds
Burrough and Helyar go on to explain how finance companies that facilitate LBOs often raise large amounts of money by selling what the authors call “junk bonds,” or pay-in-kind (PIK) securities. These are high-interest bonds that pay the interest on the bonds in the form of more of the same kind of bonds, rather than in cash.
(Shortform note: In The Intelligent Investor, Benjamin Graham defines “junk” bonds more broadly as bonds that must pay high interest rates to attract buyers because there is a significant risk that the company issuing them might run out of money and default on its bonds. He doesn’t stipulate that junk bonds would be pay-in-kind.)
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Like what you just read? Read the rest of the world's best book summary and analysis of Bryan Burrough and John Helyar's "Barbarians at the Gate" at Shortform.
Here's what you'll find in our full Barbarians at the Gate summary:
- The history of the RJR Nabisco buyout that caused drama and intrigue
- Inside information on many of the people and companies involved
- How leveraged buyouts and junk bonds work
