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Finance and capital markets
Course: Finance and capital markets > Unit 6
Lesson 8: Leveraged buy-outsBasic leveraged buyout (LBO)
The mechanics of a simple leveraged buy-out. Created by Sal Khan.
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Sal mentioned that the company in this example most likely would not be able to do an IPO because its too small. What size does a company need to be in order to do an IPO? Thanks.(6 votes)
But what about the payment of the 9 MM of principal? The return is not really 40% because you have to pay at least some of the principal and not just the interests, havent you?(4 votes)- The return is 40%. Most corporate debt and high yield debt does not pay any principal until the debt matures. When the debt matures the entire principal is paid back in one lump sum.(3 votes)
Here's what I find a bit confusing: I've borrowed 9m from the bank. How does that debt transfer to the business I've bought? Imagine that I manage the company poorly and it goes bankrupt. My understanding is that the bank gets potentially screwed because the debtor is the dying company not you, the buyer. Why does the bank permit this? Even if the company is the collateral, it doesn't seem like that should eliminate your debt.When I get a mortgage on a house, the house is collateral, but, as we know all too well these days, if the house's value drops, I'm still on the hook for the debt I incurred. How is it different when I buy a company?(1 vote)- The bank is definitely taking a bigger risk if it lends to any entity that does not have the collateral (and would probably charge higher interest). The whole point of people setting up legal entities like corporations is that it limits your liability (you can only lose what you have invested, not other assets outside of the corporation). Because of this, if you have a small corporation with very little in terms of income or assets, the bank would probably require you to personally co-sign the loan (so that they can go after your assets in case your small company goes under).(9 votes)
So you spent 1 mill of your 10 to make 400k a year. You could take the 9 mill you didn't spend and invest it in 9 more companies; making 4 mill a year.
But, you have also accrued 90 million in debt and dropped company profits by 60%. If you tried to sell those companies, they would be worth less with that debt. Or a company could go bankrupt if it couldn't pay the debt. But as owner you have already made your profit.
Isn't this short term owner profit at the expense of the company's value?(2 votes)- LBO's are actually a good way to grow a business as by purchasing the firm this way, the owner still makes 400k on their 1 million and can actually put their other 9m that wasn't used to buy the firm to grow it instead resulting in bigger revenues and profits, therefore creating a win win for both owner and firm.
The owner would also lend their 9m to the firm on a bond basis or something similar to ensure personal security in their money.
However relating to the first point of yours, the debt is in the owners name and they just hold it against the firm to pay it back, to avoid tax. The debt is not on the company. Therefore if the owner was to sell the firm to a cash buyer then to them the firm would be again producing 1m in profits as aposed to 400k.(2 votes)
Is this a legitimate economic practice or is it just exploiting a loophole to take money from the government?
This sounds like one is using the fact that debts are tax deductible to divert income that would have been taxed into one's own pocket.(2 votes)- Much of the Internal Revenue Code (a.k.a the Tax Code) that surrounds businesses is capitalist-friendly. According to the Tax Code, we as a nation want to promote growth, innovation, and overall, investment into our companies, even if that investment may be risky. As stated in a separate question, that $9M that the owner could have spent to buy the company outright can be used to purchase more companies via LBOs, or to use that money to expand and grow those companies. While it is true that the money won't be taxed, the idea is that it is going to be re-invested into the economy for further growth.(2 votes)
Ok, let's say I want to do this on a smaller scale. I go to my local bank and tell them "Hey, I'd like to buy as many shares in company X (some super stable blue chip company). I'm willing to put up those shares as collateral. Meanwhile, I promise to pay 10% interest."
My ROI is infinite; I didn't pay a cent for that loan. Right? Meanwhile, all of the interest is tax deductible, which may or may not be a concern for somebody at my income level. Also, all of the stock gains are capital gains, which are taxed at or less than income tax levels.
So, why doesn't everybody do this?(1 vote)
So it would be common and acceptable for a company to do a leveraged buyout and basically never pay back the capital on their debt? Isn't that sort of an inefficent use of money? You're basically paying to keep the debt on your books indefinitely.(1 vote)
It's not inefficient from the point of view of the buyer of the company. He could have paid 10 mill and got a 10% return, but instead only paid 1 mill and got a 40% return. Way less capital at risk, and a much higher rate of return. Assuming he actually had the 10 million, he could invest the remaining 9 million at 7%(net of taxes) and still come out ahead.(4 votes)
- is it possible to do a LBO WITHOUT a bank loan can't you say "here is $10k as a down payment" take owner ship of the company and pay off the rest with your newly acquired companies profits?(1 vote)
Yes, then you have a seller-financed LBO. It's hard to imagine any seller of a large company who is going to do that, though. What's in it for them?(2 votes)
- What incentive does the bank have for doing this? Sure, they get paid the 900k in interest, but they are still out $9 million in this scenario. How will they eventually get that 9 million back?(1 vote)
- Like all loans, that money get paid back along with the interest. The terms of the loan will dictate when the principal is repaid.(1 vote)
- So, i don´t understand. If I borrow 9 million to buy a business (with the business as collateral); Why does suddenly THE BUSINESS owe 9 million, if the business didn´t ask for a loan?(1 vote)
You're essentially transferring that loan to the books of the business. Thus the debt falls onto the business and all cash flow goes to repaying the debt(1 vote)
Video transcript
Let's say that many years ago, you started yourself a
nice little business. You have no debt and
your business every year generates a pre-tax income of a million and a half a year and a third of that goes to taxes. So you get a nice one million dollars a year of net income and
it's a super stable business, nothing risky over here. Just by virtue of what your business does, the odds of this one million a year changing for the better or
the worse isn't that likely. So this is essentially your ...
This is what your balance sheet would look like. These are your assets. You have no debt. Let's assume you have no liabilities and so you own all of the equity. You essentially own all of the assets, but you're nearing retirement and you want to kind of cash out. You don't necessarily want
to sell to your competitors or maybe there aren't any
natural competitors to sell to because you've been comp
... Well, you don't want to sell to them if they exist
because you've been competing with them for your ... for your whole life and this isn't the type of
business that you can IPO because it's not quite big enough. So maybe we bump into
to each other and I say, "Hey, this business looks
interesting. I like the idea that" "your business is stable and
can generate a lot of income" "year after year after year." So what I say is, "Hey,
would you be willing to take" "10 million dollars for your business?" So I offer ... I offer 10 million dollars. And to you that sounds pretty good. That's about ten times ...
That's exactly ten times your yearly net income. This isn't a growing
business, just very stable. Seems like a reasonable deal to you. On the other hand for
me, I'm like you know paying 10 million dollars
and getting a million dollars a year, that's kind of 10% on my money. That's okay, but maybe I
can get some leverage here. Maybe I don't have to put
all of the 10 million in maybe I could borrow some of it and maybe I'll get a
better return that way. So when it comes time to closing
... When it comes time to closing, so I'm buying the assets. So these are the same
assets that I'm buying and I'm gonna give them ...
and the money that I raise for these assets are gonna go to you, the person who started this business. So here are the assets. So instead of me putting up
the entire 10 million dollars, what I do is I put up one
million dollars myself So I put up one million dollars myself, one million from ... from me. And I go to a bank and I say, "Look, will you lend me 9
million dollars? I'm going to "put a million dollars of my
own money. Will you lend me" "9 million dollars to
help borrow ... to help" "buy this business for
10 millions dollars?" and the banks says, "I don't know. That's a lot of money." "We're putting a lot of money at risk." and I'l say, "Look, you can
charge me a decent interest rate," "maybe a 10% interest rate
and this is a super stable" "business, so clearly I'll
be able to pay the interest" "on that money from the business
and if for whatever reason" "I'm not able to pay you the money," "you can get the business. So,
I'm essentially giving you" "the business as collateral." So you find some bank to agree to it and so they will lend
you 9 million dollars. They will not lend you 9 million dollars. Nine million dollar loan and let's say that it is at
a 10% ... 10% interest level. So now, after I have ...
So 9 million from the bank, one million from me. That goes to you. You can now retire and buy your dream home or whatever else you
might have needed to do with that money. You could leave it for your
children, whatever you might ... Donate it to charity,
whatever floats your boat but now the capital
structure of the business looks like this. I now do have a lot of debt. I bought you out using leverage. This is a leveraged buyout. So now, there is one
million dollars of equity that came from me and there's 9 million dollars
of debt that came from the bank. That's 9 million dollars of debt. Assets, at least what I paid
for it was 10 million dollars. Liabilities are 9 million dollars. So what's left over is one million. And let's think about how this investment, assuming the business keeps
generating a million a year, let's think about how good
of a payoff this might be for my one million dollar investment. So before I had a pre-tax
income of 1.5 million. So 1.5 million pre-tax. Pre-tax before. Now I'm going to have
to pay some interest. So now I'm going to have to
pay ... So 9 million dollars at 10%, that is $900,000 in interest. So now my pre-tax won't be 1.5 million. I'm also going to have
to pay 900k in interest. So minus 900k means that I have 600,000, so 1.5 - 900k is 600,000
per year pre-tax income, 600,000 per year in pre-tax income and then I will pay taxes on that. The cool thing about corporate interest is that it's tax-deductible. It's deducted from your pre-tax income. So you take the 900 from
the 1.5, you have 600,000 leftover and then you pay taxes on that and let's say it's
still the same tax rate, so roughly one-third of
it goes to the government and so that you are left
with 400,000 net income and if you look at the
math, this is actually a pretty good deal for me or
I should ... I was saying you, but I'm the guy who bought it. You're the guy who sold me the business, so this is me now. I am left with $400,000
net income per year, which is pretty good because I only made a one million dollar investment. So even though this looks
like a sleepy business, even though it looked
like it was only getting a 10% yield on it, because
I was able to leverage up. I was able to do this leveraged buyout, I'm now able to make $400,000 per year on a one million dollar investment and now all of a sudden that is
a not so sleepy annual return.