About Leveraged Buyouts
Leveraged buyout takes place when one company buys another with borrowed money. The purchaser adds the purchased company's assets to its own as loan collateral. After the purchase, the purchasing company has a high debt to equity ratio. Hopes for increasing profits drive these purchases, but many will end up in bankruptcy.
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History
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Before the 1980s, leveraged buyouts were described as "bootstrap" purchases. This practice was rare, as people still remembered the Great Depression. Conglomerates grew in popularity starting in the 1960s, which created lots of middle management and reduced profitability. These companies were put up for sale at discount prices, which lead to temptations to purchase largely with credit. Corporations wanted to take advantage of these sales even if they didn't have enough cash for the purchase. This practice continued for 20 years, until corporations started to file bankruptcy in large numbers.
Effects
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This type of purchase makes it possible for a company to expand without using a lot of money. The aim is to create a bigger corporation that generates more income. The purchasers also believe that this will lead to shareholders earning more. Managers now have to find a way to get two different corporate cultures to work together as one. This action has two extreme outcomes; the company does well and makes more money or it fails. This merger affects employees as it leads to immediate layoffs.
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Misconceptions
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Leveraged buyouts are usually associated with risky business practices and predatory buyouts. However, most of the purchased companies are usually the ones that were performing poorly. These companies must adopt better business practices, usually under the guidance of the successful company that purchased it.
Benefits
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Since leveraged buyouts are done with borrowed money, management ends up with larger than normal loan payments. The best way to pay these debts is to operate the business efficiently. Management has to be more disciplined by not engaging in useless projects, and by cutting operations that aren't making profits. Depending on the company's location, the interest payments that result from these purchases may be tax deductible.
Warning
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Good business practices combined with a booming economy help increase cash inflows. Recessions and depressions decrease earnings; after a large purchase, a company can't afford an economic downturn, and a newly merged company can get hit with a severe lawsuit. A federal investigation could potentially shut a company down. All these factors will drastically limit what the company makes, thus forcing it into bankruptcy or putting the newly acquired company up for sale.
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