A buyout is a transaction in which a company or a group of individuals acquires an ownership stake in another company. Understanding buyouts is crucial for business owners, investors, and shareholders who navigate corporate transactions or for those who are planning to pursue mergers and acquisitions. This article explores the concept of corporate buyouts,delving deep into common types of buyouts and illustrated with real-life examples.
What does a buyout mean?
A buyout occurs when an acquiring party purchases a controlling part of the stock — typically over 50% of the voting shares — in the target party. This transaction transfers ownership from the target to the acquirer.
The acquirer now has decision-making authority over the target company and its further development. Buyout transactions can result in the target company eventually being sold for profit.
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Buyout vs. merger
The term company buyout refers to the acquisition of controlling interest in a company. The term merger refers to the process of combining the two companies into one after an acquisition (in other words, being merged). It’s worth noting that buyers who pursue mergers may aim for 100% ownership transfer to eliminate any influence from the target company’s shareholders.
Common types of buyouts
Common buyout types include leveraged buyouts (LBOs), management buyouts (MBOs), and employee buyouts (EBOs). They differ in several ways, including the buyer entities, financing conditions, and post-buyout outcomes.
Leveraged buyout (LBO)
A leveraged buyout (LBO) occurs when a greater portion of the purchase price is funded with money borrowed from financial institutions, pension funds, or wealthy individuals.
This enables the acquirer to invest as little capital as possible in the acquisition, making up the rest with debt finance that is later paid through the target company’s cash flows. This structure gives acquirers great purchasing power with minimal money spent.LBOs are usually associated with private equity (PE) firms that find them suitable for maximizing a return on investment (ROI).
Private equity would like to do LBOs
Melissa Knox
Global co-head of software investment banking at Morgan Stanley
Since capital investment during an LBO makes up a small portion of the purchase price, and the debt is paid through the target’s cash flows, it’s possible for buyout firms to achieve high returns, particularly with successful, financially stable target companies. This strategy helped PE firms produce an average annual return of 10.48% between 2000 and 2020, outperforming S&P 500 and Russell 2000 companies.
Management buyout (MBO)
A management buyout (MBO) occurs when the company’s existing management team, such as C-suite executives, purchases the business from its owners. This may happen when the management team believes it can run the company better than its current proprietors. MBO motivations may vary, from letting an owner-founder retire to allowing the majority shareholder to exit the business.
An MBO can be considered a subtype of a leveraged buyout since management teams often leverage debt. The management team may secure loans from PE firms to pay for the greater portion of the purchase price and use the company’s cash flows to pay the debt post-deal. Generally, several financial sources are used in management buyouts:
- Senior debt
This has the highest repayment priority. Senior debt usually comes from financial institutions.
- Sub debt
This has lower priority and bridges the gap between senior debt and available capital. It usually comes from private equity firms, hedge funds, and private investors.
- Equity finance
This comes from the company’s existing team, equity partners, such as PE firms, and private investors.
Employee buyout (EBO)
An employee buyout (EBO) occurs when the company’s employees collectively purchase the business from its owners. EBOs occur when existing employees believe selling the company to external investors would be undesirable, often due to job security concerns, compensation reduction, or potential cultural changes.
Employee buyouts are infrequent and typically happen in very small companies.
The Bank for Canadian Entrepreneurs (BDC)
Similar to leveraged and management buyouts, employee buyouts are financed with a substantial amount of debt, with the company’s assets serving as collateral to secure loans.
How do buyouts work?
The general buyout process is typically similar to that of a business acquisition. It involves valuation, initial negotiations, due diligence, contract finalization, financing, and deal closure.
Leveraged buyouts typically have additional steps: a holding period and an exit. Management and employee buyouts may bypass certain steps, such as in-depth due diligence, due to the insider nature of such transactions.
Initial screening
The initial screening phase is generally prevalent in buyouts executed by external buyers, such as private equity firms. An external buyer identifies an attractive target that fits into its investment strategy and begins researching the target’s financials and developing a business plan for the holding period (the time between acquisition and exit).
The buyout plan also incorporates the careful planning of an exit strategy, which is critical for achieving the financial goals of private equity investors. Potential exit scenarios include an initial public offering (IPO), a sale to a strategic buyer, or a sale to another private equity firm.
Business valuation
The valuation phase determines the buyout price which accounts for the target company’s financial capabilities and future growth potential. Generally, the greater the ROI potential the target company holds, the greater the proceeds the current owner can anticipate from the sale.
Conversely, companies with financial challenges or limited growth potential may be bought out at lower multiples. The following valuation methods are typically used in buyouts:
- Market-based company valuation
This involves evaluating the target company based on financial multiples of comparable companies and comparable transactions over several years.
- Discounted cash flows (DCF)
This projects future cash flows and discounts them back to present value thus determining the company’s growth trajectory and predicting ROI.
- Net asset valuation
This involves calculating the company’s value from its total assets minus liabilities. It’s generally more applicable to companies relying heavily on tangible assets, such as real estate or manufacturing businesses.
In MBOs and EBOs, management teams and employees have an information advantage over external buyers, which typically allows for more accurate valuations.
Asset acquisition vs stock acquisition: Key differences explained.
Initial buyout negotiations
Initial negotiations begin when the buyer team approaches the seller team to discuss the main terms and conditions of the buyout, including the purchase price, ownership transfer considerations, the holding period activities, exit strategies, and financing options. The nature and focus of negotiations vary in LBOs, MBOs, and EBOs.
LBO negotiations
LBO negotiations occur between the private equity firm and the target company’s owners. Initial LBO negotiations focus on the ownership transfer, price considerations, financing conditions, and exit strategies.
MBO negotiations
MBO negotiations typically occur between the company’s existing management team, the private equity provider (often a PE firm or an investment bank), and the current owner.
MBO negotiations center around price considerations but may heavily emphasize the equity partner’s ownership interest, affordability of the transaction, and financing conditions, such as interest rates and collateral conditions.
EBO negotiations
EBO negotiations occur between management teams, owners, employees, and equity partners. The process may focus on the collective ownership structure, commonly realized through the employee stock ownership plan (ESOP).
The EBO allows employees to hold a stake in the company. Senior employees and C-suite executives may receive a majority interest while regular employees may receive a minority interest.
Due diligence
The due diligence phase begins after successful initial negotiations and involves a deep investigation of the target company, aiming to prove and enhance the initial evaluation findings. The due diligence process focuses on the main aspects of the transaction:
- Financial performance
This verifies the fairness of the deal price, the company’s profitability, and potential cash flow implications of debt financing.
- Operational improvements
Identifies the financial improvement areas and the potential to implement cost-reduction initiatives without sacrificing the quality of products and services.
- Exit strategy
Determines the path to the highest ROI and works on applicable exit scenarios.
- Ability to carry the debt burden
Ensures the company generates enough income to meet debt obligations and works on potential restructuring scenarios.
Buyout finalization
During the contract finalization phase, the acquiring and selling teams finalize the terms and conditions of the business buyout agreement. The agreement outlines the price considerations, financing conditions, ownership transfer conditions, warranties and representations.
Financing
The financing phase follows the buyout agreement. It involves securing the necessary capital to finance the acquisition. Acquirers arrange loans, secured against the company’s assets.
Deal closure
During the deal closing stage, the acquirer and the seller meet the pre-closing conditions, including but not limited to shareholder approvals, payment transfers, contract approvals, regulatory approvals, and transaction filings.During deal closing, the ownership transfer occurs according to arranged conditions. It’s common for PE firms to control 60%–80% of the business while the rest of the acquired company is controlled by the company’s owners, shareholders, or managers.
A private equity firm is rarely the sole owner of a company but is almost always the majority owner.
DVS Group
In MBOs and LBOs, PE firms do not control the majority of the business but rather serve as creditors (equity partners) who provide the necessary portion of the capital to fund the deal.
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Holding period
The holding period is typically associated with leveraged buyouts and private equity firms. During that phase, a PE firm works closely with the acquired company to improve its financial performance and increase its value.
The length of the holding period for PE buyouts is determined by many factors, including market conditions, interest rates, and the success of operational improvements.
For example, in H1 2024, the median holding period of PE assets was 5.8 years, a considerable decline from the 2023 record of seven years. This was associated with the fact that PE firms were able to sell higher quality and ‘younger’ assets.
Is there a holding period for MBOs and EBOs?
In MBOs and EBOs, the acquiring party becomes the new business owner and is generally interested in long-term ownership and stability rather than selling a company for profit. The new owner runs the business as usual without considering an exit.
Exit phase
The exit phase is generally associated with leveraged buyouts and private equity firms. The exit occurs when the acquirer sells their stake in the acquired company to realize a return on investment. Here are a few peculiarities about IPO, strategic sale, and secondary sale exits:
- Initial public offering (IPO)
A company is taken public and its shares are sold on public security markets. While IPOs are quite infrequent — 551 global IPOs vs. 23,054 global M&A deals in H1 2024 — over 74% of IPO proceeds are from private equity and venture capital firms.
- A strategic buyout
A company is sold to a strategic buyer in the same or related industry. The strategic buyer benefits from potential synergies and is often willing to pay a premium, which amplifies PE returns.
- Secondary sale to another PE firm
A company is sold to another private equity firm, which may deliver moderate returns compared to IPOs and sales to strategic buyers.
Benefits of buyouts
Leveraged, management, and employee buyouts carry advantages for buyers and sellers, however, the nature of the advantage varies slightly across buyout types.
LBO benefits
LBO benefits for buyers:
- Cost efficiency of debt financing
LBOs allow acquirers to make acquisitions with minimal capital outlay. The debt burden is transferred to the acquired company, allowing the acquirer to avoid direct financial strain.
- Potential for high returns
LBOs have the potential to generate a high return on investment. Due to the nature of buyout financing, the increase in the acquired company’s value during exit can be disproportionately greater than the PE firm’s investment.
LBO benefits for sellers:
- Capital infusion
PE firms may specialize in distressed companies (those facing financial challenges). This gives the acquired company capital to realize operational improvements that would otherwise be very difficult to secure.
- Ownership retention
PE exits can give owners of acquired companies exit proceeds if such owners retain a stake in the business.
- Tax benefits
Interest payments on debt are tax-deductible, providing tax benefits to both LBO acquirers and sellers who remain in business.
MBO benefits
- Quick execution
MBOs may be executed quicker than external buyouts due to an in-depth insider knowledge of company processes. This may streamline negotiations and reduce the need for time-consuming due diligence.
- Strategic freedom
Managers have greater autonomy to implement their strategic initiatives without interference from a parent company or external shareholders.
- Potential for success
Since managers have deep expertise and knowledge of the company, they may have a greater opportunity to make informed decisions in favor of the company compared to external buyers.
- Clear exit for sellers
It may be easier for sellers to cooperate with internal buyers because there are no complexities of transferring ownership to external parties.
EBO benefits
- Employee empowerment
Employees gain a direct stake in the company, leading to a considerable financial incentive and a stronger commitment to business success.
- Preservation of company culture
Company culture is more likely to be preserved in employee buyouts than in PE-backed leveraged buyouts because of the employee-owners’ interest in the company’s values.
- Appeal for sellers
Employees may be more interested in the company’s success which may align with the intention of selling owners to preserve the company’s legacy.
Drawbacks of buyouts
Here are the potential downsides of leveraged, management, and employee buyouts.
LBO drawbacks
LBO drawbacks for buyers:
- High financial risk
If the acquired company fails to generate sufficient cash to meet debt obligations, the buyer may be exposed to financial strain.
- Market dependence
Market conditions, such as interest rates and investor appetite, play a significant role in LBO success. Economic downturns and high interest rates can make it harder for PE firms to meet debt obligations and secure buyers.
LBO drawbacks for sellers:
- Operational strain
PE firms may implement aggressive cost-cutting measures, which could potentially disrupt the company’s operations and impact the quality of its products and services.
- Employee impact
An LBO buyer may restructure an acquired company, initiating layoffs or introducing unpopular changes to employee terms, impacting long-term workforce stability.
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MBO and EBO drawbacks
Management and employee buyouts may share similar drawbacks:
- Difficulties funding a buyout
The capacity to finance the acquisition may be limited to the personal wealth of managers and collective employees. It’s often insufficient to cover the entire purchase price, forcing internal buyers to secure loans and private equity. This may place a significant financial burden on the company.
- Employee morale impact
Debt burden may strain the company’s operations and impact employee morale. In management buyouts, employees may perceive managers as prioritizing their personal gain over the wellbeing of the broader workforce. This could be aggravated by the knowledge that median CEO pay is 200 times the typical worker’s pay.
Buyout examples
Here are notable buyout examples that demonstrate the level of debt involved in the transactions and long-term implications.
LBO example: TXU
TXU, the Texas energy company, was acquired in a stock buyout for about $45 billion by two private equity firms Texas Pacific Group and Kohlberg Kravis Roberts & Co. The purchase price consisted of approximately $8.3 billion in equity and $35+ billion in leveraged debt.
This buyout resulted in a financial disaster due to enormous leverage and controversial pricing policies adopted by TXU after the buyout (renamed Energy Future Holdings). Energy Future Holdings filed for bankruptcy within seven years.
MBO example: Dell
Michael S. Dell, CEO of Dell, a multinational tech company, bought out the business from its shareholders for approximately $25 billion in 2013. Dell was taken private, giving Michael greater strategic freedom and eliminating interference from external shareholders.
Dell’s CEO secured the buyout with the help of an equity partner, private equity firm Silver Lake. The purchase price comprised Michael’s roughly $3 billion investment, $750 million cash, and $19.4 billion from Silver Lake. The buyout was considered largely successful. However, the company ended up with significant debt, while its profits fluctuated significantly.
Key takeaways
- Buyouts can be categorized into leveraged buyouts (LBOs), management buyouts (MBOs), and employee buyouts (EBOs). Leveraged buyouts are typically executed by external buyers. Management and employee buyouts are executed by internal buyers — the company’s management teams and employees.
- Leveraged, management, and employee buyouts are financed using significant amounts of borrowed money. The target company’s future cash flows are used to repay debt.
- Buyouts provide strategic freedom to internal buyers, such as managers and employees, and the potential for high ROI to external buyers, such as private equity firms and investment banks.
