When you borrow money to buy something, it’s not uncommon for the thing you bought to be used as collateral for the loan. The obvious example is a house mortgage – you borrow money, the house is the security. This makes the act of borrowing itself reasonably risk free: if the purchase falls through, the loan is dissolved and all you’re out is some administrative fees. Your real risk starts when the purchase is successful.
TL;DR – Borrowing money to buy a house is to leveraged buyouts as a pat on the cheek is to a punch to the testicles; same general act, very different implications.
The basic idea of a leveraged buyout is similar. You borrow money to buy something, and you put up collateral related to what you buy.
The way this typically works is that a group of investors with a lot of ready cash – and a friendly investment bank in their pocket – go looking for a bargain. A bargain, in this sense, is a target company in trouble – for whatever reason, it is available for sale for less than the price of its parts. An example might be a manufacturing company that is having union problems, or a transport company that’s had a management scandal, or an electronics company that’s had a product flop. Even better is a family owned business where the founder has passed on, leaving the business owned by disputing siblings. There could be any reason for it. Most target companies will be privately owned, not public – it’s easier to buy a private company (fewer shareholders to negotiate with), and public companies tend to be more closely scrutinised (which means more competition).
The investors – typically a type of private equity firm, or PEF – negotiate with the current owners and settle on a price. Good owners to negotiate with are ones with little emotional investment in the business: you want them looking for how they can get money, not caring about what happens to the company that their grand-pappy built with the sweat of his brow and the backs of a thousand illegal immigrants. The PEF will then buy the company – or at least a massive percentage of it (90%+ – enough to not worry about later shareholder lawsuits) – using their own money (that’s why you need a lot of ready cash).
At the same time – or normally well in advance – the PEF has negotiated a loan from their friendly investment bank. But the loan isn’t for the PEF – it’s for the target company. The millisecond that the transfer of ownership is complete, the target company takes out the loan, getting a sudden injection of cash. The assets of the target company are used for collateral. The cash – which matches the purchase price, or even exceeds it! – is then distributed to ‘shareholders’ – aka the PEF. With a really sweet arrangement, the PEF will negotiate a settlement period which allows them to get the loan sorted and the money transferred before they have to pay the original owners!
The difference between this sort of transaction and my home loan is the question of liability. If the PEF used their stock in the target company as collateral, it would be similar. But it’s not the PEF who have taken out the loan – it’s the target company (which is invariably a limited liability company or similar variant) that has taken out the loan. If the target company defaults, the PEF, as new owners, are not liable.
The classic way to describe this is “buying a company with their own money”. And it’s completely legal. It’s a virtually zero-risk way of investing, because you get your principal back more or less instantly, so all you’re risking is your gain.
LBOs can be virtuous. Employee buyouts are typically done as an LBO, for example. If the reason a company is struggling is because the current management is so far up its collective backside that they fart cigarette smoke, then an LBO may be a good way of putting in decent management. The company can then turn itself around financially and pay down the debt over time. The way you can tell a good LBO from a corporate equivalent of date rape is what happens to the equity – if there’s that sudden injection of cash, followed by an outflow of equity, then it’s corporate date rape at best.
Far more common is that the target company gets carved up into viable and non-viable sections. The viable parts – if any – get sold off (with the proceeds being returned to the ‘shareholders’ again), the remaining assets of the non-viable parts get sold or transferred, lots of people lose their jobs, and eventually the company is liquidated. There’s usually some cooking of the books here – various expenses will be trimmed as part of cost cutting. Little things, like R&D, or plant maintenance, or employee pension funds. The goal is to improve the revenue-to-expense ratio in the short term, while hiding the future drop in revenue or blow out in expense somewhere else. The PEF keeps sucking the money out as fast as they can get away with, until finally it’s time to drop the carcass and move on.
Oh, in addition to equity transfers, PEFs often charge ‘management consulting fees’ – basically, they get the target company, which they own, to pay for the privilege of being managed by the PEF. This is handy because management consulting fees reduce the profit of the target company, which equity transfers don’t – and reducing profits mean less corporate tax to pay. The PEF will be incorporated in some sunny Caribbean tax haven, so it doesn’t have to worry about those pesky corporate taxes, but target companies aren’t also so conveniently incorporated. Can’t have those pesky government vampires draining the corporate profits – that’s the PEFs job!
Of course, this isn’t totally risk free. Sure, there’s no way the private equity firm can lose money – they get their deposit back instantly, and all that remains is to slurp deep off the gravy train. But the investment bank – that’s at risk, isn’t it? Surely they don’t want to see their collateral at risk, so they’ll put some limits on what can happen, right?
Well, we know the answer to that one – it’s called ‘collateralized debt obligations‘, or CDOs. It turns out that debt isn’t just a liability – it’s also an asset, and can be sold. So the investment bank will on-sell the loans, thus reducing their exposure if things go bad. And to make it even more fancy – they won’t sell the loan as a package. No – they’ll sell off 1% of the loan at the time, bundled up with lots of other ‘1%s’ together into the CDO. A CDO is a collection of loans. The theory is that even risky loans don’t all go bad, so if you buy a product that represents a thousand risky loans squeezed together, most of them will be okay, right? To make it even neater, you lie about the quality of the loans in the CDO, and then you (or the people who buy your CDOs) make new CDOs out of the old ones!
The end result is that the investment bank doesn’t have any real liability either. This makes leveraged buyouts a particularly attractive way of making money for rich people – you need a lot of cash to enter the game (keeps the riff-raff who think that making money requires hard work away), and you need the right connections (aka golf buddies – and no, playing golf doesn’t count as work even for professional golfers) – but there’s no downside. You can even ‘retire’ from this hectic non-work lifestyle and still make money from it, because you still have a partial ownership in the private equity firm! Heck, even though you’re a economic leech sucking money out of productive communities and contributing nothing back, it won’t even stop you being the likely Republican candidate for the President of the United States!
Leveraged Buyouts – because describing it as ritual slaughter wouldn’t be harsh enough.
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