LBO vs. Takeover vs. Corporate Raid

An LBO, or leveraged buyout, involves acquiring a company primarily using borrowed funds, with the acquired company’s assets often serving as collateral.

A takeover refers to one company purchasing a majority stake in another, gaining control of its operations and assets.

A corporate raid is a strategy where an individual or firm buys a large stake in a corporation with the intent to push for change against the wishes of current management, often aiming for short-term gains or asset sales.

While LBOs and takeovers can be friendly or hostile, corporate raids usually have a confrontational nature.

They’re all forms of shareholder activism.

Key Takeaways – LBO vs. Takeover vs. Corporate Raid

• LBO (Leveraged Buyout): Acquiring a company using significant borrowed funds.
• Takeover: Company acquires majority stake in another to control its operations.
• Corporate Raid: Aggressive takeover often against target’s wishes; may sell off assets for profit.

Leveraged Buyout (LBO)

An LBO represents a purchase strategy where a significant amount of debt finances the acquisition of a company (typically in private equity).

In these scenarios, the assets of the target company serve as security for the borrowed capital.

Notably, LBOs often serve as mechanisms to convert public companies into private entities.

Takeover

A takeover is essentially the acquisition of one company by another.

Two primary forms exist:

• Friendly Takeover: Here, both companies’ management and board of directors concur with the acquisition process, ensuring a seamless transition.
• Hostile Takeover: In contrast to the friendly version, the acquiring company pursues control of the target company against the wishes of its management or board.

Corporate Raid

Rooted in the belief that a target company remains undervalued, corporate raiding involves an investor acquiring a significant stake.

Using their acquired voting rights, they attempt to instigate changes aiming to uplift the company’s stock value.

Contingent Value Rights (CVRs) and Their Role

CVRs function as securities, granting holders a right to future payments based on specific predetermined conditions.

Frequently encountered in LBOs, CVRs ensure that the acquirer’s interests match those of the target company’s management.

To illustrate, management might receive CVRs, which, when specific performance metrics are met (like growth in earnings or other operating metrics), entitle them to additional compensation.

During deal-making, they can bridge valuation gaps between the two parties, and effectively act as an earn-out arrangement.

It’s common for sellers to ask for a higher price than the buyer is willing to pay, and can help with the inherent asymmetric information between buyers and sellers.

Sellers inherently have more information than buyers.

Differentiating LBOs, Takeovers, and Corporate Raids

The crux of the difference lies in the acquirer’s intent:

• LBOs: These usually stem from the intent to transition a public company to a private entity. The focus is on enhancing its profitability and long-term health away from the scrutiny of quarterly reporting (which might emphasize short-termism).
• Takeovers: A more multifaceted approach, takeovers might aim at market share expansion, competitive elimination, or the procurement of new tech and capabilities.
• Corporate Raids: Predominantly what drives corporate raids is the belief that the target is undervalued and change can bring about more profitable outcomes.

Real-world Examples of LBOs, Takeovers, and Corporate Raids

• LBOs: The acquisition of RJR Nabisco by KKR in 1989 and the takeover of Toys “R” Us by Bain Capital, KKR, and Vornado Realty Trust in 2005 stand as noteworthy LBO examples.
• Takeovers: Daimler-Benz acquiring Chrysler in 1998 and AOL’s takeover of Time Warner in 2000 exemplify major takeover moves.
• Corporate Raids: Notable examples include Carl Icahn’s 20% acquisition of TWA in 1985 and Ronald Perelman securing control over Revlon in 1987.

Choosing an LBO vs. a Takeover

Companies might choose an LBO for several reasons:

Privacy

By using an LBO to take a public company private, a company can operate without public scrutiny and the pressure of quarterly earnings reports.

Financial Benefits

LBOs can be structured to provide tax benefits, as interest payments on debt are often tax-deductible.

Alignment of Interests

With significant debt, management has a strong incentive to improve operational efficiency and profitability to service the debt.

Strategic Reasons

LBOs can help in restructuring or spinning off non-core parts of a business.

Strategies to Defend Against a Hostile Takeover or Corporate Raid

Companies have several defenses against hostile takeovers:

Poison Pills

Shareholder rights plans allow existing shareholders to buy more shares at a discount if a raider buys a significant stake, diluting the raider’s position.

White Knight

Finding a friendlier company for a merger or acquisition to thwart the hostile bidder.

Golden Parachutes

Contractual provisions that give key executives significant benefits if the company is taken over.

Staggered Board

Only a fraction of directors are elected in a given year.

This makes it harder for raiders to gain control quickly.

Supermajority Provisions

Require a large majority (e.g., 80%) of shareholders to approve a takeover.

Buyback of Shares

Reducing the number of shares available (before it happens) can make the takeover more expensive or challenging.

LBO Risks

LBOs come with financial risks, primarily because of the heavy reliance on debt.

Some of these risks include:

Default Risk

If the acquired company doesn’t generate enough cash flow, it might default on its debt obligations.

Interest Rate Risk

If the borrowed funds have variable interest rates, rising interest rates can increase debt servicing costs.

Operational Risk

Overleveraging can strain a company’s resources.

It can lead to cost-cutting measures that may impair the company’s long-term health.

Economic Downturn

A recession or downturn can decrease revenues.

This can make debt servicing challenging.

Asset Depreciation

If the value of the assets used as collateral falls, it can trigger covenants or make refinancing difficult.

Why Companies Get Targeted for Corporate Raids

Several factors might make a company an attractive target for corporate raiders:

Undervalued Assets

If a company’s assets are perceived to be more valuable than its current market capitalization, raiders might see an opportunity to profit by acquiring the company and then selling off its assets.

If a company has disparate divisions, they might consider splitting it up to get more value out of each.

For example, some shareholders may like one part of a business and not the other, which prevents them from investing and hurts its collective value.

Operational Inefficiencies

Raiders might target companies they believe are poorly managed or have operational inefficiencies, thinking they can unlock value by implementing changes.

Excessive Cash Reserves

Companies with significant cash on hand might be seen as not using their resources efficiently.

Defensive Measures

Limited or weak defensive measures against hostile takeovers (discussed above) can make a company an easier target.

Shareholder Dissatisfaction

A company with disgruntled shareholders might be more susceptible to a takeover as these shareholders could be more inclined to sell to a raider.

Shareholder Benefits from LBOs or Takeovers

Shareholders can reap several benefits from LBOs or takeovers:

Premium on Shares

Typically, acquiring companies offer a premium over the current market price to entice shareholders to sell their shares.

This might be 10-25%.

Potential for Improved Operations

Especially in LBOs, the new management might introduce operational efficiencies.

This can potentially lead to an increased share price in the future.

Liquidation Opportunity

Shareholders get an opportunity to liquidate their holdings.

This might be especially beneficial if the stock has been illiquid.

Positive Market Reaction

The mere announcement of an LBO or takeover can lead to a rise in the company’s stock as the market anticipates potential growth and profitability.

Historical Lessons from LBOs and Takeovers

Historical LBOs and takeovers have provided lessons for both acquirers and target companies:

Due Diligence Importance

Failures like the AOL-Time Warner merger underscore the importance of thorough due diligence.

(The AOL-Time Warner merger failed due to cultural clashes, overestimation of synergies, and the rapid technological shifts that diminished AOL’s internet dominance.)

Debt Management

The challenges faced post-LBO by companies like Toys “R” Us have highlighted the risks of excessive leveraging.

Defensive Tactics

High-profile hostile takeovers have led many companies to implement stronger defensive measures.

Regulatory Scrutiny

Some massive takeovers have led to increased regulatory oversight to protect shareholders and maintain market competition.

Stakeholder Considerations

Some takeovers have emphasized the importance of considering all stakeholders, not just shareholders, as public sentiment and employee morale can significantly impact post-acquisition success.

Financing Structures for LBOs and Takeovers

The financing structures for LBOs and takeovers vary based on the specifics of the deal, but they typically include a mix of the following:

Senior Debt

This is usually the largest component of LBO financing and is secured by the assets of the target company.

Mezzanine Debt

A hybrid of debt and equity, mezzanine financing often includes warrants or options to convert the debt into equity.

Equity

This comes from the private equity firm or the acquiring company and represents the residual claim on the target’s assets and earnings.

Bridge Financing

Short-term loans that are intended to be replaced by long-term financing in the future.

Vendor Financing

The seller provides a loan to the buyer to finance a portion of the acquisition.

Asset Sales

Post-acquisition, some assets might be sold to reduce the debt incurred during the LBO or takeover.

These financing structures are tailored to each deal, considering factors like the target company’s cash flow, assets, interest rates, and the acquiring firm’s objectives.

FAQs – LBO vs. Takeover vs. Corporate Raid

What is a Leveraged Buyout (LBO) and how does it work?

A leveraged buyout (LBO) is a financial transaction in which a company is acquired primarily using borrowed funds.

These borrowed funds are typically secured by the assets of the company being acquired.

The acquiring company uses the target company’s cash flow to service and pay off the debt over time.

LBOs are often employed when an entity wishes to take a public company private, spin-off a portion of an existing business, or when a company seeks to be sold.

How does a takeover differ from an LBO?

A takeover is the process of one company acquiring another company.

An LBO is a method of acquisition, but it’s defined by its financing structure – using significant leverage (or borrowed money).

All LBOs can be classified as takeovers, but not all takeovers are LBOs.

A takeover can be financed in various ways, including using existing cash reserves or issuing new shares, whereas an LBO is specifically financed through heavy borrowing.

What characterizes a hostile takeover?

A hostile takeover occurs when one company attempts to acquire another company without the consent of the target company’s board of directors.

This contrasts with friendly takeovers, where both parties are in agreement.

In a hostile takeover, the acquiring company might buy shares on the open market, make a tender offer directly to shareholders, or attempt to replace the target company’s management to get approval for the acquisition.

Who are corporate raiders and what is their primary objective?

Corporate raiders are investors who buy large quantities of a target company’s shares, aiming to gain significant influence or control over its operations.

Their primary objective is often to push for changes in the company to drive up the stock price or to extract valuable assets for profit.

This can be achieved by streamlining operations, replacing management, or selling parts of the business.

The term “raider” (which became popular in the 1980s) often carries a negative connotation, suggesting aggressive and unwanted takeover attempts.

How do assets have a role in LBO transactions?

In LBOs, the assets of the target company often serve as collateral for the borrowed funds.

Lenders are more likely to finance an LBO if the target company has substantial, tangible assets because these can be sold off in the event of a default.

Additionally, the assets’ profitability and cash flow are important as they determine the company’s ability to service the LBO’s associated debt.

How do Contingent Value Rights (CVRs) benefit an LBO transaction?

CVRs can bridge valuation gaps between the buyer and seller in LBOs.

If the acquirer and the target disagree on the target’s future performance, CVRs can be used.

CVRs give the target’s shareholders the right to future payments based on specific events or milestones, such as the achievement of financial targets or the outcome of ongoing litigation.

By aligning the interests of the acquiring and target companies, CVRs can facilitate deal-making where it might otherwise be challenging due to differing valuation perspectives.

Are there legal implications or regulations surrounding hostile takeovers and corporate raids?

In many jurisdictions, laws and regulations exist to ensure that takeovers, including hostile ones, are conducted fairly and transparently.

These might include mandatory disclosure requirements, offering a minimum price to all shareholders, and adhering to waiting periods.

Additionally, antitrust laws can come into play if the takeover would lead to reduced competition in the market.

Regulatory bodies often scrutinize such deals to ensure they don’t violate these laws.

Can a hostile takeover transition into a friendly takeover?

Yes, a hostile takeover can transition into a friendly one.

If the acquiring company makes a hostile bid and the target company’s board initially opposes it, negotiations can still take place.

If terms become agreeable, the board might recommend that shareholders accept the revised offer, turning the initially hostile bid into a consensual, friendly takeover.

Are new board of directors elected every year in a public company?

No, in most public companies, board members serve staggered terms, often spanning multiple years.

This ensures continuity, with only a portion of the board being up for reelection in any given year.

How long is a board of director term and what percent of the board is turned over each year?

Conclusion

While LBOs, takeovers, and corporate raids all involve acquiring control of a company, the underlying motivation of the acquirer distinguishes them.

Whether it’s to privatize and improve profitability, expand market presence, or correct perceived undervaluation, each strategy has its unique objectives and tactics.

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