M&A and LBO
Why this chapter
To understand how a company is bought with almost none of your own money, and who ends up paying for a purchase like that.
An analogy
Imagine you buy an apartment building for a hundred, putting in twenty of your own and borrowing eighty — and agreeing that the debt will be repaid by the building itself, out of the tenants' rent. If the tenants pay on time, in a few years the building is entirely yours, and you put in only a fifth of the price. If the tenants scatter, the building goes to the lender and you lose your twenty. The sixth chapter is about the same thing, except that instead of a building there is a company, instead of rent there is its cash flow, and the debt is created by banks with the same entry as in the first chapter, just with more zeros.
How it works
LBO: buy a company putting in only part of your own money (in the classic deals of the 1980s, 10–15%; today usually 40–50%), and the rest is debt created by banks and hung on the acquired company itself. Its cash flow pays down the buyout loan for years. The banks create the money for the deal with an entry — just as in chapter 1, only with more zeros.
Goodwill is the overpayment above the value of net assets, and it becomes an asset of the buyer. Earn-out — part of the price paid in installments out of future results. Vendor loan — the seller lends to the buyer.
The bankruptcy waterfall: senior debt → subordinated → mezzanine → preferred → shareholders. Whoever stands higher sleeps better and earns less.
The words of this chapter
Leverage
The ratio of other people's money to your own in a deal. To buy with twenty of your own and eighty borrowed is to work with leverage: both the profit and the loss on your money are multiplied several times over.
It was invented not for the risk but for the return: if the business you bought brings in more than the debt costs, the difference goes to whoever put in the smaller part.
Goodwill
The overpayment above the value of the net property of the company that was bought: reputation, customers, the benefits expected from putting the businesses together. It becomes a line among the buyer's property.
It appears because a business is worth more than the sum of its desks and machines. The accounts have to put that difference somewhere.
Vendor loan
An installment plan from the seller of the business: part of the price is received not in money but as the buyer's promise to pay later.
It was invented for deals where the bank is not prepared to give everything. It also tests the seller: someone confident in their business will agree to wait.
Earn-out
The part of the price that depends on the future results of the company that was bought: hit the targets and the seller gets the rest, miss them and they do not.
It was invented as a bridge across a gulf of expectations: the seller believes in growth, the buyer does not, and the disputed part of the price is put on the table.
MBO
The buyout of a company by its own managers: they put in a small part of their own money and borrow the rest against the cash flow of the business itself.
It was invented because managers know a business better than any outside buyer and are ready to take a risk for a stake.
Dividend recap
The trick where the company that was bought takes out a new loan and pays it to its owner as a dividend. The owner gets back what they invested without selling the business itself.
It was invented by funds for the speed of returning money to their investors while the company itself has not yet been sold.
Waterfall
The queue for money in a liquidation: first senior debt, then junior debt, then the owners' share. Losses go from the bottom up, returns from the top down.
It was invented so that money of different degrees of boldness could take part in one deal, knowing its place in advance.
What happens to the balance sheet
Look at the company's balance sheet before and after the buyout. Before the deal: property and a moderate debt, and the rest is the owners' share. After: the same amount of property, and a debt grown so large that the owners' share can turn negative. This is not an accounting error but the normal state of a deal like this: the whole bet is on future cash flow. Who is the real owner of the risk at that moment? The lender. It received all the risks of an owner without receiving the right to run anything.
Where the money comes from here
The buyer earns on the difference between the return of the business it bought and the cost of the debt, multiplied by how many times more of other people's money there is than its own. The bank earns interest and an arrangement fee, and it creates the deal's money with an entry — the seller receives a new balance in an account. The seller receives a price, part of which may turn out to be a promise. The one who loses is the company that was bought, if its cash flow did not stretch to the interest: layoffs, sell-offs and sometimes bankruptcy. Here is why this matters to you: any purchase of a business on debt is a bet on the steadiness of its cash flow, not on the profit in its accounts. Profit can be drawn; interest has to be paid in money.
What people usually get wrong
The common belief. A company is bought with the buyer's money, so large deals are available only to the very rich.
What is actually true. Most of the price is usually created by banks with an entry, and the debt is hung on the company that was bought, which repays it out of its own cash flow. The managers of a small plant can buy it out by putting in a fifth of the price.
The common belief. Overpaying for a company is simply somebody's mistake in the negotiations.
What is actually true. An overpayment becomes a line among the buyer's property and lives there for years. While the business is earning, nobody touches it.
The common belief. If a company's owners' share is negative, it must be bankrupt.
What is actually true. After a buyout with heavy leverage this is the normal state: property of eighty-five, obligations of ninety. The company keeps working as long as it services the debt.
After this chapter you will be able to
- read a purchase price as the sum of the assets bought and the expectations bought
- tell the paid part of a price apart from the part that stayed a promise
- put together a buyout in which the debt is serviced not by the buyer but by the business that was bought
- tell a debt that bought an asset apart from a debt that paid for a shareholder's exit
- predict the order in which a loss climbs the floors of a capital structure
Check yourself
Who repays the loan taken out to buy a company in a leveraged buyout?
The company that was bought.
The debt is hung on the target, and its cash flow goes into servicing it for years. The buyer puts in only part of the price, and the collateral is the business that did not belong to them before the deal.
The fund did not sell the company, and yet it got its invested money back. How is that possible?
The company borrowed and paid it out to them as a dividend.
The bank created money, it flowed through the company to its owner, and an obligation stayed inside. The property did not change; what changed is only whose it now essentially is.
The structure of the deal has senior debt, junior debt and an owners' share. Who loses money first if it fails?
The owners.
Losses climb from the bottom up, and returns are handed out from the top down. That is exactly why junior money costs more: this is not greed but the price of a place in the queue.
In short
A company can be bought by putting in only part of the price and borrowing the rest. And the debt is hung not on the buyer but on the company that was bought, which repays it out of its own revenue for years. If things go well, the buyer earns a large profit on a small investment. If they go badly, the business that was bought pays, and the lenders after it. An overpayment for a company does not disappear: it hangs in the accounts as wealth for years and is written off at the most awkward moment.
Reading is half the job. In the academy this chapter is worked through by posting entries: you run the operations yourself and see whether the balance sheet still balances.