Leveraged Recapitalization

It is the process where a company considers a considerable amount of debt financing to pay a large number of dividends to shareholders to increase the market value of the company's stock.

Leveraged recapitalization is when a company considers a considerable amount of debt financing to pay a large number of dividends to shareholders or repurchase shares to increase the market value of the company's stock.

As a result, the company increases its financial leverage beyond the 'normal' proportion of the debt in the equity structure. In addition, since debt recapitalization supports the payment of large dividends to shareholders, the market value of the company's share will decrease.

Because of the company's financial leverage, which may be a high proportion of the equity structure of the company, further additional debt financing could be quite expensive.

Due to a high level of leverage, lenders or creditors may not be willing to provide the debt because of the increased default risk of the company.

Debt recap most likely becomes attractive for companies during low-interest rates. The company that benefits from debt financing also takes the particular risk of leverage.

1. Structure of debt recapitalization
The structure of leveraged recaps is the financial transaction that companies utilize to rebalance their capital structure by replacing most of their shareholders' equity with fixed-income debt securities.

And this is one of the foremost advantages of that since it decreases the financial risk of debt holders from their promised loans or leases.

2. Launch of Debt Recapitalization
Leverage recaps are utilized by the issuance of fixed income securities, which are bonds, to raise financing and use this financing to purchase company shares or distribute dividends to shareholders.

When the external party launches the above-mentioned movement, it is referred to as LBO or 'leveraged buyout.' But in the case of the company itself, which is the initiator, it is referred to as 'leveraged recapitalization.'

Leveraged recap can be the reason for the slight change in the company's capital structure; otherwise, it can be a major factor for massive change in its power structure. Usually, companies that are privately held use debt recaps as a refinancing strategy.

3. Benefits of Leveraged Finance

  • There are various benefits of leveraged recapitalization to the companies. One is that according to the Modigliani-Miller theorem, debt financing provides a tax advantage and interest tax shield benefits.
  • Interestingly, the above-stated benefits are not available when the company is financed with equity investments.
  • Debt financing to purchase the stock or satisfy previously held debt decreases the OC (opportunity cost) of the company in which the company owns to utilize its profits to do so instead.
  • During a period of low-interest rates, the company can take advantage of the low cost of leverage recap.
  • Issuing new shares causes the dilution of stockholders' equity, while leveraged recapitalization prevents the dilution of stockholders' equity, thus providing a positive outcome.

That is why leveraged recapitalization can be one of the optimal choices for the company to finance its growth in particular periods that possibly create the opportunity of generating a profit and, at the same time, internal growth of the company itself.

4. Drawbacks of Leveraged Finance

  • According to some economists' arguments, debt recapitalization cannot hold a long-term view, which may restrict the company's future growth. 
  • The present debt environment is probably not considered by leveraged financing on a certain fixed level. And as it turns out, the change in interest rates negatively impacts the company through higher interest rate expenses.
  • The major change in the company's capital structure due to the higher proportion of debt puts the company at a huge risk. It may even lead to a decrease in stockholders' equity.
  • While the company can increase the stockholders' wealth by leverage recap, the management of the company may get forced to operate more efficiently to repay the debt. But in the long term, it may lead to management-related inefficiencies.

There are many forms of managerial inefficiencies, and those inefficiencies can be relative to the compensation of employees, the risk attitude of the company, and excessive staffing.

Once those inefficiencies become present, there will be a huge negative impact on the company, which may result in lower operational profitability and poor equity market performance.

Types of Leveraged Recapitalization

There are three types of a commonly used leveraged recapitalization, which are LBO (Leveraged Buyout), MBO (Management Buy-out), and MBI ( Management Buy-in).

While LBO is leveraged by investors, who establish debt financing from outside the company, MBO is structured by the company's internal managers to purchase a significant amount of stakes in the company, thus getting the majority control.

In terms of MBI, external managers will be willing to acquire the company with debt financing and acquire the company as the MBO structure does.

1. Leveraged Buyout

LBO is a type of debt recapitalization, which is about the internal management of the company acquiring the whole or a part of the company with a significant portion of debt from borrowed funds.

When one company acquires another, the acquiring company utilizes the assets of the target company for mortgages to borrow funding to acquire the selected company.

In this matter, LBO becomes the main objective, not the recapitalization itself. Specifically, the company that is making an acquisition is not essentially intending to adjust the capital structure of the acquired company.

Despite this, due to the significance of borrowed funds, the company's debt financing will become a high proportion of the capital structure. And in turn, that leads to an automatic change of the capital structure.

2. Financing LBO

  • Fixed Income Securities - Bonds are one the most common debt instruments. Companies usually utilize bonds to get capital for funding LBO.
    Suppliers of the funds, who are investors, purchase the bond from the issuers, and in return, the issuers pay them back with coupon payments and the principal amount to the investors.
    • The principal amount, also known as the bond's face value or par value, is the agreed amount that the issuer pays at the expiration of the fixed income security.
    • The coupon payment or coupon is the timely payment paid to the investor from the issue date till the maturity (expiration date) of the bond. 
  • Bank Loan - Requesting a loan from commercial banks or other financial institutions is also considered popular for LBO funding. After certain periods, the loan borrower pays the loan back.
  • Seller Financing - this is the type of financing in which the seller of the company provides a loan to the acquiring company to purchase the acquired company.

3. Steps of LBO financing

Identifying the acquired company
Usually, private equity funds look for the target company with significant fixed assets, lacks proper management, or is not operating at the optimal capacity.

Determination of fair price of the selected company
The acquiring company collects all the relevant information to price the fair value of the target company. This will be done by preparing valuations of the selected company's assets, cashflows, profitability, and other factors

Processing leveraged buyout
LBOs are typically processed in a 'hostile takeover' ( in which the acquiring company takes control of the target company against the desire of the selected company's management).

A hostile takeover is initiated by addressing the target company's stockholders or attempting to replace the company's current management.

If the management agrees to sell the target company, the acquiring company initiates a negotiation process with the current management.

After that, the acquiring company secures the LBO deal by initiating financing by, for example, issuing bonds. Alternatively, LBO financing can be provided by a bank loan.

The company purchases considerably enough shares of the selected company to get the most out of the controlling share of the business. At that time, the company gets from a 'public' to a 'private.'

Once the LBO deal is closed, the acquiring company updates the balance sheets according to the change in debt and equity in the capital structure.

Management Buyout 

MBO is the type of debt financing that is utilized by management that is inside of the company. Since the management is financing the company, they will own a certain amount of company shares, eventually making the management the owner.  

Thus, the management, which has been operating the company, exposes the company to less risk because of the previous experience of managers within the company.

1. MBO (Management Buyout)

It is a type of acquisition process the current management team of a company purchases the majority controlling number of stocks from stockholders and takes control of the company.

The key distinguishing part of MBO is that the acquiring management has expertise and knowledge about the company. 

Despite this, sellers of the company, who are shareholders, may get disadvantaged since the management may be intended to buy the company's shares by an unfair undervaluing of the stock price.

Management Buyout can be initiated for public or private companies. When MBO deals with a public company, it gets from 'public' to 'private.' As the company becomes private, there will be some benefits in terms of expenditure.

Firstly, the company will not be required to pay listing and registration costs, fewer disclosure overheads, and regulatory procedures.

Moreover, owners may benefit from an efficient management process since they are more aware of every process and operation inside the company. It will even benefit the company in terms of decision-making in the long run.

2. Financing Management Buyout deals

During the MBO deal, the buyers, who are the management team, may not be able to provide a sufficient amount of funds to purchase the majority of controlling stocks of the company.

At this time, the management team may turn to the additional funds raised by debt. As a result, most management buyout transactions will be through leveraged finance.

3. Features of successful MBO deals

  • A company with a long record of high profitability is usually found attractive.
  • Diversification of management team members in terms of skillsets signals that the management team has loyalty and a promising commitment to expanding the company's operations.
  • Sellers, who are the company's stockholders, are interested in the sale of the company to the management team and can accept the fair transaction cost of the sale of the stocks.
  • Promising future cash flows of the company that can support the deal formation with sufficient funds.

4. Advantages of a Management buyout

MBO deals provide a straightforward ownership transition for the management team and company owners.

Because the management is taking control of the company from shareholders, there is a reduced risk of failure in operating the company forward. 

Internal and external stakeholders of the company, employees, and clients, will not get worried about the company's prospects since the existing management has solid expertise in running the company and the business operation as usual.

That is why the management team's expertise is considered one of the most crucial parts of closing MBO deals. Even suppliers of the debt financing to the management for acquiring the company analyze the management's experience, knowledge, skills, and future outlook.

MBI (Management Buy-In)

It is similar to MBO, but MBI deals are processes with external management attempts to get control of the company and may replace internal management.

Since the management is from outside the company, it has expertise, knowledge, and skills that may not be related to the acquired company's industry. Despite this, external management comes in with substantial knowledge about the particular sector or industry.

1. Process of Management Buy-In

Initially, an external management team collects all the relevant information, data, and reports to analyze the target company. Analysis may include but is not limited to:

  • A market analysis of the company,
  • The current trends of the industry and the economic sector,
  • The past performance of the internal management, 
  • The current financial position of the selected company.
  • After completing the DD as mentioned above (due diligence), the external management launches the negotiation processes with the company's existing management.

2. Benefits of MBI

In the case when internal management cannot control or operate the company, the MBI deal may be a win-win situation for both parties, the buyer and stockholders of the company.

Since the external managers have better expertise and knowledge, the company is operated efficiently and effectively.

The new management team brings a new network of professionals and expertise to the company, which opens new opportunities for the company. Internal or external company stakeholders also get motivated as the new management initiates better control of operations.

3. Difference between Management Buyout and Management Buy-In

The main distinguishing feature between MBO and MBI is that for MBI, the external management team enters the company and replaces the internal management.

Analyzing the selected company for MBI requires more DD (due diligence) than the Management Buyout deal. It is because the external management team will not have enough information to see the clear situation in the company to make an offer.

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Researched and Authored by Bakhtiyorjon (Ben) Yakubov | Linkedin

Reviewed and Edited by Aditya Salunke I LinkedIn

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