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Finance For HR Nerds: How an LBO (Leveraged Buyout) Firm Works

There's been lots of talk in this election cycle about whether LBO firms are net positive or net negative to the economy, and to a larger degree, America in general.  So it stands to reason we should talk about it, right?

LBO firms are another name for private equity firms that practice leveraged buyouts - meaning they borrow money (leverage) to buy controlling positions in companies. Gekko  

What they do after they gain control is something you'll hear a lot about in the election from now until November.  Still, it's hard to get your head around how an LBO firm operates.  Here's the best explanation/example of classic LBO firm activity I've seen from Allan Sloan's column in Fortune Magazine:

"Let's say an LBO firm spends $300 million to buy a company and borrows $200 million - two thirds of the price - to finance the purchase.  The buyout firm's investors thus have only $100 million invested.  The company's value doubles to $600 million because of luck, skill or both.  

The company then borrows another $200 million - two thirds of the increased value - and uses the cash for a payout to investors, who have now recovered more than they put in and still own the upside potential (Managers  get a piece of the profit, I'm ignoring that to keep the math simple).

Employees of the now more heavily indebted company are at greater risk because the company is more vulnerable to failing if anything goes wrong.  But the buyout firm's investors have already made out well.  Then the company runs into trouble.  Workers lose thier jobs, but investors and the LBO firm nevertheless come out ahead."

Sloan goes on to say there's no evidence on whether LBO firms add more jobs than they destroy, or vice-versa.

That's all you need to know about how an LBO performed by a private equity firm works to look smart.

Of course, after reading that and soaking on it, you may wish you didn't know.

Comments

MattL

I personally know someone who worked for a company that was "LBOd". This was over 10 years ago. He made out VERY well and is still at the company. Apparently this works out well only for companies that satisfy certain conditions (mainly financial).

The comment I still remember from this person was "I can't believe this is legal".

So is that Crony Capitalism or is it just smart guys that know how to exploit this?
Crony Capitalism versus Crony Socialism... which is worse?

Both of those last 2 quesions are meant as rhetorical.

Kevin

That's a great definition (or more accurately, one scenario) for "LBO's are evil and I'm voting for Obama." It completely ignores the fact that many private equity investments - like Bain has done for many years - more times than not save a company from ruin and grow a company long term, which benefits everyone - employees, management and investors. That's called free markets, or capitalism, or "how America was built." The ignorance around that is astounding sometimes!

Laurelannk

This is an example of how to create wealth, but not necessarily jobs. As our buddy points out above, LBOs are great for everyone as long as the company does well (or as long as the company is saved from ruin and grows in the long term.) If it doesn't, employees lose their jobs because the LBO made their company more vulnerable to failure, but investors have come out ahead. It's not a fairy-tale "win-win" for the general electorate and does not play well in the press.

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