Impact of COVID-19 on LBO transactions
Introduction
A Leveraged Buyout Out (LBO) occurs when someone buys a company using almost purely debt/ loans. The buyer in exchange puts up the assets of the company in picture up as a collateral. Buyers deposit very little of their own money as part of these purchases. Typically, the ratio of LBO purchases is 90% debt to 10% equity. If a buyer buys a company for $ 150 million, they in turn will borrow $ 135 million and pay $ 15 million in cash.
The buyer can be anyone with access to suitable banks and capital, but leveraged buyouts are usually performed by other companies or investors.
Throughout January and February, financial markets seemed to be immune from fallout due to COVID-19, a disease caused by the new coronavirus. Some market participants thought the virus could be limited to Mainland China, or that even if it spread, countries with strong health systems like The United States or Europe would not get hit so hard. Or if the disease became a global epidemic, they predicted that the market would react just like it did when previous virus crises like SARS and MERS broke out. When It was announced in early March that the COVID-19 crisis will progress differently, financial markets priced with a significant drop from the global economy, which is likely to cause global recession. Bankers who finance leveraged purchases are helping private equity firms slowly re-enter the credit markets. But they disagree with the latest upticks in stock prices. Most of Wall Street’s largest insurance companies had to freeze their loan portfolios by closing contracts for almost two months, as the pandemic sent capital and other risk assets for a toss in March.
The Truth of Leveraged Buyouts
While there are many examples of successful LBOs out there like The Hilton Hotel, PetSmart Inc., and Safeway, the cold truth is that there are countless others that just don’t work out. The biggest reason for the high number of unsuccessful LBOS is the debt that comes with it. Since the debt is legally under the name of the company, if the terms of repayment are unmeetable or even a failure to keep up with payments or a lack of revenue can cause the company to file for bankruptcy or even sell off parts of its assets like land, buildings or even IP. This has happened to not only troubled companies but also many others that were profitable before the LBO occurred.
These reasons made LBOs extremely unpredictable even before the coronavirus situation we find ourselves in today.
Impact of COVID on Lenders
Banks/ other financial institutions are expected to be less likely to lend money during these times of recession. Private banks are sitting on a cash cushion of $241 Billion as of Q2 2019 (PitchBook 2020). This means that due to the large amount of capital available to them even though we will see a dip in the amount being lent, it will not be as bad as the 2008 financial crisis. If the current scenario does not improve in the coming days, the banks will want to have enough cash reserve which means that the loans used to performed to complete an LBO could become harder to obtain in the near future.
Impact of COVID on Borrowers
Banks that agreed to help finance leveraged buyouts are starting to feel the pain from a freeze in the market for risky corporate debt. Lenders including Morgan Stanley, Bank of Ireland Group Plc and Citizens Financial Group Inc. have been forced to self-fund at least $1 billion of loans in recent weeks to ensure private-equity led acquisitions close as planned, according to people with knowledge of the matter (Bloomberg 2020). Not being able to sell the debt to investors, the banks are finding themselves in a situation in which they are owners to a high number of poor bond grade loans.
As mentioned above, since it is the company being bought that is the owner of the debt, it is the one responsible for payments, this means that they have very rough times ahead bar a few exceptions. Global lockdowns, travel bans and record high unemployment mean that people will not spend money unless it is for essential goods/ services. This is leading to a major decrease in sales revenue for many consumer goods and this effect of lack of demand has trickled its way through the economy down the sectors such that even the manufacturing and farming industries have been hit hard.
The lack of revenue means a lower EBIT and negative cash flows and will thus will prevent many of these companies from paying their payments which could lead to their assets getting seized by banks in a hope to recover what’s owed to them or even bankruptcies.
Possible Solutions
Some possible solutions for Leveraged companies to stay afloat are:
• Sell some of their land, assets which are not required in the long term. This will generate cash which is the only essential right now.
• Shut down divisions that are losing money.
• Cut down prices due to the drop in demand.
Conclusion
A leveraged buyout can be either a blessing or a curse depending on how It is handled. The entire world is seeing the financial impact of COVID-19 with many economies in/ on the brink of recessions. The current situation looks especially bad for companies having high debt. It is expected that 10,000 debt ridden businesses around the world will not be able recover after being impacted by COVID. Although banks currently have enough fallback to lend money for LBOs, availability loans are expected to become scarce in the near future. Borrowers are seeing negative cash flows and a sharp decline in sales. Companies will have to be willing to take drastic steps to survive.