companies that buy for this reason are called strategic buyers. Investment banks are often brought in during these typical M&A deals to advise on whether it makes sense or help come up with the money to make it happen.
Sometimes the target — the company being eyed — doesn’t want to be bought. And that’s when deals often turn hostile, where the investors or management of the strategic buyer are hoping to make the deal happen, but the target is resisting. Again, investment banks are often pivotal in hostile M&A deals because the buying of a company that doesn’t want to be bought often requires more brinkmanship and cash.
Pitfalls of ill-conceived mergers
One of the reasons companies engaged in merger activities call in so many investment banks and advisors is that they don’t want to blow it. Mergers are often big bets that cost a great deal of money, either consuming cash or requiring the company to borrow or sell debt. Companies, and their shareholders, don’t want companies to blow it on deals that don’t work out. You can read more about botched M&A deals in Chapter 4.
Leveraged buyouts
Leveraged buyouts are another area where investment bankers can really put their skills to use. LBOs are a form of corporate buyout, but the high-octane version. In an LBO, the acquiring company typically buys the company with a large amount of debt. The acquired company then pays off the debt over time using the cash flow generated by the business.
You can find more details about LBOs in Chapter 5. For now, just know that leveraged buyouts are typically done by specialized firms, called financial sponsors. One of the most common forms of financial sponsors are private-equity firms. These investment firms typically have a host of limited partners, or investors, who provide money to the private-equity firm. The private-equity firm uses the cash from the limited partners, plus a heap of debt, to buy companies, fix them up, and then sell them for a tidy profit. Sometimes, the management of a company, including the CEO, may look to use a leverage buyout to buy the company from investors. These management lead deals are called management buyouts.
Some of the biggest private-equity firms include Bain Capital, Blackstone, Carlyle Group, a unit of Goldman Sachs, Kohlberg Kravis Roberts, and TPG Group. These firms often work alongside investment banks to not only raise money by selling debt, but also conduct the transaction. Investment banks typically get involved in leveraged buyouts later, when the private-equity firms want to exit.
How leverage changes the nature of a deal and a firm
Private-equity firms are looking to own the companies for a relatively short period of time. Debt is a way to drive higher profitability from the company that was bought. By boosting profit, the buyer, the private-equity firm, can sell the acquired company for a big profit later. Here are some ways private-equity firms sell companies:
IPOs: One way for private-equity firms to get out of a buyout deal is by selling the company to the public. This is done by carving the company up into shares that are sold to public investors. During raging bull markets, IPOs become a popular way for private-equity firms to exit deals because they can get top dollar.
Sales to strategic buyers: If a private-equity firm wants to sell its position in a company, and the stock market is depressed, it may court big companies that may be interested in the deal.
Recapitalizations: If a private-equity firm can’t find a buyer for a business, or if the timing isn’t right, it may consider restructuring the makeup of the company’s financing. The company, for instance, may take on an additional investor as a way to reduce the amount of debt.
Why leverage is used
Private-equity firms and investment banking operations have a tight relationship because they’re very mutually beneficial. Private-equity firms are constantly looking to buy and sell firms, which is exactly in the wheelhouse of investment bankers. Meanwhile, because private-equity firms rely on financial events like IPOs to exit positions, investment banks can make money on these deals when they’re opened and closed.
The pros and cons to debt in deal making
Debt can be like dynamite for investment bankers and private-equity firms. When companies borrow, they can invest in new capacity or equipment using other people’s money. The investment can push up profit without asking shareholders to put more money into the business. That’s the upside of debt.
But debt comes with a big downside. The company must pay an interest rate to borrow the money. That interest rate is a cost that must be less than the returns being obtained from the assets bought with the debt. Also, if the interest gets too onerous and the company can’t keep up with the payments, the company may be forced into bankruptcy protection.
PRIVATE EQUITY: NOT THE TICKET TO RICHES
Private equity firms had their absolute heyday in the mid-2000s. But they rose to prominence again in 2018 and 2019.
One of the key ingredients to private-equity firms is access to cheap money. And in the mid-2000s, private-equity firms could borrow from just about anyone with a pulse at extremely low interest rates. Banks and bond investors were more than willing to lend and buy bonds offering private-equity firms practically unlimited amounts of money to buy companies. Meanwhile, pension plans and other large institutions were lining up to invest in the private-equity firms’ investment funds used to hunt down and buy companies.
Some of the biggest LBOs of all time took place during the boom years of 2005, 2006, and 2007. Car rental firm Hertz, technology services firm SunGard Data Systems, retailer Toys “R” Us, and retailer Neiman Marcus were all bought up by private-equity firms in 2005.
The crescendo of the private-equity boom was capped off when one of the top LBO firms, Blackstone, decided to sell stock of itself in an IPO. Individual investors saw the IPO of Blackstone as a way to get on the inside track of the world of high finance. But how wrong they were. In fact, Blackstone was selling out at the peak of the LBO craze.
The company sold shares in an IPO at $31 a share on June 22, 2007. But individual investors who bought the deal were paying up just as the LBO business was about to hit a wall. Shortly after the IPO of Blackstone, the financial crisis of 2007 hit. Suddenly, banks were too nervous to lend to LBO firms, and bond investors didn’t want to lend money to the speculative ventures. Shares of Blackstone fell from $31 a share to less than $5 a share in early 2009.
But the story isn’t over. Interest rates fell again in 2019. The Federal Reserve cut short-term rates to stoke the economy. That is a green light, again, for private-equity firms like Blackstone. As of late 2019, shares of the private-equity firm were trading for more than $48 per share.
Private business sales
Much of what investment banks do is out in the open and public. When a giant company like Microsoft buys LinkedIn, there’s no secret about it. For one thing, LinkedIn was a publicly traded company, meaning the shares are held by the public and free to trade on a public marketplace, called a stock exchange.
