Technology, Venture Capital, Private Equity

Given all the publicity (both positive and negative) that PE firms are getting these days in the media, some of the industry related vocabulary seems to be coming into the fold of common parlance. One such term that seems to have successfully garnered some popular attention (in India), thanks to the likes of Tata (Corus) and Birla (Hindalco) who have been famously employing it for their acquisitions is – “Leveraged Buyout” or “LBO”. When people learn about my PE affiliations, the question I sometimes get asked is – “What is this LBO thingie?” Now, who’s to explain that what I do in my job here is strictly not the financial engineering driven LBO stuff that Wall St. PE buffs are famous for (and nor is it strictly Silicon Valley style “VC”. So, what’s it that I do? – Will save that for another day…). Nonetheless, I can’t work in a PE firm and appear to be not knowing what an LBO is. So, after stretching my imagination a little, I contrived a real estate analogy to explain the same, which has met with a fair degree of success as far as a satisfactory response to the enquirer’s query goes. And it goes thus.
Imagine you are one of those who has an investable sum of a couple of million rupees and are keen to invest it in some real estate property since you strongly believe that it will fetch you a better return than other options you have. You in fact are pretty sure that the property prices will appreciate by at least 30% in one year. So, you take a look at some of the upcoming properties in your town, and find out that the lowest amount for a decent property is 5 million. So, one option for you is to dig into your reserves (like sell some other asset of yours) to make up for the shortfall. And sell the property in one year & earn a 30% return on your investment. But, there is a better option. You can pitch in with 2 million and for the remaining 3 million, you can take a bank loan at (say) 10% interest. So after one year, you now would earn 6.5 million by selling the property. You would have to pay 3.3 million to the bank in principal and interest, which will leave you with 3.2 million. So, what has happened to your return on investment? Well, it has doubled from the earlier 30% to 60% (1.2 million profits on 2 million investment). Wow! So, now you understand why the “L” in the “LBO” is so important. It should be clear that by adding a leverage (technical name for debt) component to your investment, your ROI significantly improves. That explains all the frenetic LBO activity we are seeing for the last few years. Interest rates had plummeted the world over to the extent of almost zero levels in some places (e.g. Japan). This was good for LBO dealmakers in two ways – it made huge amounts of debt available (since bankers didn’t have demand for credit from too many other folks) and it made it available at cheap rates. The more the leverage and lesser the interest rate, better will be the ROI.
But, wait a minute. Is there something missing from the above? The interest you have to pay in the above case is not a lump sum at the end of one year. You have to pay it every month. So, although your investment will come good after a year, what about the outflows in the intervening period? How do you fund them? Well, its not going to be all outflow, right? There will be some inflows as well, in the form of rent that you can get by leasing out the house. You figure out that the monthly rent you can get from this is 25,000. Therefore, that will cover all interest expenses (and also further jack up your ROI). Now, you know why stable cash flows from the company are an essential requirement for an LBO. The interest payments to a large extent are financed from the company’s operations and hence, LBOs are best suited for companies in mature industries, where uncertainty (owing to changes in technology, competitive landscape etc) are minimal.
Lets now add in some more complexity to the above scenario. The banks you meet are ready to fund your real estate investment only to the extent of 2 million. So, you would be left with still 1 million of short fall. Now, what do you do? In yet another flash of financial brilliance, you realize that the property comes with a separate security quarters, which you figure can be sold off for a million rupees, which should be sufficient to fund this shortfall. So, this is the other aspect of LBO deals. They strip the balance sheet into its various assets, identify which could be sold off so as to make up for any shortfalls and/or improve ROIs. That also explains why PE firms love companies with solid hard assets (such as real estate, heavy machinery etc) rather than those with softer ones (brand name, IP, human capital etc).
Lets now tweak it a little more. Say, the rent you expect from the property is not 25,000 p.m but 20,000 p.m. So, your monthly interest payments would require an additional upfront funding earmarked. However, there is an alternative. Say, in this hypothetical example, the security quarters mentioned above included a security guard whose monthly salary is 5,000. So, you could lay off the security guard and hunt for a tenant, who is not too particular about security and will still pay you the same rent without the security guard. Now you know why lay offs and other such cost cutting measures too are an ingredient of many LBO deals.
Trust the above example should give you a flavour for all the creative financial engineering that LBOs entail, the factors that favour LBO kind of deals and also lend some insight into which kind of companies make for good LBO targets.