In 2021 over $1trn was spent by private equity firms on corporate buyouts worldwide¹. But it’s not just private equity executing these deals. Management teams from businesses, and even employees can acquire companies.

Regardless, a buyout can have a profound impact on investors. Therefore it’s critical to understand precisely what they are, how they work, and the different types, advantages, and drawbacks of these deals.

What is a buyout? 

A buyout is when an entity acquires a majority stake of at least 51% of a firm’s voting equity to gain control over operations. Any company can be a target for acquisition. But the acquirer usually focuses on a struggling or undervalued enterprise to secure a better price. Of course, there are always exceptions, with some deals executed at a high price to tag to try and eliminate a competitor at any cost.

Generally speaking, the purpose of any buyout is to take control of a firm and make the combined enterprise a more profitable and valuable entity.

Acquiring company

If successful, for publically traded stocks, this will increase the share price over the long term. A successfully executed buyout can have a similar effect on a private business. After all, if the firm eventually goes public through an IPO or SPAC, a more profitable enterprise will command a higher issue price allowing more capital to be raised.

Acquired company

In most cases, an acquired business will be integrated into the acquiring firm’s operations. In most cases, it will be rebranded and cease to exist. For public and private shareholders, their position will typically be bought out with cash or receive shares in the acquiring company depending on how the deal is funded.

How does a buyout work?

Buyouts can be immensely complicated deals, especially when targeting large corporations. However, the process can be broken down into five primary stages:

1. Bid Offer – The acquiring company approaches the Board of Directors of the targeted company. It presents an offer and motivation for acquiring a controlling interest in the enterprise. And the presentation will include details on how many shares or even debt it wants to buy.
2. Negotiation – With an offer presented, the negotiations begin. It’s standard practice for the target company to almost always reject the first bid to try and bump up the price. The firm will also announce the offer to attract other potentially interested firms. Why? This is to try and start a bidding war to inflate the acquisition cost even more.
3. Decision – Once negotiations are complete, the target company’s Board of Directors must decide whether to accept or reject the deal. If the offer is accepted, the deal will be presented to shareholders. If it’s rejected, that might be the end of the story. However, the acquiring firm might not take no for an answer triggering an attempt at a hostile takeover. In this scenario, the acquiring company will bypass the Board of Directors and present its offer directly to shareholders.
4. Shareholder Vote – As owners of businesses, shareholders of both firms have to approve any significant buyouts. Even if the Board of Directors have come to an agreement that they are in favour of, shareholders may still reject the offer. Similarly, shareholders could accept a deal the Board rejected in a hostile takeover.
5. Regulatory Approval – In any buyout, the final decision is made by regulators. The authorities must approve all acquisitions, mergers, and takeovers. This is to prevent the rise of monopolistic corporations, as well as to protect national interests. The latter is why many buyout attempts in the defence sector from foreign parties almost always fail to receive regulatory approval.

If regulators give the green light, the buyout can proceed and is usually completed quickly.

What are the different types of buyouts? 

There are three primary types of buyouts, each with a different set of implications for shareholders.

1. Leveraged Buyout (LBO)

This is the most common type. Here, the acquiring company uses a significant amount of debt to fund the transaction. Due to the loan size, collateral will be demanded from lending institutions. And usually, the acquired assets are put up to cover this.

Leveraged buyouts often result in the acquired company being stripped and restructured, selling unwanted parts to reduce the debt incurred. Sadly that often means some employees will lose their jobs as operations are streamlined.

However, a leveraged buyout can be risky. Suppose the acquisition doesn’t deliver on expected performance. In that case, the acquiring company may have just compromised their financial health as the balance sheet becomes riddled with debt. This is especially problematic in a rising interest rate environment. After all, profit margins are squeezed as debt becomes more expensive to service. And in extreme cases, it could even lead to bankruptcy.

2. Management Buyout (MBO)

In this scenario, a management team acquires control by purchasing the majority of a target company’s shares outright. These types of deals are commonly funded with a combination of debt and equity.

Management buyouts can serve as an exit strategy for a founder. It can also be helpful to larger corporations seeking to divest parts of their non-core operations. These types of deals are usually initiated by a firm trying to sell part of itself. And therefore, are typically more straightforward transactions that are more streamlined with a greater probability of success.

When a firm disposes of part of its operations, the proceeds are often used to sure up the balance sheet and employee pension liability. Or it can be used to fund new projects. If a business has no better internal use for the capital, the profits are often returned to shareholders through a special dividend, share buyback, or both.

3. Employee Buyout (EBO)

An employee buyout is pretty rare. But sometimes, workers may be significantly dissatisfied with the management team. So much so that they are prompted to come together and acquire a controlling interest in the company they work for. This is most commonly achieved through an employee stock ownership plan (ESOP).

Not every employee buyout is successful. And these types of deals can take tremendous time and effort, mainly if the management team is not cooperating with its employees.

Hostile vs friendly takeover

As previously mentioned, taking control of a target company may be hostile or friendly. A friendly takeover occurs when the Board of Directors and shareholders are willing to relinquish ownership to the acquiring company. On the other hand, a hostile takeover is when the Board of Directors rejects an acquisition offer. However, the acquiring company still proposes the deal to shareholders who may vote in favour.

Hostile takeovers can get intense. But a management team has several tactics available to block unwanted offers.

• Poison Pill – This is arguably one of the most potent defence mechanisms if introduced quickly enough. This prevents companies or individuals from acquiring a controlling stake in the business. Poison pills are triggered once a company or individual reaches a particular threshold ownership stake, usually around 10% to 15%. After passing this threshold, each additional purchase will automatically issue new shares at discounted prices to other shareholders. The idea is to trigger equity dilution, making owning more than the threshold percentage near impossible. In the long term, poison pills can cause a lot of damage to shareholders which is why they are always temporary policies. But in the short term, they can force the acquiring company to come to the negotiating table.
• Take on Excessive Debt – Another defence is to make the target company undesirable by purposefully overleveraging the balance sheet with debt. This can be a risky move. While it may deter the acquiring company from pursuing its buyout, the target firm is now saddled with excessive debt that must be serviced and repaid.
• White Knight – If it’s too late to introduce a poison pill policy, and the group cannot support a heavy debt load, finding a White Knight investor may be the only course of action. This is when the target company searches for another friendly investor or business to take them over instead.

Advantages of buyouts 

Despite their high cost, executing buyouts can deliver some substantial advantages that would otherwise be impossible.

• Increased Efficiency – A buyout target is usually undervalued or underperforming companies. Investors take over these companies to make them more efficient, productive and profitable. This often enables a target business to benefit from economies of scale.
• Reduced Competition – Companies may buy out a company with a similar business to eliminate competition. Hence, the removal of competition means more profits for the acquiring company. 
• New Products – Larger firms often acquire smaller enterprises with promising new products. After the buyout, the larger enterprise will use its resources to accelerate development and bring the new product to market faster.
• Stimulates Growth – Buyouts enhance the growth of undervalued target companies while also expanding the business of the acquiring company.

Disadvantages of buyouts  

While these deals provide significant advantages when successful, they also have significant drawbacks to consider.

• Expensive – Buyouts are capital-intensive and often require debt. This makes the acquiring company take on loans by using the target company’s assets as collateral to cover costs. But if performance expectations aren’t met, it can compromise the balance sheet and destroy shareholder value rather than create it.
• Loss of Key Personnel – A company’s management is changed after a buyout. And some employees may not be too pleased with the change in leadership. Hence, some may resign or even be laid off due to the purchase. 
• Integration Costs – Beyond the monetary price tag, buyouts can spark many unforeseen costs relating to the merging of corporate culture and harmonising procedures.
• Potential Value Destruction – An unsuccessful buyout could fail to generate value, making the acquiring company worse off. 

The bottom line 

Both friendly and hostile buyouts play a vital role in the economy. They allow weaker businesses to be given new life. At the same time, the acquiring enterprise can bolster its cash flows creating new job opportunities and value creation for shareholders.

However, not every deal works out. And a seemingly healthy company can quickly diminish into a financial catastrophe if a management team bites off more than it can chew. Sometimes shareholders of the acquiring company must block the deal if there isn’t enough value being potentially created.

Article sources

1. Statista. “Value of private equity-backed buyout deals worldwide from 2005 to 2022“

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.t.