Comment by exelius | Hacker News Reader

Comment by exelius | Hacker News Reader

Parent Full thread

Here’s how an LBO generally works:

1. PE company secures a loan in the company’s name (usually contingent on a turnaround plan executed by the PE with a history of turning companies around)

2. Company turns around and loans the money for purchase to PE firm

3. PE firm buys the company

4. PE firm runs the company, normally collecting management fees (paid out of the pool of cash used to buy the company)

5. PE firm cashes out by IPOing the company (usually at the same or higher price paid during LBO process).

6. PE firm uses the proceeds from the IPO (which the PE keeps because they are the sole shareholders; NOT the company itself) to pay back the loan.

The PE usually breaks even on the transaction itself once transaction fees are taken into account; but they make a killing on the management fees (which can be hundreds of millions a year). Normally, the company is left in roughly the same situation as before the buyout, just with a lot more debt on the balance sheet.

So the part I've never understood is why companies accept these offer. Are we talking about hostile takeovers? Or just already-failing companies that accept the turnaround plan because they're short on options?

It looks like investors and the PE firm have obvious ways to profit here, but I can't work out what the company gets out of this.

That's really my question too. I can guess that if you are say the ceo with a golden parachute agreement if your company is bought out, then you want to 'sell' into this, cause you win, and you leave. But it's terrible for shareholders (eventual ones at least) and for employees, and I don't know if I've ever used this phrase, but it's terrible for the world, for my country.

And, who are the, apparent, idiots who invest in these companies during the IPO?

Institutional investors who need to place large sums of money without causing market shocks. Usually the company is much healthier on paper after the LBO; and to be fair some companies actually do turn it around and they end up being bargains. But a good number get caught in what I call the “PE Death Spiral” where they go through multiple rounds of LBOs and IPOs at a valuation growing right around inflation.

Yet every time they IPO their debt rating gets worse because they’re carrying more legacy debt, until finally it’s so laden no bank will fund another buyout, so there’s a fire sale on remaining assets and the company closes.

The company decision makers could be making a bad decision. They're likely in dire straits to be in this position in the first place. Add in shareholders, some slick marketing/badmouthing from Bain reps, and you have a good opportunity for people to act irrationally, in their personal dis-interest.

Also, you can imagine that Bain has a few inside managers who do very well personally from this kind of deal.

Usually this happens because the company has gotten into cash flow trouble. When that happens, the company’s creditors lose faith in its ability to invest capitol in productive ways. But an LBO is usually the option of last resort. If you don’t have cash to make payroll next month and you have 2500 employees, you take the LBO.

An LBO allows the company to raise cash to fund a turnaround; but the incentives of PEs are set up such that the PEs don’t need to actually turn it around to make money — aggressively cutting costs is often enough. The creditors don’t care because they get paid back on IPO and get to collect interest in the meantime.

The alternative is usually going to be a buyout by a competitor, chapter 7 reorganization or simply ceasing operations like Toys-R-Us is doing once their debt rating is so far past junk they can never qualify for an LBO. Then the company dies. This is the “service” PEs provide to the economy — they help wind down failing businesses in a somewhat orderly way while extracting maximum value into the economy from a company that is headed for the scrap heap. You can argue as to whether or not that’s valuable.

Thanks, this makes sense.

I could never understand why a company takes an LBO instead of just taking out a massive loan against their assets directly, but this explains it. A combination of "the existing team isn't trusted to use that money" and "the creditors can collect without a full recovery" explain it nicely; PEs might theoretically be more objective at deciding when to restructure and when to strip assets.

I've invested in private equity funds across the entire spectrum. I mainly focused on the small to medium end of the market...

The bankruptcies of the large LBO deals skew the public's perception of the industry. Sure it has faults but the reality is much more nuanced than some of the views outlined above.

Yes there are large private equity firms that will acquire companies and overload them with debt, cut costs and sell prize assets. Yes there are many other firms who operate very differently. In the smaller end of the market, debt loads are much more conservative and returns are generated through moving into new geographies (i.e. opening a new store in MA), moving into adjacent markets (i.e. we sell tables. Let's move into the chair market), let's hire more sales people, acquire complimentary products to cross-sell etc. The list goes on. There are many positive qualities to private equity but the industry is tarred because of the large amounts of money. People on the whole don't like large amounts of wealth.

So why does a company sell to an LBO? Could be any number of reasons. The founder might want to retire. Maybe the kids inherited the business and no longer want to run it. Maybe the business is in dire straits and the current owner lacks the skill or the patience to turn it around. Maybe a company wants to sell a non-core division. Maybe a parent company is financial trouble and will sell assets. Maybe the price is right.

Reply on news.ycombinator.com