Hedge funds and Private Equity - PES

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Buy-outs are typically majority investments made in companies together with the existing
management (a management buy-out or “MBO”) or with a new management team (management
buy-in or “MBI”). These normally use sophisticated financial techniques that involve bank
financing and debt financing. Opportunities for buy-outs are created from the sale of familyowned
businesses; the sale of a non-core subsidiary by a large corporation; taking a listed
company private, typically a company underpriced by the stock market; and sale by financial
shareholders. Buy-out funds do not focus on any one industry, though many managers have
sector specialities. Buy-out capital includes:
Management buy-out: financing provided to enable current operating management and
investors to acquire existing product line or business.
Management buy-in: financing provided to enable a manager or a group of managers from
outside the company to buy-in to the company with the support of private equity investors.
Leverage buy-out: financing provided to acquire a company, by using a significant amount
of borrowed money to meet the cost of acquisition.
None of these activities are transparent.
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An LBO typically involves the following three steps:
The investors form a company (often a limited company) which borrows the capital to acquire
the shares in the target company; i.e. the acquiring company is typically heavily financed by
borrowed capital.
The investors acquire the target company.
The target company is merged with the newly formed company.
The purpose of this multi-stage acquisition process is to give creditors security rights to the
assets of the target company. Given the short-term nature of the commitment, the creditors are
often willing to do without securities and/or to provide loans which rank below those of other
creditors. Since there is greater risk attached to these secondary loans, they are often provided
with debtor warrants. In a number of cases, where the merger is based on real economic
concerns for the future of the company, there may be constructive results. However, as Part II of
this report will detail, we often see a clear asset stripping of the company acquired, with major
detriment not only to its debt level, but often also to its employees and investment capability
including in R&D and long-term survival of the company.
Buyout funds purchase business divisions or a whole, big – eventually listed – company. Then
they change the liquidity / capital structure immediately, with the aim of realising the added value
created by selling the business on to an industrial buyer or to other financial investors 20 . Unfortunately
this strategy of creating added value goes too often hand in hand with short-termism,
and its negative consequences in terms of business management and competition. The buyer
generally finances the purchase of the company with the company’s own equity. The LBO only
ever uses its own money to a small degree, if at all. In other words, the majority of the funding is
borrowed. This enables it to make use of the so-called leverage effect: it is the difference
between return on equity and return on capital employed 21 . Leverage effect explains how it is
possible for a company to deliver a return on equity exceeding the rate of return on all the capital
invested in the business, i.e. its return on capital employed. However, there is also a risk of a loss
if the cost of borrowing the capital outweighs the profit – but due to the LBOs’ short-term investment
profile, this is rare.
20 Cf. Handelsblatt of 12.5.2005, p. 23.
21 For more details, see Glossary.