The following is my answer to a Quora
question: “Why
are leveraged buyouts legal?”
Before we address why they are legal, we
have to understand what they really are, and how they work. Essentially, a leveraged buyout is simply a
financial transaction in which a company is purchased through some combination
of equity and debt. The company’s cash
flow is the collateral for the debt. They
are borrowing against the company to pay for it. This is not as strange as it sounds. When you buy a car or house, you take out a
loan to buy it. You are also borrowing
against the asset to buy it. In this
case, since a company itself has no intrinsic value, they borrow against the
cashflow, future projected earnings.
In the case of companies, this makes a lot
of sense since the use of debt is cheaper than equity against the capital,
making the acquisition cost less. The
interest payments are used to offset some of the corporate tax liability. If they used equity and issued dividends after
the acquisition, that dividend is taxable as income.
As can be seen, this makes perfect
financial sense, and reduces costs all around. Few people have that much liquidity available
for outright purchases, and the use of debt instruments increases economic
activity, contributing to GDP. There are
instances, of course where the buyout fails due to the acquired company being
overleveraged on debt, and their earnings cannot fund debt payments. This is a case of overly optimistic
projections of earnings, overvalued asset, or too high a debt ratio. This is bad analysis. It does not make the majority of leveraged
buyouts illegal.
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