The Elite’s New Cash Machine: The Dark Secrets of LBOs

How they make billions while running debt-ridden companies and their workers to the ground.

Leverage Buyout — otherwise known as LBO — is probably a term that you have heard of if you read the news regularly. Perhaps you have read ‘Barbarians at the Gate’, or the acquisition of Toys “R” Us in 2005, or maybe you just heard the term while a finance bro was on a call with another finance bro. But unless you work in the finance industry, this term and what it entails likely remains an instrument shrouded in mystery.

Today we will explore what an LBO is, how it works, and what makes it so sketchy…

What Is an LBO

In theory, an LBO is the acquisition of one company by another using a significant amount of borrowed capital. In practice, it’s how the already rich get stupidly rich through acquiring a company and stripping its assets to pay themselves ‘special dividends’.

How It Works

Here is what a standard LBO scenario looks like: Let’s say we have private equity firm X trying to acquire target company Y. PE firm X will then go to institutional investors such as private investors, wealth funds, pensions funds, etc, to raise a portion of the necessary money needed to acquire the company.

What about the rest of the cost you ask? Don’t worry about that. The whole point of an LBO is that it is leveraged (hence the name), and so a large portion of the deal — as high as 90% — can be financed through debt.

Where does the debt come from then? That’s the sweet part, the debt is raised with the target company’s assets as collateral and its cashflow as security. Essentially PE firm X uses debt raised by the target company to acquire the target company and then uses its cashflow to pay down the debt and reap the profits.

Forcing Their Hand

While this all sounds fantastic from the Private equity firm’s point of view, why would any target company agree to go through with this? For one, it could be because the target company is already in distress. Its profits might be wailing, growth has plateaued, and it just can’t go anywhere. But sometimes, something more insidious happens. Private equity can ‘force’ the hand of an unwilling company to give itself up. Here’s how:

Since a large company has many shareholders, and many of them are not active in the business itself, it is easy for private equity managers to provide stock or other monetary incentives to vote in favor of an acquisition. On top of that, with the dawn of the asset management class, most companies have large shareholders like Blackrock, State Street, and Vanguard which prefer not to vote on these matters. Hence, PE managers only need to sway a minority of shareholders for votes to be cast in favor of an acquisition.

Growing

Once the company is acquired, the new manager's job is to grow the business and sell it to another firm at an increased price. Private equity funds are notorious for their cut-throat ways of expanding business by slashing wages, increasing hours, and even eviscerating entire departments or divisions. Firing workers, managers, and even senior executives becomes a daily agenda; not even the CEO is safe from these grifters and their sharp blue suits.

Continuous Funds

Here is a scenario to think about: a private equity manager manages a fund of 100 million dollars, earning the usual 2/20 management fee (2% annual fee + 20% of profits). He now grows this fund to 500 million dollars by growing the businesses he has invested in, however, he continues to earn 2 million/year (2% annual fees of his original 100 million dollars). So instead, he raises additional funds to buy up his 500 million dollar fund, allowing him to earn 10 million/year (2% of 500 million). Looks like private equity managers are ripping off their investors too!

Case Study: Red Lobster

Let’s take everybody’s beloved seafood restaurant Red Lobster as an example. Earlier last year, Red Lobster filed for bankruptcy following a series of massive financial losses and restaurant closures. Although it has since been able to crawl its way back (somewhat at least), it is likely never going to return to its former glory.

It all started in 2014 when Starboard Value — a private equity firm — published a 300-page slide deck about how Darden’s plan to sell off Red Lobster was going against the interest of shareholders. The slide deck ultimately became a hit, but Red Lobster was still sold to Golden Gate Capital through an LBO for 2.1 Billion dollars. However, soon after the transaction was made, Golden Gate Capital sold away all of Red Lobster's real estate and then leased them back in what is known as a sale-leaseback transaction. The total value of the real estate sold amounted to around 1.5 billion dollars, allowing much of the initial debt and investment principle to be recouped instantly. Of course, it would come as no surprise that some of this money went straight into the pockets of the managers in the form of special dividends.

Golden Gate Capital had no intention of expanding our building of this company. That would be too much work. No, instead, they find ways to make a quick buck while placing all of the added risk and liabilities onto Red Lobster. That is why Golden Gate Capital is still going strong today while Red Lobster is riddled with debt that ultimately culminated in their bankruptcy last year.

Case Study 2: Rockledge Hospital

No one is safe from the greed and sordid nature of private equity firms, not even our beloved hospitals; a place that was once meant for the weak and vulnerable to seek help, it has now turned into private equities’ latest money-making machine.

Steward Health is a private equity firm that specializes in acquiring and ‘managing’ hospitals. The firm owns 31 hospitals across the United States. One of the hospitals is Florida’s Rockledge Regional Medical Center, and like any hospital run by a private equity firm, it is a complete and utter disaster.

Besides the pitiful hygiene — broken sewage pipes oozing manure everywhere — Rockledge is deprived of necessary medical equipment including heart valves, urology lasers, slings, urine test reagents, etc. Doctors' salaries are constantly delayed if paid at all, and the quality of equipment is pitiful. All of this is done in the name of cutting costs to pay off debt and paying the managers hefty management fees and dividends.