Mark Gritter (markgritter) wrote,
Mark Gritter
markgritter

LBOs

Yet more coverage from Rolling Stone about how Mitt Romney made his fortune, trying to explain leveraged buyouts in simple terms.

Here's the piece I don't get: why do banks put up the money for LBOs? It seems like they are a particularly risky class of investment. The takeover firm needs to show that there's a cash flow that can service the debt--- but, once in charge, they can siphon cash off via management fees, share buybacks, etc.

Suppose there are 10 companies costing $100m. Hypothetical Capital puts up $30m for each and gets loans for the remaining $70m. If HypCap can extract $30m in fees from each company over the course of the original loan, and leave the $70m in debt on the companies' bottom line, then they're basically freerolling on the banks' money. A 50% success rate would still earn them a healthy return on capital but lead to 50% of the loans entering default.

So, either banks are charging enough interest to accommodate not only the basic investment risk but also the agency risk, or the banks are happy ending up with what they get in the bankruptcies, or the banks are taking a bath. The last seems unlikely.

The Rolling Stone article really seems to focus on the buyers, and the fate of the companies, but leaves the banks out of it. If "too many" companies died from LBOs, the credit market would dry up. (I'm not arguing that this is a particularly productive use of capital, though.)
Tags: economics, finance
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