Leveraged buyouts and the effect of capital structure on the shareholder value

Only 5 days ago, on 5^th November 2019, the Financial Times reported about meetings between the $55 billion market valued global drugstore Walgreen Boots Alliance and several private equity groups. According to the magazine, both parties evaluate a possible $70 billion leveraged buyout (LBO), constituting the largest take-private deal ever in history. Immediately after Bloomberg’s and Reuters’ media coverage of the rumours, Walgreen’s share price rose 4 percent on the New York Stock Exchange implying that investors would support the potential takeover strongly.

Figure 1. Walgreen Boots Alliance's share price development.
Reprinted from Yahoo Finance, https://finance.yahoo.com/

How is this instant value appreciation explainable in the context that Walgreen’s share price fell almost 25 percent (Bloomberg) since last year? And even more striking, why do markets have no concerns about bankruptcy due to the arising debt obligations when modern capital structure theories suggest the disadvantages of such capital restructuring?

Before going deeper into detail, I want to shortly summarize and explain the basics of Private Equity (PE) firms and their way of investing and operating. Generally, PE companies can be viewed as the fund managers, so-called General Partners, of private equity funds which are financed by institutional investors and high net-worth individuals, the so-called Limited Partners. The main goal of the private equity managers is to acquire controlling positions by engaging in buyouts of publicly listed companies in order to take on operational roles in the firms and maximize their value. By listing, merging or selling the restructured companies afterwards, the fund managers and their limited partners receive their return if they were successful. Going deeper into detail, one way to achieve the aim of delisting the public equity of the targets are the already mentioned leveraged buyouts. LBO’s are highly geared company acquisitions characterized by the fact that the raised debt is not backed by the PE firm but only by the target’s future cash flows. The purpose of this way of structured financing is the high return on equity that can be achieved according to our understanding of the capital structure and the impact of high debt on the equity cost of capital.

With that kind of knowledge, we can partly explain the share appreciation of Walgreen. Firstly, the rumours about the buyout directly imply that the target should be currently undervalued, that it can be restructured to be more profitable in the long-term and that it should be financially stable enough in terms of future free cash flow to repay all occurring debt obligations. Furthermore, there is strong academic evidence for the positive impact of leveraged buyouts on shareholder value and future financial performance. Exemplars in favour of this kind of view are Bull (1989), giving proof for superior post-buyout performance in comparison to pre-buyout performance and Torabzadeh & Bertin (1987), stating that companies acquired in LBO’s from 1982 to 1985 made statistically significant economic gains posterior the corporate restructuring. We see that PE firms are taking advantage of the implications of capital structure theory by buying strategically suitable targets in combination with the increased return on equity in order to increase shareholder value.

Although all the mentioned benefits, there is also justifiable criticism when it comes to highly indebted company acquisitions, especially such oversized mega deals like the Walgreen one. Concerning the biggest risk namely the rising probability of bankruptcy due to the high gearing, we should look at the current largest LBO ever. In 2007, a syndicate of 3 PE firms took control over the Texan power company TXU corp. for $31.8 billion (Reuters) at a point of depressed valuation with the expectation of rising of gas prices. 7 years later in 2014, TXU declared insolvency, collapsing under the obligations of more than $40 billion (Bloomberg) in debt. This is exemplary demonstrating the risk that comes along with higher return on equity demands and is in accordance with modern capital structure trade-off theory that suggests not to lever up to such excessive levels (Kraus & Litzenberger, 1973).

In conclusion, it might seem like investors are too enthusiastically focused on the upsides of the potential takeover. Since the pharma giant is going through tough times as newly digital businesses in the healthcare sector like online prescription companies are flooding the market, the shareholders might have desperately waited for a managerial turnover without critically questioning the full background of the deal. Furthermore, subjective criticism could also be the arguable managerial abilities of a few non-specialist private equity bankers to fix Walgreen’s weakened business model.

Having discussed the possible takeover, I realized how present and important modern financial capital structure theories are in daily business. One the one hand, the theories can be used to elucidate the cornerstone of investment strategies like leveraged buyouts, on the other hand, models like the trade-off theory are furthermore able to give explanations for the limitations and risks that come along with certain capital structures (Kraus & Litzenberger, 1973).

Bibliography

Bull, I. (1989). Financial Performance of Leveraged Buyouts: An Empirical Analysis. Journal of Business Venturing, 4(4), 263-279.

Fontanella-Khan, J., Vandevelde, M., Kuchler, H., & Massoudi, A. (2019). Walgreens Boots Alliance Explores $70bn Buyout. Financial Times. Retrieved from https://www.ft.com/

Kraus, A., & Litzenberger, R. H. (1973). A state‐preference model of optimal financial leverage. The Journal of Finance, 28(4), 911-922.

Torabzadeh, K. M., & Bertin, W. J. (1987). Leveraged Buyouts and Shareholder Returns. The Journal of Financial Research, 10(4), 313-319.