Economics: “Leverage Buyouts” (Essay Sample)

Name:
“Leverage Buyouts”
University Name
Martin Smith is a talented individual. In only his second year job offers started pouring in. After much thinking he joined Newport Partners. From early days of his career, he was interested in buying out companies. He was particularly interested in the Leverage buyouts. His first job was as an analyst in Goldman Sachs bank. His second job was about organizational planning and designing strategies. He joined Harvard Business School and managed to make good rapport with top CFOs, CEOS, and investment bankers.
The reason for joining Newport partners was that they were best buyout equity firm in the industry. Smith also found out that he will get more exposure and freedom to work here than if he joins any other organization. The first task that was assigned to him was a dream job. He had to choose between three buyout targets. All these companies were struggling to maintain their operations. They were part of different industries. Rustica industries were the manufacturer of industrial wires, and polymer systems. The second company was a service company. It was in the financial sector and provided payments to small scale regional merchants and home businesses. The third company was another manufacturing company known as Wildflower Corporation. The company was involved in the business of manufacturing paint applicators. It was a supplying industry. Each of these companies has different fortes and competencies.
These three options were really enticing for Martin Smith. Rustica Industries Corp was a market leader. However, the drawback was that this industry had very little barriers to entry. New competitors could easily enter this industry. This meant that competition was high in the industry, and it would grow with the passage of time. There is a rule that when the competition increases, profit margins start to fall. This is an important factor in the decision making. Usually investors make sure that they continue to earn a stable return. They do not like to invest in the industry where the profit margins would. It would lead to deterioration in the company’s portfolio and will lead to lower returns on average, if the investment is made in an asset that is earning lower return than the portfolio’s combined return. The industry had also achieved maximum growth and there were little or no chances to grow further.
The second option Wildflower was founded in the mid 1920s. It has a really good brand name and international recognition. However, the only drawback for this company, like Rustica, is that there is little room to grow. The company has already achieved the maximum growth, and now the growth will be limited only to sustainable rates. The periods of supernatural growth have come to an end. Such a company is called a Cash Cow in Finance. The share appreciation is low in such companies, but dividends are high.
The third company is Yellow Cattle Bank. The company is still growing and very low risky. Such an investment is always encouraged by investors. The company also has great room for growth as it has not achieved its financial maturity. The company is also relatively new as compared to the other options. It was found in the mind 1990s. Therefore, any improvement in the company is going to benefit the new investors as the company has not achieved its financial maturity and has not reached the level of growth that it can reach.
Financial Details:
The financial details are important for Martin Smith before finalizing his choice. Rustica is a large industrial corporation. Anyone would be enticed to buy such a large organization if it is available at a good price. However, the deal that the company is offering is very expensive. The sale price of the company is quoted at $145m. This is high because the company is under debt obligations equaling $100m. This means that capital that the company will get will amount to only $45m. This is only 31% of the original investment. Hence, such an investment means that the portfolio assets and wealth will be deteriorated. Currently the company is earning EBITDA of $21.1 million and its EBITDA ratio is close to 16%. This means that the company is only earning 16% of its total debt obligations. It is a risky sign because the company cannot meet its debt obligations from its current level of earnings. It is massively lagging behind and need to improve its income streams. The company also has a lower rate of growth than other options that are under consideration. The leverage ratio of the company is low, and it will have debt problem in the future. The value that Newport is going to get will be lower than the amount of investment. Such an investment is always a risky investment because there is no growth potential and the company is under the vicious cycles of debt. These cycles are very difficult to control because the company’s revenue streams are not enough to pay off some of the old debt and better its EBITDA ratio.
The second option is Wildflower Corporation. It is earning a higher growth than Rustica Industries Corporation. The company’s revenue is also greater than Rustica Industries. It is also less geared or less leveraged than Rustica industry. Its EBITDA is around $11.8m and EBITDA ratio is 27%. This means that the company can cover 27% of its debt from the current level of EBITDA. This is higher than Rustica Industries. The company will also get a better value on its investment by investing in Wildflower Corporation. The growth rate of the company is lower than the two other options, but it is covered up by the excellent management staff of the company. The company is the best managed company out of the three options. Another important feature of the investment is that Newport will have to invest heavily in the company to keep its operations up and running, and it will not only have to pay the price to buy the company. There will also be a need for additional cash to keep the company up and running. All of these factors make Wildflower Corporation the worst option out of the three available options.
The third option is probably the best option. Yellow Cattle Bank is a new company with plenty of potential to grow. The company will not only be earning the profits, but there will be a chance of capital appreciation because the company has not yet achieved its growth potential. There are also chances to redress the company’s management and to make improvement in the processes to increase the revenue even further. However, the company is offering only 40% of its shares for sale. This means that there will always be a conflict of interest between Newport and the original CEO. Newport will not be able to remove the CEO unless it has 51% of the voting rights. However, it seems impossible because most of the company’s shares are with the family members. Newport will not be able to implement its policies in the company, and the dividend and shares policies will be under the control of the original owner. This is a tough situation for private equity firms as they will not be able to make their own decisions with the investment. The inclination of Martin Smith towards this option is high growth rate, highly skilled CEO and growth of the industry. Another important factor in buying this company is that it is available at the P.E of 12.6x, whereas similar assets in the market are trading at close to 30x. PE or Price Earnings ratio shows the amount the investors are willing to invest for $1 of future earning of the company. Other companies are trading at $30 for every $1 of future earning, whereas Newport will only have to pay $12.6 for every $1 of future earnings. This makes that company’s future profits cheaper to the company as compared to other investments. The only problem with this investment is conflict of interest and control in the company. Control is extremely important but not as important as the growth in earnings. So if the company is growing really fast and is moving in the right direction than control issue should be ignored by the private equity partners at Newport. All of these options are really attractive, and present both opportunities and threats. However, deeper analysis clearly showed that there is only one winner and that is Yellow Cattle Bank. It is also good to have a financial services business in your portfolio because all the businesses have to transact through this company, and such companies see very little recession or slowing down of demand. Even during the period of recessions these companies make large amount of profits and churn out good money for their investors if they are managed properly.
It can be recommended that the best option available to the private equity partners at Newport is Yellow Cattle Bank (YCB). Although, the company will not be able to implement its policies in the management of the company, but the company is already moving in the right direction under its current CEO. That should be enough to convince all the partners at Newport to invest in this company. Beside, the growth in the industry is very high and the company business model is such that the growth will last for decades. It is serving small and medium sized enterprises that will continue to grow and provide more opportunities to the company. Another important feature about this investment is that it is cheap as compared to Rustica Corporation and Wildflower. They both are trading at a premium and are highly geared. Their current earnings are not enough to cover their debt obligations. All of these problems do not exist in Yellow Cattle Bank. Its future earnings are also trading at a discount as its P.E ratio is extremely low as compared to comparable assets or firms. This means that the investors will have to pay less to acquire t...