As a result of the fluctuations in the Zambian economy and the volatility of the financial performance of industries caused by aggregate shocks from macroeconomic policies, there have been many businesses in distress. High-interest rates and the weakening of the kwacha have made it difficult for Zambian businesses to stay above water as opposed to multinational companies that are able to rely on their parent companies for survival. This has resulted in numerous businesses failing and having to go through the insolvency process.
The Corporate Insolvency Act of 2017 has given businesses an alternative lifeline through Business Rescue. Business Rescue involves the rehabilitation of businesses that are deemed “financially distressed” and allows Business Rescue practitioners to temporarily supervise the management of the company enabling the company to restructure its affairs to move into a stable zone. Businesses now have an opportunity to stabilise their operations before they can be considered insolvent. The Act provides an opportunity for consulting companies to create new business lines that can focus on Business Rescue as well as create a clear path for the Private Equity (PE) industry to thrive and intervene in the private sector, specifically through leveraged buyouts.
In Zambia, there is great opportunity for economic development fuelled by the private sector as opposed to conventional means of economic development lead by NGO’s and publically funded agencies. Private Equity companies have the opportunity to thrive and source value from these business opportunities in the Zambian market and create an alternative Business Rescue strategy. The African PE scene has been more favourable to larger businesses but there is a new wave of excitement that can be seen around PE firms and middle-market companies. So why choose a leveraged buyout (LBO) as opposed to other Business Rescue strategies?
Leveraged Buyouts
A leveraged buyout (LBO) involves a specialized equity firm buying out a company using both equity financing and outside debt financing. The aim of a leveraged buyout is to gain a larger return that will outweigh the interest paid on the debt[1]. Some of the reasons for an LBO are to inject cash into companies – some of which are struggling financially or those that need to restructure – or for spin-off financing for public listings that can either be friendly or hostile depending on the nature of the buyout.[2] In order to perform an LBO, the PE Firm needs to strongly consider the company’s assets and the financial feasibility of the company[3]. A study undertaken by Blenman and Reddy (2014) states that LBO’s in developing countries are most suited in shorter time frames, taking advantage of high growth environments. For example, PE firms in developing countries experienced more gains in economic boom periods as opposed to developed countries. These economic booms were characterised by GDP growth rates between 2-5%. This shows that if initiated smartly and followed through effectively, there are advantages associated with leveraged buyouts for the PE firm, the company being acquired and the general business environments in which the companies function in.
Advantages of Leveraged Buyouts
As aforementioned, the aim of an LBO is to achieve a higher return compared to the initial investment, ensuring that the PE firm is able to repay the large sums of borrowed money used for the acquisition. This means that once the company is acquired, it is in the PE firm’s best interest to ensure that the acquired company’s returns are higher and able to cover the debt invested in the company[4].In an LBO an advantage posed to the PE Firm is that the firm usually demands a majority stake and has an active role in ensuring value maximisation through assessing and changing the company’s operations[5]. Value is also maximised through guaranteeing that the company is functioning in the best interest of the Private Equity firm. This allows PE firms to control their investment and be more accountable for their cash injection and repaying their debt. Other than paying back debt it is also in the PE Firm’s interest to generate enough returns so that they are able to cover their own overhead costs and make a profit[6]. It has been recorded that two-thirds of PE deals have resulted in the acquired company increasing their annual profits by about 20%, showing that PE is a lucrative business to be involved in if an adequate feasibility assessment is performed before the investment as well correct management of the acquired firm[7].
Furthermore, through the PE firm having an active role in value maximisation there is a benefit of skills transfer to the employees in the acquired firm. Through the specialised PE firm taking majority stake during the hold period (investment period), there is an opportunity for current staff members to gain specialised knowledge in the industry they function in. During the course of the investment, management will be required to pass on technical knowledge to enhance business operations and decisions. This can elevate the business and create a revamped standard for the company, thus creating a stronger foundation for it to function after the PE firm exits. Studies from Barber and Goold (2007) show that when an experienced PE firm is involved in the transaction there is usually a smoother exit and the business usually continues to function successfully after exit as a result of the strong foundation and controls that have been left in place. Not to mention the additional benefit of job security for the employees as opposed to those companies having to deal with liquidation.
There are numerous advantages associated with LBOs for PE firms and the acquired companies. But with a great financial investment, there are also a few disadvantages that need to be considered.
Disadvantages of Leveraged Buyouts
Firstly, despite the potential high rate of return of 20% during the holding period, there are some drawbacks of LBOs for Private Equity firms. A major flaw is the inability to redeem their debt. Once the acquisition has been made, there is a possibility that the company’s cash flow will decrease thus being insufficient compared to the cost of debt which could lead to financial distress or bankruptcy. This can be caused by factors such as unsuccessful management strategy implementation, financial crisis or a nonperforming economy which makes the company unstable and unable to generate profits. In addition to this, knowing that LBOs have high degrees of leverage which could go up to 85% or 90% of the total purchase price, PE firms may not be able to have the desired return on their investments[8].
A perfect example to illustrate the disadvantages mentioned previously is the TXU case, renamed Energy Future Holding which was one of the largest LBOs and unfortunately one of the biggest failures as well. In 2007, TXU was the greatest coal power plant operator in Texas when KKR, TPG Group, and Goldman Sachs’ private equity acquired it for $45 billion with $12 billion in debt. At that time, natural gas prices were low and were expected to increase but plummeted instead which created significant losses for investors and PE firms. The demand for natural gas kept falling and by 2012 a restructuring strategy was implemented, which divided the organisation into two main parts. However, the restructuring proved insufficient as the cumulative loss from 2007 reached $18 billion and in April 2014 $52 billion in debt was recorded[9].
Leveraged Buyouts in Zambia
The wave of Private Equity (PE) that has been seen in African countries has followed conventional and sophisticated models of developed countries. One can appreciate the lessons learned from PE in the developed sphere especially those lessons learned in the aforementioned TXU case, however, for LBO’s through PE firms to have a strong standing as a Business Rescue Strategy in Zambia, alternate models have to be generated. In order to do this, there are some factors that have to be taken into consideration.
- Firstly, attention has to be shifted to middle-market companies in distress. There have been numerous companies in the middle market sphere that have fallen victim to the sluggish economy in Zambia. These companies may have a strong management team and huge potential to flourish but are injured by an inability to service debt as a result of borrowing in foreign currency and dealing with a mismatch in repayment. Instead of focusing on the conventional large company these are the companies that PE firms should focus on and recreate the image of Zambian owned business as they have the opportunity to grow to a position where they can be listed, having a knock-on effect on growing the Lusaka Stock exchange.
- Secondly, there has to be buy-in from the banks and macroprudential regulators. For a leveraged buyout to be successful the cost of borrowing has to be reduced as an incentive for this industry to expand and thrive. There are many rewards that can be associated with LBO’s for the banks, and the economy as a whole if the industry is supported.
Conclusion
In conclusion, there are many candidates for Leveraged Buyouts in Zambia. Factors such as being able to pump money in companies and generate high returns provide an appetite for PE firms to successfully carry out LBOs. Attention has to be placed in recreating a model that suits the Zambian market and the climate of a developing country. There are drawbacks that can be associated with the practice of a leveraged buyout however, the advantages as a Business Rescue strategy outweigh the negative implications that may be at play. As a developing country, Zambia provides an exciting environment for the private sector to inject value into the economy and create opportunities for Zambian businesses to grow and business owners to create a legacy by listing their company on the LUSE.
| Katongo Mulenga is a consultant at KPMG Zambia and holds an MSc in Business Finance and a BSc in Business Management. The views expressed in this article are her own and not necessarily those of KPMG. |
[1] (Kaplan & Stro¨mberg, 2008)
[2] (Kaplan & Stro¨mberg, 2008)
[3] (AXELSON, STRÖMBERG, & MICHAEL, 2009)
[4] (Cumming, Siegel, & Wright, 2007)
[5] (Cumming, Siegel, & Wright, 2007)
[6] (Cumming, Siegel, & Wright, 2007)
[7] (AXELSON, STRÖMBERG, & MICHAEL, 2009)
[8] (Cao & Lerner, 2006)
[9] (Drake, Kasthuri, Kathrotia, & Press, 2014)
