What Is a Leveraged Buyback?
A leveraged buyback is a corporate finance transaction in which a company repurchases a portion of its outstanding shares by utilizing debt. By doing so, the number of shares rises, thereby increasing the value of the shares held by the remaining owners.
A leveraged buyback, alternatively referred to as a leveraged share repurchase, yields comparable results to dividend recapitalizations and leveraged recapitalizations, wherein corporations utilize leverage to distribute a singular dividend. Dividend recapitalizations differ in that they do not alter the ownership structure.
The Operation of a Leveraged Buyback
In theory, leveraged buybacks ought not to exert an immediate influence on a company’s share price after accounting for any tax advantages resulting from the adoption of the new capital structure and increased interest obligations. However, to meet greater interest and principal payments, the additional debt motivates management to be more disciplined and enhance operational efficiency via cost-cutting and restructuring; this is the rationale behind leveraged buyouts’ excessive debt levels. Companies with surplus cash may employ leveraged buybacks to decapitalize their balance sheets and prevent the risk of overcapitalization. Raising the level of debt reflected on the balance sheet may serve as a deterrent against hostile takeovers.
However, in contrast, leveraged buybacks, similar to other types of share repurchases, are frequently implemented for the sole purpose of augmenting return on equity (ROE), price-to-book (P/E), and earnings per share (EPS).
Buybacks Leveraged Against EPS
Although enhancing EPS via leveraged buybacks can prove to be a successful strategy for corporations, it does not indicate a positive development in the fundamental performance or worth of the company.
It may even be detrimental to the company if financial engineering results in unproductive long-term capital investments. Executives assert that investment opportunities are insufficient. Nonetheless, a significant conflict of interest exists, as executive compensation in most American corporations is tied to earnings per share.
The financial markets have rewarded firms that have resorted to buybacks instead of enhancing operational performance. Since then, it is unsurprising that buybacks have become a preferred weapon on Wall Street after the global financial crisis.
From 2008 to 2018, American corporations repurchased more than $5 trillion worth of their shares, equivalent to more than half of their profits.
Additionally, approximately 40% of EPS growth for large corporations such as Procter & Gamble, Mondelez, and Eli Lilly has been attributable to buybacks.
Returns on Leveraged Buybacks
It was reported in 2017 that leveraged buybacks had significantly revived in the United States, where share repurchases had surpassed free cash flow since 2014.
Additionally, they were utilized to circumvent the need to repatriate physical currency and fulfill tax obligations in the United States.
The buyback frenzy heightened the level of danger for shareholders and bondholders alike. Investment-grade companies were even willing to compromise their credit ratings to reduce the number of outstanding shares. An illustration of this can be seen in the case of McDonald’s, whose executives receive performance incentive payouts in part based on EPS metrics. From 2016 to 2018, the company’s credit rating declined from A to BBB due to the substantial borrowing used to fund buybacks.
Inflationary pressures may affect leveraged buybacks. But politicians could do the same. Signed into law by President Joe Biden on August 16, 2022, the Inflation Reduction Act of 2022 imposes a 1% excise tax on share repurchases exceeding $1 million after December 31, 2022.
Senate Democrats vehemently opposed the repurchase craze, contending that the benefits of Trump’s tax reform failed to be distributed to employees. The proponents sought to govern buybacks, previously regarded as market manipulation, until the Securities and Exchange Commission (SEC) sanctioned them in 1982 by adopting Rule 10b-18. This regulation safeguarded corporations against allegations of manipulating the stock market by limiting buybacks to no more than 25% of the average daily trading volume over the preceding four weeks.
The Biden State of the Union Address for 2023
President Biden stated in his February 2023 State of the Union address that he would propose a fourfold increase in the tax on corporate stock repurchases. His remarks did not specify whether or not this proposal would affect leveraged buybacks. In addition, analysts such as Tobin Marcus, an Evercore ISI strategist, predicted the likelihood of a buyback tax being enacted was low. Investors may nevertheless consider forthcoming legislation about buybacks when formulating their strategies. SEC Commissioner Allison Herren Lee advocated for corporate share repurchase policies that increase transparency “by requiring more detailed, timely, and structured disclosures” of buybacks in December 2021. Biden’s announcement reflects this.
Leveraged buybacks are what?
A form of stock repurchase known as leveraged buyback involves a company repurchasing a certain number of its shares by utilizing its debt.
What effects does a leveraged buyback have?
Numerous consequences are possible as a result of a leveraged buyback. The company’s earnings per share could experience an upward trend due to the overall reduction in outstanding shares. By increasing their debt, corporations can also use leveraged buybacks to ward off hostile takeovers.
What developments concern the future of leveraged buyback regulation?
Buybacks exceeding $1 million are subject to a 1% excise tax under the Inflation Reduction Act of 2022 as of January 1, 2023. In his State of the Union address on February 20, 2023, President Biden also hinted at his intention to propose a fourfold increase in the tax on corporate stock repurchases. However, the specific details regarding applying this proposal to leveraged buybacks remain uncertain.
In summary
Leveraged buybacks refer to corporate finance transactions in which an organization utilizes debt to repurchase a specified number of its shares. Many organizations that engage in leveraged buybacks implement cost-cutting or reduction measures with the additional debt. Frequently, a company uses leveraged repurchases to increase earnings per share by decreasing the number of outstanding shares. This has no fundamental effect on the performance or value of the organization. Additionally, this method can be utilized to decapitalize a balance sheet. The Biden administration has consistently expressed its disapproval of buybacks, initially by imposing a 1% excise tax in the Inflation Reduction Act of 2022 and more recently by using the president’s remarks at the 2023 State of the Union address.
Conclusion
- Leveraged buybacks are a type of financing that lets a business buy back some of its own stock by using debt.
- This process lowers the number of active shares, which increases the value of the shares owned by those who are still alive.
- Having more debt on their balance sheets is sometimes a way for companies to protect themselves from aggressive takeovers.
- Most of the time, they do these kinds of buybacks to boost earnings per share and other financial measures.
- There is a 1% revenue tax on some share buybacks under the Inflation Reduction Act of 2022.
