LBOs: What the little guy should fear
When private equity comes calling, there are reasons for the average Joe to worry.
NEW YORK (CNNMoney.com) -- Leveraged buyouts (LBOs) are booming, and Wall Street seems to be cheering the surge.
Cash-rich private equity firms have been on a buying spree. Global sponsor-backed buyouts have reached $372.6 billion so far this year, more than double the amount at this time last year, according to deal tracker Dealogic.
The most prominent case came Monday when hospital operator HCA (Charts) agreed to a $21 billion leveraged buyout, one of the largest LBOs ever and close to the $25 billion record set in the 1989 buyout of RJR Nabisco (Full story)
Private equity investors have for the most part shed their reputations for waging hostile takeover battles, earning the approval of Wall Street.
But there are reasons for those on Main Street to fear LBOs - deals in which investors acquire control of a company with debt that is secured by the assets of the firm being bought.
Cost cuts. For one thing, private equity investors often aim to repay their debt by improving operations, which can result in job cuts and other cost-saving plans.
Once a company looks like it's for sale or wants to sell itself, there's a ripple effect through the employment base and suppliers, according to David Brophy, a professor of finance at the University of Michigan.
"If I'm an employee of a company and buyout companies are sniffing around, I'm going to get a little worried and start sending my resume out," he said.
Threat of bankruptcy. The large amounts of debt associated with leveraged buyouts can also pose a threat to a company's financial health - and raise the risk of bankruptcy.
Highly leveraged firms are pressured to make their debt-service payments, which makes it harder for them to reinvest in the company, according to Sean Egan, managing director at credit rating firm Egan-Jones Ratings.
Case in point: His firm cut its credit rating on HCA to "B+" from "BB+" and put it on negative watch following the news of its buyout.
And with interest rates on the rise - which increases the cost of borrowing - and defaults increasing too, it's not the best time to be highly leveraged, he said.
IPO risks. After investors finish turning around a company, it's common for them to sell the company back to the public shareholders through an initial offering.
But in some of these cases, the money raised from the IPO goes to paying back debt and the original investors, while leaving new shareholders on the hook.
Shares of Burger King (Charts), a private equity-backed turnaround story, have tumbled about 17 percent since their market debut in May. And Vonage Holdings (Charts), another private equity-backed firm, staged one of the year's worst performing public offerings.
There are dissenting views.
The perception of LBO deals weakening firms and stripping them of their value is off the mark, according to Sherry Jarrell, assistant professor of finance and economics at Wake Forest University's Babcock Graduate School of Management.
"The typical LBO creates real economic value. Everyone has to keep in mind that people who want to profit are on both sides of these transactions," she said.