Devangshu Datta: The games that LBOs play

A leveraged buyout (LBO) is a popular way to mount an acquisition. LBO is simple in theory. Find a target company. Borrow and buy it. Service the debt via the target’s future cash flows and/or sale of the target’s assets. The leverage multiplies returns. Capital gains are realised via later equity sale. Taking a listed entity private, and then relisting, is common.

LBOs can be justified by efficiency gains that add value, if debt is serviced from normal cash flows. Even successful LBOs are unpopular since layoffs and cost-cuts are normal. When asset-stripping occurs, LBOs usually fail. The target often goes bankrupt after being milked. Employees become unemployment statistics.

But it makes cold sense for an LBO to be leveraged to the hilt. The higher the leverage, the higher the potential return. The buyer’s personal stake is minimal in a bust. Hence, the temptation to borrow and asset-strip. A new owner may also refinance to reduce rates or retire debt. It has been known for acquirers to lend money to refinance the business, creating a looking-glass situation where the target pays the buyer for being bought!

To add to the mess in such cases, the accounting is very creative and LBO structures are designed to obfuscate. However, despite the arcana, every football fan knows about two high-profile cases. In the past five years, Liverpool and Manchester United have been victims (there is no other description) of the worst type of LBO.

Two thriving institutions with global brands have been drowned in debt and asset-stripped. This is despite consistent high growth in turnover and earnings before interest, tax, depreciation and amortisation (Ebitda).

Deloitte’s Football Money League rates Man U as the third most valuable club on Earth (behind Real Madrid and Barcelona). Liverpool is seventh. In 2009, Man U had revenues of £327 million (up from £279 million in 2008). Liverpool had 2009 revenues of £217 million compared to £185 million in 2008. Fantastic growth in a recession.

In 2007, Dallas-based buyers George Gillett and Tom Hicks paid £219 million (£174 million to shareholders and £45 million to cover outstanding debt) to buy Liverpool. In December 2008, the duo refused a buyout offer of £450 million from Dubai International Capital.

By May 2010, Liverpool was £350 million in debt with accumulated losses of £55 million. The creditors forced a sale, after complicated legal manoeuvres, to New England Sports Ventures for £300 million. It may be coincidental but Liverpool hasn’t won anything major since 2006.

Man U has even more debt on its plate. In 2005, Florida billionaire Malcolm Glazer and family bought Man U for £790 million, of which over £700 million was borrowed. The club registered a profit in 2009 by selling Cristiano Ronaldo for £80 million and Tevez for £25.5 million.

Sans the extraordinary income from those asset-strips, Man U would have run a loss of £57 million. In 2010, Man U floated a bond to raise £500 million to refinance debt. It has sold its training ground and leased it back. It has also “borrowed” from the Glazers and paid management fees to the family. Rooney is on the block.

While Ferguson will rebuild and he has an “overdraft” facility, the stressed balance sheet means that he can’t afford the money he needs to meet expectations. (Disclosure: I’ve been a Man U fan since the George Best era). It will not be surprising if Man U also has several years of underperformance.

This was the impact of legal financial engineering on two corporatised, people-intensive businesses. That’s how messy sports financing can get, even in transparent, well-regulated financial environments. Do these case studies offer some lateral insight into IPL and CWG 2010? One despairs at the future implications.