What is a buyout?

Although it can take many forms, a buyout refers to the process by which an investor acquires a controlling interest in a company.

The controlling interest could be purchased by the company's management, a private equity firm, an investment fund, a pension fund or, more commonly, another public or private company.

To have a controlling interest in a company, an investor — or group of investors — needs to own a majority (more than 50%) of the company's shares or equity. Because of the voting rights attached to their shareholding, these shareholders significantly influence the company's future strategic direction. In essence, they can effectively take over its operations.

In most cases, a buyout will entail the acquisition of the entirety of a company's shares.

A potential acquirer will submit a proposal to the target company's board of directors. The board will then negotiate terms and provide a voting recommendation to the existing shareholders. The shareholders then vote on whether to accept or reject the buyout.

Why do companies acquire other companies through a buyout?

There are many reasons why one company may choose to acquire another company through a buyout. Some of the key motivations for this are outlined below:

'Tuck-in' acquisition

Also called a 'bolt-on' acquisition, a tuck-in acquisition refers to a company buying another business to merge into one of its existing divisions.

Companies may pursue this buyout strategy when they wish to expand their product offering but don't have the infrastructure or technology to do so. In these situations, it may be more efficient and cost-effective for the company to simply acquire a smaller company already successfully offering that product or service.

A good example of this is the acquisition of the social media company Instagram by Meta Platforms Inc (NASDAQ: META). Meta paid US$1 billion to acquire Instagram back in 2012, and it now contributes more than US$20 billion to Meta's annual revenue.

Expansion into new markets

Companies might buy out similar companies because they operate in other markets. In many ways, this is similar in concept to a tuck-in acquisition. However, the acquirer expands its geographic footprint instead of expanding its product offering. 

This is a quick and potentially less risky way for a company to access new markets, as the acquirer can leverage the target company's existing brand and customer base. It also gains access to the target company's capital and cash flow.

Spanish bank Banco Santander SA (BME: SAN) provides a good example. Throughout its 160-year history, Santander has acquired banks and financial services companies in Argentina, Puerto Rico, Chile, Brazil, Mexico, and the United Kingdom. Through these acquisitions, Santander Group has grown into one of the largest financial institutions in the world.

Large-scale strategic alignments

Companies will often acquire others that have similar growth strategies to boost revenues, realise cost synergies, and achieve their goals faster. For example, public company Ramsay Health Care Limited (ASX: RHC) acquired private company Affinity Health in 2005 and became Australia's largest private hospital operator. This acquisition quickly expanded Ramsay's market share and made it the dominant player in its industry.

Acquisitions like this can also help companies achieve faster economies of scale.

Vertical integration

This is when companies acquire other companies along their value chain. This action can give them greater control over the supply and distribution of their products and services. Vertical integration often serves as value creation for shareholders.

A good example is the American grocery chain Whole Foods Market acquisition by tech giant Amazon.com, Inc. (NASDAQ: AMZN). In addition to diversifying its product offering, the purchase gave Amazon a brick-and-mortar retail distribution network to sell its products directly to consumers.

What are the different types of buyouts?

How a buyout is classified typically depends on the proposed settlement method or which party instigates the buyout.

All-stock buyout

In an all-stock buyout, shares in the target company are traded for a set amount of new shares of the acquiring company based on an agreed conversion ratio.

The acquisition of Afterpay by United States digital payments company Block Inc (NYSE: SQ) is a good example of this. Under the terms of the deal, eligible Afterpay shareholders received 0.375 shares in Block for every ordinary Afterpay share they owned at the record date.

The advantage of this type of acquisition is that the acquiring company does not need to raise additional capital to finance the acquisition — it can simply issue new shares. 

The disadvantage is that taking this sort of action will dilute the acquiring company's share price. However, it is hoped that the business benefits stemming from the assets acquired through the buyout will more than offset those dilutive impacts over the longer term.

All-cash buyout

In an all-cash buyout, the acquiring company purchases all shares in the target company using cash. Shareholders of the target company will not be issued any shares of the acquiring company. Instead, they will simply be offered money for surrendering their shares. Often, the acquirer will offer a higher price than the market price of the shares to incentivise shareholders to accept the deal.

While this approach avoids diluting the acquiring company's share price, it does require it to have a lot of buyout funds available. This may mean it will need to borrow a significant amount of money to finance the deal, which can result in high interest payments further down the line on the debt.

Management buyout (MBO)

In this buyout type, the company's existing management team seeks to acquire a controlling interest in the same company's shares. The management team may want to take this action to secure greater potential rewards from the company's success. Their investment can also give them greater control over the company's direction.

In 2018, John Humble, the CEO of ASX skincare company BWX Ltd (ASX: BWX), attempted to buy out the company (with the financial backing of a private equity firm). 

He was reportedly frustrated that the existing BWX shareholders weren't allowing him to pursue an aggressive mergers and acquisitions strategy. While the deal ultimately collapsed, this is still an excellent example of what might motivate a company's management team to try an MBO.

Leveraged buyout (LBO)

In a leveraged buyout, a company finances an acquisition by taking out a large loan, typically using the target firm's assets as collateral. The advantage of this buyout is that companies can make large purchases without needing a lot of cash. However, like an all-cash buyout, an LBO is financed by debt and can pose financial risks if the interest payments are high.

Are buyouts good for shareholders?

Buyouts can be a bit of a mixed bag for shareholders. Typically, the acquiring company's share price will drop on the buyout news because it may have to fork out a significant amount of capital to seal the deal. However, over the longer term, the benefits of the acquisition should see greater growth in the share price.

On the other hand, the target company's share price tends to rise in line with the premium offered by the potential acquirer. While this is good news for short-term investors who might realise a quick gain on their investment, longer-term investors may be disappointed that they may be forced to give up their holdings in a company they had high hopes for, particularly in an all-cash deal.

In a worst-case scenario, a buyout may even force a shareholder to realise a loss on their holdings. For example, if you bought shares in Afterpay when it peaked at about $160 per share on the ASX, you may have lost money under the terms of the Block acquisition.

What are the potential barriers to a buyout?

For a buyout to proceed, shareholders need to vote on it – hence the requirement for potential acquirers to offer them a juicy premium. If the shareholders don't like the terms of the deal, they can vote it down and block the acquisition.

There are also regulations against companies gaining a monopoly in their industry. The Australian Competition and Consumer Commission (ACCC) reviews acquisition proposals to ensure they won't substantially reduce competition in a particular market.

For example, the ACCC initially opposed the merger of TPG Telecom Ltd (ASX: TPG) and Vodafone Hutchison Australia on the grounds it would lessen competition in the mobile telecommunications market and disadvantage the consumer.

Ultimately, the Federal Court disagreed with the ACCC and allowed the merger to proceed. However, this is an example of a roadblock that companies can face when trying to implement a buyout.