What Is a Leveraged Buyback?
Let me explain what a leveraged buyback is—it's a corporate finance move where a company buys back some of its own shares using borrowed money. This reduces the total number of shares outstanding, which means the remaining owners end up with a larger piece of the pie.
You might also hear it called a leveraged share repurchase. It's similar to leveraged recapitalizations or dividend recapitalizations, where companies use debt to pay out a one-time dividend. The key difference is that those don't change the ownership structure, but a buyback does by shrinking the share count.
Key Takeaways
In essence, a leveraged buyback lets a company repurchase its stock with debt, boosting the stakes of remaining owners by cutting down outstanding shares. Sometimes, companies do this to shield themselves from hostile takeovers by loading up on debt. More commonly, it's about pumping up earnings per share and other financial metrics. Keep in mind, the Inflation Reduction Act of 2022 slapped a 1% excise tax on certain share buybacks.
How a Leveraged Buyback Works
These buybacks shouldn't immediately affect a company's share price, aside from any tax perks from the new debt setup or the hit from higher interest payments. The added debt pushes management to tighten up operations—think cost-cutting and downsizing—to cover those bigger interest and principal payments. That's how they justify heavy debt loads in these deals.
If a company has too much cash sitting around, a leveraged buyback can help de-capitalize the balance sheet and avoid overcapitalization. Plus, piling on debt acts as a deterrent to hostile takeovers, like shark repellent.
Just like regular share repurchases, these are often about improving metrics such as earnings per share (EPS), return on equity (ROE), and price-to-earnings (P/E) ratio.
Warning: Don't Confuse It with a Leveraged Buyout
Make sure you don't mix up a leveraged buyback with a leveraged buyout. The buyback is about repurchasing the company's own shares, while a buyout uses debt to acquire another entire company.
Leveraged Buybacks and EPS
Using leveraged buybacks to boost EPS can be effective, but it doesn't mean the company's underlying performance or value has actually improved. In fact, it can harm the business if this financial tinkering means skimping on long-term productive investments.
Executives often claim there aren't enough good investment opportunities, but there's a clear conflict of interest since their pay is tied to EPS in most U.S. companies.
Markets have rewarded firms that use buybacks instead of focusing on operational improvements, so it's no surprise buybacks exploded in popularity after the global financial crisis. From 2008 to 2018, U.S. companies spent over $5 trillion on buybacks—more than half their profits. For big names like Procter & Gamble, Mondelez, and Eli Lilly, about 40% of EPS growth came from buybacks.
Important Note on Buybacks
Buybacks are a double-edged sword—they can lift EPS and metrics but also jeopardize a company's credit ratings.
Leveraged Buyback Returns
In 2017, leveraged buybacks staged a major comeback in the U.S., with repurchases outpacing free cash flow since 2014. They also helped companies avoid repatriating cash and paying U.S. taxes.
This boom raised risks for bondholders and shareholders alike. Even investment-grade firms sacrificed credit ratings to cut share counts. Take McDonald’s—their execs, whose bonuses tie to EPS, borrowed heavily for buybacks, dropping their rating from A to BBB between 2016 and 2018.
Rising interest rates can hurt these buybacks, and so can politics. The Inflation Reduction Act of 2022, signed by President Biden on August 16, 2022, imposes a 1% excise tax on buybacks over $1 million starting January 1, 2023.
Senate Democrats slammed the buyback surge, saying Trump's tax reform didn't benefit workers. They aimed to regulate buybacks, which were viewed as market manipulation before the SEC's 1982 Rule 10b-18 allowed them, as long as daily buybacks didn't exceed 25% of the prior four weeks' average volume.
Biden's 2023 State of the Union Address
In his February 2023 State of the Union, President Biden proposed quadrupling the tax on corporate stock buybacks. It wasn't clear if this would hit leveraged buybacks specifically, and analysts like Tobin Marcus from Evercore ISI doubted it would pass. Still, you should factor in potential future laws when planning investments.
This followed a 2021 push from SEC Commissioner Allison Herren Lee for better transparency in buyback disclosures.
Frequently Asked Questions
What are leveraged buybacks? They're a way for a corporation to repurchase its shares using debt.
What's the impact? They can raise EPS by reducing outstanding shares and help fend off hostile takeovers with added debt.
What's coming for regulation? The 2022 Inflation Reduction Act has a 1% tax on buybacks over $1 million from 2023. Biden proposed quadrupling it in 2023, but it didn't happen, and it's unclear if it would target leveraged ones.
The Bottom Line
To wrap this up, leveraged buybacks are transactions where companies use debt to buy back shares, often leading to cost-cutting and downsizing. They're mainly about boosting EPS by shrinking share counts, without changing the company's core value. This can also de-capitalize the balance sheet. The Biden administration has targeted buybacks with the 2022 excise tax and 2023 proposals.
Other articles for you
Uncle Sam is a personification of the U.S
A bilateral contract is a mutual agreement where both parties commit to specific obligations.
The Uptick Rule is an SEC regulation requiring short sales at a higher price than the previous trade to prevent accelerating stock price declines.
The FIFO method is an inventory valuation technique where the oldest inventory items are sold first, leading to specific financial impacts under GAAP.
A black swan is an extremely rare, unpredictable event with severe consequences that seems obvious only in hindsight.
An official settlement account tracks central banks' international reserve transactions to balance payments between nations.
A zero cost collar is an options strategy that hedges stock gains by buying an OTM put and selling an OTM call to limit losses and cap profits.
Blockchain-as-a-Service (BaaS) provides third-party cloud-based management for building and operating blockchain applications to simplify adoption for businesses.
An open order is an unfilled trade instruction that remains active until its conditions are met, it expires, or it's canceled.
Eminent domain allows governments to seize private property for public use with fair compensation.