The World of Buyouts, $ and a whole load of Junk

I'm on my second rotation now, on the High Yield trading desk - thought it would be good to explain High Yield/Junk Bonds/Leveraged Buyouts in layman terms.

Remember Barbarians at the Gate? If the title does not ring a bell, try RJR Nabisco. Kohlberg Kravis Roberts? How about Leveraged Buyout? Three names; one of the history's largest buyouts at $31.3 billion. Such is the infamy, and some might argue romance, of the leveraged buyout that the tale is relived in one of the most well read books in financial literature, even spawning a movie (arguably much less successful than the book). But financial wizardry aside, what is a Leveraged Buyout (LBO)? More importantly, why use of the term junk?

On an extremely basic level, an LBO is simply one company buying another company, but instead of funding the purchase with cash or stock, the acquirer uses debt. A lot of debt.

Consider this simple scenario. Company A wants to buy Company B for whatever reason. However, A does not have the cash to do so/ does not want to commit a large amount of cash to do so. Recall: Company A tends to be a private equity firm, private investment partnership, corporate raiders and the ilk. What does Company A do? Simple, it borrows. In a twist of financial magic however, Company A purchases B and pushes all the borrowed money into B. Here's how the magic works:

Company A creates a new Company, C. Recall: C is a SPV or special purpose vehicle, whose "special" purpose in this case is to house Company B and all the debt taken on to fund the purchase. Now, when the debt is raised, B is bought and housed into C, together with all newly issued debt. Hence the use of the word "Leveraged" since the entire investment is made using rmostly borrowed money. A Real life example, in time to coincide with the dying World Cup fever. The Glazer's bought Manchester United in a LBO, with the English club being placed into the SPV/holding company Red Football Ltd - together with that now infamous debt which has caused a minor revolt in the club's fan base.

Now, more importantly, why use of the term junk? Simple. Remember the credit rating agencies that rated all the toxic mortgages triple A? They rate bonds based on the company's ability to repay them. Basically, more bonds equals more debt equals lower chance of repayment equals lower ratings. At a predetermined point on these agencies' ratings scales lies a threshold of High Yield (Junk) status. Go below that point, and the debt is rated junk. So named due to their relatively higher probabilities of default and thus unpopularity with most investors. In an LBO, so much debt is raised that it is a virtual certainty for the new bonds/debt to be rated as junk.

Hence the term, its use in Leveraged Buyouts, and the obscene buyout amounts witnessed. All essential ingredients in a quintessential Wall Street tale.