A leveraged buyback is a strategic corporate finance maneuver enabling a company to repurchase some of its shares using debt. By reducing the number of shares outstanding, the remaining owners’ respective shares are enhanced. This approach, also referred to as a leveraged share repurchase, bears similarities to leveraged recapitalizations and dividend recapitalizations, wherein leverage is employed to pay a one-time dividend. However, dividend recapitalizations do not alter the ownership structure.
Key Takeaways
- A leveraged buyback is a financial transaction that allows a company to repurchase some of its stock utilizing debt.
- This method boosts the remaining owners’ shares by minimizing the number of shares outstanding.
- Companies sometimes employ leveraged buybacks to protect against hostile takeovers by adding extra debt to their balance sheets.
- More frequently, the purpose of these buybacks is to increase earnings per share and enhance other financial metrics.
- The Inflation Reduction Act of 2022 includes a 1% excise tax on certain share buybacks.
How a Leveraged Buyback Works
While theoretically, leveraged buybacks might have no immediate impact on a company’s share price, any tax benefits from the new capital structure, along with higher interest payments, can compel management to adopt a more disciplined approach and improve operational efficiency through cost-cutting and downsizing. This approach is often a rationalization for the extreme levels of debt found in leveraged buyouts.
Leveraged buybacks can also be used by companies with excess cash to decapitalize their balance sheets, thereby avoiding overcapitalization and providing shark repellant protection from hostile takeovers.
More often than not, leveraged buybacks, similar to other share repurchases, aim to increase earnings per share (EPS), return on equity (ROE), and price-to-book ratio. It’s important not to confuse a leveraged buyback with a leveraged buyout, as the former involves repurchasing corporate shares while the latter involves using debt to acquire another company.
Leveraged Buybacks and EPS
Boosting EPS through leveraged buybacks can be an effective tool for companies. However, it does not signify an improvement in underlying company performance or value, and can even harm the business if long-term capital investments are neglected in favor of financial engineering. Often, executive compensation is tied to EPS, creating a potential conflict of interest when buybacks are used to manipulate financial performance.
Financial markets have rewarded companies that use buybacks as a substitute for improving operational performance, leading to a surge in buybacks since the global financial crisis. Between 2008 and 2018, companies in the United States spent over $5 trillion buying back their own stock, equating to more than half their profits, with significant EPS growth seen from companies like Procter & Gamble, Mondelez, and Eli Lilly.
Leveraged Buyback Returns
In recent years, notably in 2017, leveraged buybacks have experienced a resurgence in the U.S., where share repurchases have exceeded free cash flow since 2014. This trend was also driven by the desire to avoid repatriating cash and paying U.S. taxes, increasing risk for both bondholders and shareholders. For instance, McDonald’s heavily borrowed to fund buybacks, reducing its credit rating from A to BBB between 2016 and 2018.
Rising interest rates and political actions significantly influence leveraged buybacks. For example, the Inflation Reduction Act of 2022 imposes a 1% excise tax on share buybacks exceeding $1 million as of Jan. 1, 2023. Additionally, President Biden’s 2023 State of the Union address suggested a proposal to quadruple the tax on corporate stock buybacks, hinting at possible regulatory changes in the future.
What Lies Ahead for Leveraged Buybacks?
The Inflation Reduction Act of 2022 introduces a 1% excise tax on buybacks exceeding $1 million as of Jan. 1, 2023. Moreover, President Biden announced in his February 2023 State of the Union address that he would propose quadrupling the tax on corporate stock buybacks—though details remain unclear on its applicability to leveraged buybacks. As always, investors should stay informed of potential buyback-related legislation that might influence investment strategies.
Conclusion
Leveraged buybacks represent a significant corporate finance transaction where a company repurchases shares using debt. This strategy, while potentially beneficial in reducing the number of shares and increasing EPS, does not inherently improve a company’s core performance or value. It often leads to cost-cutting or downsizing measures. Additionally, policymakers are scrutinizing buybacks more rigorously, as shown by taxes introduced in the Inflation Reduction Act and recent discussions by the administration. Leveraged buybacks remain a potent tool in corporate finance, albeit one to be navigated with strategic caution and awareness of regulatory landscapes.
Related Terms: leveraged recapitalization, dividend recapitalization, leveraged buyout, earnings per share, return on equity.
References
- Accounting Tools. “Leveraged Buyback Definition”.
- S&P Global. “Examining Share Repurchasing and the S&P Buyback Indices in the U.S. Market”, Pages 4-5.
- Tuck School of Business at Dartmouth College. “Note on Leveraged Buyouts”, Page 1.
- Financial Industry Regulatory Authority. “How Companies Use Their Cash: The Buyback”.
- J.P. Morgan. “Stock Buybacks: Is Excess Cash Being Spend Wisely?”
- Barron’s. “A Reckoning for Buybacks”.
- CRISIL. “Implications of a Share Buyback on the Credit Rating”, Page 2.
- Fitch Ratings. “US Corporate Share Buybacks Ongoing Risk for Bondholders”.
- PriceWaterhouseCooper. “The Art of Cash Repatriation”.
- McDonald’s. “2020 Notice of Annual Shareholder’s Meeting and Proxy Statement”, Pages 46-47.
- Fitch Ratings. “Fitch Affirms McDonald’s Corporation at ‘BBB’; Withdraws All Ratings”.
- Congressional Research Service. “Tax Provisions in the Inflation Reduction Act of 2022 (H.R. 5376)”, Page 3.
- Congressional Research Service. “Stock Buybacks: Background and Reform Proposals”, Page 3.
- U.S. Securities and Exchange Commission. “Division Trading and Markets: Answers to Frequently Asked Questions Concerning Rule 10b-18 (Safe Harbor for Issuer Repurchases)”.
- Yahoo! News. “President Biden calls out stock buybacks in State of the Union address”.
- U.S. Securities and Exchange Commission. “Enhancing Transparency Around Stock Buybacks: Statement on Corporate Share Repurchase Proposal”.
