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Abstract

The characteristics of the typical exploration and production company do not match that of an ideal leveraged buyout candidate. This paper discusses the reasons to undertake an LBO, describes the traits of an ideal LBO candidate and compares them to the typical petroleum industry firm.

Introduction

Seldom a week goes by without the announcement of yet another leveraged buyout in the financial press. However, the petroleum industry hasn't joined in this otherwise popular form of corporate restructuring. This has occurred for two reasons, the first is that the petroleum industry by the risky nature of the business has historically been better suited to public ownership. Public ownership allows risk that is specific to an individual firm to be diversified by the shareholder through ownership of a portfolio of investments.

The second reason that Exploration and Production companies have not attempted leveraged buyouts is that the capital structures of most industry firms today cannot support additional debt. A leveraged buyout requires a high remaining debt capacity so that the assets of the firm can be used to secure the debt necessary to buy out the existing shareholders and take the company private.

Discussion

A leveraged buyout (LBO) is a type of financial restructuring; in this transaction a publicly held company or a part of a company becomes privately owned. The purchaser borrows most of the money to buy the company and uses the assets of the firm being purchased to secure the debt.

Often the purchaser is a group of investors led by the firm's own managers. They believe that they can operate the firm more efficiently if they are free of shareholder reporting and servicing requirements and if they can reorganize the incentive structure to motivate decision makers to manage more effectively.

The money borrowed to finance the LBO transaction is paid back through funds generated by the target company's operations and/or through the sale of corporate assets.

How do you do a leveraged buyout? An investment bank, often a bank that specializes in LBO's is retained by the investor group, again often the firm's own managers. They arrange a tender offer for the majority of the company's stock.

If the tender offer is successful, usually a rather elaborate system of debt financing is arranged including layers or tiers of debt with the managers holding the least senior (most risky) debt and equity. The deal is often structured so that an investor group must take both debt and equity (strips of debt) in order to participate. Often the investment bank will retain a portion of the equity in lieu of a full fee and usually takes control of the board of directors.

The transfer of ownership from stockholders to the investor group allows previously depreciated property and equipment to be written up in value and their new basis depreciated.

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