Leveraged buyouts are back in the news. For those who thought that they had seen the last of this phenomenon with the failure of megadeals like the Federated (NYSE:FD) fiasco in the late '80s, there is a sense of deja vu in the new wave of buyouts, funded largely by private-equity investors. In recent months, we have witnessed the buyout of HCA (NYSE:HCA) for $21 billion, and we've been privy to rumors of buyouts from firms as large as Time Warner (NYSE:TWX) to those as specialized as RadioShack (NYSE:RSH).

What motivates these leveraged buyouts? Why are we witnessing a surge now? What types of firms are most likely to be targeted by investors for buyouts? And what are the determinants of success in buyouts?

Assembling a buyout
To understand how a leveraged buyout works, it is perhaps easiest to take apart a large deal and consider its key components.

First, a publicly traded company is taken private for a period of time, with the intent of going public again at the end of that period. A recent example was the 2005 initial public offering of Prestige Brands (NYSE:PBH), from which the buyout firm GTCR Golder Rauner recouped substantial returns. Another was the Blackstone buyout of Celanese (NYSE:CE), which was taken public again just months later.

During the "private period" before a company goes public, the buyout investors hope to make changes that may have been difficult to execute in a publicly traded firm. Perhaps impatient investors and analysts were unwilling to give the firm enough time to make necessary changes, or perhaps some changes, such as layoffs and divestitures, are easier to make once a company has left the glare of the financial markets.

Second, these deals are financed with disproportionately large amounts of debt, partly because of necessity, and partly because of greed. Necessity arises from the large amounts of money needed to acquire publicly traded firms; greed springs from the purchasers' unwillingness to share the spoils of a successful buyout with other equity investors.

Third, while incumbent managers are sometimes part of the buyout team, some buyouts are hostile. In this case, the buyout triggers a change in control, letting new management change the investment, financing, and dividend policies of the acquired firm.

Why now?
The recent surge in buyouts can be attributed to a confluence of events. First, the inflow of funds into private-equity funds, motivated in part by stories of past success, has left these organizations with substantial cash to invest and relatively few investment opportunities. Second, a combination of low interest rates and default spreads has made it easy for buyout investors to borrow at low rates, even as their ratings slide and default risk increases. Third, private-equity investors are tapping into a strand of strong distrust of incumbent managers at publicly traded firms, and a resurgence in corporate governance reform. From Sarbanes-Oxley in the United States to the new EU code on corporate governance, the playing field is being tilted toward activist investors.

Firms with significant operating problems that require major restructuring are most likely to be targeted in buyouts -- such as Leonard Green & Partners' turnaround investment in the troubled Rite Aid (NYSE:RAD). If, for example, operating changes have not been made already because of balky management, a buyout will be hostile, and directed at removing existing managers. If changes have been postponed because of impatient investors or bad publicity, the buyout will be initiated by incumbent managers who stay on after the acquisition. Since these buyouts are funded with debt, they are more likely to occur in firms that generate substantial cash flows from existing assets that can be used to service the debt. Growth companies would not be good targets for private equity buyouts.

Secrets, luck, and consequences
For a buyout to succeed, the implicit assumptions that underlie it must be realized. The changes planned for the private phase must bear fruition via higher earnings and cash flows, setting the stage for the reintroduction of the firm to financial markets. The higher operating cash flows, in conjunction with cash from asset sales, should allow buyers to pay down the high-cost debt that funded these buyouts.

However, the economy's performance remains the wild card in these transactions. If the economy weakens significantly, even the best-structured buyouts are in trouble. If the economy stays strong, the odds of success improve. Every leveraged buyout is a bet on the economy.

Several key consequences for investors, positive and negative, emerge from these buyouts. On the positive side, the potential for buyouts will increase the stock prices of poorly managed firms, and the threat of being acquired will put managers on notice. On the negative side, especially with management-initiated buyouts, there is the possibility for significant conflicts of interest. After all, these managers have a vested interest in buying the company at the lowest possible price, while their fiduciary responsibility to stockholders requires that they deliver the highest possible price. It will be interesting to see whether corporations' boards of directors do their job to protect stockholder interests in such situations.

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Fool contributor Aswath Damodaran is a professor of finance at the Stern School of Business at New York University. An enthusiastic teacher who has been voted Professor of the Year by the graduating MBA class five times during his career at NYU, Prof. Damodaran also provides a wealth of outstanding content on his website. Among his numerous books, Fools might be interested in Investment Fables and Investment Valuation . Prof. Damodaran owns shares of Time Warner, which is a Motley Fool Stock Advisor recommendation. The Fool has a disclosure policy.