1. Leveraged Buyout Structures and Valuation

2. Learning Objectives
Primary Learning Objective: To provide students with a knowledge of how to analyze, structure, and value highly leveraged (use debt) transactions.
Secondary Learning Objectives: To provide students with a knowledge of
The motivations of and methodologies employed by financial buyers;
Advantages and disadvantages of LBOs as a deal structure;
Alternative LBO models;
The role of junk bonds in financing LBOs;
Pre-LBO returns to target company shareholders;
Post-buyout returns to LBO shareholders, and
Alternative LBO valuation methods
Basic decision rules for determining the attractiveness of LBO candidates

3. Financial Buyers
In a leveraged buyout, all of the stock, or assets, of a public corporation are bought by a small group of investors (“financial buyers”), usually including members of existing management and a “sponsor.”
Financial buyers:
Focus on ROE (Equity) rather than ROA (assets).
Use other people’s money.
Succeed through improved operational performance.
Focus on targets having stable cash flow to meet debt service requirements.
Typical targets are in mature industries (e.g., retailing, textiles, food processing, apparel, and soft drinks)
See LBO Articles – Alchemy of LBOs & Success of LBOs - Website

4. LBO Deal Structure Advantages include the following:
Management incentives, less costly than being public company.
Tax savings from interest expense and depreciation from asset write-up,
More efficient decision processes under private ownership,
A potential improvement in operating performance, and
Serving as a takeover defense by eliminating public investors
Disadvantages include the following:
High fixed costs of debt,
Vulnerability to business cycle fluctuations and competitor actions,
Not appropriate for firms with high growth prospects or high business risk, and
Potential difficulties in raising capital.

5. Classic LBO Models: Late 1970s and Early 1980s
Debt normally 4 to 5 times equity. Debt amortized over no more than 10 years.
Existing corporate management encouraged to participate.
Complex capital structure: As percent of total funds raised
Senior debt (60%)
Subordinated debt (26%)
Preferred stock (9%)
Common equity (5%)
Firm frequently taken public within seven years as tax benefits diminish

6. Break-Up LBO Model (Late 1980s)
Same as classic LBO but debt serviced from operating cash flow and asset sales
Changes in tax laws reduced popularity of this approach (post TRA 1986)
Asset sales immediately upon closing of the transaction no longer deemed tax-free
Previously could buy stock in a company and sell the assets. Any gain on asset sales was offset by a mirrored reduction in the value of the stock. Corporate entity pays tax & stock holders pay tax when profit distributed.

7. Strategic LBO Model (1990s)
Exit strategy is via IPO
D/E ratios lower so as not to depress EPS
Financial buyers provide the expertise to grow earnings
Previously, their expertise focused on capital structure
Deals structured so that debt repayment not required until 10 years after the transaction to reduce pressure on immediate performance improvement. (Balloon)
Buyout firms often purchase a firm as a platform (double lever) for leveraged buyouts of other firms in the same industry

8. LBOs in the New Millennium
Explosion in frequency and average size of LBOs in the U.S. during period ($5-$10 billion range)
Globally numbers doubled, volume quadrupled¹
Tendency for buyout firms to bid for targets as a group
Increased effort to “cash out” earlier than in past to boost returns due to increased competition for investors
LBO “boom” fueled by
Global savings glut resulting in cheap financing
Excess capacity in many industries encouraging consolidation
Attempt to avoid onerous reporting requirements of Sarbanes-Oxley
LBOs increasingly common in European Union due to liberalization and “catch-up” to U.S.
¹ Current Credit Instruments and Climate Make LBO Market Hard to Evaluate, Journal of Applied Finance- Vol. 19, No.4, pgs 44-53

9. New Millennium + 7-11Years¹
Summer 2007 banks reduced/stopped lending
LBO frenzy prior two years, banks kept liquid selling debt hedge funds looking at high yields
Banks stuck $330+B debt, limits loan ability.
Subprime loans, limiting commercial paper.
Investment banks restricted vs commercial –Goldman, M.S., Lehman, Bear. $75B of $330.
BOA, Citi, DB,JPM, UBS –big balance sheets
¹ LBO Deals on Hold Until 2008 as Crunch Worsens, Reuters, August 23, 2007.

10. New Millennium + 7-11Years
Commercial bank – Accounting rules favor -“available for sale” or “held to maturity”.
“Available” – require mark to market.
“No deals for 6-9 months”¹
“LBOs been around 30 years, not going to evaporate in 30 days”²
Research supports Ryan.³ It is cyclical.
LBOs dropped 90%, prices rose, debt 90% of capital, credit quality often very low.
– LBO market returned; debt ratios close to 80%
¹ Anonymous M&A Banker at major bank
² Michael Ryan, Cleary Gottlieb, M&A Lawyer
3 Current Credit Instruments and Climate Make LBO Market Hard to Evaluate, Journal of Applied Finance- Vol. 19, No.4, pgs

11. New Millennium + 7-11Years
Volume declined 40% from 2007.
Public company LBOs by private equity firm dropped from 30% of the volume to 5% as lenders had difficulty moving LBO loans from their balance sheet to secondary buyers.
Debt to EBITDA ratios down 4:1, equity ↑50%
Strategic (≈ 93%, smaller ($250M) & cross border deals more resilient.

12. New Millennium + 7-11Years
Late 2010 – “Don’t Call It a Comeback”¹ but $16B for 76 buyouts in 2009 versus $75B for 193 deals through early December 2010.
Some big deals Burger King, Interactive Data, TransUnion, J.Crew and Del Monte.
Basics remain – leveraged loans/junk bonds.
Debt increasing at record pace.
Most to cover current investments not new ones.
¹ DealB%k, LBOs: Don’t Call It A Comeback, New York Times, December 7, 2010

13. New Millennium + 7-11Years
Refinance costs $100B higher than expected.
Average LBO loan now 6 years, 1 year longer than last year.
Private equity firms not signing fresh deals.
volume 89% lower than 2007 records.
Exits by PE firm 44% lower than $300B in 2007
Conclusion: It is not a comeback!!!
BOA (9/2011) did not finance $2B Morgan Keegan deal. Concerned with MK liabilities.¹
BOA has beat all its rival in LBO fees 2010 & 2011.
Volatile stock prices, decline in optimism by CEOs.
¹ Banks Shun Financing of Riskier Buyouts, Chon & Ng Wall Street Journal – Deal Journal, September 21, 2011

14. New Millennium + 7-11Years
Other banks on the sidelines: Barclays, Citigroup, Credit Suisse, Goldman, JP Morgan, and Morgan Stanley for less than stellar credit.
Banks cannot sell the debt.
Junk rates now 9% over prime versus 7% July.
August 2011:
$2.2B GoDaddy;
$2.8 BJ’s;
$1.6 Blackboard

15. Future LBOs ¹
Greater percentage of purchase price consideration paid in cash/stock of Buyer rather than from proceeds of debt financing.
More Seller take-back financing, retained equity or purchase price earn- outs to satisfy declining lender leverage ratios and to bridge Seller valuation/purchase price expectations.
Post closing purchase price adjustments to reflect adverse changes in pre- closing net working capital or post closing EBITDA results secured by post closing escrows.
Extended due diligence periods to enable Buyers and lenders to “drill down” for unforeseen effects of the current economic slowdown.
Return of traditional “financing out” condition to Buyers based on credit market turmoil with fewer “reverse breakup fees” for middle market transactions.
¹ From Compilation of Sources including: M&A Trends in Today’s Turbulent Credit and Economic Market, Corporate and
Finance Alert, Gibbons, December 2008.

16. Future LBOs
Specific quantitative material adverse change benchmarks to enable Buyer to “walk” from transaction without liability in the event financial and business conditions of Seller deteriorate after signing M&A agreement.
As the result of recently litigated deals, clarity in drafting M&A agreements to provide certainty on the remedies of the parties if the deal is terminated, eg., no specific performance rights for failure to close for any reason. Litigation may increase for busted deals or closed deals that do not perform to Buyer expectations.
Tighter Seller representations and warranties subject to qualifications based on quantitative criteria rather than subjective “materiality” exceptions and longer survival periods for Seller indemnifications, reduced “baskets”, “caps” and “collars” on indemnity claims and escrows or other security devices to secure Sellers’ indemnification obligations.

17. Future LBOs
Acquisition debt financing based on reduced leverage ratios, rigorous underwriting requirements and strict financial loan covenants. Lender imposed re-pricing of loans or other economic considerations in exchange for covenant waivers and a flight to quality by lenders in terms of collateral with less cash flow and more asset based lending. Sub-debt lenders may seek to fill the void left by senior lenders by requesting partial security with traditional higher sub-debt pricing.
Decreased opportunities for Bankruptcy acquisitions pursuant to a
reorganization plan due to scarcity of debtor-in-possession financing
which will result in more piecemeal liquidations rather than sales as going concern.

18. Future LBOs
More opportunistic minority equity investments in distressed companies to cure loan covenant defaults (Warren Buffet $6.5B) (eg., net working capital, fixed charge coverage ratios and other financial covenants) without triggering a change of control event of default in lieu of an acquisition of a target with replacement credit facility due to the uncertainty of credit markets, risks of likely re-pricing and more stringent credit terms. Also, increased opportunities for secured party UCC sales of troubled company assets by secured lenders as alternative to time consuming and costly stalking horse bankruptcy sales.

19. Role of Junk Bonds in Financing LBOs
Junk bonds are non-rated debt (very high risk hence higher rate)
Contrary to typical concept of bond (i.e. safe investment w/nominal rate) ¹
Bond quality varies widely
Rates > 3-5 percentage points above the prime rate ↑ UST
Bridge or interim financing was obtained in LBO transactions to close the transaction quickly because of the extended period of time required to issue “junk” bonds.
These high yielding bonds represented permanent financing for the LBO
Junk bond financing for LBOs dried up due to the following:
A series of defaults of over-leveraged firms in the late 1980s
Insider trading and fraud at such companies a Drexel Burnham, the primary market maker for junk bonds
Junk bond financing is highly cyclical, tapering off as the economy goes into recession and fears of increasing default rates escalate
French, 2012: The Year of the Junk Bond, Christian Science Monitor, April 3, Most since $75
Billion by 130 companies.

20. Factors Affecting Pre-Buyout Returns
Premium paid to target firm shareholders frequently exceeds 40%
These returns reflect the following (in descending order of importance):
Anticipated improvement in efficiency and tax benefits
Wealth transfer effects
Superior Knowledge
More efficient decision-making
Recall discussion of goodwill impairment.

21. Factors Determining Post-Buyout Returns
Empirical studies show investors earn abnormal post-buyout returns
Full effect of increased operating efficiency not reflected in the pre-LBO premium. Underpriced
Studies may be subject to “selection bias,” i.e., only LBOs that are successful are able to undertake secondary public offerings.
Abnormal returns may also reflect the acquisition of many LBOs 3 years after taken public. Proven

22. Valuing LBOs
A LBO can be evaluated from the perspective of common equity investors or of all investors and lenders
LBOs make sense from viewpoint of investors and lenders if present value of free cash flows to the firm is ≥ to the total investment consisting of debt and common and preferred equity
However, a LBO can make sense to common equity investors but not to other investors and lenders. The market value of debt and preferred stock held before the transaction may decline due to a perceived reduction in the firm’s ability to
Repay such debt as the firm assumes substantial amounts of new debt and to
Pay interest and dividends on a timely basis.

23. Valuing LBOs: Cost of Capital Method1
Adjusts for the varying level of risk as the firm’s total debt is repaid.
Step 1: Project annual cash flows until
target D/E achieved
Step 2: Project debt-to-equity ratios
Step 3: Calculate terminal value
Step 4: Adjust discount rate to reflect changing risk
Step 5: Determine if deal makes sense
1Also known as the variable risk method.

24. Cost of Capital Method: Step 1
Project annual cash flows until target D/E ratio achieved
Target D/E is the level of debt relative to equity at which
The firm will have to resume payment of taxes and
The amount of leverage is likely to be acceptable to IPO investors or strategic buyers (often the prevailing industry average)

25. Cost of Capital Method: Step 2
Project annual debt-to-equity ratios
The decline in D/E reflects
the known debt repayment schedule and
The projected growth in the market value of the shareholders’ equity (assumed to grow at the same rate as net income)

26. Cost of Capital Method: Step 3
Calculate terminal value of projected cash flow to equity investors (TVE) at time t, (i.e., the year in which the initial investors choose to exit the business).
TVE represents PV of the dollar proceeds available to the firm through an IPO or sale to a strategic buyer at time t.

27. Cost of Capital Method: Step 4
Adjust the discount rate to reflect changing risk. See prior valuation info.
Β (risk) will always be higher in LBOs.
The firm’s cost of equity will decline over time as debt is repaid and equity grows, thereby reducing the leveraged ß. Estimate the firm’s ß as follows:
ßFL1 = ßIUL1(1 + (D/E)F1(1-tF))
where ßFL = Firm’s levered beta in period 1
ßIUL1 = Industry’s unlevered beta in period 1
= ßIL1/(1+(D/E)I1(1- tI))
ßIL = Industry’s levered beta in period 1
(D/E)I1 = Industry’s debt-to-equity ratio in period 1
tI = Industry’s marginal tax rate in period 1
(D/E)F1 = Firm’s debt-to-equity ratio in period 1
tF = Firm’s marginal tax rate in period 1
Recalculate each successive period’s ß with the D/E ratio for that period, and using that period’s ß, recalculate the firm’s cost of equity for that period.

28. Cost of Capital Method: Step 5
Determine if deal makes sense
Does the PV of free cash flows to equity investors (including the terminal value) equal or exceed the equity investment including transaction-related fees?

29. Evaluating the Cost of Capital Method
Advantages:
Adjusts the discount rate to reflect diminishing risk as the debt-to-total capital ratio declines. Rate need not be static.
Takes into account that the deal may make sense for common equity investors but not for lenders or preferred shareholders
Disadvantage: Calculations more burdensome than Adjusted Present Value Method

30. Valuing LBOs: Adjusted Present Value Method (APV)
Separates value of the firm into (a) its value as if it were debt free and (b) the value of tax savings due to interest expense. Often termed “With” and Without”.
Step 1: Project annual free cash flows to equity investors and interest tax savings
Step 2: Value target without the effects of debt financing and discount projected free cash flows at the firm’s estimated unlevered cost of equity.
Step 3: Estimate the present value of the firm’s tax savings discounted at the firm’s estimated unlevered cost of equity.
Step 4: Add the present value of the firm without debt and the present value of tax savings to calculate the present value of the firm including tax benefits.
Step 5: Determine if the deal makes sense.

31. APV Method: Step 1
Project annual free cash flows to equity investors and interest tax savings for the period during which the firm’s capital structure is changing.
Interest tax savings = INT x t, where INT and t are the firm’s annual interest expense on new debt and the marginal tax rate, respectively
During the terminal period, the cash flows are expected to grow at a constant rate and the capital structure is expected to remain unchanged

32. APV Method: Step 2
Value target without the effects of debt financing and discount projected cash flows at the firm’s unlevered cost of equity.
Apply the unlevered cost of equity for the period during which the capital structure is changing.
Apply the weighted average cost of capital for the terminal period using the proportions of debt and equity that make up the firm’s capital structure in the final year of the period during which the structure is changing.

33. APV Method: Step 3
Estimate the present value of the firm’s annual interest tax savings.
Discount the tax savings at the firm’s unlevered cost of equity
Calculate PV for annual forecast period only, excluding a terminal value, since the firm is sold and any subsequent tax savings accrue to the new owners.

34. APV Method: Step 4
Calculate the present value of the firm including tax benefits
Add the present value of the firm without debt and the PV of tax savings

35. APV Method: Step 5 Determine if deal makes sense:
Does the PV of free cash flows to equity investors plus tax benefits equal or exceed the initial equity investment including transaction-related fees?

36. Evaluating the Adjusted Present Value Method
Advantage: Simplicity.
Disadvantages:
Ignores the effect of changes in leverage on the discount rate as debt is repaid,
Implicitly ignores the potential for bankruptcy of excessively leveraged firms, and
Unclear whether true discount rate should be the cost of debt, unlevered cost of equity, or somewhere between the two.

37. Things to Remember…
LBOs make the most sense for firms having stable cash flows, significant amounts of unencumbered tangible assets, and strong management teams.
Successful LBOs rely heavily on management incentives to improve operating performance and a streamlined decision-making process resulting from taking the firm private.
Tax savings from interest expense and depreciation from writing up assets enable LBO investors to offer targets substantial premiums over current market value. Shelf life
Excessive leverage and the resultant higher level of fixed expenses makes LBOs vulnerable to business cycle fluctuations and aggressive competitor actions. Fixed outflows & less mobile
For an LBO to make sense, the PV of cash flows to equity holders must equal or exceed the value of the initial equity investment in the transaction, including transaction-related costs.