Presentation on theme: "No one spends other people’s money"— Presentation transcript:
1Financing the Deal: Private Equity, Hedge Funds, and Other Sources of Financing
2No one spends other people’s money as carefully as they spend their own.—Milton Friedman
3Part IV: Deal Structuring and Financing Exhibit 1: Course Layout: Mergers, Acquisitions, and OtherRestructuring ActivitiesPart IV: Deal Structuring and FinancingPart II: M&A ProcessPart I: M&A EnvironmentCh. 11: Payment and Legal ConsiderationsCh. 7: Discounted Cash Flow ValuationCh. 9: Financial Modeling TechniquesCh. 6: M&A Postclosing IntegrationCh. 4: Business and Acquisition PlansCh. 5: Search through Closing ActivitiesPart V: Alternative Business and Restructuring StrategiesCh. 12: Accounting & Tax ConsiderationsCh. 15: Business AlliancesCh. 16: Divestitures, Spin-Offs, Split-Offs, and Equity Carve-OutsCh. 17: Bankruptcy and LiquidationCh. 2: Regulatory ConsiderationsCh. 1: Motivations for M&APart III: M&A Valuation and ModelingCh. 3: Takeover Tactics, Defenses, and Corporate GovernanceCh. 13: Financing the DealCh. 8: Relative Valuation MethodologiesCh. 18: Cross-Border TransactionsCh. 14: Valuing Highly Leveraged TransactionsCh. 10: Private Company Valuation
4Learning ObjectivesPrimary Learning Objective: To provide students with a knowledge of how M&A deals are financed and the role of private equity and hedge funds in this process.Secondary Learning Objectives: To provide students with a knowledge ofAdvantages and disadvantages of LBO structures;How LBOs create value;Leveraged buyouts as financing strategies;Factors critical to successful LBOs; andCommon LBO capital structures.
5How are M&A Transactions Commonly Financed? Borrowing Options:Asset based or secured lendingCash flow or unsecured lenders (senior and junior debt)Long-term financing (junk bonds, leveraged bank loans, convertible debt)Bridge financingPayment-in-kind
6Financing M&As: Borrowing Options Alternative Forms of BorrowingType of SecurityBacked ByLenders Loan Up toLending SourceSecured DebtShort-Term (<1Yr.)Intermediate Term(1-10 Yrs.)Liens generally on receivables and inventoryLiens on Land and Equipment50-80% depending on qualityUp to 80% of appraised value of equipment; 50% of real estateBanks, finance and life insurance companies; private equity investors; pension and hedge fundsUnsecured Debt (Subordinated incl. seller financing)Bridge FinancingPayment-in-KindCash generating capabilities of the borrowerLife insurance companies, pension funds, private equity and hedge funds;target firms
7Financing M&As: Equity Options Alternative Forms of EquityEquity TypeBacked ByInvestor TypesCommon StockCash generating capabilities of the firmLife insurance companies, pension funds, hedge funds, private equity, and angel investorsPreferred Stock--Cash Dividends--Payment-in-KindSame as above
8Financing M&As: Seller Financing Seller defers a portion of the purchase priceAdvantages to seller:Buyer may be willing to pay seller’s asking price since deferral will reduce present valueMakes sale possible when bank financing not available (e.g., )Advantages to buyer:Shifts operational risk to seller if buyer defaults on loanEnables buyer to put in less cash at closing
9Financing M&As: Cash on Hand and Selling Redundant Assets “Cash on hand” represents cash in excess of normal operating requirements on the acquirer or target’s balance sheet.Target’s excess cash can be used to buy target firm’s outstanding shares.Redundant assets are those owned by the acquirer or target firm that are not considered germane to the acquirer’s business strategy.
10Financial Buyers/Sponsors In a leveraged buyout, all of the stock, or assets, of a public or private corporation are bought by a small group of investors (“financial buyers aka financial sponsors”), often including members of existing management and a “sponsor.” Financial buyers or sponsors:Focus on ROE rather than ROA.Use other people’s money.Succeed through improved operational performance, tax shelter, debt repayment, and properly timing exit.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)
11Role of Private Equity and Hedge Funds in Deal Financing Financial IntermediariesServe as conduits between investors/lenders and borrowersPool resources and invest/lend to firms with attractive growth prospectsLenders and Investors of “Last Resort”Buyers of about one-half of private placementsSource of funds for firms with limited access to credit marketsProviders of Financial Engineering1 and Operational Expertise for Target FirmsLeverage drives need to improve operating performance to meet debt serviceImproved operating performance enables firm to increase leveragePrivate equity owned firms survive financial distress better than comparably leveraged firmsPre-buyout announcement date shareholder returns often exceed 40% due to investor anticipation of operational improvement and tax benefitsPost-buyout returns to LBO shareholders exceed returns on S&P 500 due to improved operating performance (better controls, active monitoring, willingness to make tough decisions)1Financial engineering describes the creation of a viable capital structure that magnifies financial returns to equity investors.
12Leveraged Buyouts (LBOs) Finance a substantial portion of the purchase price using debt.Frequently rely on financial sponsors for equity contributionsTarget firm management often equity investors in LBOsManagement buyouts (MBOs) are LBOs initiated by management
13LBOs As Financing Strategies LBOs are a commonly used financing strategy employed by private equity firms to acquire targets using mostly debt to pay for the cost of the acquisitionTarget firm assets used as collateral for loansMost liquid assets collateralize bank loansFixed assets secure a portion of long-term financingPost-LBO debt-to-equity ratio substantially higher than pre-LBO ratio due to debt incurred to buy shares from pre-buyout private or public shareholdersDebt-to-equity ratio also may increase even if pre-and post-LBO debt remains unchanged if the target’s excess cash and the proceeds from sale of target assets used to buy out target shareholders (Why? Assets decline relative to liabilities shrinking the target’s equity)
14Impact of Leverage on Financial Returns Impact of Leverage on Return to ShareholdersAll-CashPurchase($Millions)50% Cash/50%Debt20% Cash/80%Purchase Price$100Equity (Cash Investment by Financial Sponsor)$50$20Borrowings$80Earnings Before Interest and Taxes (EBIT)10%1$5$8Income Before Taxes$15$12Less Income 40%$6$4.8Net Income$9$7.2After-Tax Return on Equity (ROE)212%18%36%1Tax shelter in 50% and 20% debt scenarios is $2 million (I.e., $5 x .4) and $3.2 million (i.e., $8 x .4), respectively.2If EBIT = 0 under all three scenarios, income before taxes equals 0, ($5), and ($8) and ROE after tax in the 0%, 50% and 80% debt scenarios = $0 / $100, [($5) x (1 - .4)] / $50 and [($8) x (1 - .4)] / $20 = 0%, (6)% and (24)%, respectively. Note the value of the operating loss, which is equal to the interest expense, is reduced by the value of the loss carry forward or carry back.
15LBO’s Impact of Target Firm Employment, Innovation, and Capital Spending Net reduction in employment at firms several years after undergoing LBOs is 1%Employment at target firms declines about 3% in existing operations compared to other firms in the same industryBut employment at new ventures increases about 2%Employment at private firms may increaseLBOs often increase R&D and capital spending relative to peersOperating performance particularly for private firms undergoing LBOs improves significantly due to increased access to capital
16Discussion QuestionsDefine the financial concept of leverage. Describe how leverage may work to the advantage of the LBO equity investor? How might it work against them?What is the difference between a management buyout and a leveraged buyout?What potential conflicts might arise between management and shareholders in a management buyout?
17LBO Advantages and Disadvantages Advantages include the following:Management incentives,Better alignment between owner and manager objectives (reduces agency conflicts),Tax savings from interest expense and depreciation from asset write-up,More efficient decision processes under private ownership,A potential improvement in operating performance, andServing as a takeover defense by eliminating public investorsDisadvantages include the following:High fixed costs of debt raise the firm’s break-even point,Vulnerability to business cycle fluctuations and competitor actions,Not appropriate for firms with high growth prospects or high business risk, andPotential difficulties in raising capital.
18How LBOs Create Value Factors Contributing to LBO Value Creation Buyouts of Public FirmsBuyouts of Private FirmsKey Factor: Alleviating Agency ProblemsKey Factor: Provides Access to CapitalFactors Common to LBOs of Public and Private FirmsDeferring TaxesDebt ReductionOperating Margin ImprovementTiming of the Sale of the Firm
19Reinvestment Adds to Free Cash Flow by Improving Operating Margins LBOs Create Value by Reducing Debt and Increasing Margins Thereby Increasing Potential Exit MultiplesFirm ValueYear Year Year Year Year Year Year 7Debt Reduction & Reinvestment Increases Free Cash Flow and In turn Builds Firm ValueDebt ReductionReinvest in FirmDebt Reduction Adds to Free Cash Flow by Reducing Interest & Principal RepaymentsReinvestment Adds to Free Cash Flow by Improving Operating MarginsFree Cash FlowTax Shield Adds to Free Cash FlowTax Shield1Year Year Year Year Year Year Year 71Tax shield = (interest expense + additional depreciation and amortization expenses from asset write-ups) x marginal tax rate.
20LBO Value is Maximized by Reducing Debt, Improving Margins, and Properly Timing Exit Case 1:Debt ReductionCase 2:Debt Reduction + Margin ImprovementCase 3:Debt Reduction + Margin Improvement + Properly Timing ExitLBO Formation Year:Total DebtEquityTransaction/Enterprise Value$400,000,000100,000,000$500,000,000Exit Year (Year 7) Assumptions:Cumulative Cash Available forDebt Repayment1Net Debt2EBITDAEBITDA MultipleEnterprise Value3Equity Value4$150,000,000$250,000,000$100,000,0007.0 x$700,000,000$450,000,000$185,000,000$215,000,000$130,000,000$910,000,000$695,000,0008.0 x$1,040,000,000$825,000,000Internal Rate of Return24%31.2%35.2%Cash on Cash Return54.5 x6.95 x8.25 x1Cumulative cash available for debt repayment increases between Case 1 and Case 2 due to improving margins and lower interest and principal repayments reflecting the reduction in net debt.2Net Debt = Total Debt – Cumulative Cash Available for Debt Repayment = $400 million - $185 million = $215 million3Enterprise Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year4Equity Value = Enterprise Value in 7th Year – Net Debt5The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return, because it accounts for the time value of money.
21Common LBO Deal Structures Direct merger: Target firm merged directly into the firm controlled by the financial sponsorSubsidiary merger: Target firm merged into a acquisition subsidiary wholly-owned by the parent firm which in turn is controlled by the financial sponsorA reverse stock split: Used when a firm is short of cash to reduce the number of shareholders below 300 which forces delisting of the firm from public exchanges. Majority shareholders retain their shares after the reverse split reduces the number of shares outstanding; minority shareholders receive a cash payment.
22Direct Merger Target Firm Target Firm Shareholders Lender Financial Sponsor (Limited Partnership Fund)Equity ContributionTarget Merges with AcquirerAcquirer(Controlled by Financial Sponsor)Target FirmLoanTarget StockLenderTarget Firm ShareholdersAcquirer Cash and Stock
23Subsidiary Merger Financial Sponsor Limited Partnership Fund Equity ContributionParent(Controlled by Financial Sponsor)Target FirmMerger Sub SharesMerger Sub Merges Into TargetEquity ContributionLoan GuaranteeMerger Sub Cash & SharesLenderMerger SubTarget Firm ShareholdersLoanTarget Firm Shares
25Case Study: Cox Enterprises Takes Cox Communications Private In an effort to take the firm private, Cox Enterprises announced a proposal to buy the remaining 38% of Cox Communications’ shares not currently owned for $32 per share. Valued at $7.9 billion (including $3 billion in assumed debt), the deal represented a 16% premium to Cox Communication’s share price at that time. Cox Communications is the third largest provider of cable TV, telecommunications, and wireless services in the U.S, serving more than 6.2 million customers. Historically, the firm’s cash flow has been steady and substantial.Cox Communications would become a wholly-owned subsidiary of Cox Enterprises and would continue to operate as an autonomous business. Cox Communications’ Board of Directors formed a special committee of independent directors to consider the proposal. Citigroup Global Markets and Lehman Brothers Inc. committed $10 billion to the deal. Cox Enterprises would use $7.9 billion for the tender offer, with the remaining $2.1 billion used for refinancing existing debt and to satisfy working capital requirements.Cable service firms have faced intensified competitive pressures from satellite service providers DirecTV Group and EchoStar communications. Moreover, telephone companies continue to attack cable’s high-speed Internet service by cutting prices on high-speed Internet service over phone lines. Cable firms have responded by offering a broader range of advanced services like video-on-demand and phone service. Since 2000, the cable industry has invested more than $80 billion to upgrade their systems to provide such services, causing profitability to deteriorate and frustrating investors. In response, cable company stock prices have fallen. Cox Enterprises stated that the increasingly competitive cable industry environment makes investment in the cable industry best done through a private company structure.Discussion Questions:1. What is the equity value of the proposed deal?Why did the board feel that it was appropriate to set up special committee of independent board directors?Why does Cox Enterprises believe that the investment needed for growing its cable business is best done through a private company structure?Is Cox Communications a good candidate for an LBO? Explain your answer.How would the lenders have protected their interests in this type of transaction? Be specific.
26Things to Remember…M&As commonly are financed through debt, equity, and available cash on balance sheet or some combination.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 and depreciation expense from writing up assets enable LBO investors to offer targets substantial premiums over current market value.Excessive leverage and the resultant higher level of fixed expenses makes LBOs vulnerable to business cycle fluctuations and aggressive competitor actions.