Lecture 15 Leveraged Buy Outs

LBO Acquisition of a company or division of a company with a substantial portion of borrowed funds. The goal of an LBO is to use the target company to finance the purchase. LBO analysis is based on cash flow projections and takes a company’s leveraged capital structure into consideration. The buyer, which is known as the LBO sponsor, equity sponsor or financial sponsor, uses debt to pay the majority of the purchase price of the company. The rest of the purchase price is funded with equity by the LBO sponsor.

LBOs LBOs are a way to take a public company private, or put a company in the hands of the current management, MBO. LBOs are financed with large amounts of borrowing (leverage), hence its name. LBOs use the assets or cash flows of the company to secure debt financing, bonds or bank loans, to purchase the outstanding equity of the company. After the buyout, control of the company is concentrated in the hands of the LBO firm and management, and there is no public stock outstanding.

Fewer long-term invest-ments The leverage is the key Higher returns % Tax deduc-tions Fewer long-term invest-ments Debt …”

Characteristics of LBO Significant increase in financial leverage Average debt/total capital increases from 20% to 70% Management ownership interest increases Median ownership of a Fortune 500 U.S. Corporation is 0.5%, for Value Line 1000 is 5% After an LBO the ownership is 10% - 35% Non-mgmt equity investors join the board Before an LBO, non-management directors have almost no ownership. After, non-management directors may represent 40%-60% of equity holders Typical board of 5 individuals, 2-3 from the LBO sponsor

LBOs Many variations are found Converting equity to debt requires shareholder approval Private equity firm restructures the target and plans to sell at a substantial profit Increased leverage leads to an increase in default risk

Motivations for LBO Increase in debt and concentrated ownership increase incentives to maximize value. Non-management on board with significant equity stakes increases board effectiveness Advantage to being private (filings, etc.) Beneficial tax consequences (debt, step-up) Transfer wealth from other stakeholders in the firm such as employees & bondholders

LBO Structure Varies over time with market conditions Debt Financing Total debt often 60-80% of entire deal (4-5 x LTM EBITDA, but depends on industry, cash flow, etc. 40% - 60% senior bank debt (repayment in 5-7 years) 0-15% senior subordinated (repayment in 8-12 years) 0-20% junior subordinated (repayment in 8-12 years) 0 - 15% preferred stock 10% - 50% common equity Equity Ownership 10% - 35% management/employee owned 40% - 60% investors with board representation 20% - 25% owned by investors not on board

LBO Financing LBO sponsors have equity funds raised from institutions like pensions & insurance companies Some have mezzanine funds as well that can be used for junior subordinated debt and preferred Occasionally, sponsors bring in other equity investors or another sponsor to minimize their exposure Balance from commercial banks (bridge loans, term loans, revolvers) & other mezzanine sources Banks concentrate on collateral of the company, cash flows, level of equity financing from the sponsor, coverage ratios, ability to repay (5-7 yr)

Management Ownership Management puts up 60% to 70% of wealth (excluding residence) Management share of equity (sometimes called management promote) usually increases year by year as they meet targets (e.g., revenue and EBITDA and non-financial targets) through performance vesting options. Strike price usually at equity buy-in price at time of deal. Managers are sometimes offered chance to buy stock with a mixture of recourse and non-recourse notes – potential tax advantages for managers. Managers often already own shares in a company that does an LBO and they do not necessarily cash out those shares – that equity goes into the new entity – called rollover equity.

LBO Sponsors Typically won’t put more than certain percentage of a fund in one company and another percentage of a fund in one industry. Increases in % of financing that is equity has caused deal sharing. Razor edge margins because of the high risk profiles. Shooting for 20% - 30% on every deal, some earn 100%, some 4%, some -80%, etc. Typically assume will take 3-5 years to invest a fund and then another 3-5 years to cash out (monetize) the investments. Expertise in layering risk, financial structure

LBO Sponsors Normally get a management fee that is 1% to 1.5% of fund size. In addition, they split returns between investors and themselves and often get a percentage in the capital gain of the fund (so called carried interest). In addition, they invest their own money in the fund.

LBO Strategies Finding cheap assets – buying low and selling high (value arbitrage or multiple expansion) Unlocking value through restructuring: Financial restructuring of balance sheet – improved combination of debt and equity Operational restructuring – improving operations to increase cash flows

LBO Candidates History of profitability Predictable cash flows to service financing Low current debt and high excess cash Readily separable assets or businesses Strong management team - risk tolerant Known products, strong market position Little danger of technological change (high tech?) Low-cost producers with modern capital Take low risk business, layer on risky

Risk Profile Questions Is cash flow consistent (no cyclical industries)? Is a turnaround required to meet projections? Any outside threats to long-term performance? Are there larger, better capitalized competitors? Does the firm have high quality management? Are there other successful LBOs in that industry? Can the company grow with the leverage increase? What is the exit strategy?

Valuation of LBO Cash Flow determines what the LBO sponsor would be willing to pay for an asset based on target investment returns. The interaction of the following two factors drives valuation: Debt Capacity: Maximizing the leverage or debt capacity of the company will allow the equity sponsor to maximize the purchase price and contribute as little equity as possible. Equity Return: Once the debt capacity has been determined, the initial equity investment will be determined by assumed equity returns and exit proceeds. Target returns are usually around 20-30% IRR.

Average Debt Multiples Average Equity Contribution ________________ Source: S&P Leveraged Commentary & Data. Excludes media loans. Too few deals in 1991 to form a meaningful sample. Average Equity Contribution

An LBO effectively trades equity for debt A private equity firm partners with financial institutions to buy a public company 25% of deal is provided by the private equity firm, which becomes an equity stake in the target company Financial institutions provide the other 75% which becomes debt in the target company

Value Creation in LBO Management incentives and agency cost effects Increased ownership stake may provide increased incentives for improved performance Better aligns manager / shareholder interests Lower agency costs of free cash flows: debt from LBO commits cash flows to debt Debt puts pressure on managers to improve firm performance to avoid bankruptcy

Value creation in LBO Wealth transfer Wealth transfer from current employees to new investors – low management turnover (but sometimes new mgmt. team), slower growth in number of employees Tax benefits in LBO constitute subsidy from public and loss of revenue to government – LBO premiums positively related to tax benefit Net effect of LBO on government tax revenues may be positive due to gains to shareholders and increased profitability Many of tax benefits could be realized without LBOs

Value Creation in LBO Asymmetric information and underpricing Managers, investor groups have better information on value of firm than shareholders Large premium signals that future operating income will be larger than expectations – investor group believes new company is worth more than purchase price Other efficiency considerations More efficient decision process as private firm Influence of favorable economic environment

Exit Strategies Exit strategies include: IPO Buyout by a strategic buyer Buyout by another financial buyer Leveraged recapitalization --- not really an exit, but essentially after the debt is paid down to a reasonable level, the entity issues a new round of debt and pays a large dividend to equityholders (or repurchases shares). Some, but not all, equityholders may be taken out.