Prof. Ian Giddy New York University Structured Finance: Leveraged Buyouts
Copyright ©2002 Ian H. Giddy Structured Finance 2 Structured Finance l Asset-backed securitization l Corporate financial restructuring l Structured financing techniques
Copyright ©2002 Ian H. Giddy Structured Finance 3 Leveraged Financing Leveraged Finance is the provision of bank loans and the issue of high yield bonds to fund acquisitions of companies or parts of companies by l an existing internal management team (a management buy-out), l an external management team (a management buy-in), or l a third party (a leveraged acquisition).
Copyright ©2002 Ian H. Giddy Structured Finance 4 Case Study l The John Case LBO Proposal l Devise a recommended financing plan John Case (owner) BuyersVC Investors
Copyright ©2002 Ian H. Giddy Structured Finance 5 Corporate Restructuring l Divestiture—a reverse acquisition—is evidence that "bigger is not necessarily better" l Going private—the reverse of an IPO (initial public offering)—contradicts the view that publicly held corporations are the most efficient vehicles to organize investment.
Copyright ©2002 Ian H. Giddy Structured Finance 6 Divestitures Divestiture: the sale of a segment of a company to a third party l Spin-offs—a pro-rata distribution by a company of all its shares in a subsidiary to all its own shareholders l Equity carve-outs—some of a subsidiary' shares are offered for sale to the general public l Split-offs—some, but not all, parent-company shareholders receive the subsidiary's shares in return for which they must relinquish their shares in the parent company l Split-ups—all of the parent company's subsidiaries are spun off and the parent company ceases to exist.
Copyright ©2002 Ian H. Giddy Structured Finance 7 Divestitures Add Value l Shareholders of the selling firm seem to gain, depending on the fraction sold: l Total value created by divestititures between 1981 and 1986 = $27.6 billion. % of firm soldAnnouncement effect 0-10% 10-50% 50% % +8%
Copyright ©2002 Ian H. Giddy Structured Finance 8 Going Private A public corporation is transformed into a privately held firm l The entire equity in the corporation is purchased by management, or managment plus a small group of investors l These account for about 20% of public takeover activity in recent years in the United States. l Can be done in several ways : "Squeeze-out"—controlling shareholders of the firm buy up the stockholding of the minority public shareholders Management Buy-Out—management buys out a division or subsidiary, or even the entire company, from the public shareholders Leveraged Buy-Out (LBO)
Copyright ©2002 Ian H. Giddy Structured Finance 9 Leveraged Buy-Outs LBO is a transaction in which an investor group acquires a company by taking on an extraordinary amount of debt, with plans to repay the debt with funds generated from the company or with revenue earned by selling off the newly acquired company's assets l Leveraged buy-out seeks to force realization of the firm’ potential value by taking control (also done by proxy fights) l Leveraging-up the purchase of the company is a "temporary" structure pending realization of the value l Leveraging method of financing the purchase permits "democracy" in purchase of ownership and control--you don't have to be a billionaire to do it; management can buy their company.
Copyright ©2002 Ian H. Giddy Structured Finance 10 LBOs, Agency Costs and Free Cash Flow l "Free cash flow" is cash-cow type earnings in excess of amounts required to fund all positive-NPV projects l Payout of free cash flow, to stockholders, reduces the amount of resources under managment's discretion. Forces management to go out into the markets and justify raising funds l Thus debt has a disciplining role. “Safe” managers choose less debt.
Copyright ©2002 Ian H. Giddy Structured Finance 11 M&A and Leverage n Leveraged buyout? Company has unused debt capacity n Leveraged recapitalization? n Takeover?
Copyright ©2002 Ian H. Giddy Structured Finance 12 Typical LBO Sequence Company gets bloated or slack and stock price falls LBO offer made LBO completed Restructuring Efficiencies Divestitures Financial ? years3-9 months5-7 years IPO or sale of company
Copyright ©2002 Ian H. Giddy Structured Finance 13 Case Study: John M. Case Company l Bank debt and equity-linked structured financing in the context of leveraged buyout financing, including valuation and exit strategies. Convertibles and bridge financing. l What financial structure enables the acquiring group to retain control? l What is the cost of financing? l “How much equity should/must our client give up in order to get the funding we need?”
Copyright ©2002 Ian H. Giddy Structured Finance 14 The John M Case Leveraged Buy-Out 1.What are the most important operating and financial characteristics of the Case Company? 2.Is the company worth Mr Case's $20 million asking price? 3.Can the $20 million purchase be financed so that management can retain at least 51% ownership? What sources should management tap? In what amounts? Is the return being sought by the venture capital reasonable?
Copyright ©2002 Ian H. Giddy Structured Finance How compelling a buyout opportunity is this proposition for the four managers? 5. Would you, as a commercial banking lender, provide the loan needed to finance the seasonal buildup in accounts receivable and inventory? On what terms? 6. Would you, as the venture capital firm, provide the balance of the funds needed? If so, on what terms? The John M Case Leveraged Buy-Out
Copyright ©2002 Ian H. Giddy Structured Finance 16 l Bank Loan l Loan from Mr Case l Venture Capitalists' Investment Financing Sources
Copyright ©2002 Ian H. Giddy Structured Finance 17 POSITIVES : l The company has a stable product l The company enjoys good profit margins l There are important barriers to competitor entry l The business is not too asset-intensive l The four key managers know the business well
Copyright ©2002 Ian H. Giddy Structured Finance 18 NEGATIVES : l Sales growth is probably quite limited l This low-tech product has no patent protection l Even if outsiders find it difficult to penetrate the market, that may not apply to vendors already in the industry, most particularly, the Watts Company
Copyright ©2002 Ian H. Giddy Structured Finance 19 Simplified Balance Sheet for a restructured J.M.Case Company Cash$5762 Current Liab $1266 Other current 3236Bank loan 6000 Fixed & other 2184Case loan 4000 Good will10084Plug figure 9500 Managers’ equity 500 Total21,266Total21,266 AssetsLiabilities
Copyright ©2002 Ian H. Giddy Structured Finance 20 WACC johncaselbo.xls
Copyright ©2002 Ian H. Giddy Structured Finance 21 Feasibility of the Price l Book Value Basis l Stock Market Valuation Basis l Comparable Company Value l Discounted Cash Flow Basis
Copyright ©2002 Ian H. Giddy Structured Finance 22 Book Value Basis : l Asking price : twice the value of the company’s equity l Why would anyone pay this ? l If the profitability of the company justifies it l - in this case, it appears to – ROE around 20 % or $ 2 million in 1984
Copyright ©2002 Ian H. Giddy Structured Finance 23 Stock Market Valuation l If a company is publicly traded, the valuation accorded its outstanding market shares can be a starting point for valuation l In this case, the company is not publicly traded, so no opportunity is available here
Copyright ©2002 Ian H. Giddy Structured Finance 24 Comparable Company Value l Common practice to compare its value with those accorded to publicly traded companies in a similar business l After comparisons made, it is seen that the Case asking price is in line with the market value of a publicly traded competitor
Copyright ©2002 Ian H. Giddy Structured Finance 25 John Case Valuation
Copyright ©2002 Ian H. Giddy Structured Finance 26 Case Study: Le Meridien l What kind of financing package would enable Royal Bank to beat other commercial and investment banks in the Meridien deal? Who are potential rivals, and what strengths might give them a competitive edge? l If RBS offers sale-and-leaseback financing, what should be the structure and terms of the deal, terms that make sense for the client as well as for the bank? l If RBS offers equity participation, what form should this take? Common stock or mezzanine finance? Or should the bank avoid the risks of an equity investment? l Would asset-backed securities be suitable as a financing source for this acquisition?
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Copyright ©2002 Ian H. Giddy Structured Finance 31 Contact Info Ian H. Giddy NYU Stern School of Business Tel ; Fax