Financing the Deal: Private Equity, Hedge Funds, and Other Sources of Financing

No one spends other people’s money as carefully as they spend their own. —Milton Friedman

Part IV: Deal Structuring and Financing Exhibit 1: Course Layout: Mergers, Acquisitions, and Other Restructuring Activities Part IV: Deal Structuring and Financing Part II: M&A Process Part I: M&A Environment Ch. 11: Payment and Legal Considerations Ch. 7: Discounted Cash Flow Valuation Ch. 9: Financial Modeling Techniques Ch. 6: M&A Postclosing Integration Ch. 4: Business and Acquisition Plans Ch. 5: Search through Closing Activities Part V: Alternative Business and Restructuring Strategies Ch. 12: Accounting & Tax Considerations Ch. 15: Business Alliances Ch. 16: Divestitures, Spin-Offs, Split-Offs, and Equity Carve-Outs Ch. 17: Bankruptcy and Liquidation Ch. 2: Regulatory Considerations Ch. 1: Motivations for M&A Part III: M&A Valuation and Modeling Ch. 3: Takeover Tactics, Defenses, and Corporate Governance Ch. 13: Financing the Deal Ch. 8: Relative Valuation Methodologies Ch. 18: Cross-Border Transactions Ch. 14: Valuing Highly Leveraged Transactions Ch. 10: Private Company Valuation

Learning Objectives Primary 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 of Advantages and disadvantages of LBO structures; How LBOs create value; Leveraged buyouts as financing strategies; Factors critical to successful LBOs; and Common LBO capital structures.

How are M&A Transactions Commonly Financed? Borrowing Options: Asset based or secured lending Cash flow or unsecured lenders (senior and junior debt) Long-term financing (junk bonds, leveraged bank loans, convertible debt) Bridge financing Payment-in-kind

Financing M&As: Borrowing Options Alternative Forms of Borrowing Type of Security Backed By Lenders Loan Up to Lending Source Secured Debt Short-Term (<1Yr.) Intermediate Term (1-10 Yrs.) Liens generally on receivables and inventory Liens on Land and Equipment 50-80% depending on quality Up to 80% of appraised value of equipment; 50% of real estate Banks, finance and life insurance companies; private equity investors; pension and hedge funds Unsecured Debt (Subordinated incl. seller financing) Bridge Financing Payment-in-Kind Cash generating capabilities of the borrower Life insurance companies, pension funds, private equity and hedge funds; target firms

Financing M&As: Equity Options Alternative Forms of Equity Equity Type Backed By Investor Types Common Stock Cash generating capabilities of the firm Life insurance companies, pension funds, hedge funds, private equity, and angel investors Preferred Stock --Cash Dividends --Payment-in-Kind Same as above

Financing M&As: Seller Financing Seller defers a portion of the purchase price Advantages to seller: Buyer may be willing to pay seller’s asking price since deferral will reduce present value Makes sale possible when bank financing not available (e.g., 2008-2009) Advantages to buyer: Shifts operational risk to seller if buyer defaults on loan Enables buyer to put in less cash at closing

Financing 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.

Financial 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)

Role of Private Equity and Hedge Funds in Deal Financing Financial Intermediaries Serve as conduits between investors/lenders and borrowers Pool resources and invest/lend to firms with attractive growth prospects Lenders and Investors of “Last Resort” Buyers of about one-half of private placements Source of funds for firms with limited access to credit markets Providers of Financial Engineering1 and Operational Expertise for Target Firms Leverage drives need to improve operating performance to meet debt service Improved operating performance enables firm to increase leverage Private equity owned firms survive financial distress better than comparably leveraged firms Pre-buyout announcement date shareholder returns often exceed 40% due to investor anticipation of operational improvement and tax benefits Post-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.

Leveraged Buyouts (LBOs) Finance a substantial portion of the purchase price using debt. Frequently rely on financial sponsors for equity contributions Target firm management often equity investors in LBOs Management buyouts (MBOs) are LBOs initiated by management

LBOs 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 acquisition Target firm assets used as collateral for loans Most liquid assets collateralize bank loans Fixed assets secure a portion of long-term financing Post-LBO debt-to-equity ratio substantially higher than pre-LBO ratio due to debt incurred to buy shares from pre-buyout private or public shareholders Debt-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)

Impact of Leverage on Financial Returns Impact of Leverage on Return to Shareholders All-Cash Purchase ($Millions) 50% Cash/50% Debt 20% Cash/80% Purchase Price $100 Equity (Cash Investment by Financial Sponsor) $50 $20 Borrowings $80 Earnings Before Interest and Taxes (EBIT) Interest @ 10%1 $5 $8 Income Before Taxes $15 $12 Less Income Taxes @ 40% $6 $4.8 Net Income $9 $7.2 After-Tax Return on Equity (ROE)2 12% 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.

LBO’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 industry But employment at new ventures increases about 2% Employment at private firms may increase LBOs often increase R&D and capital spending relative to peers Operating performance particularly for private firms undergoing LBOs improves significantly due to increased access to capital

Discussion Questions Define 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?

LBO 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, and Serving as a takeover defense by eliminating public investors Disadvantages 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, and Potential difficulties in raising capital.

How LBOs Create Value Factors Contributing to LBO Value Creation Buyouts of Public Firms Buyouts of Private Firms Key Factor: Alleviating Agency Problems Key Factor: Provides Access to Capital Factors Common to LBOs of Public and Private Firms Deferring Taxes Debt Reduction Operating Margin Improvement Timing of the Sale of the Firm

Reinvestment Adds to Free Cash Flow by Improving Operating Margins LBOs Create Value by Reducing Debt and Increasing Margins Thereby Increasing Potential Exit Multiples Firm Value Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Debt Reduction & Reinvestment Increases Free Cash Flow and In turn Builds Firm Value Debt Reduction Reinvest in Firm Debt Reduction Adds to Free Cash Flow by Reducing Interest & Principal Repayments Reinvestment Adds to Free Cash Flow by Improving Operating Margins Free Cash Flow Tax Shield Adds to Free Cash Flow Tax Shield1 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 1Tax shield = (interest expense + additional depreciation and amortization expenses from asset write-ups) x marginal tax rate.

LBO Value is Maximized by Reducing Debt, Improving Margins, and Properly Timing Exit Case 1: Debt Reduction Case 2: Debt Reduction + Margin Improvement Case 3: Debt Reduction + Margin Improvement + Properly Timing Exit LBO Formation Year: Total Debt Equity Transaction/Enterprise Value $400,000,000 100,000,000 $500,000,000 Exit Year (Year 7) Assumptions: Cumulative Cash Available for Debt Repayment1 Net Debt2 EBITDA EBITDA Multiple Enterprise Value3 Equity Value4 $150,000,000 $250,000,000 $100,000,000 7.0 x $700,000,000 $450,000,000 $185,000,000 $215,000,000 $130,000,000 $910,000,000 $695,000,000 8.0 x $1,040,000,000 $825,000,000 Internal Rate of Return 24% 31.2% 35.2% Cash on Cash Return5 4.5 x 6.95 x 8.25 x 1Cumulative 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 million 3Enterprise Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year 4Equity Value = Enterprise Value in 7th Year – Net Debt 5The 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.

Common LBO Deal Structures Direct merger: Target firm merged directly into the firm controlled by the financial sponsor Subsidiary merger: Target firm merged into a acquisition subsidiary wholly-owned by the parent firm which in turn is controlled by the financial sponsor A 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.

Direct Merger Target Firm Target Firm Shareholders Lender Financial Sponsor (Limited Partnership Fund) Equity Contribution Target Merges with Acquirer Acquirer (Controlled by Financial Sponsor) Target Firm Loan Target Stock Lender Target Firm Shareholders Acquirer Cash and Stock

Subsidiary Merger Financial Sponsor Limited Partnership Fund Equity Contribution Parent (Controlled by Financial Sponsor) Target Firm Merger Sub Shares Merger Sub Merges Into Target Equity Contribution Loan Guarantee Merger Sub Cash & Shares Lender Merger Sub Target Firm Shareholders Loan Target Firm Shares

Typical LBO Capital Structure Common Equity (10%) Equity (25%) Preferred Equity (15%) Purchase Price Revolving Credit (5%) Term Loan A Debt (75%) Senior Secured Debt (40%) Term Loan B Term Loan C 2nd Mortgage Debt Sub Debt/Junk Bonds (30%) Mezzanine Debt & PIK

Case 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.

Things 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.