Leverage Buyouts Arzac, Chapter 13

How To Go Private four commonly used techniques for going private transactions shell corporation that combines with firm via merger asset sales tender offer reverse stock split

“Going Private” leverage transaction of public firm into privately held company LBO MBO often associated with improvement in performance

LBOs peak from 1986 to 1989 largest was RJR Nabisco in 1988 with price of $24.6b and then Beatrice in 1985 at $5.4b (Mergerstat) buying group generally includes current mgt expectation at some point that reverse transaction will occur

Why Pay Premiums? premiums paid for firms in LBOs average 40% of market price 1-2 months prior to announcement of buyout gains do occur and are achieved through stock price performance sources of gains: taxes management incentives wealth transfer effects asymmetric information and underpricing efficiency considerations

Strip Financing LBOs sometimes structured to use strip financing nonequity financing like senior debt, subordinated debt, convertible debt, and preferred stock often used others below senior and above common are mezzanine level strip says buyer who purchases X% of any mezzanine level security must purchase X% of all mezzanine level securities and some equity too

Ownership Structure Changes most complete form of ownership change when take a public firm private through an LBO purchase control using a high debt component with mgt often part of equity base fundamental operating changes generally made in attempt to increase profitability and firm value

Financing firms with valuations less than about $400 will not generally have access to public high yield market to raise funds for LBO used secured debt from bank – private placement of subordinated debt and equity participation typical financial structure for smaller firms prior to 1980s debt – about 5X EBITDA equity – about 1-1.5X EBITDA everything changed in 1980s for larger firms because of high-yield debt market secured financing – about 3X EBITDA high-yield financing – about 2.5-3X EBITDA equity – about 1.5X EBITDA sales about 7-8X EBITDA problem when high-yield debt market is not as active mezzanine financing fills in gap

Example 1 Let the LBO purchase price be $210 million, of which $60 million is secured debt. $100 million is subordinated debt with a below-market coupon interest of 6% plus 27% of the equity, and $50 million is invested by the sponsor for 73% of the equity. Assume the FCFs generated during the first 5 years go to pay interest and amortize the secured debt in its entirety and that cash balances are negligible. Furthermore, let expected year-5 EBITDA equal $49.5 million and assume that the company is expected to be sold for 8 times EBITDA or $396 million net of fees and expenses. Then, the cash flows and the return to subordinated holders are as follows:

LBO Financing determine debt capacity determine equity needed from sponsor find total financing amount find purchase price in terms of EBITDA determine if lender’s equity requirement satisfies return required by sponsor

Debt Capacity need to find in order to determine affordable price for LBO example 3 (Arzac) – Consider a target with 1st-year pro-forma EBITDA of $150m, growth rate of sales and EBITDA of 7%, initial cash balance of $1.9m, and senior secured debt making up 73% of total borrowing to be amortized in 7 years. (Firm has debt capacity of about 4.74x EBITDA or 4.74*150m = $710.8m, amortize $322.8m of it, and be left with the $388m of subordinated debt at the end of year 5 and a cash balance of $2.6m. See Exhibit 7.5.) Assume that the LBO sponsor expects to exit the investment in 5 years at 7x forward EBITDA. What is residual equity at the end of the 5th year? If the sponsor requires 30% return, what is the max equity that can be used and an affordable purchase multiple? Fees and expenses are .15x EBITDA.

Peregrine Coatings Peregrine Coatings was a small specialty chemical company engaged in the manufacturing and distribution of coatings, paints, and related products primarily in the United States. In the spring of 2005, its owner, a diversified chemical company decided to sell Peregrine Coatings. As is customary in this type of transaction, Peregrine was to be sold with no cash and no outstanding debt. Assume that lenders are willing to lend on a secured basis up to 60% of total debt and required 25% of the purchase price to be equity. They would be charged 6.7% cash interest and require the term loan to be paid down with all available pre-loan amortization cash flow over 7 years. Subordinated lenders would provide 40% of the total debt at 8% cash interest with principal due in 7 years. Both loans would be callable after 12/31/2010 without penalty. The sponsor needed to supply the remaining 25% of the capital and required a 25% IRR. Fees and expenses associated with the transaction would be about 2% of the purchase price.