1. Lecture 15 Leveraged Buy Outs

2. 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.

3. 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.

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

5. 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

6. 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

7. 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

8. 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

9. 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)

10. 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.

11. 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

12. 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.

13. 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

14. 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

15. 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?

16. 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.

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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.