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J. K. Dietrich - FBE 532 – Spring, 2006
Module II: Private Equity Financing
Week 4 –February 2, 2006
J. K. Dietrich - FBE 532 – Spring, 2006
Objectives of this Lecture
Contrast venture capital, hedge funds, and other sources of private equity
Discuss the role of venture capitalists in providing capital to new firms and to companies attempting to go private
Understand why leveraged buyouts are profitable and how LBOs are done
Analyze the impact of LBOs
J. K. Dietrich - FBE 532 – Spring, 2006
Private Equity Managed pools of capital not subject to
SEC review or regulation Major types are venture capital, hedge
funds, and other limited partnerships Most funds are managed by specialized
experts who are general partners Funds are raised in “rounds” and have
specified goals and time limits Efforts to regulate hedge funds by SEC
J. K. Dietrich - FBE 532 – Spring, 2006
Venture Capital Venture capital is a global phenomenon
although it is largest in the United States Venture capitalists invest in firms started by
entrepreneurs They are a temporary source of financing
with a limited time horizon They provide entrepreneurs with more than
money– Management advice and strategic planning– Personnel services– Additional financing
J. K. Dietrich - FBE 532 – Spring, 2006
Venture Capital
Venture capital is early stage financing of new and young firms looking to grow quickly
Venture capitalists are an important source of funds for these firms
Venture capital is also critical when a company goes private.
J. K. Dietrich - FBE 532 – Spring, 2006
Types of Venture Capitalists
Venture capitalists supply capital; there are several types:– High Net Worth Individuals (“Angels”) and
Families– Private Partnerships and Corporations
» Arthur Rock & Co.
– Large Industrial or Financial Corporations» Example: Citicorp Venture Capital
J. K. Dietrich - FBE 532 – Spring, 2006
Venture Capital Financing Stages
Several distinct stages– Seed money: to “prove” the product or concept– Start-up: Funds for marketing and product
development for new firms– First-Round Financing: Supplements to
start-up funds to begin sales and manufacturing
J. K. Dietrich - FBE 532 – Spring, 2006
Venture Capital Financing Stages
– Second-Round Financing: Funds earmarked for working capital beyond first-stage financing
– Mezzanine Financing: Financing for a profitable firm contemplating expansion
– Bridge Financing: Funds for firms likely to go public within a year.
J. K. Dietrich - FBE 532 – Spring, 2006
Venture Capital
In IPO situations, venture capitalists often require rates of return of 25-50% on an annualized basis
To achieve this with loans, they usually demand and get warrants (“equity kickers”) that effectively give them an equity stake as well.
J. K. Dietrich - FBE 532 – Spring, 2006
Example
In 1999, EDT Inc. decides to go private. – It obtains a loan of $30 million from a venture
capitalist in the form of a zero coupon bond with maturity 2006 and face value $50 million.
– In addition, the VC demands warrants that can be exercised in 2006. Using the Black-Scholes formula, these warrants are valued at $11 million currently.
Determine the VC’s rate of return
J. K. Dietrich - FBE 532 – Spring, 2006
Return to Venture Capitalist (Millions of dollars)
1999 2000 2001 2002
Loan 50Value of Warrants 11Initial Cash Flow -30 Total -19 0 0 50
Internal Rate of Return 38%
Computation
Notice that we use the
PV of warrants in year 0
J. K. Dietrich - FBE 532 – Spring, 2006
Issues in LBOs
Why do LBOs occur? How are such deals structured? How can venture capitalists obtain their
required rates of return? What is the source of value?
Do LBOs represent an expropriation of shareholder wealth by management? Do they hurt minority shareholders?
J. K. Dietrich - FBE 532 – Spring, 2006
Hedge Funds
Name comes from “short-long” strategies and use of hedging strategies
Subject of intense interest globally and in U.S. because of failure of LTCM
Hedge funds are evolving– Multiple strategies– Active role in management– Assuming credit risk and others in hedged
portfolios
J. K. Dietrich - FBE 532 – Spring, 2006
Types of LBOs
Going Private: This occurs if the entire public stock interest of the firm is bought by management exclusively; this is sometimes known as a management buyout
LBO: Ownership in the subsequent private firm is shared by management and third-party investors and some (often large) financing in the form of debt
J. K. Dietrich - FBE 532 – Spring, 2006
Anatomy of Going Private
Merger: Management forms a shell that merges with the original firm, paying with cash or securities; requires shareholder approval.
Asset Sales: Similar in that a vote is required, and assets are purchased by a shell corporation owned by management
J. K. Dietrich - FBE 532 – Spring, 2006
Anatomy of Going Private
Tender Offer: No vote required, and minority shareholders are not required to involuntarily surrender their shares
Reverse Stock-Split: requires holders of fractional shares to sell their ownership back to the firm -- rare
J. K. Dietrich - FBE 532 – Spring, 2006
Anatomy of an LBO
Leveraged buyouts involve purchase of the entire public stock interest of the firm
Typically, the transaction is heavily debt financed; additional sources of funds are often found in the cash reserves of the firm itself
J. K. Dietrich - FBE 532 – Spring, 2006
Financing an LBO
LBOs are often financed with several layers of non-equity financing such as senior debt, subordinated debt, convertible debt, and preferred stock.
Mezzanine level financing refers to the securities between senior debt and common stock, e.g., subordinated and convertible debt
J. K. Dietrich - FBE 532 – Spring, 2006
Financing an LBO
Subordinate Debt
Preferred Stock
Convertible Debt
Senior Debt
Common Stock
Strip Financing
Mezzanine Financing
J. K. Dietrich - FBE 532 – Spring, 2006
Financing an LBO
Strip financing is common in LBOs This requires that a buyer purchasing, say,
12% of any mezzanine level security must also purchase 12% of all mezzanine level securities and some equity
J. K. Dietrich - FBE 532 – Spring, 2006
Financing an LBO
Strip Financing has two advantages– As each level of financing senior to equity goes
into default, the strip holder automatically gets new rights to intercede in the organization.
– Eliminates conflicts between senior and junior claim holders
J. K. Dietrich - FBE 532 – Spring, 2006
Sources of Financing
Senior Debt: Usually banks Equity: Venture capitalists (up to 80%)
and management; venture capitalists usually get warrants attached to bonds
Mezzanine: Third-party financiers, holding strips and maybe equity as well
J. K. Dietrich - FBE 532 – Spring, 2006
LBO Targets
Firms with large cash flows Firms in less risky industries with stable
profits Firms with unutilized debt capacity Example
– O. M. Scott
J. K. Dietrich - FBE 532 – Spring, 2006
Gains from LBOs
Reduced regulatory and listing costs:– Exchange registration and listing costs and
shareholder servicing costs are eliminated– If costs are, say, $200,000 annually, the present
value at 10% is $2 million, which may be significant for small firms
– For large firms, these gains may be insignificant.
J. K. Dietrich - FBE 532 – Spring, 2006
Gains from LBOs
Reduction in agency costs: – LBOs align the interests of management and
shareholders, increasing management performance
– Management has strong incentives to cut costs given the high ratio of interest expense to cash flow -- this may lead to “downsizing” that hurts other stakeholders
J. K. Dietrich - FBE 532 – Spring, 2006
Gains from LBOs
Increased monitoring: – High debt provides strong incentives for
outside auditing by the lenders and venture capitalists
– The conflicts between stockholders and bondholders may be reduced; strip financing allows quick replacement of management
J. K. Dietrich - FBE 532 – Spring, 2006
Free Cash Flow Argument
When the firm’s actual growth rate is less than its sustainable growth rate, cash accumulates within the corporation:– Although this belongs to shareholders, it is
controlled by management– Jensen observes that managers may waste
shareholder wealth High debt places limits on such managerial
“excess”
J. K. Dietrich - FBE 532 – Spring, 2006
The Trigger Strategy
Debt
Equity Paid In
Retained Earnings
Red arrows mark the amount of firm value that can be lost without triggering bond-holder action
Normal HighDebt
J. K. Dietrich - FBE 532 – Spring, 2006
The Trade-Off
The costs of financial distress may be reduced as reorganization is triggered earlier.
But the commitment of free cash flow to service debt reduces management discretion.
J. K. Dietrich - FBE 532 – Spring, 2006
Evaluation
The free cash flow argument will work for companies that derive value from assets in place rather than discretionary investment
For companies with high R&D costs and high capital expenditures, you may cut muscle with the fat.
J. K. Dietrich - FBE 532 – Spring, 2006
Example of O.M. Scott
O.M. Scott was a division of ITT; in 1986, there was a divisional LBO
Venture capitalists were Clayton and Dublier, with 70% of equity
Post-buyout leverage was 90%
J. K. Dietrich - FBE 532 – Spring, 2006
O.M. Scott
Operating performance increased in 1986-1988– EBIT rose 56% (Baker and Wruck)
Organizational changes focused on incentives– Bonuses for top managers increased dramatically
– There was increased monitoring because of covenants
J. K. Dietrich - FBE 532 – Spring, 2006
Empirical Evidence
LBOs can be very profitable for the new owners– Kohlberg, Kravis, Roberts & Co. (KKR) earned
an average annualized return over 60% on its equity in highly levered transactions
– DeAngelo, DeAngelo, and Rice report that buyout specialist Carl Ferenbach has a required rate of return of 50% on its equity investment
J. K. Dietrich - FBE 532 – Spring, 2006
Empirical Evidence
LBO’s involve a potential conflict of interest– Managers are insiders and may make deals at
the expense of minority shareholders– Managers may also have better information
than the shareholders; – Managers often have majority voting rights
J. K. Dietrich - FBE 532 – Spring, 2006
Empirical Evidence
One way to assess the relative importance of the positive and negative effects is to look at the share price reaction when an LBO is announced
Focus on abnormal (excess) returns
][( ,., tftmtftt rrrrAR
J. K. Dietrich - FBE 532 – Spring, 2006
Empirical Evidence
There are positive excess returns following LBO/private announcements
DeAngelo, DeAngelo, and Rice find a two-day excess return of 22% following the initial announcement of an LBO.
Accounting for leakage in the 40 trading days before the announcement, the cumulative excess return is 30%.
J. K. Dietrich - FBE 532 – Spring, 2006
Empirical Evidence
However, these returns are below the 56% average premium offered in LBO transactions
The difference is explained by the high percentage of offers (23%) withdrawn following announcement
J. K. Dietrich - FBE 532 – Spring, 2006
Problems
The problem is that we cannot separate the effect of good insider information from the other benefits such as the reduction in agency costs
Accordingly, research has focused on whether minority shareholders win or lose
J. K. Dietrich - FBE 532 – Spring, 2006
Minority Shareholders
For offers that are subsequently withdrawn, prices Spring by 9%
Clearly, even minority shareholders benefit from LBOs
The division of the gains is still an open question
J. K. Dietrich - FBE 532 – Spring, 2006
Alternatives to LBOs
Cost-cutting associated with LBOs often gives them a bad name
One option is a voluntary restructuring Donaldson discusses the case of General
Mills
J. K. Dietrich - FBE 532 – Spring, 2006
Restructuring and General Mills
In the 1980s, the company was over-diversified and lacked focus
They decided to concentrate on core areas Change in incentive compensation to focus
on ROE
J. K. Dietrich - FBE 532 – Spring, 2006
Results
In 1980, General Mills had a ROE of 16.7% By 1989, ROE had risen to 56.6% Positive stock Market response
J. K. Dietrich - FBE 532 – Spring, 2006
Caveats
Debt also increased: The leverage ratio rose from 27% to 74%
Orderly implementation “LBO-like” But, did it take too long?
J. K. Dietrich - FBE 532 – Spring, 2006
Conclusions
Highly levered transactions are a source of value; restructurings may do the same
Although they can be highly profitable, the evidence is difficult to interpret
There is no evidence that minority shareholders are hurt as a result of LBOs - the same cannot be said of other stakeholders