LBO ppt(1)

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Leverage Financing

This is only a summary. Please read the text book and assigned

readings for details. Removal of errors and omissions, if any, in this ppt

are your responsibility.

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Agenda

Leverage Financing

LBO

Strip Financing

Empirical evidence

Numerical Valuation

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Leverage 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

In leverage financing the buyer invests a small amount of money and borrows the rest (usually)

The buyer's own equity thus leverages a lot more money from others

The buyer can achieve this due to the targeted acquisition, if operated efficiently would be highly

profitable and have sufficient cash to repay the debt

and provide returns to equity holders

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Leverage Financing

Leverage Financing is used for three purposes

Taking a public company private (public-to-private) Financing spin-offs Carrying out ownership changes in small business

or some form of private property transfer (private

deals)

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Leverage Financing

Some special cases of LBOs

Management Buy Out - existing internal management team acquires a sizeable portion

of the shares of the company (could make it

private)

Management Buy In - external management team acquires the shares of the target

Buy In Management Buy Out - combination of internal existing managers and external

investors with some stake

Secondary or tertiary buyouts - third party private equity firms

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LBO

In a leveraged buyout, all of the stock, or assets, of a public corporation are bought by a small group of

investors (financial buyers), usually including members of existing management

Focus is on ROE The group that buys out uses other peoples money Success is through improved oper. performance LBO operators target firms having stable cash flow

to meet debt service requirements

Typical targets are in mature industries The acquirer purchases the target with a loan

collateralized by the target's own assets

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LBO

Operating Characteristics: significant market

position, capable management team, strong brand

names, good relationships with key customers and

suppliers, mature industry, steady growth

Financial Characteristics: high debt capacity, steady

cash flow, operating improvement possibilities, low

operating leverage, possibility of substantial cost

reduction

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LBO

Advantages include

Management incentives aligned Reduction in agency costs debt provides a

monitoring role

Tax savings from interest expense and depreciation from asset write-up and current loss acctg

Efficient decision processes under pvt. ownership A potential improvement in operating performance A form of takeover defense by eliminating public

investors

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LBO

Disadvantages include

High fixed costs of debt Vulnerability to business cycle fluctuations and

competitor actions due to high leverage

Complex capital structure often loss of transparency

Not appropriate for firms with high business risk, and potential difficulties in raising capital

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LBO

Role of Junk bonds in LBO financing

Junk bonds are rated by credit agencies as below investment grade or they are non-rated debt with wide variation in bond quality

Interest rates in the 1980s was usually 3-5% above the prime rate or government rate

Fallen Angels or Rising Stars

Started out as interim bridge loans but became a permanent form of financing with high yields

Junk bond financing is highly cyclical, and tapers off as the economy goes into recession due to fears of increasing default rates

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LBO

Role of Junk bonds in LBO financing

Junk bond financing for LBOs dried up due to series of defaults of over-leveraged firms in the late 1980s

Another factor was insider trading and fraud at such companies as Drexel Burnham, the primary market maker for junk bonds

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LBO

Remember the example we discussed previously

ABC XYZ

Total Capital 200 200

EBITDA margin 0.2 0.2

Debt % 0 0.5

Interest rate 0.07 0.07

Tax rate 0.3 0.3

Firm Value 300 300

The only difference is that company XYZ has 50% or $100m

of its $200m capital structure in debt

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LBO

The interest expense for

XYZ amounts to $7 leading

to a difference in the PAT for

both organizations

Lets us analyze the problem

a bit differently..

ABC XYZ

EBITDA 20 20

Int 0 7

EAIBT 20 13

Tax 6 3.9

PAT 14 9.1

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LBO

Suppose you own both the debt and the equity of XYZ, then what CF would you receive? In other words what is the FCFF?

$9.1 + $7 = $16.1 m

Suppose you owned all of ABC, the no-debt corp., you would

receive $14m (a difference of $2.1m)

This is the interest expense/tax arbitrage

In effect the government is subsidizing your capital structure

because interest expense is tax deductible

LBO's operate under this kind of interest subsidy where

wealth is in effect redistributed

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LBO

Even though tax is still owed note that the tax is paid by the debt holder (individual) vs. the corporation Individuals may more effectively manage their personal tax and consequences than a large corporation; some individuals may also be in a lower tax bracket than a corporation The after-tax cost of debt is much cheaper than the implied cost of equity (based on risk etc.) If XYZ is privately owned, the owner can take out $2.1m more than in an equity financed business Debt can be retired and soon the owner may have the optimum level of debt and start earning equity profits

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LBO

Subordinate Debt

Preferred Stock

Convertible Debt

Senior Debt

Common Stock

Strip Financing

Mezzanine Financing

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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

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

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LBO

In an LBO

Senior Debt: Usually banks (30%-60% - usually 5-8 years)

Mezzanine: Third-party financiers, holding strips and maybe equity as well (20%-30% - usually 7-10

years)

Equity: Venture capitalists and management; venture capitalists usually get warrants attached to

bonds (approx. 25% - usually 7-12 years)

Expected returns is correlated to the risk

Senior Debt: 10% 15% Mezzanine: 20% - 25% Equity: over 28%

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Strip Financing

Consider two firms identical in every respect except

financing

Firm A is entirely financed with equity, and firm B is highly leveraged with senior subordinated debt,

convertible debt and preferred as well as equity

Suppose firm B securities are sold only in strips, that is, a buyer purchasing X percent of any

security must purchase X percent of all securities,

and the securities are "stapled" together so they

cannot be separated later

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Strip Financing

CF to the firms may be the same but, organizationally the two firms are very different

If firm B managers withhold dividends to invest in value reducing projects or if they are incompetent,

strip holders have recourse through covenants

not available to the equity holders of firm A

Each firm B security specifies the rights its holder has in the event of default on its dividend or

coupon payment, for example, the right to take

the firm into bankruptcy or to have board

representation

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Strip Financing

It is easier and quicker to replace managers in firm B

There are no conflicts among senior and junior claimants over reorganization of the claims in the

event of default to the strip holder it is a matter of

moving funds from one pocket to another

Thus firm B never needs to go into bankruptcy, the reorganization can be accomplished probably

voluntarily, quickly, and with less expense and

disruption than through bankruptcy proceedings

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Empirical Evidence

Empirical evidence on LBO performance

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

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 Yet, no strong evidence that minority

shareholders are negatively affected

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Empirical Evidence

Alternatives to LBO voluntary restructuring

Cost-cutting associated with LBOs often gives

them a bad name

One option is a voluntary restructuring which

provides the same improved performance, if

implemented properly

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LBO - India

Indian companies can undertake a LBO of a foreign

target by obtaining financing from foreign banks

and is then subject to the legal issues of the targets country

There is also a LBO possibility of an Indian target

by another Indian company or a foreign company

via FDI or FII each with its own regulatory issues and restrictions

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LBO - India

Examples of foreign targets

Tetley Tata tea Whyte & Mackay UB Group Corus Tata Steel Hansen Transmissions Suzlon Energy American Axle potential bid by Tata Motors,

Lombardini buyout attempt by Zoom Auto Ancillaries

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LBO - India

Examples of Indian targets

Flextronics Software Systems (renamed Aricent) KKR (LBO)

GE Capital International Services General Atlantic Partners (LBO)

Nitrex Chemicals Actis Capital (MBO) Nirulas Navis Capital Partners (MBO) ACE Refratories ICICI Venture (LBO) Infomedia India ICICI Venture (LBO)

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LBO - India

Private Equity in India

In many firms the owners and managers are the same making it difficult for a private equity

investor to gain control for instituting necessary

changes

Thus several private equity transactions that take place are minority transactions based on personal

relationship

In the absence of control, it may be difficult to use debt - no control on operations and performance

Minority private investors may not be able to sell

their stake thus limiting exit options

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LBO - India

MBOs in India

Indian model is different from the west given the business environment

In the west, usually management creates the deal and seeks investors

In India the promoters usually spin off or divest and the private equity player partners with some

of the existing management

Management does not have the resource to engineer a buyout, given the risk appetite and

market structure

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LBO - India

The corporate debt market is small and marginal Private placements are common, limiting

transparency

The dominance of private placements has been attributed to several factors - ease of issuance and

cost efficiency being the major ones

Highly rated debt is preferred by Indian investors The junk bond market as in the west has no role or

equivalence in India since these bonds pay a high

return but have no covenants and protection against

default

Credit derivative market helps transfer risk such a market is non-existent in India

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LBO - Return to Investors

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 free cash flows generated during the

5 years go to pay interest and amortize the secured debt in

its entirety and that cash balances are negligible.

Furthermore, let the 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, which, after paying the debt balance, leaves $296

of equity for distribution between the sponsor and

management. Discuss the CF to the subordinated debt and

the sponsor

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What is this equity kicker?

Brings returns to the acceptable levels to the

lender

Compensates for the lower coupon interest of

the bond

Other than LBO - an convertible bond has a

low coupon because of

the convertible feature

The sweetener could be a warrant, combination

of stocks and warrants

Year 0 1 2 3 4 5

Bond price -100

Coupon 6 6 6 6 6

Principal 100

Equity kicker 80

Total cash flow -100 6 6 6 6 186

Blended IRR 17.30%

In this case the equity kicker = 296 * 27%

Equity amount Part of the contract

is 27% equity

Let us consider the CF to the subordinated debt

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Exit proceeds = 296 * 73%

Equity amount Part of the original

arrangement: 73%

Let us consider the CF to the sponsor

Year 0 1 2 3 4 5

Initial investment -50

Exit Proceeds 216

Return multiple(=216/50) 4.3

IRR 34%

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Numerical 1

Consider a firm undergoing LBO with the following details

Asset beta = 1, rf = 10%, risk premium = 8% EBIT is growing at 15%, and in year 1 = $14,000 The firm has two categories of debt: senior debt of 50,000

at the annual rate of 12% and subordinate debt of

$40,000 at the annual rate of 15%

Debt declines over time as the available cash flow is used to pay down the debt

Noncash adjustments year 1 year 6 are: $1000, $500, -$100, -$100, -$100 and -$100

The after-tax asset sale amounts to $20,000 in year 1 The firm is in the 32% marginal tax bracket

Set up the cash flows for year 1- year 6 and compute the

enterprise value assuming 0%, 5% and 10% growth rates

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Numerical 2

FAT corporation stock is currently trading at $40 per share There are 20m shares o/s and the firm has no debt

You are a partner in a firm that specializes in LBOs and your analysis indicates that the operations of this target

could be improved considerably with some management

change

You estimate that with your capable management team in place the value of the firm will increase by 50%

You decide to initiate an LBO and issue a tender offer for a controlling interest of at least 50% of the o/s shares

What is the max amount of value you can extract and still complete the deal?

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Numerical 3

Detailed LBO example - refer to the word doc for the problem

Firm C was a small specialty chemical company engaged in the manufacturing and

distribution of coatings, paints, and related products primarily in the USA. In the spring of

2005, its owner, a diversified chemical company, decided to sell Firm C. As it customary in

this type of transaction, Firm C was to be sold with no cash and no outstanding debt.

The debt capacity of the company, which depends on the lending terms available in the

market: (a) The fraction of the capital that could be borrowed via banks and the rate of

interest and the amortization period of secured loans: (b) the availability and terms of

subordinated debt, and (c) the minimum equity required by lenders. Assume that the firm

can initially borrow $569.9 m where lenders were 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 charge

6.7% cash interest and require the term loan to be paid 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% capital and

required a 25% IRR. Fees and expenses associated with the transaction would be about

2% of the purchase price. The current cash interest rate is 5%.

2005 sales equals 578.0 m, Capex equals 34.0m and net increase in working capital

including cash equals 7.1m. Following are the assumptions that the analyst has used in the

evaluation.

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Numerical 3

Actual Projection ------->

Assumptions: 2005 2006 2007 2008 2009 2010 2011 2012

Net sales growth 9.0% 9.0% 8.5% 8.5% 8.0% 7.5% 7.0% 7.0%

EBITDA margin 16.1% 17.0% 17.5% 18.0% 18.0% 18.0% 17.5% 17.5%

Net fixed assets/sales 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%

Net working capital

less cash/sales 12.0% 11.5% 11.0% 11.0% 11.0% 11.0% 11.0% 11.0%

Cash and marketable

securities/sales 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0%

Depreciation/sales 2.8% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%

Deffered taxes/sales 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0%

Examine the possibility of acquiring Firm C via an LBO led by an equity investor

and Firm Cs management. Set up the relevant cash flows and amortization Set up the sources and uses of funds what is the purchase price? What multiple of EBITDA can the buyout finance? Evaluate the exit equity return at the end of 2010? If the median publicly traded comparable EBITDA multiple was 7.8 how

much more could the offer have been?

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Numerical 4

You work for a LBO firm and are evaluating a potential candidate -

XYZ Corp. Details of the firm as follows:

The current stock price of XYZ is $20 and it has 2m shares outstanding

If your firm can buy XYZ and replace the management, you believe that XYZs value will increase by 40%

You are planning an LBO and will offer $25 per share for control of the company

Questions:

Assuming that you will get 50% control, what will happen to the price of the untendered shares

Given the answer (price of the untendered shares) above, will the shareholders tender their shares, not tender their

shares or be indifferent

What will your firm gain from the transaction

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Numerical 5

You are considering whether to invest $10m in the 5 year subordinated

notes of HTF, Inc. on October 1, 2007. The annual coupon of these notes

is 8%, and its principal is due at the end of fifth year. In order to obtain an

acceptable return you demand equity participation. HTFs current revenue and EBITDA are $30m and $5m respectively. The EBITDA

margin is 20%, and the future EBITDA is expected to equal 0.20 revenue - 1000 with revenue growing 12% per year during the following 5

years. Fifth year net debt is projected at $15m.

a. What equity participation (percent ownership) would you demand if

you require 17% expected returns from the joint proceeds of the

subordinated note and the equity and you assume exit in year 5 at

an EBITDA multiple equal to 6. Under what conditions would your

return be more (less) than 17%?

HTF is not expected to make cash distributions during this period.

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Numerical 6

You have invested $1 million for a 25% equity stake in a new

venture. Current sales are $8.1 million and EBITDA is 10% of

sales. You expect to recover your investment plus return in 4

years via the sale of the company at an expected exit EBITDA

multiple of 8. No further equity shares are contemplated but the company will have $6 million of net debt at exit time. Fees

and expenses will amount to 4% of sale price of the enterprise

(net debt plus equity).

a. What growth rate of sales is needed in order to provide you

with a 40% return?

b. What return will you attain if sales grow at half the required

rate and the exit EBITDA multiple is only 6?

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Numerical 7

ABC Corp. is a privately owned manufacturer of light trailers

that are sold to rental companies and individuals. Its sole

owner, Mr. Benjamin Webster is presently considering a

purchase offer from Prentice Works. The offer for the equity of

ABC Corp. is as follows:

1. A cash payment for $5 million due at closing

2. A 7.5% annual coupon 5-year subordinated note issued

by Prentice Works for $7 million with principle payable at

maturity and annual CF of $315,000 till maturity

3. An earnout agreement stipulating a payment to take

effect at the end of the 3rd year equal to 0.5 times 3rd

year EBITDA

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Numerical 7

Prentice Works will assume ABC Corp.s present net debt of $14.8 million. Furthermore ABC Corp. would become a wholly owned subsidiary of

Prentice, and Mr. Webster would stay as its president with a 3-year contract

and competitive compensation, at the end of which he would retire.

The following additional information is available:

Prentice Works outstanding subordinated notes are considered risk free and the riskless rate is 5%

Mr. Webster believed that he could make ABC Corp.s revenue grow at 10% per year during the following 3 years

Current revenue is $50 million EBITDA = 0.15Revenue-1.5million such that current EBITDA is 6 million Firms with characteristics similar to ABC have a WACC of about 14% Prentice Works corporate tax rate is 40% The 95% confidence range of ABC Corp.s revenue growth is [-20%,

+40%] implying an estimated volatility of 15%

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Numerical 7

a. Estimate the cost of the offer by Prentice Works?

b. What is the value of the earnout agreement?

c. How much is Prentice Works offering for the

enterprise (net debt plus equity) of ABC Corp.?

d. What is the initial enterprise value EBITDA multiple

offered by prentice?

e. Use option valuation methodology to price the

earnout using the volatility information given

Documents

LBO ppt(1)