Leveraged buy outs and Leveraged buy outs and buy insbuy ins

Dr Clive Vlieland-BoddyDr Clive Vlieland-Boddy

TerminologyTerminology• MBO = Management Buy-Out The purchase of a business by its existing management team• MBI = Management Buy-InSimilar, but the Entrepreneurs leading the transaction will be

from OUTSIDE the company• Leveraged = Using external financing, debt and equity• LBO = Leveraged buy out normally be existing

management• LBI = Leveraged buy in. Normally by external parties.• EBITDA = Earnings before Interest, Tax, Depreciation and

amortisation

MBO / MBI s and MBO / MBI s and EntrepreneurshipEntrepreneurship

• Entrepreneurship can involve the purchase of an existing business as well as the creation of a new one.

• Leading individuals in MBO/MBIs display similar characteristics and motivations to those of Entrepreneurs generally.

MBO Vs MBIMBO Vs MBI

• MBO

– Recent research shows the importance of innovative behaviour, and new product development, which may not otherwise have happened

– Significantly better performance over 3-5 years than comparable non-buy-outs

Why do MBO / MBIs Occur?Why do MBO / MBIs Occur?

• Typically, because of corporate restructuring activity, leading the parent company to want to divest a subsidiary.

• BOs are the most common method of privatisation• Or, in the private arena, if an entrepreneur has no

family to succeed him/her in the business• Significant levels of business exist – in 1999 this

represented $50bn in value• An increasing proportion is in private companies – in

the UK in 1998 half of all MBO/MBIs were in private organisations.

Why do Management teams do Buy-Outs?Why do Management teams do Buy-Outs?

Competitive reasons:• To acquire additional skills and competencies• To secure a source of supply, or distribution• To acquire new technologiesPlus:• The entrepreneurial realisation of an opportunity• To speed market entry• To get assets cheaply• To acquire an opportunity in the form of an

enterprise which is not realising its full potential

WHY?WHY?• Opportunity to enhance performance

(commonly for privatisations• Retaining the management team gives

additional stability• Wealth Creation – studies prove that in the

short term after a buy-out there is substantial improvements in profitability, cash flow and productivity measures

Leveraged Buyout General Leveraged Buyout General CharacteristicsCharacteristics

• Leverage ranges from 6:1 to 12:1. Debt to EBITDA ranges from 3.5 times to 6 times or even more.

• Investors seek equity returns of 20 percent or more – focus is on equity IRR rather than free cash flow.

• Average life of 6.7 years, after which investors take the firm public. Bank amortizes senior debt over 3-7 years.

• Characteristics– Strong and stable cash flows– Low level of capital expenditures– Strong market position– Low rate of technological change– Relatively low market valuation

European buyout valueEuropean buyout value

European buyout value: €72 billion in Q1-Q3 2008

MBO vs MBIMBO vs MBI

• MBI– Typically involve extensive restructuring

(traditional accusations of asset stripping)– Performance generally less strong than MBOs– Therefore pure MBIs (lacking in knowledge of

this particular business) are often replaced by the hybrid BIMBO (Buy In Management Buy Out)

Leveraged Finance - IntroductionLeveraged Finance - Introduction• Leveraged Finance simply means funding a company or

business unit with more debt than would be considered normal for that company or industry.

• Higher-than-normal debt implies that the funding may be riskier, and therefore more costly, than normal borrowing -- higher credit spreads and fees. It is often also more complex with covenants and waterfalls.

• Hence leveraged finance is commonly employed to achieve a specific, often temporary, objective: to make an acquisition, to effect a buy-out, to repurchase shares or fund a one-time dividend, or to invest in a self sustaining, cash-generating asset.

Definition of an LBODefinition of an LBO

Transaction in which a group of private investors uses debt financing to purchase a corporation or a corporate division. Equity securities of the company are no longer publicly traded, though the debt and preferred stock may be publicly traded. Uses entire borrowing structure

Often involves an LBO sponsor who contributes capital and expertise (KKR, Bass Brothers, Blackstone, etc.) and management team.

Leveraged Buyout ProcessLeveraged Buyout Process• A group takes over control of a company (sometimes with

hostile takeovers).• Use high level of leverage and multiple debt layers to take

control• Once in control, improve operations – increase EBITDA, divest

unrelated businesses to generate cash for transaction, re-sell the new company for a profit.

• High amortization assures self-restraint on behalf of the borrower.

• In a typical LBO, capital expenditures do not exceed depreciation by much.

• By changing the relative participation of debt and equity in the capital structure, an LBO redistributes returns and risks among providers of capital.

Typical LBO StructureTypical LBO Structure

Incremental Debt to EBITDA ratio

This totals 7-8 x EBITDA

4-6

RewardsRewards

• £££££– Because of the way deals are structured, the

management team will often be given a larger percentage of the equity than is warranted just by their £ investment

• Equity ownership gives increased entrepreneurial control and opportunity to develop their own strategy

Costs / RisksCosts / Risks• Cost:

– Is the cheapest disposal option for the existing owner

• Risk for the Management team– Do they genuinely have the skills to make it work?– Faced with an MBO opportunity, the management

often have little idea what is involved (but have to learn quickly)

– Very hard work, doesn’t always work out– If external financing is involved (particularly VC) the

banks will put the management team under a lot of pressure, and usually appoint their own FD, and non-exec Chairman.

Distinct Features of an LBODistinct Features of an LBO

• Significant increase in financial leverage– Average debt/total capital increases from 20% to

70%• Management ownership interest increases• 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

Characteristics of PotentialCharacteristics of Potential LBO Candidates 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 financing

Typical LBO StructureTypical 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

LBO FinancingLBO 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)

LBO Financing – Senior Bank DebtLBO Financing – Senior Bank Debt

• Senior bank debt which is secured with assets like receivables, inventory, PP&E

• Often in tranches where first tranche is repaid quickly and other tranches are not due until maturity (7-8 year maturity with average life of 4-5 years)

• Bankers like to see 25% to 35% equity for protection

LBO Financing – Unsecured DebtLBO Financing – Unsecured Debt

• Unsecured debt (senior and junior)

• Longer maturity than bank debt

• Covenants not to pay dividends, increase debt or sell assets

• Supported by cash flows and operations of the business.

Common EquityCommon Equity

• Typically 25% - 35% of capital structure now, but varies over time.

• Typically seeking a 20%-30% IRR• Often assume exit and entry multiples are the

same, but not necessarily a good assumption – rarely expect multiple expansion

• Ask what the exit strategy is likely to be.

Management OwnershipManagement 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

• Managers are sometimes offered chance to buy stock

• Managers often already own shares in a company that does an LBO and they do not necessarily cash

Exit StrategiesExit 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 equity holders (or repurchases shares). Some, but not all, equity holders may be taken out.

Potential Motivations for an LBOPotential Motivations for an 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

Changes in Financial PerformanceChanges in Financial Performance• In three year period after the buyout relative to the

year before the buyout– EBIT increases by 42%– EBIT/assets increases by 15%– EBIT/sales increases by 19%– EBIT-CAPEX increases by 96%– EBIT-CAPEX/assets increases by 79%– EBIT-CAPEX/sales increases by 43%– working capital management improves– no decline in advertising, maintenance or R&D– CAPEX falls by 33% relative to industry

Simple Example Simple Example Albert EnterprisesAlbert Enterprises

Simple Example – Albert EnterprisesSimple Example – Albert Enterprises• Albert Enterprises is a long established

manufacturing enterprise.• Run for over 40 years by the principal shareholder

(100%) who is now approaching retirement.• The key management want to buy the business but

do not have any real capital.• The business is successful. EBITDA for last 10

years is €5m before tax at 30%, and has not grown. • The management want to grow the business but

the owners dislikes risks. They estimate that profits could grow by 10% per annum

Simple Example – Albert EnterprisesSimple Example – Albert Enterprises

• The business has been valued at €40m.

• It has a freehold factory valued at €15m.

• It has cash in the bank of €5m.

• It has no bank loans.

• A private Equity firm has offered to finance the MBO.

Simple Example – Albert EnterprisesSimple Example – Albert Enterprises

Suggestions……..

Simple Example – Albert EnterprisesSimple Example – Albert Enterprises

• The company could borrow say 80-90% of the value of the freehold factory. This would generate say €12m at a low rate of say 5% per annum interest.

• The management could request that the owner takes out the cash in bank of €5m.

• That would leave a balance of €23m.

• Private Equity has agreed to provide the following:– 7 year loan of €20m at a rate of 8%.– 2 year loan of €3m at a rate of 10%– Equity kicker of 25% of the equity.

Simple Example – Albert EnterprisesSimple Example – Albert Enterprises

Lets look at the figuresLets look at the figuresBefore LBO• Profits were €5.0m• Less Tax 30% €1.5m• Post Tax €3.5m

After LBO (Year 1)• Profits were €5.0m• Add growth €0.5m• New Profits €5.5m• Less Interest

– 12m @ 5% €0.6m– 20m @ 8% €1.6m– 3m @ 10% €0.3m

• Pre Tax Profit €3.0m• Less tax 30% €0.9m• Post Tax €2.1m

Vendor FinancingVendor Financing

Reasons for Vendor FinancingReasons for Vendor Financing

• Normally buyer cannot raise the capital.

• Vendor keen to sell.

Vendor FinancingVendor Financing

• The seller agrees that all or part of the agreed sale price will be financed by him.

• He knows the business he is selling and is in a good position to assess the risks.

• Often the consideration that the seller is to receive is larger than his requirements.

• The purchasers are also protected by knowing that if there turns out to be undisclosed issues then they have some redress.