Class 2 - University of Southern California
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Transcript Class 2 - University of Southern California
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
J. K. Dietrich - FBE 532 – Spring, 2006
the VC’s rate of return
Computation
Return to Venture Capitalist (Millions of dollars)
1999
Loan
Value of Warrants
Initial Cash Flow
Total
Internal Rate of Return
2001 2002
50
11
-30
-19
Notice that we use the PV
of warrants in year 0
J. K. Dietrich - FBE 532 – Spring, 2006
2000
0
0
50
38%
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 thirdparty 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
Senior Debt
Subordinate Debt
Mezzanine
Financing
Convertible Debt
Preferred Stock
Common Stock
J. K. Dietrich - FBE 532 – Spring, 2006
Strip
Financing
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
Red arrows mark the amount
of firm value that can be lost
without triggering bondholder action
Retained Earnings
Equity Paid In
Normal
J. K. Dietrich - FBE 532 – Spring, 2006
Debt
High
Debt
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
ARt rt (rf ,t [rm.t rf ,t ]
J. K. Dietrich - FBE 532 – Spring, 2006
Empirical Evidence
There
are positive excess returns following
LBO/private announcements
DeAngelo, DeAngelo, and Rice find a twoday 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 overdiversified 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
J. K. Dietrich - FBE 532 – Spring, 2006
Next Week – February 9
Review
RWJ, Chapter 22 to 24
Read Term Sheet Negotiations for
Trendsetter Inc. case and begin to think
about the issues
J. K. Dietrich - FBE 532 – Spring, 2006