Transcript OVERVIEW OF MERGERS

Leveraged Buyouts
Characteristics
Evidence on LBOs
An LBO (Private Equity) Model
Reverse LBOs
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Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2007
Definition of an LBO
• No precise definition -- different forms
• 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.
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Corporate Valuation -- Chapter 18
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Distinct Features of an 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
equityholders
– Typical board of 5 individuals,
2-3 from the LBO
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sponsor
Characteristics of Potential
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
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financing
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Typical 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
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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)
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LBO Financing – Senior Bank Debt
• Senior bank debt which is secured with assets like receivables,
inventory, PP&E is often priced at T-Bills, LIBOR or prime + 400
to 700 basis points (recently spreads were much lower).
• 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)
• 2.5 – 3.5 x LTM EBITDA (varies by industry and rating)
• Lend up to X % (40%-65%) of receivables less than Y (90) days,
over certain $ amount, at T-Bill, LIBOR or Prime, plus a risk
premium
• Inventory usually 20% to 60%
• Securities 10% to 90% (US Govt Bonds @ 90%)
• PP&E (Cars (60%), Computers (25%), Building (60% to 70%,
unique factories (10% to 30%)
• Bankers like to see 25% to 35% equity for protection
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Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2007
LBO Financing – Unsecured Debt
• Unsecured debt (senior and junior)
• Potentially many different pieces (cash pays are
senior and senior subordinated while junior
subordinated may be zero coupon issued by holding
company)
• Longer maturity than bank debt
• Covenants not to pay dividends, increase debt or sell
assets
• Supported by cash flows and operations of the
business.
• High-yield a favorite (senior subordinated), but hard
to sell high yield for less than $150 million and highyield market not always viable.
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• High-yield is typically non-callable
for about
five years
Copyright,
Robert Holthausen,
2007
Junior Subordinated and
Preferred
• Below the high-yield bonds (or below the bank debt if the deal
isn’t big enough to support high-yield bonds) but above the
common would be junior subordinated and preferred stock.
• Junior subordinated may be PIK (zeros) for some time period.
May be issued by a holding company of the operating company
and may be issued with warrants. Holding company notes
almost always PIK because there is no cash flow into the
holding company for some time.
– In transactions of this type, the PIK interest may not be
deductible until it is paid in cash or the bond matures and is
paid off (so called AHYDO rules)
• Preferred can be PIK as well, so dividends accrue but are not
paid and at sale of the company the preferred holders get their
investment plus accrued dividends (often call the liquidation
preference) -- often sold with warrants. Alternatively, can issue
convertible preferred instead of including warrants.
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Common 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.
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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.
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Corporate Valuation -- Chapter 18
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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.
• Sponsor takes funds from pension funds only when
required, a draw down notice (LBO sponsors do not
want to be generic portfolio managers).
• 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
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Corporate Valuation -- Chapter 18
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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.
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Financial Sponsor M&A
Activity
1999-2007 Global Sponsor M&A Activity
$ in billions
% of Total Value
$1,200
50%
$1,105
$1,100
45%
$1,000
40%
$900
35%
$800
$759
$700
30%
$600
25%
$500
20%
$400
15%
$232
$300
$200
$50
$87
$103
10%
$151
$92
$95
$64
$100
5%
$0
0%
1998
___________________________
1999
2000
2001
2002
2003
Total $ Value of Sponsor Deals
2004
2005
2006
2007
% of Total Value of M&A Deals
Source: SDC.
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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?
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• Wharton
What isSchool
the exit strategy?
Copyright, Robert Holthausen, 2007
U.S. LBO Acquisition Financing
Market
Trends
Sample Capital Structure Terms for Leveraged Deals
Average Debt Multiples
6.7x
6x
3x
6.0x
5.4x 5.0x 5.2x 5.3x 5.2x 5.8x 5.7x 5.2x
0.6
4.5x 4.1x
4.4x 4.4x
3.3
4.0x
4.2x
3.8x
3.7x
2.3
2.1
2.0
1.7 1.2
2.4 2.5 2.5 1.9
1.2 1.5 1.4 1.7 1.5 1.3 1.1
5.4
3.4 3.4 2.6 2.7 2.8 3.3 3.5 3.6 3.5 3.3 2.9
3.3
3.1
2.7
2.2 2.4 2.3
0x
1989 1990 1992
1993 1994 1995
1996 1997 1998
Bank Debt/EBITDA
1999 2000 2001
2002 2003 2004
2005 2006 2007
Non-Bank Debt/EBITDA
Average Equity Contribution to LBO
50%
25%
0%
25% 26% 24% 23%
22% 22%
45%
42% 41% 43%
40%
38% 34% 34% 35%
33% 36%
36% 38% 35% 40% 40% 35% 32% 31% 33%
13%
32%
30%
10%
21% 22% 25% 26% 24% 23% 3% 4% 4% 4% 6% 3% 5% 3% 2% 3% 2%
10% 13%
1988 1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Rollover Equity
Contributed Equity
________________
Source: S&P Leveraged Commentary & Data. Excludes media loans. Too few deals in 1991 to form a meaningful sample.
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Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2007
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.
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Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2007
Potential 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)
• Wharton
Transfer
wealth
from
other
stakeholders
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Valuation -- Chapter 18
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Copyright, Robert Holthausen, 2007
in the firm such as employees
&
Performance of LBOs
• Evidence indicates that the median
premium paid to existing shareholders
is 42% (1980’s data).
• What are the potential sources of
value?
– Improved operating performance
– wealth transfers from employees
– reduction of taxes
– wealth transfers from pre-buyout
debtholders
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– overpayment by post-buyout
investors
Changes in Median Performance
• In three year period after the buyout relative
to the year before the buyout (1980s data)
–
–
–
–
–
–
–
–
–
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
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Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2007
Transfers from Employees
• No evidence that investor wealth gains
can be attributed to wage reductions or
layoffs
– median change in number of employees is
0.9% among all LBOs and is 4.9% among
LBOs that did not engage in divestitures
– significant increase in average annual
compensation for non-management
employees
– there is evidence that LBOs are not adding
to their payrolls at the same rate as the
industry
(12%
declines
for
all,
6.2%
decline
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Valuation
-- Chapter 18
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Copyright, Robert Holthausen, 2007
for those with no divestitures)
Tax Effect of LBOs
• Firms’ interest deductions increase
substantially after an LBO. Depending on
how you value them & how long you think the
highly levered structure will be in place, 21%
to 70% of the premium is attributable to the
interest
• Additional depreciation (pre-1986 Tax Reform
Act accounted for at least 30% of the
premium
• Ratio of federal taxes/EBIT falls from 20%
pre-buyout to 1% for 2 yrs. after buyout.
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Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2007
Transfers from Bondholders
• If leverage increases dramatically, prebuyout debtholders with no protection
could experience wealth losses
– on average, pre-buyout debtholders lost
2.1%
– represents 3% of the premium paid
– wealth losses accrue only to those
bondholders not safeguarded by protective
covenants (limitations on debt issuance,
etc.)
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Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2007
Overpayment by Post-Buyout
Investors
• Evidence indicates over three years
subsequent to the buyout, post-buyout
equity investors earned a mean excess
return of 45% (again, 1980s data).
• Evidence for debtholders is less clear
as it is difficult to track bonds that
default. Default rates on low grade
bonds were roughly 2.5% per year, but
returns are less easily quantified
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Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2007
John Harland -- An LBO?
• Typical LBO Model
• Model cash flows -- see how it supports
the debt financing structure
• Treat exit year as a choice variable to
determine sensitivity of IRR to exit date.
• Determine the IRR for the mezzanine
and equity providers and see if it hits
target
• Models don’t typically assess value
Corporate
Valuation
-- Chapter
exceptSchool
as exit multiple
(can
do
DCF
of 18
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Copyright, Robert Holthausen, 2007
LBO Models as an Alternative
Valuation
• LBO models can serve as an alternative
valuation.
• Take the cash flow forecasts, determine the
amount of financing available in the market
place currently and the IRR that LBO
sponsors would target for this company.
Based on all that, determine the maximum
amount that could be paid as an LBO
transaction that satisfies the required IRR.
• Triangulate with DCF and Market Multiple
Valuations
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Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2007
LBO Model Logic
• Create a sources (debt, equity contribution)
and uses (purchase price, fees, debt payoff)
statement for inception of LBO
• Debt schedules
• Proforma balance sheet, income statement
and statement of cash flows based on
operating assumptions
• Cash flows pay down the debt (senior first
and then mezzanine)
• Perform valuations at alternative exit dates
and determine IRR to equity holders
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Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2007
Reverse Leveraged Buyouts
• Reverse LBO occurs when an LBO goes
public
• Constituted roughly 10% of IPO market in
1980s
• Leverage and ownership changes at time of
reverse LBO that moves them back toward
pre-LBO structure
• Leverage falls from 83% to 56% (debt/capital)
• Inside ownership falls from 75% to 49%
(management and board -- includes sponsor).
• Board size increases from 5 to 7, roughly 1/3
each of operating management,
non
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Valuation -- Chapter 18
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Copyright,
Robert
Holthausen, 2007
management capital providers
and
external
Financial Performance
OCF Before Interest and Taxes
•
Year
–
-1
–
0
– +1
– +2
– +3
– Avg +1 to +3
Firm
19.3%
14.6%
11.9%
14.3%
13.5%
13.9%
Industry-Adjusted
9.2%
4.7%
1.5%
4.1%
2.4%
2.9%
• Doing much better than their industry, but
evidence of deterioration relative to prior
performance
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Discretionary Expenditures
• Discretionary expenditures defined as capital
expenditures, advertising and R&D.
– Spending as much as their industry prior to the
reverse LBO and increases subsequently
(discretionary expend./sales) 2% greater than
industry
– CAPEX low before reverse LBO and normal after
– Advertising above industry before and after
– R&D tracks industry before and after
• Employees/sales same as industry both
before and after the reverse LBO
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Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2007
Effect of ownership and leverage
• No evidence that changes in leverage affect
performance
• Significant correlation between decline in
performance and decline in ownership.
– 10% additional decline in percentage equity
owned by managers results in an additional 3.6%
fall in OCF/assets over three subsequent years
– 10% additional decline in percentage equity
owned by non-management insiders results in an
additional 4.1% fall in OCF/assets over three
subsequent years
• Suggests important role for ownership
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incentive
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Stock Market Performance
• Evidence of a large increase in stock
prices of the reverse LBO firms over the
next four years.
• Large increase in stock prices exactly
tracks the stock market. As such, there
is no evidence of positive or negative
excess returns
• Very different from IPOs in general.
Strong evidence of negative excess
returns
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