Transcript Class 2

Module II:
Venture Capital Financing
Week 5 –September 23 and 25, 2002
J. K. Dietrich - FBE 432 – Fall, 2002
Objectives of this Lecture
 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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 2002 and face value $50 million.
– In addition, the VC demands warrants that can
be exercised in 2002. Using the Black-Scholes
formula, these warrants are valued at $11
million currently.
 Determine
J. K. Dietrich - FBE 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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
J. K. Dietrich - FBE 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
Financing an LBO
Senior Debt
Subordinate Debt
Mezzanine
Financing
Convertible Debt
Preferred Stock
Common Stock
J. K. Dietrich - FBE 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
Minority Shareholders
 For
offers that are subsequently withdrawn,
prices fall by 9%
 Clearly, even minority shareholders benefit
from LBOs
 The division of the gains is still an open
question
J. K. Dietrich - FBE 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
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 432 – Fall, 2002
Next Week – September 30 and
October 2, 2002
 Review
RWJ, Chapter 21 and 23, sections 1
to 3
 Read Term Sheet Negotiations for
Trendsetter Inc. case and begin to think
about the issues
 Review course materials and cases for
weeks 1 to 5
J. K. Dietrich - FBE 432 – Fall, 2002