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Leveraged Buyout Structures and Valuation. Financial Buyers. 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 and a “sponsor.” Financial buyers:
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Financial Buyers 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 and a “sponsor.” Financial buyers: • Focus on ROE (Equity) rather than ROA (assets). • Use other people’s money. • Succeed through improved operational performance. • Focus on targets having stable cash flow to meet debt service requirements. • Typical targets are in mature industries (e.g., retailing, textiles, food processing, apparel, and soft drinks) • See LBO Articles – Alchemy of LBOs & Success of LBOs - Website
LBO Deal Structure • Advantages include the following: • Management incentives, less costly than being public company. • Tax savings from interest expense and depreciation from asset write-up, • More efficient decision processes under private ownership, • A potential improvement in operating performance, and • Serving as a takeover defense by eliminating public investors • Disadvantages include the following: • High fixed costs of debt, • Vulnerability to business cycle fluctuations and competitor actions, • Not appropriate for firms with high growth prospects or high business risk, and • Potential difficulties in raising capital.
LBOs in the New Millennium • Explosion in frequency and average size of LBOs in the U.S. during 2005-2007 period ($5-$10 billion range) • 2005-7 Globally numbers doubled, volume quadrupled¹ • Tendency for buyout firms to bid for targets as a group • Increased effort to “cash out” earlier than in past to boost returns due to increased competition for investors • LBO “boom” fueled by • Global savings glut resulting in cheap financing • Excess capacity in many industries encouraging consolidation • Attempt to avoid onerous reporting requirements of Sarbanes-Oxley • LBOs increasingly common in European Union due to liberalization and “catch-up” to U.S. ¹ Current Credit Instruments and Climate Make LBO Market Hard to Evaluate, Journal of Applied Finance- Vol. 19, No.4, pgs 44-53
New Millennium + 7-11Years • 2007- 2008¹ • Summer 2007 banks reduced/stopped lending • LBO frenzy prior two years, banks kept liquid selling debt hedge funds looking at high yields • Banks stuck $330+B debt, limits loan ability. • Subprime loans, limiting commercial paper. • Investment banks restricted vs commercial –Goldman, M.S., Lehman, Bear. $75B of $330. • BOA, Citi, DB,JPM, UBS –big balance sheets ¹ LBO Deals on Hold Until 2008 as Crunch Worsens, Reuters, August 23, 2007.
New Millennium + 7-11Years • Commercial bank – Accounting rules favor -“available for sale” or “held to maturity”. • “Available” – require mark to market. • “No deals for 6-9 months”¹ • “LBOs been around 30 years, not going to evaporate in 30 days”² • Research supports Ryan.³ It is cyclical. • 1988-1991- LBOs dropped 90%, prices rose, debt 90% of capital, credit quality often very low. • 2003-2006 – LBO market returned; debt ratios close to 80% ¹ Anonymous M&A Banker at major bank ² Michael Ryan, Cleary Gottlieb, M&A Lawyer 3 Current Credit Instruments and Climate Make LBO Market Hard to Evaluate, Journal of Applied Finance- Vol. 19, No.4, pgs. 44-53
New Millennium + 7-11Years • 2008-2009 • Volume declined 40% from 2007. • Public company LBOs by private equity firm dropped from 30% of the volume to 5% as lenders had difficulty moving LBO loans from their balance sheet to secondary buyers. • Debt to EBITDA ratios down 4:1, equity ↑50% • Strategic (≈ 93%, smaller ($250M) & cross border deals more resilient.
New Millennium + 7-11Years • 2010 -2011 • Late 2010 – “Don’t Call It a Comeback”¹ but $16B for 76 buyouts in 2009 versus $75B for 193 deals through early December 2010. • Some big deals Burger King, Interactive Data, TransUnion, J.Crew and Del Monte. • Basics remain – leveraged loans/junk bonds. • Debt increasing at record pace. • Most to cover current investments not new ones. ¹ DealB%k, LBOs: Don’t Call It A Comeback, New York Times, December 7, 2010
New Millennium + 7-11Years • Refinance costs $100B higher than expected. • Average LBO loan now 6 years, 1 year longer than last year. • Private equity firms not signing fresh deals. • 2010-2011 volume 89% lower than 2007 records. • Exits by PE firm 44% lower than $300B in 2007 • Conclusion: It is not a comeback!!! • BOA (9/2011) did not finance $2B Morgan Keegan deal. Concerned with MK liabilities.¹ • BOA has beat all its rival in LBO fees 2010 & 2011. • Volatile stock prices, decline in optimism by CEOs. ¹Banks Shun Financing of Riskier Buyouts, Chon & Ng Wall Street Journal – Deal Journal, September 21, 2011
New Millennium + 7-11Years • Other banks on the sidelines: Barclays, Citigroup, Credit Suisse, Goldman, JP Morgan, and Morgan Stanley for less than stellar credit. • Banks cannot sell the debt. • Junk rates now 9% over prime versus 7% July. • August 2011: • $2.2B GoDaddy; • $2.8 BJ’s; • $1.6 Blackboard
Future LBOs ¹ • Greater percentage of purchase price consideration paid in cash/stock of Buyer rather than from proceeds of debt financing. • More Seller take-back financing, retained equity or purchase price earn- outs to satisfy declining lender leverage ratios and to bridge Seller valuation/purchase price expectations. • Post closing purchase price adjustments to reflect adverse changes in pre- closing net working capital or post closing EBITDA results secured by post closing escrows. • Extended due diligence periods to enable Buyers and lenders to “drill down” for unforeseen effects of the current economic slowdown. • Return of traditional “financing out” condition to Buyers based on credit market turmoil with fewer “reverse breakup fees” for middle market transactions. ¹ From Compilation of Sources including: M&A Trends in Today’s Turbulent Credit and Economic Market, Corporate and Finance Alert, Gibbons, December 2008.
Future LBOs • Specific quantitative material adverse change benchmarks to enable Buyer to “walk” from transaction without liability in the event financial and business conditions of Seller deteriorate after signing M&A agreement. • As the result of recently litigated deals, clarity in drafting M&A agreements to provide certainty on the remedies of the parties if the deal is terminated, eg., no specific performance rights for failure to close for any reason. Litigation may increase for busted deals or closed deals that do not perform to Buyer expectations. • Tighter Seller representations and warranties subject to qualifications based on quantitative criteria rather than subjective “materiality” exceptions and longer survival periods for Seller indemnifications, reduced “baskets”, “caps” and “collars” on indemnity claims and escrows or other security devices to secure Sellers’ indemnification obligations.
Future LBOs • Acquisition debt financing based on reduced leverage ratios, rigorous underwriting requirements and strict financial loan covenants. Lender imposed re-pricing of loans or other economic considerations in exchange for covenant waivers and a flight to quality by lenders in terms of collateral with less cash flow and more asset based lending. Sub-debt lenders may seek to fill the void left by senior lenders by requesting partial security with traditional higher sub-debt pricing. • Decreased opportunities for Bankruptcy acquisitions pursuant to a reorganization plan due to scarcity of debtor-in-possession financing which will result in more piecemeal liquidations rather than sales as going concern.
Future LBOs • More opportunistic minority equity investments in distressed companies to cure loan covenant defaults (Warren Buffet $6.5B) (eg., net working capital, fixed charge coverage ratios and other financial covenants) without triggering a change of control event of default in lieu of an acquisition of a target with replacement credit facility due to the uncertainty of credit markets, risks of likely re-pricing and more stringent credit terms. Also, increased opportunities for secured party UCC sales of troubled company assets by secured lenders as alternative to time consuming and costly stalking horse bankruptcy sales.
Role of Junk Bonds in Financing LBOs • Junk bonds are non-rated debt (very high risk hence higher rate) • Contrary to typical concept of bond (i.e. safe investment w/nominal rate) ¹ • Bond quality varies widely • Rates > 3-5 percentage points above the prime rate. 7.98 ↑ UST • Bridge or interim financing was obtained in LBO transactions to close the transaction quickly because of the extended period of time required to issue “junk” bonds. • These high yielding bonds represented permanent financing for the LBO • Junk bond financing for LBOs dried up due to the following: • A series of defaults of over-leveraged firms in the late 1980s • Insider trading and fraud at such companies a Drexel Burnham, the primary market maker for junk bonds • Junk bond financing is highly cyclical, tapering off as the economy goes into recession and fears of increasing default rates escalate • French, 2012: The Year of the Junk Bond, Christian Science Monitor, April 3, 2012. Most since 1980. $75 Billion by 130 companies.
Things to Remember… • LBOs make the most sense for firms having stable cash flows, significant amounts of unencumbered tangible assets, and strong management teams. • Successful LBOs rely heavily on management incentives to improve operating performance and a streamlined decision-making process resulting from taking the firm private. • Tax savings from interest expense and depreciation from writing up assets enable LBO investors to offer targets substantial premiums over current market value. Shelf life • Excessive leverage and the resultant higher level of fixed expenses makes LBOs vulnerable to business cycle fluctuations and aggressive competitor actions. Fixed outflows & less mobile • For an LBO to make sense, the PV of cash flows to equity holders must equal or exceed the value of the initial equity investment in the transaction, including transaction-related costs.