7. Leverage buy Out

1. 7. Leverage buy Out

2. Introduction A leveraged buyout (LBO) is an acquisition of a company or a segment of a company funded mostly with debt. A financial buyer (e.g. private equity fund) invests a small amount of equity (relative to the total purchase price) and uses leverage (debt or other non-equity sources of financing) to fund the remainder of the consideration paid to the seller. The practice was Pioneered by houses such as Kohlberg, Kravis & Roberts (KKR) in the 1970s and over the last two to three decades LBOs have assumed an ever-greater importance.

3. Rationale A highly leveraged entity has a number of advantages for an equity investor, including the following: • Interest on debt is tax deductible and the cost of debt is generally lower that the cost of equity. As a result, increasing a company’s gearing should reduce its cost of capital. In other words, given the effect of taxes, debt is cheaper than equity • In a highly leveraged company, a relatively small increase in the company’s enterprise value can lead to a substantial increase in the value of its equity. In a bull market, the attractiveness of an LBO will therefore increase. Of course, the gearing effect also means that high gearing increases an equity investor’s risk, since a relatively small decline in enterprise value could severely impact the value of the equity investment. Moreover, high interest charges increase the risk of default by the company

4. High gearing tends to be a discipline on management, since a company’s cash flow is usually quite tight due to the necessary pay-down of interest and debt . Management is therefore likely to focus on driving down costs and controlling capital expenditure • Many LBOs are structured so that managers have substantial incentives to increase the value of the business. In these acquisitions, management will subscribe for a small proportion of the equity. A ‘ratchet’ will often be put into place which will give management an increased share of the company’s equity in circumstances where the returns accruing to shareholders are greater than a pre-determined level. Whilst the ratchet allows management to benefit disproportionately compared with other equity investors, other investors usually recognise the additional value for them

5. LBO Scheme

6. Why do private equity firms use leverage when buying a company? By using significant amounts of leverage (debt) to help finance the purchase price, the private equity firm reduces the amount of money (the equity) that it must contribute to the deal.  Reducing the amount of equity contributed will result in a substantial increase to the private equity firm’s rate of return upon exiting the investment (e.g. selling the company five years later).

7. Impact of Leverage on Financial Returns 1Tax shelter in 50% and 20% debt scenarios is $2 million (I.e., $5 x .4) and $3.2 million (i.e., $8 x .4), respectively.

8. LBO Deal Structure • Advantages include the following: • Management incentives, • Better alignment between owner and manager objectives, • 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 raises firm’s break-even point, • 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.

9. LBO Financing • Secured Debt • Secured debt is also called asset-based lending, and it can be either senior or intermediate term debt. • Senior Debt • Comprises loan secured by liens on particular assets of the company. • The collateral includes physical assets such as land, plant and equipment, accounts receivable, and inventories. • Lenders will usually advance 85% of the value of the accounts receivable and 50% of the value of the target inventories. • The process of determining the collateral value of the LBO candidate's assets is sometimes called qualifying the assets.

10. Buyout Benefits • Tax savings • Stepped up asset base. • Approximately half of the companies involved in LBOs stepped up their asset base in 1980's (Kaplan, Journal of Financial Economics, 1989) • Tax shields from interest payments. • One should realize, however, that these benefits should be relatively low when all of the costs and benefits are factored in. Most likely the LBO companies do not have the optimal capital structure in the first few years after the LBO - why would they otherwise not keep those high debt levels?

11. Buyout Benefits Continued • Expropriation of “old” bondholders • LBOs increase riskiness of old debt without increasing their promised interest payments. • A bond with covenants to protect against this are said to have “event risk protection.” • Bonds with event risk protection were common in the early 1990’s. • Response to several large investment grade bond issues that were reduced to high yield status overnight via leveraged buyouts. • Few bonds now carry event risk protection.

12. Buyout Benefits Continued • Expropriation of employees • Anecdotal evidence: easier layoffs and reduction in over-funded pension plans.

13. Buyout Benefits Continued • Exploiting undervaluation. • Management has more information about future cash-flows than outside owners. Although selling shareholders are receiving high premiums, managers are possibly paying a too low price. • Evidence: • Median annualized rate of return on equity to post-buyout shareholders in a firm that goes public again was 286% in 1980-1987. • This gain was positively related to managerial ownership. • However, there also exists evidence that stock prices fall back to their pre-buyout levels in failed MBOs.

14. Buyout Benefits Continued • Reducing costs of being a public company. • These costs include administrative costs inside the company as well as regulatory costs to the stock exchange.

15. Buyout Costs • Cost of financial distress. • Managers become undiversified and may be less willing to take risks. • Inappropriate investment policy (underinvestment) because of high leverage.

16. Buyout Costs • Cost of financial distress. • Managers become undiversified and may be less willing to take risks. • Inappropriate investment policy (underinvestment) because of high leverage.

17. Good LBO Candidates • High potential benefits: • Potentially high agency costs: • Small managerial ownership currently • Large excess cash • High marginal tax rate and stable earnings. • Makes debt financing attractive. • Low current leverage. • No need for new equity financing.

18. Applications of the LBO Analysis • Determine the maximum purchase price for a business that can be paid based on certain leverage (debt) levels and equity return parameters. • Develop a view of the leverage and equity characteristics of a leveraged transaction at a given price. • Calculate the minimum valuation for a company since, in the absence of strategic buyers, an LBO firm should be a willing buyer at a price that delivers an expected equity return that meets the firm's hurdle rate.

19. Steps in the LBO Analysis • Develop operating assumptions and projections for the standalone company to arrive at EBITDA and cash flow available for debt repayment over the investment horizon (typically 3 to 7 years). • Determine key leverage levels and capital structure (senior and subordinated debt, mezzanine financing, etc.) that result in realistic financial coverage and credit statistics. • Estimate the multiple at which the sponsor is expected to exit the investment (should generally be similar to the entry multiple). • Calculate equity returns (IRRs) to the financial sponsor and sensitize the results to a range of leverage and exit multiples, as well as investment horizons. • Solve for the price that can be paid to meet the above parameters (alternatively, if the price is fixed, solve for achievable returns).

20. Returns In LBO transactions, financial buyers seek to generate high returns on the equity investments and use financial leverage (debt) to increase these potential returns. Financial buyers evaluate investment opportunities with by analyzing expected internal rates of return (IRRs), which measure returns on invested equity. IRRs represent the discount rate at which the net present value of cash flows equals zero. Historically, financial sponsors' hurdle rates (minimum required IRRs) have been in excess of 30%, but may be as low as 15-20% for particular deals under adverse economic conditions. Hurdle rates for larger deals tend to be a bit lower than hurdle rates for smaller deals.

21. Returns • The returns in an LBO are driven by three factors, which we demonstrate in our topic on creating value in LBOs: • De-levering (paying down debt) • Operational improvement (e.g. margin expansion, revenue growth) • Multiple expansion (buying low and selling high)

22. Risk • Equity holders – In addition to the operating risk assumed risk arises due to significant financial leverage. Interest costs resulting from substantial amounts of debt are "fixed costs" that can force a company into default if not paid. Furthermore, small changes in the enterprise value (EV) of a company can have a magnified effect on the equity value when the company is highly levered and the value of the debt remains constant. • Debt holders– The debt holders bear the risk of default equated with higher leverage as well, but since they have the most senior claims on the assets of the company, they are likely to realize a partial, if not full, return on their investments, even in bankruptcy.

23. Exit Strategies Ideally, an exit strategy enables financial buyers to realize gains on their investments. Exit strategies most commonly include an outright sale of the company to a strategic buyer or another financial sponsor, an IPO, or a recapitalization. A financial buyer typically expects to realize a return on its LBO investment within 3 to 7 years via one of these strategies.

24. LBOs Create Value by Reducing Debt and Increasing Margins Thereby Increasing Potential Exit Multiples Firm Value Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Debt Reduction & Reinvestment Increases Free Cash Flow and in turn Builds Firm Value Debt Reduction Reinvest in Firm Debt Reduction Adds to Free Cash Flow by Reducing Interest & Principal Repayments Reinvestment Adds to Free Cash Flow by Improving Operating Margins Free Cash Flow Tax Shield Adds to Free Cash Flow Tax Shield Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

25. Issues to Consider in an LBO Transaction • Industry characteristics: • Type of industry • Competitive landscape • Major industry drivers • Potential outside factors (politics, changing laws and regulations, etc.)

26. Company-specific characteristics: • Strategic positioning within the industry (market share) • Growth opportunity • Operating leverage • Sustainability of operating margins • Potential for margin improvement • Level of maintenance CapEx vs. growth CapEx • Working capital requirements • Minimum cash required to run the business • Ability of management to operate effectively in a highly levered situation

27. Market conditions: • Accessibility and cost of bank and high yield debt • Expected equity returns

28. Pros and cons of leveraged buyouts Corporate restructuring Cons- Corporate restructuring from leveraged buyouts can greatly impact employees. At times, this means companies may have to downsize their operations and reduce the number of paid staff, which results in unemployment for those who will be laid off. In addition, unemployment after leveraged acquisition of a company can result in negative effects of the overall community, hindering its economic prosperity and development. Some leveraged buyouts may not be friendly and can lead to rather hostile takeovers, which goes against the wishes of the acquired firms’ managers. Pros-One positive aspect of leveraged buyouts is the fact that poorly managed firms prior to their acquisition can undergo valuable corporate reformation when they become private. By changing their corporate structure (including modifying and replacing executive and management staff, unnecessary company sectors, and excessive expenditures), a company can revitalize itself and earn substantial returns.

29. An example hostile takeover occurred when the PepsiCo acquired the Quaker Oats Company, an American food company well-known for its breakfast cereals and oatmeal products. In 2001, PepsiCo, in an attempt to diversify its portfolio in non-carbonated drinks, primarily acquired Quaker Oats because QO owned the Gatorade brand. Even though this merger created the fourth-largest consumer goods company in the world, many of Quaker Oats’ managers were against the acquisition, claiming that such a merger was unlawful and contrary to the public interest.

30. Characteristics of a Good LBO Candidate The following characteristics define the ideal candidate for a leveraged buyout. While is it very unlikely that any one company will meet all these criteria, some combination thereof is need to successfully execute an LBO. • Strong, predictable operating cash flows with which the leveraged company can service and pay down acquisition debt • Mature, steady (non-cyclical), and perhaps even boring • Well-established business and products and leading industry position • Moderate CapEx and product development (R&D) requirements so that cash flows are not diverted from the principle goal of debt repayment • Limited working capital requirements • Strong tangible asset coverage • Undervalued or out-of-favor • Seller is motivated to cash out of his/her investment or divest non-core subsidiaries, perhaps under pressure to maximize shareholder value • Strong management team • Viable exit strategy

31. Management Buyouts (MBOs) Management buyouts are similar to LBO, except that the management team of the target company acquires the company rather than a financial sponsor. For example, the sole owner of a private company might be nearing his twilight years and wishes to exit the business he started years ago. The management team might believe strongly in the prospects of the company and agree to buy out the owner's equity interest and assume control of the company.

32. Management buyout Pros- As mentioned earlier, management buyout of a company is a common business practice. Often times, MBOs occur as a last resort to save an enterprise from permanent closure or replacement of existing management teams by an outside company. Many analysts strongly believe management buyouts greatly promote executive and shareholder interests as well as management loyalty and efficiency. Cons- Not every MBO turns out to be successful as planned. Management buyouts can generate substantial conflicts of interest among employees and managers alike. Management and executive teams can easily be lured to propose a short-term buyout for personal profit. In addition, they can also corruptly mismanage a company, leading to an enterprise’s depreciated stock.

33. An example of a successful management buyout is Springfield Remanufacturing Corporation, or SRC, an engine remanufacturing plant located in Springfield, Missouri. In 1983, SRC was at risk for permanent closure and was being bought by an outside company until their employees decided to buyout the company. The management buyout of SRC resulted in extreme success. Since 1983, it has grown exponentially from one company within $10,000 of being shut down to a proud assembly of 23 small businesses with a combined profit of over $120 million today.

34. Economy Cons- On the other hand, a weak economy is highly indicative of a problematic LBO. During an economic crisis, money may be difficult to come by and dollar weakness could make acquiring companies result in poor financial returns. In addition, acquisition can affect employee morale, increase animosity against the acquiring corporation, and can hinder the overall growth of a company. Pros- Every leveraged buyout can be considered risky, especially in reference to the existing economy. If the existing economy is strong and remains solid, then the leveraged buyout can greatly improve its chances for success.

35. Conclusion There are many advantages and disadvantages concerning leveraged buyouts. First, this type of agreement can allow many large companies to acquire smaller-sized enterprises with very little personal capital. Second, since corporate restructuring can take place, the acquired company can benefit from necessary reorganization and reform. In addition, management buyout can prevent a company from being acquired by external sources or from being shut down completely. However, there are many disadvantages imposed by LBOs as well. Often times, the restructuring can lead a company to downsize and can even result in hostile takeovers. The high interest rates from the high debt-to-equity amounts can result in a corporation’s bankruptcy, especially if the company is not generating substantial returns after acquisition. Lastly, management buyouts can produce conflicts of interest among employees, executives, and management teams as well as possible mismanagement by the buyout owners. With the potential for enormous profit, it is no wonder that leveraged buyout strategies expanded throughout the 1980s and have recently made a comeback in modern corporate America.