Highly Leveraged Transactions: Going Private and LBOs

1. Highly Leveraged Transactions: Going Private and LBOs Chapter 13 Part 1

2. A Roadmap for Today • Core deal: Buying out public SHs at premium using borrowed $; mgt w/ bigger share of remaining equity • Finance: Where does the new value come from? • Improving bottom Line. How? • Improving Management Incentives How? • Improving Monitoring • Taking from Other Stakeholders? • What comes next? • Controlling Distress Costs– the big downside • Exit • Law • Form of the transaction • Additional protection for SH? For others?

3. Wealth Effects - Evidence • Public stockholders: 56% Buyout premium • Convertible debt & preferred stock: Similar gains • Straight debt: • Bond ratings fall • If LBO protected, then either debt repurchased at face value or interest rate is raised & bonds gain in value • If unprotected, bonds lose 7% of value on average

4. Wealth Effects - Evidence • Management: • Realizes greater gains than common stockholders • Forced to invest substantial portion of wealth in stock – bears large undiversified risk • Buyout funds: Returns have ranged from 20% to 35% • Thomas Lee had 50% + for over 10 years • Employees: Often head count rapidly reduced • US Government: Losses substantial taxes

5. Improving the Bottom Line • From Additional Leverage • Tax Shield Effect- interest paid on taxes generates a tax deduction, reducing taxes paid and increasing cash flow • Cost Savings • Additional accounting & disclosure costs of being public • Managing to analysts & quarterly expectations (e.g. questions such as appropriate leverage)

6. Stronger Management Incentives • Raises mgmt dollar investment in firm shares • Raises mgmt % share ownership substantially • High leverage makes firm’s stock price highly sensitive to changes in firm value (multiplier effect) • Substantial risk of bankruptcy in early years – focuses the mind

7. Facilitating Monitoring Changes • Increasing the Discipline of the Market • Reduction in free cash flow means managers will have to go to the market for capital • Reduces empire building • Increases sensitivity to credit markets • Shareholder monitoring differs • A more concentrated equity ownership gives both greater incentive and eases coordination costs • Director monitoring differs • Permits more specialization • Less “independent;” more accountable to SH

8. Wealth Transfer from Stakeholders • Bondholders • See Metropolitan Life • Is all debt effected? • Employees • Government • See Tax Shield discussion • Suppliers • Comparing Chrysler & GM in 2009

9. Going Forward: Controlling Distress Costs • Rapidly reduce expenses & expand revenues – Why? • Quickly sell what kinds of assets? • Rapidly reduce initial high leverage – Why? • Employ private debt using a few sophisticated lenders – What are benefits? • Limit number of classes of debt – Why? • Give debt holders: convertibles, warrants or some stock – Why? • Use strip financing – What is it? Why use it?

10. Going Forward: Empirical Evidence on LBOs -Improved Operating Efficiency • Board composition substantially changes & its size isreduced, and mgmt is usually retained • LBO firms become almost twice as profitable as industry competitors while privately held • LBO firms outperform competitors in operating income & stock returns for at least 4 years following going public again • LBO firms show improved focus, shed excess assets

11. Going Forward: Empirical Evidence on LBOs -Improved Operating Efficiency • Compared to competitors, LBO firms : • Use only half the working capital • Have largeraverage advertising budget • Overall investment level is lowered • R&D & maintenance expenses are unchanged! • Tax payments are reduced substantially

12. Going Forward: LBO EXITS • Sell-off firm: • Once efficiency gains are realized or after consolidation or roll-up (i.e. use firm as platform to buy up other firms in the industry) • IPO (reverse LBO) • Second LBO (fairly common) • Piecemeal divestitures & liquidation

13. Going Private Methods • Merger Shareholders get cash, partnership interests or subsidiary stock. Merger requires shareholder approval. • Sale of operating assets to privately held company. Requires shareholder approval of target. • Issuer cash tender offer or debt-for-equity exchange offer for public shares, followed by freeze-out merger. Mgmt usually doesn’t tender. • Reverse stock split (10,000 to 1) with cash redemption of fractional shares. • Leverage ESOP All the above are just different ways private entity acquires business of public entity and eliminates public shareholders.

14. Legal Protections • Shareholder Voice • Merger vs. tender offer vs. reverse stock split • Disclosure • State law • Federal law • Appraisal • Fiduciary Duty • Conflict? • Does Revlon apply?

15. Legal Protection for Bondholders • Fiduciary Duty • http://papers.ssrn.com/sol3/papers.cfm?abstract_id=195588 • Contract

16. Metropolitan Life Ins. Co. v, RJR Nabisco, Inc. • RJR was the largest LBO of the 20th century • Book/movie Barbarians at the Gate; defined era for many • Plaintiff Metropolitan Life Insurance Company -- one of the largest and most sophisticated insurance companies • Metropolitan (or companies that it acquired) had loaned RJR money to be paid back over a longish period. • The interest rate reflected the risk profile of RJR as it existed at the time of borrowing. • Twelve or 13 years later, the LBO changed that profile dramatically. • The new debt taken on in the transaction substantially increases the chance of bankruptcy. • The bonds held by Met Life are now worth less • From simple eyeball analysis, looks like that some of the large amount received by the RJR shareholders came from the reduced value of the bondholders.

17. MetLife v. RJR Nabisco • The legal claim is a duty asserted to be owed to the bondholders. • The court says no. • Information revealed n the opinion shows that Met Life knew the risk it was taking—it knew the risk that applied without covenants as opposed to the lesser risk with covenants. • Even worse, Met Life had agreed to exchange certain debt with covenants for new debt without covenant that would risk what the RJR planners could do. • This was done when RJR acquired Nabisco, as opposed to when RJR went private with no new assets, but other evidence showed Met Life understood leveraged and the LBO trend.

18. HCA, Inc., A Case Study • The (then) largest LBO in history • $33 billion transaction announced 7/24/06 • Eclipsed RJR Nabisco as the largest LBO in history • WSJ: “Barbarians at the Bedside: How Wall Street Securities Firms Plan to Profit in HCA Hospitals; Juggling Many Roles in Buyout”

19. A Good Time to Go Private • Creating New Value • Costs of being public • Quarterly earnings focus • Dealing with activists shareholders • The Supply Side • Mega funds of private equity-more firms able to do big deals • Favorable borrowing rates– at historical lows; supply of banks

20. HCA’s Attractiveness to Private Equity • Predictable cash flow generation • Industry leading management team • Attractive capital structure • Diverse portfolio of hospitals provides good margins, cash flow and high value assets

21. HCA: A Snapshot • Founded in 1968 by Dr. Thomas Frist, Sr., Jack Massey & Dr. Thomas Frist, Jr. • Went public in 1969 (eleven hospitals) • Prior LBO and then another IPO • At the time of the deal: • Among the largest healthcare service provider in the country • 179 hospitals and 104 freestanding surgery centers in 21 states, England & Switzerland • Revenues of $24.9 Billion

22. Getting to an LBO: The Prior Strategy • Strategies to increase market value • Capital investment ($8B over last 5 years) • Improving Operations (e.g. patient safety, quality) • Addressing migration to outpatient-$260M/2 years • Divesting non-core assets (10 announced in ‘05) • Strategies to utilize cash flow • Increased dividend (17% avg. increase last 2 yrs.) • Share repurchases ($8 B since ‘01 including Dutch auction completed in Nov. 2005)

23. Reactions to the Prior Strategies • “Didn’t move the needle” • Analysts negative on the hospital sector • “hospital trends are still weak and we are certainly not willing to call a rebound.” • Public markets not rewarding HCA for its strategy & cash flow • Limits on leverage public markets could take • Access to public markets not as critical to HCA • Limited opportunity for stock as acquisition currency • HCA as a net buy not seller on public markets

24. What were the Strategic Alternatives? • Acquire • Another public hospital company • Various not for profits • International • Ancillary businesses • Cash Generation • Spinoff of outpatient • Divesting non-core hospitals • Spin-off of the hospital company • LBO • Is $33B doable?

25. What Would LBO Capital Structure Look like? • Investment Amount % • Term Debt $11,600 • Euro loan 1,250 • ABL Facility 1,750 • High Yield Notes 5,700 • Existing Debt 7,700 • Total Debt $28,000 85% • Sponsor Equity 4,200 • Frist & Management 800 • Total Equity 5,000 15%

26. Where Will the Value Come From? • Leverage • Replaces $21B in public equity with $5B in private equity • Debt/EBITDA from 2.8 to 6.5 • Use of Cash-flow to pay down debt • Selected divestitures • Other monetization • Exit for Sponsors • Dividend • Another IPO

27. The Players • Insiders Bovender (CEO), Frist • Ind. Directors • Company Counsel Cheek of Bass Berry • Company IB ML; (McKinsey) • Sponsors (i.e. equity) KKR, Bain, ML GPE • Banks (i.e. debt) BofA, Citigroup, ML • Special Committee +CS, MS, Shearman

28. Legal Questions • What is the likelihood of litigation? • Why? • How is it different from other acquisitions? • How are the conflicts different?

29. How would you address legal issues? • During the initial meeting with sponsors • No discussion of management participation • No confidential info at first meeting • When do you let management off leash? • Babysitting mgt meeting with each group • Special committee • When? Who? • Revlon duties • Preserving space to do nothing • Preserving opportunity to get a better deal • Go Shop • Termination fees, MACs etc/

30. Timeline of the Deal • April 5: Senior Mgt & ML meet • April 11: Team meets with Small group of PE • May 3: Sponsors say LBO doable; request permission to do due diligence • May 24-25:Bd meets; approves exploration • June 30: Sponsors signal definitive offer; special committee formed • July 11: Sponsors & S. Cmmtte. Discuss valuation • July 14-18: Sponsors & S. Cmmttee Negotiate • July 19-21: Lawyers draft merger agreement • July 23-24: S. Cmmtte, then Full Board approves • July-mid Sept: Go Shop (no offers)

31. Buyer- the Sponsors 7/14 $48.75 compared to mkt high $30s 7/17 $50.50 7/18 (evening) $50.75 “best and final offer” 7/18 (midnight) $51 Seller-the Committee 7/17 Pencils down until significantly higher offer 7/18 –would consider a proposal of $52 7/18 $51 take it or leave it Price Negotiations

32. The Litigation in the HCA Deal • Settled by addressing additional sentences of disclosure • No economic payment • Attorneys fees under $500K • Litigation resolved before deal closed

33. Will LBOs Continue? • Gains are financial not synergy • Private Equity funds still have money • Banks have a lot less money