Leveraged Buyout Structures Structures and and Va Valuation
M & A a n d ) t h e r * e s tr u c t u ri n g A c t i v i ti e s
M & A E n v ir o n m e n t
M & A ! roce ss
Deal S t ru c t u r i n g
A lte r n a t iv e * e s t r u c t u r in g S tr a t e g i e s
M o ti v a ti o n s fo r M & A
B u s in e s s & A c u i s it io n ! l a n s
! u % l ic & ! r iv a t e C o m a n y V a lu a t io n
D iv e s t i t u r e s ' S i n ( ) ff s ' & C a rv e ( ) u ts
C o m m o n T a k e o v e r T a c ti c s a n d D e fe n s e s
S e a r c h T h ro u g h C l o s i n g A c t i v it i e s
$ i n a n c ia l M o d e lin g T e c h n i u e s
B an k ru t c y & L i u id a t io n
A l t e r n a t iv e Structures
T a " & A c c o u n tin g #s s u e s
Learning )%+ectives ,
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!rimary Learning )%+ective- To &rovide students .ith a kno.ledge of ho. to analy/e' structure' and value highly leveraged transactions0 Secondary Learning )%+ectives- To &rovide students .ith a kno.ledge of 1 The motivations of and methodologies em&loyed %y financial %uyers2 1 Advantages and disadvantages of LB)s as a deal structure2 1 Alternative LB) models2 1 The role of +unk %onds in financing LB)s2 1 !re(LB) returns to target com&any shareholders2 1 !ost(%uyout returns to LB) shareholders' and 1 Alternative LB) valuation methods 1 Basic decision rules for determining the attractiveness of LB) candidates
$inancial Buyers #n a leveraged %uyout' all of the stock' or assets' of a &u%lic cor&oration are %ought %y a small grou& of investors 34financial %uyers56' usually including mem%ers of e"isting management0 $inancial %uyers, $ocus on *)E rather than *)A0 , 7se other &eo&le8s money0 , Succeed through im&roved o&erational &erformance0 , $ocus on targets having sta%le cash flo. to meet de%t service reuirements0 1 Ty&ical targets are in mature industries 3e0g0' retailing' te"tiles' food &rocessing' a&&arel' and soft drinks6
LB) Deal Structure , Advantages include the follo.ing 1 Management incentives' 1 Ta" savings from interest e"&ense and de&reciation from asset .rite(u&' 1 More efficient decision &rocesses under &rivate o.nershi&' 1 A &otential im&rovement in o&erating &erformance' and 1 Serving as a takeover defense %y eliminating &u%lic investors ,
Disadvantages include the follo.ing 1 9igh fi"ed costs of de%t' 1 Vulnera%ility to %usiness cycle fluctuations and com&etitor actions' 1 :ot a&&ro&riate for firms .ith high gro.th &ros&ects or high %usiness risk' and 1 !otential difficulties in raising ca&ital0
Classic LB) ModelsLate ;<=>s and Early ;s , De%t normally @ to times euity0 De%t amorti/ed over no more than ;> years0 , E"isting cor&orate management encouraged to &artici&ate0 , Com&le" ca&ital structure- As &ercent of total funds raised 1 Senior de%t 3>6 1 Su%ordinated de%t 36 1 !referred stock 3<6 1 Common euity 36 , $irm freuently taken &u%lic .ithin seven years as ta" %enefits diminish
Break(7& LB) Model 3Late ;s6 , Same as classic LB) %ut de%t serviced from o&erating cash flo. and asset sales , Changes in ta" la.s reduced &o&ularity of this a&&roach 1 Asset sales immediately u&on closing of the transaction no longer deemed ta"(free 1 !reviously could %uy stock in a com&any and sell the assets0 Any gain on asset sales .as offset %y a mirrored reduction in the value of the stock0
Strategic LB) Model 3;<<>s6 , E"it strategy is via #!) , DE ratios lo.er so as not to de&ress E!S , $inancial %uyers &rovide the e"&ertise to gro. earnings 1 !reviously' their e"&ertise focused on ca&ital structure , Deals structured so that de%t re&ayment not reuired until ;> years after the transaction to reduce &ressure on immediate &erformance im&rovement , Buyout firms often &urchase a firm as a &latform for leveraged %uyouts of other firms in the same industry
*ole of Funk Bonds in $inancing LB)s ,
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Funk %onds are non(rated de%t0 1 Bond uality varies .idely 1 #nterest rates usually G( &ercentage &oints a%ove the &rime rate Bridge or interim financing .as o%tained in LB) transactions to close the transaction uickly %ecause of the e"tended &eriod of time reuired to issue 4+unk5 %onds0 1 These high yielding %onds re&resented &ermanent financing for the LB) Funk %ond financing for LB)s dried u& due to the follo.ing 1 A series of defaults of over(leveraged firms in the late ;s 1 #nsider trading and fraud at such com&anies a Dre"el Burnham' the &rimary market maker for +unk %onds Funk %ond financing is highly cyclical' ta&ering off as the economy goes into recession and fears of increasing default rates escalate
$actors Affecting !re(Buyout *eturns , !remium &aid to target firm shareholders consistently e"ceeds @> , These returns reflect the follo.ing 3in descending order of im&ortance6 1 Antici&ated im&rovement in efficiency and ta" %enefits 1 Health transfer effects 1 Su&erior Ino.ledge 1 More efficient decision(making
$actors Determining !ost(Buyout *eturns , Em&irical studies sho. investors earn a%normal &ost( %uyout returns , $ull effect of increased o&erating efficiency not reflected in the &re(LB) &remium0 , Studies may %e su%+ect to 4selection %ias'5 i0e0' only LB)s that are successful are a%le to undertake secondary &u%lic offerings0 , A%normal returns may also reflect the acuisition of many LB)s G years after taken &u%lic0
Valuing LB)s , A LB) can %e evaluated from the &ers&ective of common euity investors or of all investors and lenders , LB)s make sense from vie.&oint of investors and lenders if &resent value of free cash flo.s to the firm is greater than or eual to the total investment consisting of de%t and common and &referred euity , 9o.ever' a LB) can make sense to common euity investors %ut not to other investors and lenders0 The market value of de%t and &referred stock held %efore the transaction may decline due to a &erceived reduction in the firm8s a%ility to 1 *e&ay such de%t as the firm assumes su%stantial amounts of ne. de%t and to 1 !ay interest and dividends on a timely %asis0
Valuing LB)s- Varia%le *isk Method Ad+usts for the varying level of risk as the firm8s total de%t is re&aid0 , Ste& ;- !ro+ect annual cash flo.s until target DE achieved , Ste& - !ro+ect de%t(to(euity ratios , Ste& G- Calculate terminal value , Ste& @- Ad+ust discount rate to reflect changing risk , Ste& - Determine if deal makes sense
Varia%le *isk Method- Ste& ; , !ro+ect annual cash flo.s until target DE ratio achieved , Target DE is the level of de%t relative to euity at .hich 1 The firm .ill have to resume &ayment of ta"es and 1 The amount of leverage is likely to %e acce&ta%le to #!) investors or strategic %uyers 3often the &revailing industry average6
Varia%le *isk Method- Ste& , !ro+ect annual de%t(to(euity ratios , The decline in DE reflects 1 the kno.n de%t re&ayment schedule and 1 The &ro+ected gro.th in the market value of the shareholders8 euity 3assumed to gro. at the same rate as net income6
Varia%le *isk Method- Ste& G , Calculate terminal value of &ro+ected cash flo. to euity investors 3TVE6 at time t' i0e0' the year in .hich the initial investors choose to e"it the %usiness0 , TVE re&resents the !V of the dollar &roceeds availa%le to the firm through an #!) or sale to a strategic %uyer at time t0
Varia%le *isk Method- Ste& @ , Ad+ust the discount rate to reflect changing risk0 , The firm8s cost of euity .ill decline over time as de%t is re&aid and euity gro.s' there%y reducing the leveraged J0 Estimate the firm8s J as follo.sJ$L; K J#7L;3; 3DE6$;3;(t$66 .here J$L; J#7L;
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K $irm8s levered %eta in &eriod ; K #ndustry8s unlevered %eta in &eriod ; K J#L;3;3DE6#;3;( t#66 J#L; K #ndustry8s levered %eta in &eriod ; 3DE6#; K #ndustry8s de%t(to(euity ratio in &eriod ; t# K #ndustry8s marginal ta" rate in &eriod ; 3DE6$; K $irm8s de%t(to(euity ratio in &eriod ; t$ K $irm8s marginal ta" rate in &eriod ;
*ecalculate each successive &eriod8s J .ith the DE ratio for that &eriod' and using that &eriod8s J' recalculate the firm8s cost of euity for that &eriod0
Varia%le *isk Method- Ste& , Determine if deal makes sense 1 Does the !V of free cash flo.s to euity investors 3including the terminal value6 eual or e"ceed the euity investment including transaction(related fees
Evaluating the Varia%le *isk Method , Advantages 1 Ad+usts the discount rate to reflect diminishing risk as the de%t(to(total ca&ital ratio declines 1 Takes into account that the deal may make sense for common euity investors %ut not for lenders or &referred shareholders , Disadvantage- Calculations more %urdensome than Ad+usted !resent Value Method
Valuing LB)s- Ad+usted !resent Value Method 3A!V6 Se&arates value of the firm into 3a6 its value as if it .ere de%t free and 3%6 the value of ta" savings due to interest e"&ense0 , Ste& ;- !ro+ect annual free cash flo.s to euity investors and interest ta" savings , Ste& - Value target .ithout the effects of de%t financing and discount &ro+ected free cash flo.s at the firm8s estimated unlevered cost of euity0 , Ste& G- Estimate the &resent value of the firm8s ta" savings discounted at the firm8s estimated unlevered cost of euity0 , Ste& @- Add the &resent value of the firm .ithout de%t and the &resent value of ta" savings to calculate the &resent value of the firm including ta" %enefits0 , Ste& - Determine if the deal makes sense0
A!V Method- Ste& ; , !ro+ect annual free cash flo.s to euity investors and interest ta" savings for the &eriod during .hich the firm8s ca&ital structure is changing0 1 #nterest ta" savings K #:T " t' .here #:T and t are the firm8s annual interest e"&ense on ne. de%t and the marginal ta" rate' res&ectively 1 During the terminal &eriod' the cash flo.s are e"&ected to gro. at a constant rate and the ca&ital structure is e"&ected to remain unchanged
A!V Method- Ste& , Value target .ithout the effects of de%t financing and discount &ro+ected cash flo.s at the firm8s unlevered cost of euity0 1 A&&ly the unlevered cost of euity for the &eriod during .hich the ca&ital structure is changing0 1 A&&ly the .eighted average cost of ca&ital for the terminal &eriod using the &ro&ortions of de%t and euity that make u& the firm8s ca&ital structure in the final year of the &eriod during .hich the structure is changing0
A!V Method- Ste& G , Estimate the &resent value of the firm8s annual interest ta" savings0 1 Discount the ta" savings at the firm8s unlevered cost of euity 1 Calculate !V for annual forecast &eriod only' e"cluding a terminal value' since the firm is sold and any su%seuent ta" savings accrue to the ne. o.ners0
A!V Method- Ste& @ , Calculate the &resent value of the firm including ta" %enefits 1 Add the &resent value of the firm .ithout de%t and the !V of ta" savings
A!V Method- Ste& , Determine if deal makes sense 1 Does the !V of free cash flo.s to euity investors &lus ta" %enefits eual or e"ceed the initial euity investment including transaction(related fees
Evaluating the Ad+usted !resent Value Method , Advantage- Sim&licity0 , Disadvantages 1 #gnores the effect of changes in leverage on the discount rate as de%t is re&aid' 1 #m&licitly ignores the &otential for %ankru&tcy of e"cessively leveraged firms' and 1 7nclear .hether true discount rate should %e the cost of de%t' unlevered cost of euity' or some.here %et.een the t.o0
Things to *emem%erN ,
LB)s make the most sense for firms having sta%le cash flo.s' significant amounts of unencum%ered tangi%le assets' and strong management teams0
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Successful LB)s rely heavily on management incentives to im&rove o&erating &erformance and a streamlined decision(making &rocess resulting from taking the firm &rivate0
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Ta" savings from interest e"&ense and de&reciation from .riting u& assets ena%le LB) investors to offer targets su%stantial &remiums over current market value0
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E"cessive leverage and the resultant higher level of fi"ed e"&enses makes LB)s vulnera%le to %usiness cycle fluctuations and aggressive com&etitor actions0
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$or an LB) to make sense' the !V of cash flo.s to euity holders must eual or e"ceed the value of the initial euity investment in the transaction' including transaction(related costs0
