corporate valuation -- chapter 18 copyright, robert holthausen, 2009 wharton school 1 leveraged...

Corporate Valuation -- Chapter 18Copyright, Robert Holthausen, 2009

Wharton School 1

Leveraged Buyouts

CharacteristicsEvidence on LBOs

An LBO (Private Equity) ModelReverse LBOs


Wharton School 2

Definition of an LBO

• No precise definition -- different forms• Transaction in which a group of private

investors uses debt financing to purchase a corporation or a corporate division. Equity securities of the company are no longer publicly traded, though the debt and preferred stock may be publicly traded. Uses entire borrowing structure

• Often involves a financial sponsor who contributes capital and expertise (KKR, Bass Brothers, Blackstone, etc.) and management team.


Wharton School 3

Distinct Features of an LBO

• Significant increase in financial leverage– Average debt/total capital increases substantially

• Management ownership interest increases– Median ownership of a Fortune 500 U.S. Corporation

is 0.5%, for Value Line 1000 is 5%– After an LBO the ownership is 10% - 35%

• Non-mgmt equity investors join the board– Before an LBO, non-management directors have

almost no ownership. After, non-management directors may represent 40%-60% of equityholders

– Typical board of 5 individuals, 2-3 from the LBO sponsor


Wharton School 4

Historical Characteristics of Potential

LBO Candidates• History of profitability• Predictable cash flows to service financing• Low current debt and high excess cash• Readily separable assets or businesses• Strong management team - risk tolerant• Known products, strong market position• Little danger of technological change (high

tech?)• Low-cost producers with modern capital• Take low risk business, layer on risky financing


Wharton School 5

Typical LBO Structure• Varies tremendously over time with market conditions• Debt Financing

– Total debt sometimes 60-80% of entire deal (4-5 x LTM EBITDA, but depends on industry, cash flow, and time period etc.

– 40% - 60% senior bank debt (repayment in 5-7 years)– 0-15% senior subordinated (repayment in 8-12 years)– 0-20% junior subordinated (repayment in 8-12 years)– 0 - 15% preferred stock– 10% - 50% common equity

• Equity Ownership– 10% - 35% management/employee owned– 40% - 60% investors with board representation– 20% - 25% owned by investors not on board


Wharton School 6

LBO Financing• Financial sponsors have equity funds raised from

institutions like pensions & insurance companies• Some have mezzanine funds as well that can be used

for junior subordinated debt and preferred• Occasionally, sponsors bring in other equity investors

or another sponsor to minimize their exposure• Balance from commercial banks (bridge loans, term

loans, revolvers) & other mezzanine sources• Banks concentrate on collateral of the company, cash

flows, level of equity financing from the sponsor, coverage ratios, ability to repay (5-7 yr)


Wharton School 7

LBO Financing – Senior Bank Debt• Senior bank debt which is secured with assets like receivables, inventory,

PP&E is often priced at T-Bills, LIBOR or prime + 400 to 700 basis points (two years ago spreads were much lower).

• Often in tranches where first tranche is repaid quickly and other tranches are not due until maturity (7-8 year maturity with average life of 4-5 years)

• 2.5 – 3.5 x LTM EBITDA (varies by industry and rating and with credit market conditions)

• Lend up to X % (40%-65%) of receivables less than Y (90) days, over certain $ amount, at T-Bill, LIBOR or Prime, plus a risk premium

• Inventory usually 20% to 60%• Securities 10% to 90% (US Govt Bonds @ 90%)• PP&E (Cars (60%), Computers (25%), Building (60% to 70%, unique

factories (10% to 30%)• Bankers historically like to see 25% to 35% equity for protection (now

much more)


Wharton School 8

LBO Financing – Unsecured Debt• Unsecured debt (senior and junior)• Potentially many different pieces (cash pays are senior

and senior subordinated while junior subordinated may be zero coupon issued by holding company)

• Longer maturity than bank debt• Covenants not to pay dividends, increase debt or sell

assets• Supported by cash flows and operations of the business.• High-yield a favorite (senior subordinated), but hard to sell

high yield for less than $150 million and high-yield market not always viable.

• High-yield is typically non-callable for about five years and then have call penalties for 3-5 years.


Wharton School 9

Junior Subordinated and Preferred

• Below the high-yield bonds (or below the bank debt if the deal isn’t big enough to support high-yield bonds) but above the common would be junior subordinated and preferred stock.

• Junior subordinated may be PIK (zeros) for some time period. May be issued by a holding company of the operating company and may be issued with warrants. Holding company notes almost always PIK because there is no cash flow into the holding company for some time.– In transactions of this type, the PIK interest may not be

deductible until it is paid in cash or the bond matures and is paid off (so called AHYDO rules)

• Preferred can be PIK as well, so dividends accrue but are not paid and at sale of the company the preferred holders get their investment plus accrued dividends (often called the liquidation preference) -- often sold with warrants. Alternatively, can issue convertible preferred instead of including warrants.


Wharton School 10

Common Equity• Typically 20% - 45% of capital structure

historically, but varies over time (more right now).

• Typically seeking a 20%-40% IRR but depends on how levered the capital structure

• Often assume exit and entry multiples are the same, but not necessarily a good assumption – rarely expect multiple expansion

• Ask what the exit strategy is likely to be.


Wharton School 11

Management Ownership• Management puts up 60% to 70% of wealth

(excluding residence)• Management share of equity (sometimes called

management promote) usually increases year by year as they meet targets (e.g., revenue and EBITDA and non-financial targets) through performance vesting options. Strike price usually at equity buy-in price at time of deal.

• Managers are sometimes offered chance to buy stock with a mixture of recourse and non-recourse notes.

• Managers often already own shares in a company that does an LBO and they do not necessarily cash out those shares – that equity goes into the new entity – called rollover equity.


Wharton School 12

Financial Sponsors• Typically won’t put more than certain percentage of a

fund in one company and another percentage of a fund in one industry. Increases in % of financing that is equity has caused deal sharing.

• Razor edge margins because of the high risk profiles. Shooting for 20% - 30% on every deal, some earn 100%, some 4%, some -80%, etc.

• Sponsor takes funds from pension funds only when required, a draw down notice (LBO sponsors do not want to be generic portfolio managers).

• Typically assume will take 3-5 years to invest a fund and then another 3-5 years to cash out (monetize) the investments.

• Expertise in layering risk, financial structure


Wharton School 13

Financial Sponsors• Normally get a management fee

that is 1% to 1.5% of fund size.• In addition, they split returns

between investors and themselves and often get a percentage in the capital gain of the fund (so called carried interest).

• In addition, they invest their own money in the fund.


$221

$382

$994

$898

$507

$118

$159 $178

$120 $145$187

$357

$0

$200

$400

$600

$800

$1,000

$1,200

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 20090%

5%

10%

15%

20%

25%

30%

Global Sponsor Activity Volume % of Total Global M&A Volume

$ in billions % of Total Value

___________________________

Source: Thomson Financial based on rank date excluding equity carveouts, exchange offers, and open market repurchases. As of 12/31/09. (1) Total Global M&A Volume includes government interventions, defined as deals in which a government entity is the acquiror, excluding SWF transactions.

Financial Sponsor M&A Activity1998-2009 Global Sponsor M&A Activity

(1)

14


Financial Sponsor M&A Activity 2007-2009

265386

209135 100

16247 45 55 93

707

1,032

570727

445 420

540

$972

$1,418

$896 $879

$670

$895

$800

$522$473 $498 $474

$633

2873

744733

475 452

688

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009

$ in billions

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Sponsor % of Market

Sponsor Volume Strategic Volume Sponsor % of Market

Global Sponsor Quarterly M&A Activity

Sponsor Volume has declined by significantly more than strategic volume in the last 2 years 2008 Sponsor volume was off 62% from 2007 year-over-year average; Strategic volume was down 21% 2009 Sponsor volume was off 42% from 2008 volume; Strategic volume was down 26%

___________________________

Source: Thomson Financial based on rank date excluding equity carveouts, exchange offers, and open market repurchases. As of 12/31/09. (1) Total Global M&A Volume includes government interventions, defined as deals in which a government entity is the acquiror, excluding SWF transactions.

(1)

15


Harder time getting to DCF range, cheap credit subsidy gone

Less leverage available to drive IRRs; return hurdles will drop further

Beginning to reemerge due to reopening of credit markets

Portfolio backlog waiting to be monetized

Search for assets where they have a comparative advantage as buyer

Deal size sweet spot for Financial Sponsors moves to the midcap market

MBO no longer a viable path for CEOs No longer getting out-bid – Ability to

push the strategic agenda Synergies > financing subsidy Resurgence of stock as an acquisition

currency Investment grade corporates “rule” with

maximum financial flexibility

Strategics are Driving the M&A Market

Risk right-sizing in credit markets will continue to allow strategics to be more competitive buyers of assets

Financial Sponsors Strategics

16


Wharton School 17

Risk Profile Questions

• Is cash flow consistent (no cyclical industries)?• Is a turnaround required to meet projections?• Any outside threats to long-term performance?• Are there larger, better capitalized competitors?• Does the firm have high quality management?• Are there other successful LBOs in that industry?• Can the company grow with the leverage

increase?• What is the exit strategy?


0.2

6.7x5.4x 5.2x 5.3x 5.2x

5.8x 5.7x 5.2x4.5x 4.1x 3.7x 3.8x 4.0x 4.2x 4.4x 4.4x

6.0x4.7x

4.0x

3.84.15.4

3.33.12.72.32.42.22.93.33.53.63.53.32.82.72.63.43.4

0.60.6

1.11.31.51.71.41.51.21.21.72.12.31.92.52.52.42.0

3.35.0x

0x

3x

6x

1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Bank Debt/EBITDA Non-Bank Debt/EBITDAColumn 3

________________Source: S&P Leveraged Commentary & Data. As of 12/31/09. 1) Excludes media loans. Too few deals in 1991 to form a meaningful sample.2) Rollover equity prior to 1996 is not available. Too few deals in 1991 to form a meaningful sample.

13%21%

25% 26% 24% 23%30% 32% 36% 38% 41% 40% 39%

35% 32% 33% 33%

43%52%

3% 6%4%2% 2%3% 4% 4% 6% 3% 5% 3% 2%

46%39%

31%31%30%33%35%37%35%34%32%28%27%23%24%26%25%22%21%13%

22%

0%

25%

50%

1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Rollover Equity Contributed Equity

Sample Capital Structure Terms for Leveraged Deals

U.S. LBO Acquisition Financing Market Trends

Average Debt Multiples (1)

Average Equity Contribution to LBO (2)

36


Wharton School 19

State of the Market 3/19/10

• Market is in mid-recovery. What kinds of deals can get done is a function of size, industry, quality of asset, quality of sponsor, quality of management team.

• As equity valuations have rebounded and stabilized, sellers are becoming more comfortable with valuations and believe they are not selling in the trough.

• This is continually evolving right now (always is, but now more than ever). Deal structures change monthly.

• Right now can probably do a deal up to about $3-5 Billion if everything is perfect (asset, sponsor, management, etc).

• Deals greater than $5 billion unlikely to get done because of the lack of depth of the market and size of the accompanying equity check (majority of deals are 40%-50% equity).


Wharton School 20

State of the Market 3/19/10• High yield market functioning pretty well (access to market), however

underwriters’ capacity is a constraint ($2 billion full committment is now a couple of banks, used to be one and fees for those commitments are unattractive).

• Leverage loan market which are 5 to 7 year term loans with some amortization (from banks and senior loan funds) has rebounded but lags high-yield market.

• Deal action seen mainly in industries with stable cash flows and little cyclicality. Some industries that have had highly levered deals in the past (e.g., media) are lagging because the leverage terms do not support valuations that are considered attractive.

• Typical capital structure right now is 40%-50% equity, senior secured or first lien debt of about 35%-40%% and subordinated debt/mezzanine at 10%-15%.

• Senior debt yielding around 7% to 10% right now and the mezzanine debt at least mid-teens (coupon rates) but depends on credit risk.

• Sponsor firms looking for mid 20% IRR on equity.• Recent LBOs include IMS Health, Busch Theme Parks, Skype


Wharton School 21

Exit Strategies• Exit strategies include:

– IPO– Buyout by a strategic buyer– Buyout by another financial buyer– Leveraged recapitalization --- not really an exit,

but essentially after the debt is paid down to a reasonable level, the entity issues a new round of debt and pays a large dividend to equityholders (or repurchases shares). Some, but not all, equityholders may be taken out.


Wharton School 22

Potential Motivations for an LBO• Increase in debt and concentrated ownership

increase incentives to maximize value.• Non-management on board with significant

equity stakes increases board effectiveness• Advantage to being private (filings, etc.)• Beneficial tax consequences (debt, step-up)• Transfer wealth from other stakeholders in the

firm such as employees & bondholders


Wharton School 23

Performance of LBOs

• Evidence indicates that the median premium paid to existing shareholders is 42% (1980’s data).

• What are the potential sources of value?– Improved operating performance– wealth transfers from employees– reduction of taxes– wealth transfers from pre-buyout debtholders– overpayment by post-buyout investors


Wharton School 24

Changes in Median Performance• In three year period after the buyout relative to

the year before the buyout (1980s data)– EBIT increases by 42%– EBIT/assets increases by 15%– EBIT/sales increases by 19%– EBIT-CAPEX increases by 96%– EBIT-CAPEX/assets increases by 79%– EBIT-CAPEX/sales increases by 43%– working capital management improves– no decline in advertising, maintenance or R&D– CAPEX falls by 33% relative to industry


Wharton School 25

Transfers from Employees• No evidence that investor wealth gains can

be attributed to wage reductions or layoffs– median change in number of employees is 0.9%

among all LBOs and is 4.9% among LBOs that did not engage in divestitures

– significant increase in average annual compensation for non-management employees

– there is evidence that LBOs are not adding to their payrolls at the same rate as the industry (12% declines for all, 6.2% decline for those with no divestitures)


Wharton School 26

Tax Effect of LBOs

• Firms’ interest deductions increase substantially after an LBO. Depending on how you value them & how long you think the highly levered structure will be in place, 21% to 70% of the premium is attributable to the interest

• Additional depreciation (pre-1986 Tax Reform Act accounted for at least 30% of the premium

• Ratio of federal taxes/EBIT falls from 20% pre-buyout to 1% for 2 yrs. after buyout.


Wharton School 27

Transfers from Bondholders

• If leverage increases dramatically, pre-buyout debtholders with no protection could experience wealth losses– on average, pre-buyout debtholders lost

2.1%– represents 3% of the premium paid– wealth losses accrue only to those

bondholders not safeguarded by protective covenants (limitations on debt issuance, etc.)


Wharton School 28

Overpayment by Post-Buyout Investors

• Evidence indicates over three years subsequent to the buyout, post-buyout equity investors earned a mean excess return of 45% (again, 1980s data).

• Evidence for debtholders is less clear as it is difficult to track bonds that default. Default rates on low grade bonds were roughly 2.5% per year, but returns are less easily quantified


Wharton School 29

John Harland -- An LBO?

• Typical LBO Model• Model cash flows -- see how it supports

the debt financing structure• Treat exit year as a choice variable to

determine sensitivity of IRR to exit date.• Determine the IRR for the mezzanine and

equity providers and see if it hits target• Models don’t typically assess value except

as exit multiple (can do DCF of course)


Wharton School 30

LBO Models as an Alternative Valuation

• LBO models can serve as an alternative valuation.

• Take the cash flow forecasts, determine the amount of financing available in the market place currently and the IRR that LBO sponsors would target for this company. Based on all that, determine the maximum amount that could be paid as an LBO transaction that satisfies the required IRR.

• Triangulate with DCF and Market Multiple Valuations


Wharton School 31

LBO Model Logic• Create a sources (debt, equity contribution) and

uses (purchase price, fees, debt payoff) statement for inception of LBO

• Debt schedules• Proforma balance sheet, income statement and

statement of cash flows based on operating assumptions

• Cash flows pay down the debt (senior first and then mezzanine)

• Perform valuations at alternative exit dates and determine IRR to equity holders


Wharton School 32

Reverse Leveraged Buyouts• Reverse LBO occurs when an LBO goes public• Constituted roughly 10% of IPO market in 1980s• Leverage and ownership changes at time of

reverse LBO that moves them back toward pre-LBO structure

• Leverage falls from 83% to 56% (debt/capital)• Inside ownership falls from 75% to 49%

(management and board -- includes sponsor).• Board size increases from 5 to 7, roughly 1/3 each

of operating management, non management capital providers and external board members


Wharton School 33

Financial PerformanceOCF Before Interest and Taxes

• Year Firm Industry-Adjusted– -1 19.3% 9.2%– 0 14.6% 4.7%– +1 11.9% 1.5%– +2 14.3% 4.1%– +3 13.5% 2.4%– Avg +1 to +3 13.9% 2.9%

• Doing much better than their industry, but evidence of deterioration relative to prior performance


Wharton School 34

Discretionary Expenditures

• Discretionary expenditures defined as capital expenditures, advertising and R&D.– Spending as much as their industry prior to the

reverse LBO and increases subsequently (discretionary expend./sales) 2% greater than industry

– CAPEX low before reverse LBO and normal after– Advertising above industry before and after– R&D tracks industry before and after

• Employees/sales same as industry both before and after the reverse LBO


Wharton School 35

Effect of ownership and leverage

• No evidence that changes in leverage affect performance

• Significant correlation between decline in performance and decline in ownership.– 10% additional decline in percentage equity owned

by managers results in an additional 3.6% fall in OCF/assets over three subsequent years

– 10% additional decline in percentage equity owned by non-management insiders results in an additional 4.1% fall in OCF/assets over three subsequent years

• Suggests important role for ownership incentive


Wharton School 36

Stock Market Performance

• Evidence of a large increase in stock prices of the reverse LBO firms over the next four years.

• Large increase in stock prices exactly tracks the stock market. As such, there is no evidence of positive or negative excess returns

• Very different from IPOs in general. Strong evidence of negative excess returns

corporate valuation -- chapter 18 copyright, robert holthausen, 2009 wharton school 1 leveraged...

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