Leveraged Buyout Structures and Valuation

No one spends other peoples money as carefully as they spend their own. Milton Friedman

Cross-BorderTransactions

Learning ObjectivesPrimary Learning Objective: To provide students with a knowledge of how to analyze, structure, and value highly leveraged transactions.Secondary Learning Objectives: To provide students with a knowledge of The motivations of and methodologies employed by financial buyers;Advantages and disadvantages of LBOs as a deal structure;Alternative LBO models;The role of junk bonds in financing LBOs;Pre-LBO returns to target company shareholders;Post-buyout returns to LBO shareholders, and Alternative LBO valuation methodsBasic decision rules for determining the attractiveness of LBO candidates

Financial Buyers or SponsorsIn a leveraged buyout, all of the stock, or assets, of a public or private corporation are bought by a small group of investors (financial buyers aka financial sponsors), usually including members of existing management and a sponsor. Financial buyers or sponsors:Focus on ROE rather than ROA. Use other peoples money.Succeed through improved operational performance, tax shelter, debt repayment, and properly timing exit.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)

Impact of Leverage on Financial Returns1Tax 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.2If EBIT = 0, ($5), and ($8), ROE in 0%, 50% and 20% debt scenarios = $0 / $100, [($5) x (1 - .4)] / $50 and [($8) x (1 - .4)] / $20 = 0%, (6)% and (24)%, respectively. Note the value of the operating loss, which is equal to the interest expense, is reduced by the value of the loss carry forward or carry back.

Impact of Leverage on Return to Shareholders All-Cash Purchase ($Millions) 50% Cash/50% Debt ($Millions) 20% Cash/80% Debt ($Millions)Purchase Price$100 $100$100Equity (Cash Investment by Financial Sponsor)$100$50$20Borrowings0 $50$80Earnings Before Interest and Taxes (EBIT)$20$20$20Interest @ 10%10 $5$8Income Before Taxes$20$15$12Less Income Taxes @ 40%$8 $6$4.8Net Income$12$9 $7.2After-Tax Return on Equity (ROE)212%18%36%

LBOs Create Value by Reducing Debt and Increasing Margins Thereby Increasing Potential Exit Multiples

Firm ValueDebt ReductionReinvest in FirmFree Cash Flow Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 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 Tax Shield Adds to Free Cash FlowDebt Reduction Adds to Free Cash Flow by Reducing Interest & Principal RepaymentsReinvestment Adds to Free Cash Flow by Improving Operating MarginsTax Shield

LBO Value is Maximized by Reducing Debt, Improving Margins, and Properly Timing Exit

Case 1: Debt ReductionCase 2: Debt Reduction + Margin ImprovementCase 3: Debt Reduction + Margin Improvement + Properly Timing ExitLBO Formation Year: Total Debt Equity Transaction Value$400,000,000 100,000,000$500,000,000$400,000,000 100,000,000$500,000,000$400,000,000 100,000,000$500,000,000

Exit Year (Year 7) Assumptions: Cumulative Cash Available for Debt Repayment1 Net Debt2 EBITDA EBITDA Multiple Transaction Value3 Equity Value4

$150,000,000$250,000,000$100,000,0007.0 x$700,000,000$450,000,000

$185,000,000$215,000,000$130,000,007.0 x $910,000,000$695,000,000

$185,000,000$215,000,000$130,000,0008.0 x$1,040,000,000$825,000,000Internal Rate of Return24%31.2%35.2%Cash on Cash Return54.5 x6.95 x8.25 x1Cumulative cash available for debt repayment increases between Case 1 and Case 2 due to improving margins and lower interest and principal repayments reflecting the reduction in net debt.2Net Debt = Total Debt Cumulative Cash Available for Debt Repayment = $400 million - $185 million = $215 million3Transaction Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year4Equity Value = Transaction Value in 7th Year Net Debt5The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return, because it accounts for the time value of money.

LBO Deal StructureAdvantages 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, andServing as a takeover defense by eliminating public investorsDisadvantages include the following:High fixed costs of debt raises firms break-even point,Vulnerability to business cycle fluctuations and competitor actions,Not appropriate for firms with high growth prospects or high business risk, andPotential difficulties in raising capital.

Classic LBO Models: Late 1970s and Early 1980sDebt normally 4 to 5 times equity. Debt amortized over no more than 10 years.Existing corporate management encouraged to participate.Complex capital structure: As percent of total funds raisedSenior debt (60%) Subordinated debt (26%)Preferred stock (9%)Common equity (5%)Firm frequently taken public within seven years as tax benefits diminish

Break-Up LBO Model (Late 1980s)Same as classic LBO but debt serviced from operating cash flow and asset salesChanges in tax laws reduced popularity of this approachAsset sales immediately upon closing of the transaction no longer deemed tax-freePreviously could buy stock in a company and sell the assets. Any gain on asset sales was offset by a mirrored reduction in the value of the stock.

Strategic LBO Model (1990s)Exit strategy is via IPOD/E ratios lower so as not to depress EPS Financial buyers provide the expertise to grow earningsPreviously, their expertise focused on capital structureDeals structured so that debt repayment not required until 10 years after the transaction to reduce pressure on immediate performance improvementBuyout firms often purchase a firm as a platform for leveraged buyouts of other firms in the same industry

LBOs in the New MillenniumExplosion in frequency and average size of LBOs in the U.S. during 2005-2007 period ($5-$10 billion range)Tendency for buyout firms to bid for targets as a group (Club Deals)Increased effort to cash out earlier than in past to boost returns due to increased competition for investorsLBO boom fueled byGlobal savings glut resulting in cheap financingFed easy money policiesExcess capacity in many industries encouraging consolidationAttempt to avoid onerous reporting requirements of Sarbanes-OxleyLBOs increasingly common in European Union due to liberalization and catch-up to U.S.

Role of Junk Bonds in Financing LBOsJunk bonds are non-rated debt. Bond quality varies widelyInterest rates usually 3-5 percentage points above the prime rateBridge 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 LBOJunk 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 (Michael Milken), the primary market maker for junk bondsJunk bond financing is highly cyclical, tapering off as the economy goes into recession and fears of increasing default rates escalate

Discussion QuestionsDefine the financial concept of leverage. Describe how leverage may work to the advantage of the LBO equity investor? How might it work against them?What is the difference between a management buyout and a leveraged buyout?What potential conflicts might arise between management and shareholders in a management buyout?

Factors Affecting Pre-Buyout ReturnsPremium paid to target firm shareholders frequently exceeds 40%

These returns reflect the following (in descending order of importance):Anticipated improvement in efficiency and tax benefitsWealth transfer effects (e.g., from bondholders to shareholders)Superior KnowledgeMore efficient decision-making

Factors Determining Post-Buyout ReturnsEmpirical studies show investors earn abnormal post-buyout returns due to --Full effect of increased operating efficiency not reflected in the pre-LBO premium.--More professional management, tighter performance monitoring by owners, and reputation of financial sponsor.--Studies may be subject to selection or survival bias, i.e., only LBOs that are successful are able to undertake secondary public offerings.--Abnormal returns may also reflect the acquisition of many LBOs 3 years after taken public.--Properly timing when to exit the business.

Valuing LBOsA leveraged buyout can be evaluated from the perspective of common equity investors or of all investors and lendersFrom common equity investors perspective, NPV = PVFCFE IEQ 0 Where NPV = Net present value PVFCFE = Present value of free cash flows to common equity investors IEQ = The value of common equityFrom investors and lenders perspective,NPV = PVFCFF ITC 0 Where PVFCFF = Present value of free cash flows to the firm ITC = Total investment or the value of total capital including common and preferred stock and all debt.

Decision RulesLBOs make sense from viewpoint of investors and lenders if PV of free cash flows to the firm is to the total investment consisting of debt and common and preferred equityHowever, a LBO can make sense to common equity investors but not to other investors and lenders. The market value of debt and preferred stock held before the transaction may decline due to a perceived reduction in the firms ability toRepay such debt as the firm assumes substantial amounts of new debt and toPay interest and dividends on a timely basis.

Valuing LBOs: Cost of Capital Method1Adjusts for the varying level of risk as the firms total debt is repaid.Step 1: Project annual cash flows until target D/E achievedStep 2: Project debt-to-equity ratiosStep 3: Calculate terminal valueStep 4: Adjust discount rate to reflect changing riskStep 5: Determine if deal makes sense1Also known as the variable risk method.

Cost of Capital Method: Step 1 Project annual cash flows until target D/E ratio achievedTarget D/E is the level of debt relative to equity at whichThe firm will have to resume payment of taxes andThe amount of leverage is likely to be acceptable to IPO investors or strategic buyers (often the prevailing industry average)

Cost of Capital Method: Step 2Project annual debt-to-equity ratiosThe decline in D/E reflects the known debt repayment schedule and The projected growth in the market value of the shareholders equity (assumed to grow at the same rate as net income)

Cost of Capital Method: Step 3Calculate terminal value of projected cash flow to equity investors (TVE) at time t, (i.e., the year in which the initial investors choose to exit the business).TVE represents PV of the dollar proceeds available to the firm through an IPO or sale to a strategic buyer at time t.

Cost of Capital Method: Step 4Adjust the discount rate to reflect changing risk.The firms cost of equity will decline over time as debt is repaid and equity grows, thereby reducing the leveraged . Estimate the firms as follows:

FL1 = IUL1(1 + (D/E)F1(1-tF))

where FL1 = Firms levered beta in period 1 IUL1 = Industrys unlevered beta in period 1 = IL1/(1+(D/E)I1(1- tI)) IL1 = Industrys levered beta in period 1 (D/E)I1 = Industrys debt-to-equity ratio in period 1 tI = Industrys marginal tax rate in period 1 (D/E)F1 = Firms debt-to-equity ratio in period 1 tF = Firms marginal tax rate in period 1

Recalculate each successive periods with the D/E ratio for that period, and using that periods , recalculate the firms cost of equity for that period.

Cost of Capital Method: Step 5Determine if deal makes senseDoes the PV of free cash flows to equity investors (including the terminal value) equal or exceed the equity investment including transaction-related fees?

Evaluating the Cost of Capital MethodAdvantages:Adjusts the discount rate to reflect diminishing risk as the debt-to-total capital ratio declinesTakes into account that the deal may make sense for common equity investors but not for lenders or preferred shareholdersDisadvantage: Calculations more burdensome than Adjusted Present Value Method

Valuing LBOs: Adjusted Present Value Method (APV)Separates value of the firm into (a) its value as if it were debt free and (b) the value of tax savings due to interest expense.Step 1: Project annual free cash flows to equity investors and interest tax savingsStep 2: Value target without the effects of debt financing and discount projected free cash flows at the firms estimated unlevered cost of equity.Step 3: Estimate the present value of the firms tax savings discounted at the firms estimated unlevered cost of equity. Step 4: Add the present value of the firm without debt and the present value of tax savings to calculate the present value of the firm including tax benefits.Step 5: Determine if the deal makes sense.

APV Method: Step 1 Project annual free cash flows to equity investors and interest tax savings for the period during which the firms capital structure is changing.Interest tax savings = INT x t, where INT and t are the firms annual interest expense on new debt and the marginal tax rate, respectivelyDuring the terminal period, the cash flows are expected to grow at a constant rate and the capital structure is expected to remain unchanged

APV Method: Step 2Value target without the effects of debt financing and discount projected cash flows at the firms unlevered cost of equity.Apply the unlevered cost of equity for the period during which the capital structure is changing.Apply the weighted average cost of capital for the terminal period using the proportions of debt and equity that make up the firms capital structure in the final year of the period during which the structure is changing.

APV Method: Step 3Estimate the present value of the firms annual interest tax savings.Discount the tax savings at the firms unlevered cost of equityCalculate PV for annual forecast period only, excluding a terminal value, since the firm is sold and any subsequent tax savings accrue to the new owners.

APV Method: Step 4 Calculate the present value of the firm including tax benefitsAdd the present value of the firm without debt and the PV of tax savings

APV Method: Step 5Determine if deal makes sense:Does the PV of free cash flows to equity investors plus tax benefits equal or exceed the initial equity investment including transaction-related fees?

Evaluating the Adjusted Present Value MethodAdvantage: Simplicity.Disadvantages:Ignores the effect of changes in leverage on the discount rate as debt is repaid,Implicitly ignores the potential for bankruptcy of excessively leveraged firms, andUnclear whether true discount rate should be the cost of debt, unlevered cost of equity, or somewhere between the two.

Discussion QuestionsCompare and contrast the cost of capital and the adjusted present value valuation methods?Which do you think is a more appropriate valuation method? Explain your answer.

Things to RememberLBOs 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.Excessive leverage and the resultant higher level of fixed expenses makes LBOs vulnerable to business cycle fluctuations and aggressive competitor actions.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.

***********************************