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Leveraged Buyout Structures and Valuation
No one spends other people’s money as carefully as they spend their own. —Milton Friedman
Course Layout: M&A & Other Restructuring Activities Part I: M&A Environment Part II: M&A Process Part III: M&A Valuation & Modeling Part IV: Deal Structuring & Financing Part V: Alternative Strategies Motivations for M&A Business & Acquisition Plans Public Company Valuation Payment & Legal Considerations Business Alliances Regulatory Considerations Search through Closing Activities Private Company Valuation Accounting & Tax Considerations Divestitures, Spin-Offs & Carve-Outs Takeover Tactics and Defenses M&A Integration Financial Modeling Techniques Financing Strategies Bankruptcy & Liquidation Cross-Border Transactions
Learning Objectives • Primary 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 methods – Basic decision rules for determining the attractiveness of LBO candidates
Financial Buyers or Sponsors In 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 people’s 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 Returns Impact of Leverage on Return to Shareholders All-Cash Purchase ($Millions) 50% Cash/50% Debt ($Millions) 20% Cash/80% Debt ($Millions) Purchase Price $100 Equity (Cash Investment by Financial Sponsor) $100 $50 $20 Borrowings 0 $50 $80 Earnings Before Interest and Taxes (EBIT) $20 $20 Interest @ 10%1 0 $5 $8 Income Before Taxes $20 $15 $12 Less Income Taxes @ 40% $8 $6 $4. 8 Net Income $12 $9 $7. 2 After-Tax Return on Equity (ROE)2 1 Tax $100 12% 18% 36% 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. 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. 2 If
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 Adds to Free Cash Flow by Reducing Interest & Principal Repayments Debt Reduction Reinvest in Firm Free Cash Flow Reinvestment Adds to Free Cash Flow by Improving Operating Margins Tax Shield Adds to Free Cash Flow Tax Shield Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
LBO Value is Maximized by Reducing Debt, Improving Margins, and Properly Timing Exit Case 1: Debt Reduction Case 2: Debt Reduction + Margin Improvement Case 3: Debt Reduction + Margin Improvement + Properly Timing Exit LBO Formation Year: Total Debt Equity Transaction Value $400, 000, 000 100, 000, 000 $500, 000, 000 $400, 000 100, 000 $500, 000 Exit Year (Year 7) Assumptions: Cumulative Cash Available for Debt Repayment 1 Net Debt 2 EBITDA Multiple Transaction Value 3 Equity Value 4 $150, 000 $250, 000 $100, 000 7. 0 x $700, 000 $450, 000 $185, 000 $215, 000 $130, 00 7. 0 x $910, 000 $695, 000 $185, 000 $215, 000 $130, 000 8. 0 x $1, 040, 000 $825, 000 Internal Rate of Return 24% 31. 2% 35. 2% Cash on Cash Return 5 4. 5 x 6. 95 x 8. 25 x 1 Cumulative 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. 2 Net Debt = Total Debt – Cumulative Cash Available for Debt Repayment = $400 million - $185 million = $215 million 3 Transaction Value = EBITDA in 7 th Year x EBITDA Multiple in 7 th Year 4 Equity Value = Transaction Value in 7 th Year – Net Debt 5 The 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 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.
Classic LBO Models: Late 1970 s and Early 1980 s • Debt 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 raised – Senior 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 1980 s) • Same as classic LBO but debt serviced from operating cash flow and asset sales • Changes in tax laws reduced popularity of this approach – Asset sales immediately upon closing of the transaction no longer deemed tax-free – Previously 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 (1990 s) • Exit strategy is via IPO • D/E ratios lower so as not to depress EPS • Financial buyers provide the expertise to grow earnings – Previously, their expertise focused on capital structure • Deals structured so that debt repayment not required until 10 years after the transaction to reduce pressure on immediate performance improvement • Buyout firms often purchase a firm as a platform for leveraged buyouts of other firms in the same industry
LBOs in the New Millennium • Explosion 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 investors • LBO “boom” fueled by – Global savings glut resulting in cheap financing – Fed “easy” money policies – Excess capacity in many industries encouraging consolidation – Attempt to avoid onerous reporting requirements of Sarbanes. Oxley • LBOs increasingly common in European Union due to liberalization and “catch-up” to U. S.
Role of Junk Bonds in Financing LBOs • Junk bonds are non-rated debt. – Bond quality varies widely – Interest rates usually 3 -5 percentage points above the prime rate • Bridge 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 LBO • Junk bond financing for LBOs dried up due to the following: – A series of defaults of over-leveraged firms in the late 1980 s – Insider trading and fraud at such companies a Drexel Burnham (Michael Milken), the primary market maker for junk bonds • Junk bond financing is highly cyclical, tapering off as the economy goes into recession and fears of increasing default rates escalate
Discussion Questions 1. Define the financial concept of leverage. Describe how leverage may work to the advantage of the LBO equity investor? How might it work against them? 2. What is the difference between a management buyout and a leveraged buyout? 3. What potential conflicts might arise between management and shareholders in a management buyout?
Factors Affecting Pre-Buyout Returns • Premium paid to target firm shareholders frequently exceeds 40% • These returns reflect the following (in descending order of importance): – Anticipated improvement in efficiency and tax benefits – Wealth transfer effects (e. g. , from bondholders to shareholders) – Superior Knowledge – More efficient decision-making
Factors Determining Post-Buyout Returns • Empirical studies show investors earn abnormal postbuyout 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 LBOs • A leveraged buyout can be evaluated from the perspective of common equity investors or of all investors and lenders • From 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 equity • From 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 Rules • LBOs 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 equity • However, 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 firm’s ability to – Repay such debt as the firm assumes substantial amounts of new debt and to – Pay interest and dividends on a timely basis.
Valuing LBOs: Cost of Capital Method 1 Adjusts for the varying level of risk as the firm’s total debt is repaid. • Step 1: Project annual cash flows until target D/E achieved • Step 2: Project debt-to-equity ratios • Step 3: Calculate terminal value • Step 4: Adjust discount rate to reflect changing risk • Step 5: Determine if deal makes sense 1 Also known as the variable risk method.
Cost of Capital Method: Step 1 • Project annual cash flows until target D/E ratio achieved • Target D/E is the level of debt relative to equity at which – The firm will have to resume payment of taxes and – The amount of leverage is likely to be acceptable to IPO investors or strategic buyers (often the prevailing industry average)
Cost of Capital Method: Step 2 • Project annual debt-to-equity ratios • The 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 3 • Calculate 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 4 • • Adjust the discount rate to reflect changing risk. The firm’s cost of equity will decline over time as debt is repaid and equity grows, thereby reducing the leveraged ß. Estimate the firm’s ß as follows: ßFL 1 = ßIUL 1(1 + (D/E)F 1(1 -t. F)) where ßFL 1 ßIUL 1 = Firm’s levered beta in period 1 = Industry’s unlevered beta in period 1 = ßIL 1/(1+(D/E)I 1(1 - t. I)) ßIL 1 = Industry’s levered beta in period 1 (D/E)I 1 = Industry’s debt-to-equity ratio in period 1 t. I = Industry’s marginal tax rate in period 1 (D/E)F 1 = Firm’s debt-to-equity ratio in period 1 t. F = Firm’s marginal tax rate in period 1 • Recalculate each successive period’s ß with the D/E ratio for that period, and using that period’s ß, recalculate the firm’s cost of equity for that period.
Cost of Capital Method: Step 5 • Determine if deal makes sense – Does 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 Method • Advantages: – Adjusts the discount rate to reflect diminishing risk as the debt-to-total capital ratio declines – Takes into account that the deal may make sense for common equity investors but not for lenders or preferred shareholders • Disadvantage: 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 savings • Step 2: Value target without the effects of debt financing and discount projected free cash flows at the firm’s estimated unlevered cost of equity. • Step 3: Estimate the present value of the firm’s tax savings discounted at the firm’s 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 firm’s capital structure is changing. – Interest tax savings = INT x t, where INT and t are the firm’s annual interest expense on new debt and the marginal tax rate, respectively – During 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 2 • Value target without the effects of debt financing and discount projected cash flows at the firm’s 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 firm’s capital structure in the final year of the period during which the structure is changing.
APV Method: Step 3 • Estimate the present value of the firm’s annual interest tax savings. – Discount the tax savings at the firm’s unlevered cost of equity – Calculate PV for annual forecast period only, excluding a terminal value, since the firm is sold any subsequent tax savings accrue to the new owners.
APV Method: Step 4 • Calculate the present value of the firm including tax benefits – Add the present value of the firm without debt and the PV of tax savings
APV Method: Step 5 • Determine 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 Method • Advantage: 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, and – Unclear whether true discount rate should be the cost of debt, unlevered cost of equity, or somewhere between the two.
Discussion Questions 1. Compare and contrast the cost of capital and the adjusted present value valuation methods? 2. Which do you think is a more appropriate valuation method? Explain your answer.
Things to Remember… • LBOs 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.