Highly Leveraged Transactions: Going Private and LBOs
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Transcript of Highly Leveraged Transactions: Going Private and LBOs
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Highly Leveraged Transactions: Going Private and LBOs
Chapter 13 Part 1
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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?
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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
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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
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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)
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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
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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
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Wealth Transfer from Stakeholders• Bondholders– See Metropolitan Life
– Is all debt effected?
• Employees
• Government– See Tax Shield discussion
• Suppliers– Comparing Chrysler & GM in 2009
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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?
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Going Forward: Empirical Evidence on LBOs -Improved Operating Efficiency
• Board composition substantially changes & its size is reduced, 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
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Going Forward: Empirical Evidence on LBOs -Improved Operating Efficiency
• Compared to competitors, LBO firms :– Use only half the working capital – Have larger average advertising budget
• Overall investment level is lowered• R&D & maintenance expenses are unchanged!• Tax payments are reduced substantially
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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
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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.
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Legal Protections• Shareholder Voice– Merger vs. tender offer vs. reverse stock split
• Disclosure– State law
– Federal law
• Appraisal
• Fiduciary Duty– Conflict?
– Does Revlon apply?
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Legal Protection for Bondholders
• Fiduciary Duty
– http://papers.ssrn.com/sol3/papers.cfm?abstract_id=195588
• Contract
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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.
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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.
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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”
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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
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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
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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
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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)
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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
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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?
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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%
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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
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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
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Legal Questions
• What is the likelihood of litigation?
• Why?– How is it different from other acquisitions?– How are the conflicts different?
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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/
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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)
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Price Negotiations• Buyer- the Sponsors
– 7/14 $48.75compared 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
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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
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Will LBOs Continue?
• Gains are financial not synergy
• Private Equity funds still have money
• Banks have a lot less money