Leverage Buyouts

Arzac, Chapter 13

How To Go Private

• four commonly used techniques for going private transactions• shell corporation that combines with

firm via merger• asset sales• tender offer• reverse stock split

“Going Private”

• leverage transaction of public firm into privately held company• LBO• MBO

• often associated with improvement in performance

LBOs

• peak from 1986 to 1989• largest was RJR Nabisco in 1988 with

price of $24.6b and then Beatrice in 1985 at $5.4b (Mergerstat)

• buying group generally includes current mgt

• expectation at some point that reverse transaction will occur

Why Pay Premiums?

• premiums paid for firms in LBOs average 40% of market price 1-2 months prior to announcement of buyout• gains do occur and are achieved through

stock price performance• sources of gains:

• taxes• management incentives• wealth transfer effects• asymmetric information and underpricing• efficiency considerations

Strip Financing

• LBOs sometimes structured to use strip financing

• nonequity financing like senior debt, subordinated debt, convertible debt, and preferred stock often used

• others below senior and above common are mezzanine level• strip says buyer who purchases X% of any

mezzanine level security must purchase X% of all mezzanine level securities and some equity too

Pro Forma Cash Flows for Leverage Buyout

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5EBIT 150.0 165.0 181.5 199.7 219.6 241.6Interest 88.5 76.5 62.2 45.0 24.5EBT 76.5 105.0 137.5 174.6 217.1Taxes @ 40% 30.6 42.0 55.0 69.8 86.8Net Income 45.9 63.0 82.5 104.8 130.3Depreciation 30.0 30.0 30.0 30.0 30.0Cash Flow 75.9 93.0 112.5 134.8 160.3Amortization of loans 60.9 72.9 87.2 104.4 129.9Cash Flow Cushion 15.0 20.1 25.3 30.4 35.4

Changing Debt Ratio in an LBO

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Equity 50.0 95.9 158.9 241.4 346.2 476.5Debt 450.0 389.1 316.2 229.0 124.6 0.0Total Assets 500.0 485.0 475.1 469.7 470.1 476.5Percent Debt 90% 80% 67% 49% 26% 0%

Ownership Structure Changes

• most complete form of ownership change when take a public firm private through an LBO

• purchase control using a high debt component with mgt often part of equity base

• fundamental operating changes generally made in attempt to increase profitability and firm value

Financing• firms with valuations less than about $400 will not

generally have access to public high yield market to raise funds for LBO• used secured debt from bank – private placement of

subordinated debt and equity participation• typical financial structure for smaller firms prior to 1980s

• debt – about 5X EBITDA• equity – about 1-1.5X EBITDA

• everything changed in 1980s for larger firms because of high-yield debt market• secured financing – about 3X EBITDA• high-yield financing – about 2.5-3X EBITDA• equity – about 1.5X EBITDA• sales about 7-8X EBITDA

• problem when high-yield debt market is not as active• mezzanine financing fills in gap

Example 1

• Let the LBO purchase price be $210 million, of which $60 million is secured debt. $100 million is subordinated debt with a below-market coupon interest of 6% plus 27% of the equity, and $50 million is invested by the sponsor for 73% of the equity. Assume the FCFs generated during the first 5 years go to pay interest and amortize the secured debt in its entirety and that cash balances are negligible. Furthermore, let expected year-5 EBITDA equal $49.5 million and assume that the company is expected to be sold for 8 times EBITDA or $396 million net of fees and expenses. Then, the cash flows and the return to subordinated holders are as follows:

Year 0 1 2 3 4 5

Bond price -100Coupon 6 6 6 6 6Principal 100Equity Kicker 80Total CF -100 6 6 6 6 186IRR 17.30%

RETURN TO SPONSOR:Year 0 1 2 3 4 5

Initial Investment -50Exit Proceeds 216Return Multiple (216/50) 4.3XIRR 34.00%

LBO Financing

1) determine debt capacity2) determine equity needed from sponsor3) find total financing amount4) find purchase price in terms of EBITDA5) determine if lender’s equity

requirement satisfies return required by sponsor

Debt Capacity

• need to find in order to determine affordable price for LBO

• example 3 (Arzac) – Consider a target with 1st-year pro-forma EBITDA of $150m, growth rate of sales and EBITDA of 7%, initial cash balance of $1.9m, and senior secured debt making up 73% of total borrowing to be amortized in 7 years. (Firm has debt capacity of about 4.74x EBITDA or 4.74*150m = $710.8m, amortize $322.8m of it, and be left with the $388m of subordinated debt at the end of year 5 and a cash balance of $2.6m. See Exhibit 7.5.) Assume that the LBO sponsor expects to exit the investment in 5 years at 7x forward EBITDA. What is residual equity at the end of the 5th year? If the sponsor requires 30% return, what is the max equity that can be used and an affordable purchase multiple? Fees and expenses are .15x EBITDA.

Peregrine Coatings• Peregrine Coatings was a small specialty chemical company

engaged in the manufacturing and distribution of coatings, paints, and related products primarily in the United States. In the spring of 2005, its owner, a diversified chemical company decided to sell Peregrine Coatings. As is customary in this type of transaction, Peregrine was to be sold with no cash and no outstanding debt. Assume that lenders are willing to lend on a secured basis up to 60% of total debt and required 25% of the purchase price to be equity. They would be charged 6.7% cash interest and require the term loan to be paid down with all available pre-loan amortization cash flow over 7 years. Subordinated lenders would provide 40% of the total debt at 8% cash interest with principal due in 7 years. Both loans would be callable after 12/31/2010 without penalty. The sponsor needed to supply the remaining 25% of the capital and required a 25% IRR. Fees and expenses associated with the transaction would be about 2% of the purchase price.

Exhibit 13.2. Peregrine Coatings. Seven-Year Projections($ millions)

Actual

2006 2007 2008 2009 2010 2011 2012 2013

Sales 578.0 630.0 683.6 741.7 801.0 861.1 921.4 985.9 EBITDA 93.1 107.1 119.6 133.5 144.2 155.0 161.2 172.5 Depreciation 16.0 18.9 20.5 22.3 24.0 25.8 27.6 29.6 Deferred taxes 11.6 12.6 13.7 14.8 16.0 17.2 18.4 19.7 Capital expenditures 34.0 29.3 31.2 33.9 35.9 37.8 39.7 42.5 Increase in net working capital including cash 7.1 4.1 3.8 7.6 7.7 7.8 7.8 8.4

Projection assumptions:Net sales growth 9.0% 9.0% 8.5% 8.5% 8.0% 7.5% 7.0% 7.0%EBITDA margin 16.1% 17.0% 17.5% 18.0% 18.0% 18.0% 17.5% 17.5%Net fixed assets/sales 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%Net working capital less cash/sales 12.0% 11.5% 11.0% 11.0% 11.0% 11.0% 11.0% 11.0%Cash and marketable securities/sales 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0%Depreciation/sales 2.8% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%Deferred taxes/sales 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0%

5.31% 5.12% 5.59% 5.44% 5.30% 5.16% 5.16%

Exhibit 13.3. Peregrine Coatings. Debt Capacity of Leveraged Buyout as of 12/31/2006 ($ millions)

Year-end 2006 2007 2008 2009 2010 2011 2012 2013

Net Sales 578.0 630.0 683.6 741.7 801.0 861.1 921.4 985.9 EBITDA 93.1 107.1 119.6 133.5 144.2 155.0 161.2 172.5 Depreciation 16.0 18.9 20.5 22.3 24.0 25.8 27.6 29.6 EBIT 77.1 88.2 99.1 111.3 120.2 129.2 133.6 142.9 Interest income @ 5.00% 0.6 0.7 0.7 0.8 0.9 0.9 1.0 Senior debt interest @ 6.70% 22.9 21.1 18.7 16.0 12.8 9.0 4.8 Subordinated debt interest expense @ 8.00% 18.2 18.2 18.2 18.2 18.2 18.2 18.2 Income before taxes 47.7 60.4 75.0 86.7 99.0 107.3 120.9 Provision for tax 40% 19.1 24.2 30.0 34.7 39.6 42.9 48.4 Net income 28.6 36.3 45.0 52.0 59.4 64.4 72.6 Deferred taxes 12.6 13.7 14.8 16.0 17.2 18.4 19.7 Depreciation 18.9 20.5 22.3 24.0 25.8 27.6 29.6 Capex and incr in net work. capital. incl. cash 33.4 35.0 41.4 43.6 45.7 47.5 50.9

Available for debt retirement 26.7 35.4 40.7 48.5 56.8 62.9 71.0

Debt amortization Senior debt 341.9 315.3 279.8 239.2 190.7 133.9 71.0 0.0

Subordinated debt 228.0 228.0 228.0 228.0 228.0 228.0 228.0 228.0 Debt balance 569.9 543.2 507.8 467.1 418.7 361.9 299.0 228.0 Cash balance 12.6 13.7 14.8 16.0 17.2 18.4 19.7 21.1

Debt/2006 EBITDA 5.32

EBITDA net interest coverage 2.6 3.1 3.7 4.3 5.1 6.1 7.8

Lender requirement: 25% of purchase price, hencePercent EBITDAx ($000)of capital

Debt capacity 75% 5.3 569.9 Equity 25% 1.8 190.0 Total 100% 7.1 759.8 Fees and expenses 2% 15.2

744.7 Less cash 12.6 Offer price 732.1 2006 EBITDA 107.1 EBITDAx 6.835 2012 EBITDA 161.24 Enterprise Value at entry multiple of 6.84 1,102.1 Minus fees & expenses 2% 22.0 Minus net debt at end of 2010 343.4

736.6 Sponsor's IRR with exit in 2010 31.1%

Exhibit 13.4. Peregrine Coatings LBO Return on Equity and Affordable Bid($ millions)

2012 EBITDA 161.2 EBITDAx 6.84 Enterprise Value before+C113 fees & expenses 1,102.1 Minus fees & expenses 2% 22.0 Minus net debt at the end of 2011 343.4 Exit equity 736.6 Present value of equity at 25% 241.4 Return multiple 3.1x

Net debt 554.7 Equity 241.4 Affordable bid for enterprise $796.1EBITDAx 7.43x

Exhibit 13.5. Peregrine Coatings LBOValuation of Unit of Note and Equity Kicker($ millions)

Year-end 2006 2007 2008 2009 2010 2011

Junior subordinated note principal 110.95 Coupon payments @ 5.0% 5.55 5.55 5.55 5.55 5.55 Principal repayment 110.95 Note cash flow 5.55 5.55 5.55 5.55 116.50 Equity kicker to yield 12.0% 49.34 Expected cash flow on unit 5.55 5.55 5.55 5.55 165.83 Present value of unit @ 12.0% 110.95

Equity Kicker($ millions)

2011 EBITDA 161.2 EBITDAx 6.84 Enterprise Value minus fees & expenses 2% 1,102.1 Minus net debt at the end of 2010

Senior debt 146.0 Subordinated note 228.0 Junior subordinated note 110.9 Minus cash balance 18.4 466.5 Exit equity 635.6 Required equity kicker 49.3 Equity kicker as percent of equity 7.76%

Exhibit 13.6. Peregrine Coatings LBO Valuation of Junior Subordinated Note and Original Issue Discount Amortization

($ millions)

Year-end 2006 2007 2008 2009 2010 2011 2012 2013

Junior subordinated note principal 110.9$ Coupon payments @ 5.0% 5.5 5.5 5.5 5.5 5.5 5.5 5.5 Principal repayment 110.9 Note cash flow 5.5 5.5 5.5 5.5 5.5 5.5 116.5 Present value of note @ 8.75% 89.8 92.1 94.7 97.4 100.4 103.6 107.1 110.9 Original issue discount (OID) 21.1$ 18.8 16.3 13.6 10.6 7.3 3.8 - OID amortization 2.3 2.5 2.7 3.0 3.2 3.5 3.8

Exhibit 13.7. Peregrine Coatings Cash Flow and Debt Balance with Junior Subordinated Financing($ millions)

Year-end 2006 2007 2008 2009 2010 2011 2012 2013

Net Sales 578.0 630.0 683.6 741.7 801.0 861.1 921.4 985.9 EBITDA 93.1 107.1 119.6 133.5 144.2 155.0 161.2 172.5 Depreciation 16.0 18.9 20.5 22.3 24.0 25.8 27.6 29.6 EBIT 77.1 88.2 99.1 111.3 120.2 129.2 133.6 142.9 Interest income @ 5.00% 0.6 0.7 0.7 0.8 0.9 0.9 1.0 Senior debt interest @ 6.70% 22.9 21.3 19.1 16.5 13.4 9.8 5.7 Sub. debt interest @ 8.00% 18.2 18.2 18.2 18.2 18.2 18.2 18.2 Jr sub note interest @ 5.00% 5.5 5.5 5.5 5.5 5.5 5.5 5.5 Original issue discount amortization 2.3 2.5 2.7 3.0 3.2 3.5 3.8 Income before taxes 39.8 52.2 66.4 77.7 89.6 97.4 110.6 Provision for tax 40% 15.9 20.9 26.6 31.1 35.8 39.0 44.2 Net income 23.9 31.3 39.8 46.6 53.7 58.5 66.4 Deferred taxes 12.6 13.7 14.8 16.0 17.2 18.4 19.7 Depreciation and oth non-cash items 18.9 20.5 22.3 24.0 25.8 27.6 29.6 OID amortization 2.3 2.5 2.7 3.0 3.2 3.5 3.8 Capex and incr in net work. Capital 33.4 35.0 41.4 43.6 45.7 47.5 50.9 Available for debt retirement 24.3 33.0 38.2 46.0 54.4 60.5 68.6 Debt amortization Senior debt 341.9 317.7 284.7 246.4 200.4 146.0 85.5 16.9 Subordinated debt 228.0 228.0 228.0 228.0 228.0 228.0 228.0 228.0 Junior subordinated debt 110.9 110.9 110.9 110.9 110.9 110.9 110.9 110.9 Debt balance 680.8 656.6 623.6 585.3 539.3 484.9 424.4 355.8 Cash balance 12.6 13.7 14.8 16.0 17.2 18.4 19.7 21.1 EBITDA net interest coverage 2.3 2.7 3.2 3.7 4.3 4.9 6.0

Exhibit 13.8. Peregrine CoatingsOwnership with Management Stock Options($ millions, except share value and exercise price)

2011 Enterprise value minus fees & expenses 1,102.1 Minus fees and expenses 2% 22.0 Net debt 466.5 2011 Equity value 613.5 Options 500,000 Exercise price 20.60 Exercise proceeds 10.3

623.8 Diluted shares 10,500,000 Value per share 59.41 Management ownership 4.76% 29.7 Mezzanine ownership 7.91% 49.3 Sponsor ownership 87.33% 544.8 Total 100.00% 623.8

Initial ownership:Mezzanine investors 8.30% 830,453 Sponsor 91.70% 9,169,547

100.00% 10,000,000

Exhibit 13.9. Peregrine Coatings. Adjusted Present Value as of 12/31/2006($000)

Year-end 2006 2007 2008 2009 2010 2011

Net Sales 578.0 630.0 683.6 741.7 801.0 861.1 EBITDA 93.1 107.1 119.6 133.5 144.2 155.0 Depreciation 16.0 18.9 20.5 22.3 24.0 25.8 EBIT 77.1 88.2 99.1 111.3 120.2 129.2 Taxes 40% 30.8 35.3 39.6 44.5 48.1 51.7 Unlevered net income 46.3 52.9 59.5 66.8 72.1 77.5 Defered taxes 12.6 13.7 14.8 16.0 17.2 NOPAT 65.5 73.1 81.6 88.1 94.7 Depreciation 18.9 20.5 22.3 24.0 25.8 CAPEX & increase in net WC. 33.4 35.0 41.4 43.6 45.7 Unlevered free cash flow 51.0 58.6 62.4 68.5 74.9 Net interest expense 48.4 46.9 44.8 42.5 39.6 Tax shield 19.4 18.8 17.9 17.0 15.8

Unlevered cost of equity 13.58%PV FCF 2007-2011 @ 13.58% 213.7 Continuation value @ EBITDAx 7.8x 1,257.7 PV 2011 continuation value @ 13.58% 665.4 PV Tax shield @ 8.75% 70.2 Enterprise value (EV) 949.2 Private equity discount on EV 20% 189.8 EV after private equity discount 759.4

Peregrine Coatings Cost of Capital Calculation

Unlevered kLong-term government bond yield 4.60%Market equity premium 4.35%Beta coefficient 1.17 Cost of equity before small cap premium 9.68%Small capitalization premium 3.90%Peregrine Coatings cost of equity 13.58%