Leveraged Buyouts

Wharton School Corporate Valuation -- Chapter 18Copyright, Robert Holthausen, 2007

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Leveraged Buyouts

CharacteristicsEvidence on LBOs

An LBO (Private Equity) ModelReverse LBOs


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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 an LBO sponsor who contributes capital and expertise (KKR, Bass Brothers, Blackstone, etc.) and management team.


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Distinct Features of an LBO• Significant increase in financial leverage

– Average debt/total capital increases from 20% to 70%• 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


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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


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

– Total debt often 60-80% of entire deal (4-5 x LTM EBITDA, but depends on industry, cash flow, 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


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LBO Financing• LBO 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)


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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 (recently 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)• 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 like to see 25% to 35% equity for protection


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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.


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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 call the liquidation preference) -- often sold with warrants. Alternatively, can issue convertible preferred instead of including warrants.


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Common Equity• Typically 25% - 35% of capital

structure now, but varies over time.• Typically seeking a 20%-30% IRR• 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.


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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 – potential tax advantages for managers.

• 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.


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LBO 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


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LBO 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.


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Financial Sponsor M&A Activity

$759

$232

$50 $87 $103

$64$92 $95

$151

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

$1,000

$1,100

$1,200

1998 1999 2000 2001 2002 2003 2004 2005 2006 20070%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Total $ Value of Sponsor Deals % of Total Value of M&A Deals

$ in billions % of Total Value

___________________________

Source: SDC.

1999-2007 Global Sponsor M&A Activity

$1,105

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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?


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U.S. LBO Acquisition Financing Market Trends

3.4 3.4 2.6 2.7 2.8 3.3 3.5 3.6 3.5 3.3 2.9 2.2 2.4 2.3 2.7 3.1 3.35.4

3.3 2.0 2.4 2.5 2.5 1.9 2.3 2.1 1.7 1.2 1.2 1.5 1.4 1.7 1.5 1.3 1.1

0.6

0x

3x

6x

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

Bank Debt/EBITDA Non-Bank Debt/EBITDA

Average Debt Multiples

________________Source: S&P Leveraged Commentary & Data. Excludes media loans. Too few deals in 1991 to form a meaningful sample.

10% 13% 21% 22% 25% 26% 24% 23%30% 32% 36% 38% 35% 40% 40% 35% 32% 31% 33%

2%2% 3%3% 4% 4% 4% 6% 3% 5% 3%0%

25%

50%

1988 1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Rollover Equity Contributed Equity

Average Equity Contribution to LBO

Sample Capital Structure Terms for Leveraged Deals

10%22% 22% 25% 26% 24% 23%

33% 40%36% 42% 41% 43% 45%38% 34%

13%

6.7x5.4x 5.0x 5.2x 5.3x 5.2x 5.8x 5.7x 5.2x 4.5x 4.1x 3.7x 3.8x 4.0x 4.2x 4.4x

34%

6.0x

35%

4.4x

30


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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.


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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


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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


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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


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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)


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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.


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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.)


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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


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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)


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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


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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


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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


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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


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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


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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


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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

Leveraged Buyouts

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