Prof. Ian Giddy New York University Structuring LBO Financing.

Prof. Ian GiddyNew York University

StructuringLBO Financing

Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 2

Leveraged Buy-Outs

LBO is a transaction in which an investor group acquires a company by taking on an extraordinary amount of debt, with plans to repay the debt with funds generated from the company or with revenue earned by selling off the newly acquired company's assets

Leveraged buy-out seeks to force realization of the firm’ potential value by taking control (also done by proxy fights)

Leveraging-up the purchase of the company is a "temporary" structure pending realization of the value

Leveraging method of financing the purchase permits "democracy" in purchase of ownership and control--you don't have to be a billionaire to do it; management can buy their company.


Leveraged Financing

Leveraged Finance is the provision of bank loans and the issue of high yield bonds to fund acquisitions of companies or parts of companies by

an existing internal management team (a management buy-out),

an external management team (a management buy-in), or

a third party (a leveraged acquisition).


M&A and Leverage

Leveraged buyout?

Company has

unused debt

capacity Leveraged

recapitalization?

Takeover?


Corporate Restructuring

Divestiture—a reverse acquisition—is evidence that "bigger is not necessarily better"

Going private—the reverse of an IPO (initial public offering)—contradicts the view that publicly held corporations are the most efficient vehicles to organize investment.


Going Private

A public corporation is transformed into a privately held firm

The entire equity in the corporation is purchased by management, or managment plus a small group of investors

These account for about 20% of public takeover activity in recent years in the United States.

Can be done in several ways: "Squeeze-out"—controlling shareholders of the firm buy up

the stockholding of the minority public shareholders Management Buy-Out—management buys out a division or

subsidiary, or even the entire company, from the public shareholders

Leveraged Buy-Out (LBO)


LBOs, Agency Costs and Free Cash Flow "Free cash flow" is cash-cow type

earnings in excess of amounts required to fund all positive-NPV projects

Payout of free cash flow, to stockholders, reduces the amount of resources under managment's discretion. Forces management to go out into the markets and justify raising funds

Thus debt has a disciplining role. “Safe” managers choose less debt.


Seagate

1. Show, with a diagram, the restructuring that resulted in the Seagate LBO

2. How would the buyers create value?

3. How would they realize that value?


Seagate

1998

SEAGATE

VERITAS

40% for $1.8b


Seagate

2000

SEAGATE

VERITAS

40% worth $22b

100% worth $16b

Seagate

shareholders

Distribution taxable at

39.2%?


Seagate

Nov 2000

VERITAS

Seagate

shareholders

SEAGATE Disk drive

business

109m Veritas shares

(worth $18.7b)

NEWCO128m Veritas

shares

(worth $22b)

$2b cash

Management,

Chase,

Goldman

Silver Lake

Partners

Cost $1.65b

after tax


Seagate

NEWCO

Disk

drive

businessEquity $1b

Debt $1b

Management,

Chase,

Goldman


Typical LBO Sequence

Company gets bloated or slack and stock price falls

LBO offer made

LBO completed

Restructuring Efficiencies Divestitures Financial

? years 3-9 months 5-7 years

IPO or sale of company


Can the Financing Work?

1 2 3 4 5 6Debt ($m) 5.5 5 4.5 4 3.5 3Equity ($m) 1 1.09 1.273 1.55845 1.957218 2.4818

EBITDA 1080000 1401000 1761150 2166323 2623271 2835434Interest 550000 500000 450000 400000 350000 300000Coverage Ratio 1.96 2.80 3.91 5.42 7.50 9.45

LBO Leverage Analysis

0

2

4

6

8

10

1 2 3 4 5 6

Debt ($m) Equity ($m) Coverage Ratio


Can the Financing Work?

Free Cash Flow Analysis of LBO

-800000

-600000

-400000

-200000

0

200000

400000

600000

1 2 3 4 5 6

FCFF Interest*(1-T) Principal repayment FCFE

1 2 3 4 5 6FCFF 220000 253000 290950 334592.5 384781.4 404020.4

- Interest*(1-T) 330000 300000 270000 240000 210000 180000- Principal repayment 500000 500000 500000 500000 500000 0

= FCFE -610000 -547000 -479050 -405408 -325219 224020.4


LBO Financing

NEWCO

Disk

drive

businessEquity $0.25b

Senior

debt $1b What securities?

What returns?

What investors?Mezzanine


The Financing SpectrumE

xpec

ted

Ret

urn

Risk

Senior secured debtSenior secured debt

EquityEquity

Senior unsecured debtSenior unsecured debt

Subordinated debtSubordinated debt

Preferred equityPreferred equity

Convertible debtConvertible debt


What Are The Alternatives?

Asset-backed or cash flow-backed debt Senior debt Subordinated debt Subordinated debt with upside

participation Subordinated debt with equity option Preferred equity Restricted shares Common stock


Subordinated High Yield Debt

“Junk bonds” – like equity, but allow increased financial leverage

Tax advantage over equity Big market in USA (institutional investors) and

increasing in Europe Leveraged loans favored by certain

commercial banks Often used in connection with M&A and LBOs Behave like equity – and often have equity

participation


Sub Debt -- Motivations

Optimization of financial leverage Regulatory-driven capital requirements Rated asset securitizations (senior-sub

structure in asset-backed securities) Insider or supplier-credit subordination

(eg in project finance) Work-outs and restructurings (existing

borrowers agree to seniority of new loans, to buy time)


Sub Debt’s Big Problem: High Interest!

Solutions Deep discount subordinated debt Subordinated debt with equity warrants Convertible subordinated debt Participating subordinated debt Puttable subordinated debt


Convertibles

ConversionValue

StraightBond Value

Market ValueMarket Premium

Value

of

Convertible

Bond

($) 0

Price Per Share of Common Stock


Warrants

TheoreticalValue

Market ValueMarket Premium

Value

of

Warrant

($)

0Price Per Share of Common Stock ($)


Preferred Equity

Legally a form of equity Claim senior to ordinary equity May have fixed dividend, or may be

“participating” But cannot trigger liquidation if payment

missed Par value determines liquidation claim


Convertible Preferred

Used by venture capital firms Permit investors to participate in growth But give preference in liquidation if the

venture fails And disguise share value (tax!) A variant – PERCS* give issuer right to

convert into common stock

*Preferred equity redemption cumulative stock


Preferred Stock: Pros and Cons

Advantages No dilution of control Dividends

conditional on availability of earnings

Omission cannot force liquidation

Disadvantages Higher after-tax cost

than debt Lower return on

equity Limited investor

interest


Motivations for Issuing Hybrid Bonds

Company has a view There are constraints on what the

company can issue The company can arbitrage to save

money Always ask: given my goal, is there an

alternative way of achieving the same effect (e.g., using derivatives?)


Why Use a Hybrid?

Motivations for Hybrids

Linked to business risk

Linked to

market risk

Cannot hedge

with derivatives

Driven by investor needs

Company hedges

Company does not

hedge

Debt or

equity are

Not good enough


Case Study: Le Meridien

What kind of financing package would enable Royal Bank to beat other commercial and investment banks in the Meridien deal? Who are potential rivals, and what strengths might give them a competitive edge?

If RBS offers sale-and-leaseback financing, what should be the structure and terms of the deal, terms that make sense for the client as well as for the bank?

If RBS offers equity participation, what form should this take? Common stock or mezzanine finance? Or should the bank avoid the risks of an equity investment?

Would asset-backed securities be suitable as a financing source for this acquisition?


Case Study

The John Case LBO Proposal Devise a recommended financing plan

John Case (owner)

Buyers VC Investors

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Prof. Ian Giddy New York University Structuring LBO Financing.

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