Leverage Buyout

Debt component roughly classified into 4 categories

1. LT Senior Debt (commercial banks, insurance co and pension funds) 2. Medium-Term Debt (Commercial Banks) 3. Revolving Credit (commercial banks) 4. Subordinated (unsecured) debt: (commercial banks, insurance companies, mezzanine, and high-yield funds). May include equity component via warrants, etc.

Sources of Funds

1. Newco debt & preferred stock --Financial sponsors take on a lot of debt. 2. Sponsor Equity --LBO sponsors finance remainder of purchase price using their own equity 3. Excess Cash --Sponsors assume Oldco's debt as well as cash

What is a "PIK" security?

It stands for Paid-in-Kind. Instead of paying someone cash interest or dividends, you simply pay them with more debt or preferred stock. This conserves cash for the company but compounds the obligations each year

What is an LBO?

Leveraged buyout is a specific type of acquisition transaction, where most of the purchase price is funded with debt, and the company is "taken private" --The remaining portion is funded with equity by the financial sponsors, or PE investors --Under an LBO, a company that undergoes a recapitalization to a highly leveraged financial structure becomes a new company

What is the basic intuition underlying an LBO?

Real Estate Property: --The enterprise value is the value of the entire property, and the equity value is the residual value after all non-equity claims are paid off --As CFs generated through the asset's operations are used to pay down debt principle, the equity value of the asset increases --Monetize their profits through: 1. Selling the company 2. Taking it public (IPO) 3. Recapitalization: essentially involved dividending equity investors and financing it via newly borrowed debt

LBO Considerations

While LBO sponsors consider CCA, CTA and DCF to determine value, most important pricing considerations: 1. Cash generating capability 2. Debt amortization payments 3. Internal Rate of Return (IRR) 4. Multiple of Invested Capital (MOIC) To execute an LBO, enough cash must be raised from equity investors and debt sources to buy out existing shareholders and pay off debt holders

LBO REMEMBER

--An LBO analysis will give you a "floor" value because any strategic bidder should be able to outbid a financial sponsor if it is able to realize revenue or cost cutting synergies from the deal --Strategic bidders typically have a lower required rate of return than financial sponsors, effectively allowing them to increase their offer price and not worry as much about the lower returns as consequence

How do you determine Enterprise Value and Equity Value in the exit year?

--Enterprise Value = Exit year proj EBITDA * assumed EBITDA multiple --Equity Value = Enterprise Value - net debt in exit year

What is the rationale behind an LBO? Walk me through it.

--In an LBO, equity investors initially finance the acquisition with a lot of debt and put up relatively small amount of equity. Let's conservatively assume that the pre-LBO EV/EBITDA multiple persists until sponsor's exit. If the owners can successfully pay down debt over time, they will earn large returns (30-40%) on their equity investment (which grows as a portion of the total enterprise value)

What are advantages and disadvantages of both senior debt and subordinated (mezzanine) debt?

--Senior: lowest interest rate, but most restrictive covenants --Subordinated: least restrictive, but highest interest rates

Debt

--The balance of purchase price funds typically comes from commerical and IBs in the form of BRIDGE loans, TERM loans, and/or REVOLVERS --Focus for lenders is on the collateral of the company (hard assets vs. cash flow), on the level of equity financing being provided by the sponsor, the creditworthiness of the newly recapitalized company (coverage ratios), and the number of years required for the new company to repay the bank debt (usually 5 years)

Uses of Funds

1. Buyout of Oldco Shareholders --Sponsors acquire Oldco's equity by purchasing Oldco's shares outstanding 2. Oldco Debt Refinanced --The sponsors also assume existing debt 3. Purchase of Oldco preferred stock 4. Financing Fees --Acquirers incur borrowing-related financing fees 5. Transaction fees

General lending ratios

1. Debt / Equity 2. EBIT Coverage = EBIT/Interest Exp 3. EBITDA Coverage = EBITDA/Interest Ep 4. (EBITDA - CapEx) / Interest Exp 5. Total Debt / EBITDA 6. Senior Debt / EBITDA 7. Interest / EBITDA

LBO Analysis Advantages

Advantages: --Will help determine realizable financial value that any strategic bidder will have to exceed --LBO value is realistic, in the sense that it can be achieved by a well-defined process

What makes a good LBO candidate?

As a result of high debt burden, good LBO candidates: --Steady, predictable CFs with little cyclicality --Minimal ongoing CapEx and WC investment requirements --Little existing leverage ->ability to take on leverage and restructure --Business is deemed undervalued in the market --Subsidiary business that can be sold to help pay down debt --Tax benefits from interest expense --Strong managment team that believes it is being hampered operating as a public company

LBO Analysis Disadvantages

Disadvantages: --Stand-alone LBO may underestimate strategic sale value by ignoring synergies with acquirer --Value obtained is sensitive to projections and aggressiveness of operating assumptions (less so than DCF) --Only meaningful for companies which could operate under high financial leverage (i.e. steady CFs, non cyclical) --Need realistic projected financial statements over 4-5 years --Sales growth rate, margins, and discount rates are key to valuation

Capital Structure

Equity/Debt ratios from 10/90% in 1980s to around 35/65% today

Characteristics of an LBO?

Higher debt level = higher debt-related pmts = lower CFs = Restricts managment --Cant afford to have a bad year --Forces mgmt to become extremely disciplined --Often takes form of conservative capital spending (limit expansionary capital expenditures to a min, where D&A move towards alignment with CapEx) --Cant make large acquisitions --Reduce capital spending (CapEx) increases FCF (since FCF=OpCF - CapEx)

Where do financial sponsors typically get their money?

Insurance companies, pension funds, endowments, high net worth individuals, etc.