leveraged-buyouts; market mechanism, tax shield and exiting of an lbo
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MARKET MECHANISM, TAX SHIELD AND EXITING OF AN LBO
Research report drafted by Guillaume ALLEGRE Under the supervision of Jean-‐François Louit, Partner in Scotto & Associés.
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Acknowledgements
Before beginning this research report, I would like to express my appreciation and thanks to my supervisor, Partner Jean-‐François Louit who has been a great advisor for me. You encouraged me in my research and help me in order to construct the best plan I can find.
I would also like to thank Laurent Durieux who has been so precious to explain what I have to look for in order to draft this research report. I can’t thank you enough for encouraging me throughout this experience. Your advices on my research as well as on my career have been invaluable.
I would like to take this opportunity to thank Partner Richard Schepard and all his associates of Bredin Prat Paris Office who have devoted few time in order to help me in my research about LBO transactions.
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Table of Contents
PART I – PLAYERS AND FUNDS TO BUILD AN LBO. .............................................................................................. 9 CHAPTER I – PLAYERS. ................................................................................................................................................................ 9 SECTION I – Current owners and investors. ....................................................................................................................... 9
I – The investor in an LBO transaction. ................................................................................................................................................................. 9 A) The financial impact of private equity funds. ......................................................................................................................................... 9 B) Return on investor’s investment. .............................................................................................................................................................. 11
II – The seller of the company. ................................................................................................................................................................................ 12 A) Different alternatives to sell a company. ............................................................................................................................................... 12 B) Selling a company through an LBO transaction. ................................................................................................................................ 12
SECTION II – Lenders, debt investors and existing creditors. .................................................................................. 14 I – Banks, the major lenders. ................................................................................................................................................................................... 14 II – The unsecured lenders. ...................................................................................................................................................................................... 16 III – The risky situation of existing lenders. ..................................................................................................................................................... 17
CHAPTER II – SOURCES AND USES OF FUNDS. .............................................................................................................. 18 SECTION I – Sources of funds. ................................................................................................................................................ 18
I – Equity capital. .......................................................................................................................................................................................................... 18 II – Tranches of debt. .................................................................................................................................................................................................. 19
A) First lien debt. ................................................................................................................................................................................................... 20 B) Second lien debt. .............................................................................................................................................................................................. 20 C) High yields and junk bonds. ........................................................................................................................................................................ 21 D) Mezzanine debt. ............................................................................................................................................................................................... 22
SECTION II – Uses of funds. ..................................................................................................................................................... 23 I – Structuring an LBO transaction. ...................................................................................................................................................................... 23 II – Share deal and purchase agreement. ........................................................................................................................................................... 24
A) Acquisition equity. ........................................................................................................................................................................................... 24 B) Target’s net debt. ............................................................................................................................................................................................. 25
PART II – TAX SHIELD AND STRATEGIES FOR EXITING AN LBO. ................................................................... 26 CHAPTER I – TAX SHIELD IN AN ACQUISITION BY LBO. ............................................................................................ 26 SECTION I – Tax aspects in the world. ............................................................................................................................... 27
I – Deductibility of interest expenses. ................................................................................................................................................................. 27 II – Parameters existing in France in order to reduce taxes. ..................................................................................................................... 30
SECTION II – Limitation of tax leverage: example in France, The Netherlands. ............................................. 32 I – Example in France. ................................................................................................................................................................................................ 32
A) The “Charasse amendment” followed by the “Carrez amendment”. ......................................................................................... 32 1 – Charasse amendment. ............................................................................................................................................................................ 33 2 – Carrez amendment. ................................................................................................................................................................................. 34
B) Parent-‐subsidiary regime: a new French tax on dividend distributions. ................................................................................ 35 II – The Netherlands. .................................................................................................................................................................................................. 36
CHAPTER II – EXIT ROUTES IN LBO TRANSACTIONS. ................................................................................................ 37 SECTION I – Exit planning considerations. ...................................................................................................................... 37
I – Initial public offering; “Reverse LBO”. .......................................................................................................................................................... 37 II – Alternative ways for exiting an LBO . .......................................................................................................................................................... 39
SECTION II – Capital gain, carried interest and tax aspects. ................................................................................... 40 I – Concept of carried interest. ............................................................................................................................................................................... 40 II – Comparison between the USA and in France. .......................................................................................................................................... 41
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List of abbreviations.
LPs: Limited Partnerships,
LLPs: Limited Liability Partnerships
LLCs: Limited Liability Companies
LBOs: Leveraged Buyouts
PEF: Private Equity Funds
EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization
LIBOR: London Interbank Offered Rate
ESOP: Employee Stock Ownership Plan
SPA: Share Purchase Agreement
SEC: U.S. Securities and Exchange Commission
TEV: Transaction Enterprise Value
ETR: Effective Tax Rate
GAAR: General Anti Avoidance Rule
SPV: Special Purpose Vehicle
IPO: Initial Public Offering
CFC: Controlled Foreign Corporation
CBTD: Cross Border Tax Differential
CPS: Cash Pooling Scheme
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Today, every student who is looking for a job in investment banking law or corporate finance is probably going to have to know one thing or two about companies buying others.
There are many types of transactions to buy a company but one of them will be especially studied during this research report, the LBO.
An LBO or leveraged buyout is simply put, one company buying another one and using for this a large amount of debt. That’s it. So why all the fuss about this type of transaction? Why today the international press speak about the LBO and his bad economics consequences? Why does this type of transaction is preferred from other types of mergers and acquisitions?
In fact, the answer rests in the inherent risks that go with a transaction that financed primarily with borrowed money that is to say with debt. By way of introduction, there are few specifics things that we need to mention about the debt used in a leveraged buyout transaction.
At first, the assets of the target very often secure the debt that we use to acquire the target company. That’s an essential point in every LBO. Indeed, the potential buyer, namely, the person who would like to acquire the target, does not necessarily need to possess the financial amount to purchase this target.
Indeed, the target just needs to have enough available collateral (in the form of assets) to allow an outside purchaser to have bank debt financing in order to pay for the transaction and the cost that has been stipulated. This plan supposes the target’s assets secure the bank debt.
The second point to mention about the nature of the debt is that it can come from either bonds or bank loans (these notions will be detailed after).
If the case of bonds, this means that it’s issued and sold to investors in capital markets.
As we study it later, the high levels of debt associated in LBO’s transactions very often results in the bonds being rated as junk or below investment grade. We easily understand that as credit ratings are used to appreciate the risk of default, loading up a target with debt will naturally increase this risk.
Moreover and to continue in this idea, the higher the risk, the higher the interest rate the bank or the market is going to demand for lending the money.
In the case of the debt is structured by bank loans, financing means come directly from banks rather than buyers of bonds in capital markets. That’s an advantage for the purchaser in terms of security of the debt. Bank loans included interest expenses, which will be often calculated as a variable rate. It’s common for the lender to charge
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the borrower an interest rate of LIBOR and an additional amount of money which is called “spread”.
The LIBOR is the short term for London Interbank Offered Rate. Simply, it’s the interest rate at which banks offer to lend funds to one another in the international and interbank market. It’s set every day approximately at 11 AM, by a certain number of international banks.
The spread is an indicator of the risk that is associated with the borrower and the seniority of the loan in the case of default.
Another important point of bank loans is that the lending is often syndicated amongst a group of banks in order to decrease the amount of lending exposure to any borrower that is to say, in order to reduce the risk of bad loans. Indeed, it’s easily to understand that if the amount of loan is split into many banks, the risk of a default scenario is consequently reduced.
For example, if a bank would lend an amount of money to a fund in order to buy a target with an LBO transaction, this bank has a couple of choices. On the one hand, the bank can lend $100 million to the buyer and charge an interest expense of LIBOR plus the spread. On the other hand, the bank can lend $10 million to the investor and get nine other banks in order to lend the remaining amount that is to say $90 million. The rate of interest charged will still be LIBOR and the same spread.
Under both scenarios, the sum of money that the bank earned from interest charged is the same but there is a reason to choose the second possibility. Indeed, what makes this option the better is about a default scenario namely when the buyer can’t reimbursed the amount granted.
If the bank chooses the first scenario and if the buyer is not able to pay back its loan, the bank takes on solely all the losses associated with this bad loan. By contrast, if the second possibility is chosen, the losses are split over the ten lending banks and interest that has been charged is still coming in from the other nine banks that are current with their interest payments.
In general, we can’t deny the fact that bank loans are far more complicated and so, multi faceted than bonds.
There are many different types of loans, including term loans, revolving credit facilities, but the most important thing to realize is that these banks loans can have floating interest rate and very often times, these loans are syndicated amongst several lenders as we said it above.
Contrary to banks loans, bonds are considered as fixe rated instruments and consequently, sold in capital markets.
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Why do a leveraged buyout? The answer is quite simple: to build an LBO requires a very close cooperation between the equity and debt providers but the purpose in the end is to make money. Indeed, any LBO has for essential goal to achieve the higher return on the initial equity investment of the investor.
For example, we can imagine a company purchased for an amount of $100 million. If the investor acquires this company with 100% equity capital and later, sold it for $110 million. In this case, the investor just made a 10% return on his initial investment. Alternatively, if the investor is able to obtain a (secured) loan for $90 million and made an initial equity capital investment of $10 million. He has to pay interest expense on the loan contracted, which happens approximately to be 7% per year.
After one year, if the investor is able to sell the company for $110 million, he will have to pay down the $90 million loan and pay $6,3 million for interest expense. He is left with approximately $14 million for himself, so a gain of $4 million compared with the first investment.
However, if it’s true to say that a leverage transaction present several advantages to investors, we can’t forget that at the same time, an LBO bring significant risks. It’s principally the ability of corporations to execute restructuring plans (steps post LBO), which will determine if a company can sufficiently handle the interest burden.
Where come from the leverage in an LBO? Classically, the leverage comes from the following three factors. At first, a financial leverage that is to say, an optimisation of the costs of funds. Secondly, a legal leverage namely, the possibility to take the control of the target with minimal equity capital. In the end, a fiscal leverage. On this point, we will study later that tax shield results on the debt financing.
Financial and fiscal leverage are of course, greatly reliant on the ability of the target group to service the acquisition finance. Legal leverage is organized around mezzanine finance or quasi-‐equity (it’s subordinated loans or convertible loans), one or more acquisitions vehicles and dynamic equity instruments and other vehicles such as securitisation (all these points will be developed later in the report).
What about the history of leveraged buyouts? LBOs reached a peak approximately in 2005 but the first big leveraged buyout took place in 1955 when McLean Industries Incorporation bought two companies 1 . The amount of money that has been borrowed was $42 million and this transaction raised a great return of investment. A new leveraged buyout boom took place in 1980, particularly in 1976 with the formation of KKR (Kohlberg, Kravis and Roberts), a private equity fund specialised in leveraged buyouts. One of the largest LBO is certainly the acquisition by KKR and Goldman Sachs of Energy Future Holdings for $44 million in 2007. Since our currently
1 International Chamber of Commerce n° MC-‐F5876.
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economic slowdown, the number of LBO has decreased and today, the returns of investment are more modest than the last 10 years.
Indeed, the crisis has resulted in a diminution of gains for the investors who would purchase a company by an LBO transaction. It’s easily understandable because a lot of company are today in financial troubles and we know that leveraged buyouts comes with risks.
When times are good that is to say, when a company is producing enough earnings to pay its suppliers, employees and the others, LBO is a beautiful thing. But in times of trouble, as today with the crisis, when the target acquired is not generating profits, LBO can be a deathblow. The principal risk is the risk of bankruptcy if the company’s returns are less than the cost of the debt financing.
Moreover, about a certain number of situations, it’s possible that investors are not able to respect their interest expense obligation. In good times, leverage seems as a wonderful idea but in bad times, the interest burden can weigh on the company; it becomes a weight and can sink the company in an ocean of debt. In the case of a bleak economic horizon, it’s very possible that the company has to file for bankruptcy and will be liquidated by the sale of its assets. So what is the situation of the players who participated in the LBO transaction?
Obviously, the lenders are first in line to obtain any proceeds from this sale. They recoup a portion of the debt they granted in the leveraged transaction so their losses may be limited. What about the equity investor? Unfortunately for him, he’s wiped out for his initial 10% (or more) equity investment.
During this research report, two parts will be successively dedicated to leveraged buyouts. In the first part, it will be important to define the general structure of an LBO. In other words, our attention must be focused on two aspects of this type of transaction. On the one hand, the different players who decide to build an LBO. On the other hand, sources and uses of funds which are used within this transaction.
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PART I – PLAYERS AND FUNDS TO BUILD AN LBO.
We need to distinguish between two types of issues. Who are the main actors and what is their role in the transaction? Secondly, where are the funds come from and how can players use of it?
CHAPTER I – PLAYERS. All players have a decisive role in an LBO. They can be split into two categories. There is the seller who manages the target and who must decide to accept or not the purchase offer. But the principal actor in this transaction will definitely be the investor. It can be an individual or a private equity group.
SECTION I – Current owners and investors.
Every LBO starts with the investor who has the central role. Everything starts when the individual or private equity group sees an opportunity and sets the process in motion. So, what is a private equity fund and how the investor can realize the greatest return possible on his initial equity investment?
I – The investor in an LBO transaction.
Leveraged buyouts are the most common investment strategy used by private equity firms.
A) The financial impact of private equity funds.
A private equity fund is often used to making investments and profits. Classically, in a private equity deal, an investor or a group of investors buys a stake in a company that he has chosen with the hope of ultimately, making an increase in the value of his initial investment.
Today, we can say that it exists a private equity industry2, which is a major force in the world.
When funds take the control of the company, they will usually take the company off the market if the company isn’t private already, go through a certain period of restructuring process and then, relist this company on the stock market.
Private equity funds are typically organized as limited liability partnerships – LLP, where institutional investors make a capital commitment to fund investments over
2 “Valuation ; measuring and managing the value of companies”, written by McKinsey and Company incorporation, July 26, 2010.
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the duration of the fund. Of course, private equity funds have a large variety of investment strategies but they tend to be specialized in venture capital funds and as far as we are concerned, buyout funds.
Buyout funds have typically sought to leverage their equity investment with debt, and are more concerned with the ability of a company to generate cash flows (which will be used to reimbursed the debt) than are a venture capital fund.
At its most basic level, a private equity fund is a large sum of money that is invested in a public (more rarely private…) company. The fund is managed by a team of skilled investment professionals who rapidly identify investment opportunities, make transactions and provide management.
Structuring a fund requires a particularly attention about state regulations, including securities law issues, tax problems, liability, or other issues. Generally, funds solve these issues through a limited partnership model, in which the investors hold limited partner’s interests and the management team holds an interest in an entity that serves as the general partner (refer to the drawing below). For example, in the USA, private equity funds are typically organized under “Investment Advisers Act”3. More especially, US based funds are often organized as Delaware limited partnerships. Indeed, Delaware law is used because of its familiarity to most practitioners and investors. Private equity funds formed to invest outside of the US are often formed as LPs or LLCs in offshore jurisdictions with favourable tax regimes like the Cayman Islands, the Channel Islands or Luxembourg.
The purpose of the fund limited partnership is to eliminate entity-‐level tax and protect the investors in the fund from personal liability for debts and obligations of the fund. As we have said, this model is most typically implemented through a limited partnership, but benefits can be achieved through a limited liability company – LLC – in jurisdictions where this form exists.
Private equity funds are managed by a management company organized by the 3 Investment Advisers Act, 1940, amended and approved January 3, 2012.
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sponsor, which may act as the “general partner” of the fund. This management company will play an important role in order to raise investment capital and execute investment transactions.
The purpose of a private equity fund that engage in LBO transactions is to achieve the most significant return on investment.
B) Return on investor’s investment.
Private equity funds have access to capital for investment and the best way for them to make money is to put the money that they do have to work, in the form of investments.
They look for a strong takeover target with small amounts of debt, strong cash flow and assets free for use as collateral. The investors spend lots of time analysing the potential returns from prospective deals and eventually choose whether to move on a company or not.
The choice of the target is so very important for any LBO transaction because the amount of debt will be reimbursed by dividends from the target.
The investor is so the “catalyst” behind the transaction. He must decide how aggressive or conservative should be any offer that is put forth the current ownership. To a certain extent, he also decides how much leverage to use in the transaction and more exactly, it’s only to a certain extent because at points of excessive leverage or non-‐creditworthy deals the lenders will decline to award credit.
The investor has totally discretion over the multiple of earnings it is wiling to assign as valuation and therefore the purchase price for the target company. It’s up to the investor to decide what is a reasonable valuation and what is offer price for a company. It’s naturally a decision that must take multiple factors in consideration. Of course, the investor will negotiate with the seller of the company in order to reduce the price as much as possible.
The investor is motivated to ultimately realize the greatest return possible on his investment. This is easier said than done. There are many factors that can affect the outcome but in the simplest sense, it is easier to realize greater returns on equity capital if that equity is a small number. In other words, the greater the amount of capital is low and so, the greater the amount of money borrowed is important, the greater the leverage will be important so the investor has to play as much as possible with the financial leverage.
However, the investor doesn’t want to saddle the company with such debt that he risks losing his entire investment because of a possible default. So for this reason, the investor is motivated to find a balance. The ideal is the greatest amount of debt possible that will not also sink the company down the road, leaving it able to pay
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down debt, increase earnings and eventually be sold at greater multiple of earnings than it was purchased for.
The investor has so a primary role in an LBO but this role is equally risky. To a certain extent, we can say that the fate of the transaction is already known when the amount of debt and equity are determined after negotiations although unpredictable events may affect the transaction.
II – The seller of the company.
A) Different alternatives to sell a company.
Based upon the attributes of the business and the overall objectives of the owners of the target, there are a certain number of alternatives that might be a better fit in order to sell a company. These alternatives, including for example dividend recapitalization and leveraged buyouts, can be attractive to shareholders from both a valuation and great outcome.
Dividend recapitalization is a process that provides shareholders with the ability to take cash out of the company by raising bank debt to support a special dividend. This strategy was particularly popular, for example in the USA in 2010, in anticipation of expected capital gains tax increases in 2011.
Another alternative would be to adopt an employee stock ownership plan, a widely used method in the USA. It involves the creation of a retirement benefit plan that borrows money in order to acquire stock in the company. Company assets must guarantee the debt and the proceeds are also used to purchase stock from existing shareholders and from the company. The main advantage of this method is tax issues.
But today, if you are a business owner looking to sell your company, your potential buyer will most likely include private equity funds as previously said. An LBO can also be accomplished through a private equity firm.
B) Selling a company through an LBO transaction.
To gauge the potential interest level of private equity funds, a business owner should develop an understanding of what this fund look for in an acquisition and why.
The seller also has an important role in the transaction. Indeed, the current owners of the company are the people who should know the most about the target, both inside and out. They understand the history and development of the company as well as the operating environment in which they do business.
The seller and investors should cooperate. The owner of the target is more likely to provide information about income, assets, financial, economic and social organization of the target.
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The current owners should also have a keen sense of where the market for their product is heading. It would be wrong to say that the seller has a passive role in the LBO, he has a really interest in working hand in hand with investor.
It’s up to the owners of the company to consider and ultimately accept or decline offers to sell their ownership in the company. As part of the process, the owners will most likely try to negotiate a larger multiple of earnings into the purchase price.
It is the job of the owners to test the upper limits of what the purchasers are willing to pay for the target and then, try to take that offer price a little further.
Business owners will find all sorts of justification for deserving a large multiple for their earnings; after all, that is what they are supposed to do…
When a business owner arrives at the decision to sell, there are few greater motivations than money. Although, some business owners may also consider such things as the identity of the purchaser, the future of the company post-‐sale, and the likelihood and degree of cost cutting after sale, rarely do any of these considerations trump monetary pay-‐off. It is safe to say that the primary motivation of the business owner is to get the greatest valuation and sale price possible for the business.
If the company has a bright future en growth potential is still relatively high, a savvy owner will logically demand a greater multiple of earnings for a purchase price before agreeing to sell.
Today, business sellers, buyers and advisors of them are facing many problems with respect to bringing a transaction with a successful conclusion. The values are down, financing is tough even non-‐existent, liquidations are increasing, and sellers and buyers are also giving up. Buyers’ advisors say that the valuation is too high based on financing; the sellers’ advisors say the price is too low and the sellers need in a certain extent an all cash sale to avoid risk.
While the economy has made it more difficult for buyers to obtain the optimal amount of financing required for leveraged buyouts, those buyers can attempt to bridge this financing gap by having sellers provide seller financing, for example in the form of seller notes or earn out payments.
We can define seller notes as a common means used to bridge the financing gap also it consists in asking the seller of a business to provide seller financing by taking a portion of the purchase price in the form of a “note” issued by the target. So more simply, it’s a form of debt financing used generally in small business acquisitions in which the seller agrees to receive a portion of the purchase price as a series of instalment payments. In some LBOs, the business buyer and seller may agree on deferred or interest only payments initially in order to reduce the cash flow pressure on the buyer during the business ownership transaction period.
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Concerning earn out payments in an LBO transaction, it is a contractual agreement by the investor of the target to pay to the seller of this company an additional value or compensation in the future depending upon how the target performs. There are a lot of ways to calculate and pay the compensation, but in general, it as a bonus that is paid based upon future performance. The measure used to calculate an earn out is generally based upon a percentage of the revenue. An earn out is usually used to close the value gap between the asking price of the seller and the purchase price which the buyer is willing to pay.
An earn out structure can take on many forms and the earn out amount is usually paid in either cash or equity.
For buyers, to set up an earn out clause reduces the risks of the purchase. By establishing a payment plan based on target performances in the future, investors can protect themselves from unwise purchasing decisions that have been made.
Sellers, on the other hand, can benefit from an earn out agreement because they can earn more over time from the sale if the clause is structured correctly and the company's performance is great. However, sellers also run a risk and could not obtain the full purchase price if the target performs poorly.
When the buyer has identified the target company and the seller is willing to sell, it is necessary to associate moneylenders. Without them, a leverage buyout can’t be realized because the financial and so, tax leverage depends on the amount of debt used to acquire the target.
SECTION II – Lenders, debt investors and existing creditors.
A leveraged buyout is a type of takeover where a substantial proportion of the acquisition price is financed by borrowings, using the target company's assets to reimburse the amount of debt. In other words, in an LBO transaction, the debt-‐equity level is very high.
Multiple tranches of debt are commonly used to finance LBOs, so there is no only one type of lender. Lenders are often classified into several categories according to the priority of debt reimbursement.
I – Banks, the major lenders.
The banks are without doubt one of the major lenders in every leveraged buyout transaction.
Typically, banks extend loans that are senior in the credit pecking order and secured by the assets of the target that is to say, company being acquired, and sometimes, by the assets of the investing company (hereafter, the “Newco”). This fact raises this following question; how would the lenders protect themselves?
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The transaction between a lender and Newco would generally involve the negotiation of a loan agreement where the lender would want various representations and warranties to be inserted.
In particular, the lender would want to accelerate the repayment of the loan in case of major breaches of the “entrenched covenants” and the specified “events of default”.
Also, the lender may want to impose restrictions on the creation of further charges on the security, or the disposal of the assets, investments in business or shares, issuance of new shares, etc. While negotiating, these requirements may conflict with Newco's desire to maintain flexibility as regards its business operations.
This problem may be reduced if banks participate as syndicated lenders as said in the introduction of this report. Under this scenario, several banks will come together to lend a portion of the total amount of debt. This reduces consequently the credit exposure each bank has to regarding to the borrower, while still allowing them to participate as a lender.
An investment bank often arranges the syndication, while commercial banks makeup a large number of the lenders, along with other investment banks participating in the syndication as lenders in the deal. Commercial banks have traditionally played an important role in leveraged buyout financing, as provide the majority of buyout debt, typically in the form of short-‐term and covenant-‐heavy term loans and revolving lines of credit.
Plainly, banks play an important role in takeover finance in general and more particularly in LBO transactions. Commercial bank lending facilitates LBO deals. Consequently to the extent that they exercise their authority, banks have placed themselves in a position to control the borrowing firm’s capital. Indeed, the lending bank can design a loan contract to protect its interests against substantive changes in the borrowing firm’s operating and financial condition.
Without diminishing their function of resource allocation, banks also contribute importantly to the borrowing firm’s operational and financial decisions.
Along with the credit supplied to the borrowing firm are explicit conditions that restrain management’s actions regarding the firm’s operations, asset disposition and executive changes;
It’s the role of the bank to evaluate the projected credit situation of the company post-‐transaction and to offer or decline lending terms based on the creditworthiness of the company under the proposed capital structure (capital structure will be detailed later in this report).
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The banks are motivated to assess the risk of lending correctly and set interest rates that are an appropriate reflection of that risk.
If a bank does lend, it wants to make sure it is receiving adequate payment for the risks involved.
II – The unsecured lenders.
Debt investors are oftentimes the unsecured creditors in the deal and, as a matter of course, command a higher fixed rate of interest, often referred to as high yield, which is compensation for firstly, being unsecured and secondly, being junior in the credit pecking order to the senior secured bank debt.
Indeed, these creditors find their place in the deal through the purchase of high yield bonds, which are underwritten and arranged by an investment bank.
Unsecured lenders are often professional fixed-‐income investors that understand the risks associated with high-‐yield corporate bonds.
As the senior secured lenders, the unsecured lender’s role is to evaluate the credit quality of the company post-‐leveraged buyout and determine the risk of the company not being to pay back its loan. The unsecured lender must consider the fact that it will only receive its money after the senior secured lender gets paid.
In the end, the amount granted of unsecured debt that is issued can make a significant difference in the amount of leverage available in a deal.
Moreover, unsecured creditors are motivated by the large interest payments that are associated with high-‐yield bonds. Although unsecured loans used to finance leveraged buyout carry significant risks, ultimately it is the large coupon payments that bring investors forward to purchase the securities once the investment bank issues the bonds.
Once again the motivation is a balance between the greed and fear of the creditor, the same two things that run the entire credit markets.
In return for the burden of assuming this high risk, unsecured lenders typically require a higher interest rate often called “equity kicker”, also known as equity sweetener. It’s a warrant or an option to buy equity, attached to debt that is used to finance leveraged buyouts.
The percentage of ownership can be as little as 9% or as high as 80% of the target’s shares. The percentage is higher when the lender perceives the greater risk.
It’s very often used in mezzanine financing where the lender receives equity interests from the borrower, regarding as an additional financial reward for according loans. Equity kickers are generally structured as conditional rewards, so that the lender only
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receives its equity if the borrower's business meets certain specified performance goals.
Unsecured lenders are entitled to receive the proceeds of the sale of the secured assets after full payment has been made to the secured lenders so it can explain what unsecured component receive a higher return to compensate for assuming the greater risk in the LBO transaction.
III – The risky situation of existing lenders.
This category of lenders is made up of creditors that issued debt to the company before there was any talk of a leveraged buyout. The existing lenders presumably lent money to the company to help them expand operations or meet liquidity needs or both.
Most likely, existing lenders are traditional creditors, such as a commercial bank specializing in making traditional commercial loans.
This group likely has a relationship with the company and has a reasonable understanding of the company’s credit situation.
The existing lenders doesn’t play a major role in an LBO transaction. Classically, they receive the loan principal and any interest due and pre-‐payment fees once the LBO transaction goes through.
In a situation such as the pre-‐payment of a bank loan there is typically a pre-‐payment fee between 1% and 1,5% that is agreed at the initial extending of the loan.
The fee is paid to the lender at the time of pre-‐payment. Once a borrower decides to pre-‐pay a loan, the existing creditors then becomes focused on seeing that its extended loans and other monies due and receivable are paid back.
In the event that a lender is large enough, it may be motivated to seek participation as one of the lenders in the leveraged buyout transaction. This would present an opportunity for the lender to extended additional loans.
But undeniably, the biggest losers in an LBO transaction are the firm's existing creditors because the buyout is financed primarily with debt so existing creditors become creditors of a much riskier firm.
After listing the main actors involved in an LBO transaction, focus should be sources of funds and uses of them in the buyout. Indeed, we must study what are the various tranches of debt which are the main part of financing in an LBO transaction and more particularly, how can investors use the funds they have.
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CHAPTER II – SOURCES AND USES OF FUNDS. Building a leveraged buyout is about organization and capital structure. The first step in building is preparing the sources and uses of funds for the LBO. In other words, you have to know how much a buyout will cost for the investor this is the question of uses of funds, but before, where the money to pay for this might come from and this is the question of sources of funds.
SECTION I – Sources of funds.
We need to figure out how we are going to get the money. Sources of funds are made up of the various types of capital used to complete the transaction. One part of the price of an LBO transaction comes from equity but this part is minor. Indeed, the major part of the price comes from debt in order to maximize tax leverage (PART II) and financial leverage.
I – Equity capital.
One part of funds must be provided by the investors.
The common equity/equity capital comes from a private equity fund (CHAPTER I) that pools capital raised from various sources. These sources might include pensions, insurance companies, wealthy individuals.
The objective is to rely on this equity capital to build a Newco that is large enough to be leveraged later with senior and subordinated debt and to use leverage with an important degree in order to realize future acquisitions.
The level of equity capital provides more flexibility to the Newco in making acquisitions. The buyer also can obtain more attractive financing in terms of structure and pricing because, the total amount of equity represents the sum that the investors so generally, private equity funds, are willing to put at risk in the LBO deal.
In other words, equity capital represents invested money that, in contrast to debt capital, will be not repaid to the investors in the course of transaction. It represents the risk staked by the buyers. For the bank, the equity capital represents the sum that could be seized so, this amount represents a guarantee for lenders.
With the equity capital, a larger pool of lenders will be probably available to provide funding. Lenders know that all or an important amount of the investor’s funds has been invested in the plan before the bank lends its money.
What are different possibilities to invest equity capital in the Newco structure?
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Equity capital give legally the property of the holding to investors. This capital contribution may be in cash, but can also be realized in the form of a transfer of assets.
The seller may also bring part of its securities within the target company into the acquiring holding company. This method enables the seller to remain involved in the transaction once the LBO has been set up, keeping in mind that the value of the share contribution will have to be assessed by a statutory registrar.
This method can be advantageous in a certain number of States like France. Indeed, when the seller is located in France, a transfer of assets allows him to differ taxation in accordance with the 150-‐OB article of the “CGI”4. Although, generally, the majority of the equity capital represents cash.
Typically, the common equity represents 25-‐35% of capital structure but it’s a question of financial analysis. Indeed, in every LBO transaction, investors must see how returns are affected with changes in the amount of equity capital that bas been invested in this transaction.
II – Tranches of debt.
Multiple tranches of debt are used to finance an LBO transaction, and may including any of the following tranches of capital listed in descending order of seniority.
Firstly, the Newco can obtain a revolving credit facility also called revolver. A revolver is a form of senior bank debt that we can compare as a credit card and that is generally used to help fund a company's working capital.
The Newco can use the revolving credit up to the credit limit when it needs cash in the LBO transaction, but must repay the amount when an excess of cash is available. What is very advantageous is there is generally no repayment penalty for using revolver.
The revolver offers Newco a lot of flexibility according to its capital needs and allowing access to cash without having to obtain additional either debt or equity financing as seen before (§ I).
Although, there are two different costs associated with revolving credit. On the one hand, the interest rate.
On the other hand, an undrawn commitment fee. The interest rate that is charged on the revolver balance is usually LIBOR, which must be added a premium that depends on the credit conditions obtained by the Newco.
4 CGI : the french « Code général des impôts » that contains tax law.
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The undrawn commitment fee is usually a fixed rate that is multiplied by the difference between the revolver's limit and any drawn amount.
A) First lien debt.
The senior bank debt is a lower cost-‐of-‐capital and more exactly, lower interest rates than subordinated debt but there are typically more restrictive provisions and limitations than mezzanine debt for example.
Bank debt generally needs a fully amortization over a 5 to 8 year-‐period. Provisions typically restrict the Newco’s flexibility either to make further acquisitions or raise additional debt holders. Senior bank debt also contains financial maintenance clauses that are generally secured by the assets of the borrower.
Senior bank debt can take two forms. On the one hand, a term loan A. This tranche of debt is generally amortized evenly over 5 to 7 years. In other words, loan tranche A characterised by a fixed amortisation schedule with maturity reached after seven years.
On the other hand, a term loan B that usually involves a repayment over 5 to 8 years, with a large payment in the last year.
In other words, the latter allows borrowers to defer reimbursement of a large amount of the loan but it’s more costly for the Newco than term loan A.
However, at present, tranche A debt, amortised over its maturity, is shrinking while tranche B, which carry no periodic capital repayment, is preferred by banks to improve the leverage degree.
The interest rate charged on senior bank debt is often a floating rate that is approximately equal to the LIBOR and a premium, depending on the credit conditions of the borrower. If the borrower has negotiated a great credit terms, bank debt may be repaid early without penalty.
B) Second lien debt.
In a second lien debt or second lien loan transaction, the second lien lenders hold a second priority security interest about the borrower’s assets.
Second lien financing continue to be popular, particularly in the USA, with deal volumes reaching approximately $27.8 billions during 2008, but have also gained a large growth in Europe, with approximately 3 billions raised in 20075.
Second lien debt is simply, as this name suggests, debt which benefits principally from the same security as secured senior debt as we have seen previously, on a second ranking basis. 5 According to 18th annual Thomson Reuters LPC loan market conference.
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The senior lenders (so who can called first lien lenders) and second lien lenders agree that on respect of the security, the senior lenders will be fully paid before the second lien lenders.
The second lien debt can have the form of a loan or bonds and is typically lent at the same level as the senior debt.
Second lien debt is not new in Europe and differs from mezzanine debt in that the repayment right of the second lien lender isn’t normally subordinated to those of the senior lender.
The price and flexibility are the two factors that attract borrowers to second lien deals. It’s more expensive than senior bank debt but second lien debt in the USA and Europe is significantly less expensive than mezzanine loans as we’ll see just after.
The price depends on risk profile and more particularly in Europe, second lien is generally priced between 400 and 700 basis points6, against 11.000 basis points or more for certain mezzanine vehicles.
To conclude, the second lien loan is situated between senior debt and mezzanine senior debt. It offers larger repayment duration than the senior debt and its remuneration is higher. Since the second-‐lien is second in ranking behind the traditional senior credit facility, its repayment will be made in full, at maturity, once the first lien senior debt has been fully repaid.
C) High yields and junk bonds.
This tranche of debt is typically very unsecured. High yield debt is often referred to as “junk bonds,” but this term is past. Today, high yield bonds are a mature asset can provide a number of advantages to investors who understand and accept the risks.
Companies with credit ratings that are beneath investment-‐grade offer those bonds7. Investment grade companies are large multinational firms with massive recurring revenues and a lot of cash on their balance sheets. In other words, there is no chance that they will default, or fail to make their interest and principal payments on time.
Companies with outlooks that are questionable enough and also, could default, have lower credit ratings and investors demand higher yields to own their bonds.
High-‐yield debt characteristic is very high interest rates, which compensate investors for their risk as we said previously. This tranche of debt is often used to increase leverage levels.
High-‐yield bonds don’t offer any access to capital. 6 Basis point; unit of measure using to describe the percentage change in the value or rate of a financial instrument ; one basis point is equivalent to 0,01%. 7 Investment grade; for example, Microsoft or Apple.
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D) Mezzanine debt.
One reason why the second lien concept is difficult to settle down in Europe is the presence of a healthy junior debt market.
The mezzanine ranks last in the hierarchy of tranches of debt. Private equity investors and hedge funds8 often finance this type of debt.
Mezzanine financing is an intermediate step between equity capital and debt. It’s a hybrid-‐financing instrument that can be used to improve creditworthiness, to optimise tax structures, and to achieve a better rating of the company.
The mezzanine capital that can be provided has a lower ranking than senior debt but a higher ranking than shareholders' equity.
In the USA, a company doesn’t grant security to mezzanine investors, and so the market for second lien debt was untapped until recent years. On insolvency, the USA second lien lenders now fit into the debt structure, ranking just behind senior secured debt, but just ahead of the unsecured subordinated mezzanine lenders and high yield bondholders.
The USA senior lenders have become more comfortable with the reduced exposure that has been offered by a new class of second ranking debt.
On the other hand, European mezzanine debt, although usually contractually subordinated through an intercreditor agreement, benefits from second lien debt over the assets of the borrower’s company.
European senior banks often already have the reduced exposure offered by a second ranking secured debt, but that debt is also usually contractually or structurally subordinated.
In other words, the mezzanine debt is a hybrid component of the financing in an LBO transaction, between senior debt and equity capital. It incorporates convertible bonds or bonds attached to subscription warrants, and it gives the bond lenders the rights to convert to an ownership or equity interest in the Newco if the loan is not paid back in time and fully.
The reimbursement, generally made in full at maturity, is subordinated to the repayment of senior debt. It provides flexibility for setting-‐up and, by diversifying the financing sources, its fulfils the needs of senior lenders and those of equity investors.
There are other sources of funds equally important like seller credit. It meets the concern of the buyer. Part of the target company's price is materialized through a loan granted by the seller. By getting involved in this financing scheme, the seller 8 It’s an aggressively structure, different to a private equity fund, which managed portfolio of investments in order to maximize the return of investment;
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expresses his confidence in the success of the transaction and so, in the event such transaction fails, the amount of the granted loan will not be repaid. As the seller grants financing facilities, he will try to negotiate a higher purchase price as well as higher interest rates.
Regarding the senior debt lenders, they often demand that this loan shall be subordinated to the senior debts.
The targets company's cash flow, apart from cash flow invested for saving the activity, may also be used in the LBO deal. There could be an extraordinary distribution of dividends to the purchaser. In other words, they are distributable reserves not mentioned within the deduction part of the tax return, which avoids tax payment on this dividend return (this point will be more especially detailed in the PART II of this report).
Lastly, the company could sell one or several of its fixed assets to use them as a source of funds, provided that certain precautions should be respected. Businesses can use them as a source of finance. The company can own buildings that, although desirably situated, are not totally used or which are likely to be located in areas where the price of land is low. It will be worth selling these assets at good conditions and it will generate a sufficient profit, returned to the purchaser in the form of dividends.
After listing the available funds for the investors in an LBO transaction, we must consider how they should be used.
SECTION II – Uses of funds.
The purchaser must first establish a business plan. This selling tool reveals to investors and bankers cash movements over a period of approximately five years.
The business plan must be explicit and shall highlight the appropriateness of the LBO project.
The aim of the plan is to convince the purchaser's partners and more particularly the private equity sponsor of the profitability of such an investment.
I – Structuring an LBO transaction.
The two most common ways of structuring an LBO are through acquisition of either the assets of the target company or its stock. After a target has been identified, generally a special purpose vehicle or a shell corporation that is typically called Newco, is created for the purpose of making the acquisition.
In asset acquisition, Newco buys the assets of the target company and secures the loan (SECTION I, § II) on these assets. The target company may become a pool of cash
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with no assets, and it may either grant a liquidating dividend to its shareholders or become an investment company.
In an asset purchase, the current owner retains ownership of shares of stock of the company. Only assets and liabilities that are identified in the purchase agreement are transferred to the buyer. All of the other assets remain with the existing business and thereby the seller. Asset purchase transactions are generally more complicated because ownership of the assets and liabilities must be transferred, sometimes through the filing of documents with governmental offices.
Let’s detail more precisely the acquisition of shares of the target company. If you decide as an investor to build an LBO through an acquisition of shares, the loan may be granted either to Newco or to the target company.
If the amount granted is lent to the former, Newco uses the loan to buy the stock from the existing shareholders, and in the same time, pledges this stock with the secured lenders, or it may require the target company to issue a guarantee to the lender, or it may cause the target company to merge with it, and then secure the loan on the assets of the target company, which now also belong to Newco.
Alternatively, since mergers take a long time to materialise, the LBO transaction can be structured to take place through a two-‐step process; a tender offer followed by a merger.
If the loan is given to the target, it may either purchase its own shares or may make a further loan to Newco to enable it to purchase the shares.
II – Share deal and purchase agreement.
In an acquisition of shares, there are three major uses of funds. Firstly, the major use of funds is the purchase of the company’s equity.
A) Acquisition equity.
Investor must calculate how much money is going to be required to buy the equity of the target. In order to obtain this amount, we have to multiply the acquisition stock price by the number of shares outstanding.
The acquisition stock price (or current stock price) is the last sale price of shares prevailing in the market at a specific moment. Purchasers typically pay at least a 20 or 40% transaction premium over the current stock price. Naturally, the purpose of the purchaser of shares is to buy the equity at a price that is less than what the company will later be sold for post restructuring (PART II).
On the other hand, the equity seller has to sell the stock if he thinks that the premium price is above what the stock is really worth. If he thinks the stock is really
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worth more than what is being offered and this for whatever reason it’s not being reflected the market price, he wouldn’t naturally accept the offer.
In order to obtain the acquisition stock price, investor has to multiply the current stock price by the transaction premium that represents a percentage and depends on cases.
When the purchaser has the acquisition stock price, he has to find the number of fully diluted shares outstanding in the target annual report or in the 10-‐K9, which is sometimes required by the SEC. Fully diluted shares outstanding is the number of common shares that would be outstanding if all instruments that can be converted to common equity such as options ere converted.
Now, the buyer knows the amount of cash that it will be used in order to purchase the equity of the target.
B) Target’s net debt.
Another major use of funds that an investor has to consider in an LBO transaction is the purchase of the target company’s net debt.
Indeed, the amount of net debt must be added to the equity purchase price in order to obtain an implied transaction enterprise value – TEV. TEV can be defined as the amount of money that is purely required in order to realize the LBO of the target, but without taking in consideration the cost of doing this transaction that is to say bankers’ fees, lawyers’ fees etc.
The TEV concept is very important because it tell us if the price of the LBO transaction is within investor’s reach or not, depending on the funds he believes to be available. In order to better understand the relative value concerning the LBO transaction, investors and bankers will look at the TEV either as a multiple of revenue or of EBITDA.
Typically, the calculation of net debt is quite simply. The investor has to add the short-‐term debt of the target, it long term debt minus the cash on the target’s balance sheet. He finds all those information on the latest target balance sheet.
The final cost that an investor has to consider in order to build his business plan is transaction costs. Those costs will include the fees that are paid to the lawyers, advisors, brokers10 and all other parties that are involved in some way with the LBO transaction.
9 it’s a form that the SEC requires from publicly traded companies and sometimes, private companies to file every year. 10 Persons or firms that conducts transactions for a client.
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It remains to know what are the main reasons that may influence an investor to buy a business especially through an LBO. There are indeed many techniques in order to buy a company. If investors choose particularly LBO transactions, it is maybe to use the leverage and more especially, tax leverage in order to further optimize the purchase of the company. But after executing the LBO and developed the activity of the target, investors want LBO exit and sell their shares in order to realize an important capital gain. We will also examine the main exit opportunities and strategies for the investors in order to maximize their gains.
PART II – TAX SHIELD AND STRATEGIES FOR EXITING AN LBO.
Let’s begin with the principal leverage in an LBO transaction namely, tax leverage. Various commercial and legal factors, not directly related to the tax distinction between debt and equity, are relevant to the choice between debt and equity for a corporation.
In recent decades, a very substantial portion of the acquisition market has been driven by private equity funds, and more particularly as LBO.
Because cash used for interest payments is generally deductible by the target enterprise, the capitalized value of cash flowing to debt is determined on a pre-‐tax basis, thereby increasing the value of the enterprise.
Moreover, if returns from the investment exceed the rate paid on the debt, the excess accrues to the equity holders and, therefore, their return is increased by the leverage.
Concerns have been expressed for many years, with regard to leveraged buyouts and other transactions, such as stock repurchases, that overly lenient interest deductibility rules have resulted in distortion of corporate ownership and of financing decisions. For instance, Germany’s tax laws discourage leveraged buyouts by reducing the tax shield attractively. We can observe the same movement in France since the latest financial law.
CHAPTER I – TAX SHIELD IN AN ACQUISITION BY LBO. It’s usually said that the only two certainties in the life are death and taxes. Unfortunately, LBO transactions don’t escape the latter.
However, motivating forces for corporate acquisitions include the free cash flow problem, tax incentives, deregulation, synergies etc. But, of this list, tax incentive is the most frequently discussed motivation for corporate acquisitions, especially in leveraged buyouts.
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SECTION I – Tax aspects in the world.
We must study the tax incentives for leveraged buyouts by measuring the change in taxes paid by a firm due to a buyout. Tax incentives are numerous and differ depending on where the LBO transaction takes place in the world. But nevertheless, we can focus on the deductibility of interest generated by the high level of debt used for the acquisition. This is the main incentive tax in an LBO transaction.
I – Deductibility of interest expenses.
The deduction of loan interest is an essential point in all LBO transaction and in almost every country in the world.
Firstly, Switzerland is a very attractive market for the purchase of companies using high leverage, so LBO transactions. Especially, interest expenses which are paid is tax deductible from the income and with a large degree of debt financing what is a major characteristic for every LBO transaction, there will be a tax reducing effect, which is called as tax shield. The Newco is generally used in another country that Switzerland, and merged with the target company in order to create a debt pushdown11. But this scheme is in principle not really accepted by the Swiss tax authorities. Investors should be careful because the LBO could quickly lose any incetive effect if the tax authorities invalidate the scheme.
In the UK, an important tax reform has significantly increased the tax costs of leveraged buyouts and also in generally, mergers and acquisitions. It’s the Tax Reform Act – TRA dated 1986 that created a major change in leveraged buyout tax structures. Tax practitioners now must carefully consider taxable income levels about operations in structuring an LBO. Today, we can say that the UK has made great efforts in order to reform its corporate tax rules and make them competitive for the UK multinationals. Corporates are indeed entitled to request an interest deduction in respect of acquisition debt. The UK executive power has considered whether it should restrict or not the right to deduct interest expenses but finally, he has always decided against any this restriction. There are of course a certain number of specific anti-‐avoidance rules that restrict interest deduction but the general principle, however, is that acquisition debt is totally deductible for tax purposes, whatever the acquisition is unlikely ever to generate any UK taxable incomes. These rules are very useful for highly leveraged acquisitions and so in LBO transactions. In some jurisdictions in European Union like France as we will see after, a general interest restriction has been introduced, with an excessive interest being denied if the total interest deduction exceeds a certain percentage of taxable incomes.
11 A debt push down consists in the creation of an acquisition structure in order to shift debt to a subsidiary company and realize a tax benefit.
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What is the situation in the USA? An LBO purchaser may be able to deduct interest against its taxable income, whereas dividends on stock are non-‐deductible. Interest paid during the year by the company is in principle allowed as a tax deduction during this taxable year subject to a certain number of exceptions.
In Belgium, companies can deduct all length business expenses when calculating taxable income. Interest is generally deductible up to a reasonable amount given the risk associated with the loan that has been lent. Where a Belgian financial institution has made the loan, interest expenses are automatically deductible. But when a company pays interest to a beneficial owner that is a tax exempt company or a company for which interest income is subject to a tax regime more interesting than in Belgium, the debt is called “tainted.” Consequently, the interest payment rests tax deductible but only if the company proves that the debt relates to real transactions and that the conditions of the loan are normal.
In Germany, the government introduced fixe years ago the “Interest barrier (Zinsschranke in German), which was viewed as a new thin-‐capitalization-‐rule. It marked the deepest cuts in modern German tax history and we could assume that this reform has been motivated by the crisis. The German interest barrier also massively restricts the deductibility of interest expenses (as well intra-‐group debt financing as bank loans) for German corporate income tax. Introducing today the unique concept in the world of the interest barrier with the German business tax reform 2008, the law limits the tax deduction of interest expenses that the Newco could pay to the bank in an LBO transaction. According to the interest barrier rule, a German Newco could only deduct interest expenses of up to 30% of taxable income before interest expenses, taxes, depreciation and amortization (called EBITDA) per fiscal year. The amount of interest expenses must be understood as a net amount. Consequently, the interest barrier has a very bad influence on investments in Germany, particularly in LBO transactions because the tax leverage has lost its principal interests, although it rests others. Although, companies and lawyers have found some means in order to optimize and reduce German tax perspective. Intra-‐group cross-‐border debt financing is maybe the most interesting instrument of international tax planning for companies and groups in order to reduce considerably their ETR12. In a German tax scheme, many parameters must be studied in order to benefit effectively from the cross-‐border tax differential by shifting profits from high-‐taxed German corporations to a foreign country with a low tax rate with an intra-‐group debt financing. One of those parameters is the fact that German CFC taxation (Controlled Foreign Company law) doesn’t apply or if not, negative tax effects of German CFC-‐Taxation can be minimized enough. German CFC taxation is defined as an anti-‐avoidance rule that has been enacted in order to avoid the utilization of the cross-‐border tax differential. The interest income produced by a foreign low taxed corporation or permanent establishment is attributed to the German parent
12 Effective tax rate is the average rate at which the taxpayer is taxed.
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company and will be taxed on the current basis. Double taxation can be avoided by a tax credit for taxes of the foreign establishment paid in its country.
The application of the interest barrier extremely depends on the legal structure of the German financed entity. In the case of a German fiscal group the interest barrier is only applicable at the level of the parent company. Interest expenses are tax deductible up to the amount of the interest earned per business without limits. So consequently, the interest barrier is not applicable in the case of intra fiscal group debt financing. The scheme shows us an example of a cross-‐border tax differential.
II – Tax optimisation in France.
The leverage used for LBO financing has also continued to rise in Germany over the past few years, following the international trend. The clearly growing importance of LBOs in Germany is being reflected in their growing share of the total German market for mergers and acquisitions. In the second half of 2010, the volume of LBOs surpassed the amount of non-‐LBOs for the first time.
Another country, Ireland, has recently developed a great reputation for the establishment of both European Union and more generally, international holding companies because this country also offers a favourable tax regime for holding companies, particularly for interest expenses. In general, interest paid by an Irish holding company is not deductible for Irish tax. However, where an Irish holding company borrows funds in order to acquire shares or assets, interest expenses may qualify for relief.
To conclude, we can say few words about Luxembourg. Luxembourg tax law permits the deduction of normal operating expenses in calculating taxable income. Deductible items include for example interest paid to third parties as well banks as another company, which has lent the loan. Luxembourg is a really attractive country
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for multinational cash pooling. Cash pooling is a method that allows equalizing the accounts of subsidiaries, saving costs due from financial market imperfections. The efficiency of a cash pooling is really impacted for example by withholding taxes on interest payments and limited deductibility of interest expenses. However, anti-‐avoidance rules restricting tax planning opportunities, as well as stamp duties and registration taxes. Here is an example of a cash pooling scheme.
Inefficiency of cash pooling may arise if the deductibility of interest expenses paid by the pool-‐leader to pool-‐members were restricted for income tax purposes, whereas the corresponding income realized by the pool-‐members would be taxable for the full amount. The limited deductibility of interest expenses may be due to numerous reasons as thin capitalization rules, interest barrier rules in Germany as we have just seen before, CFC legislation and anti-‐avoidance rules. Unlike some other European countries, Luxembourg hasn’t enacted interest barrier rules, local anti-‐avoidance rules or a CFC legislation. Interest expenses charged on a Luxembourg pool-‐leader should also be deductible for income tax purposes.
Moreover, Luxembourg is a member of the European Union so CFC legislation or anti-‐avoidance rules existing in a European country as Germany should not be applicable to interest payments made by pool-‐members located in those countries, to the extent the Luxembourg pool-‐leader has sufficient “substance” in Luxembourg.
II – Parameters existing in France in order to reduce taxes.
Also in France, the debt interest expenses are tax deductible, even if the Finance Act for 2013 has profoundly changed the tax treatment of those expenses. However, other mechanisms have a tax decisive impact in an LBO transaction and are necessary in order to optimize the tax cost of this operation.
The integration tax regime13 is one of those tax incentives. Under an optional tax consolidation regime, a French company can include the income of its French affiliates companies of which it controls at least 95% of the capital in its taxable income. If the parent company controls this minimum percentage, this company pays the corporation tax for all the affiliates companies in the group. Moreover and since 2008, groups in which the parent company controls at least 95% of a French affiliate
13 Article 223A of French Code Général des Impôts.
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company through one or several companies that are based in the European Union can also choose this regime. This second possibility is the consequence of a decision of the European Court of Justice in 2008, “Papillon”14.
In this decision, the Court sanctioned the fact that the French legislation allowed to build a group tax if the parent company which was resident in France held subsidiaries and sub-‐subsidiaries which were also resident in this State, but by contrast, was unavailable for a parent company if its sub-‐subsidiaries were controlled through a subsidiary which was resident in another European State. France adapted his legislation in order to conform to this European rule.
The French law doesn’t set out the manner in which the tax paid by the parent company should be split out between the companies. This is also set out from a tax group agreement signed at the moment the group is formed.
In an acquisition financed in majority by debt through a holding company, so in an LBO transaction, the regime of French integration tax provides a significant advantage than the parent-‐subsidiary regime because by virtue of the former, the Newco can charge interests expenses on the taxable results of the whole group. However, as we will see just after (SECTION II), this tax incentive effect has been considerably reduced by an amendement in 2005, and more recently by the Financial Law for 2013.
Another French mecanism is very important in LBO transactions, it’s the parent-‐subsidiary regime. Indeed, the integration tax regime allows to deduct a part of interest expenses generated by the debt, but it’s not sufficient.
The French parent-‐subsidiary regime is available when several specific conditions regarding the shareholding interest, the holding period, and the shares and their origin are met. Those conditions15 have been modified by the Financial law for 2005.
The first condition is that the parent company has to keep the shares of subsidiaries for at least a two-‐year period. If the parent company doesn’t meet this condition, the benefit of the regime would be lost. The beneficiary company would pay the corresponding corporate income tax assessed on the full amount of dividends (with a late payment interest of 0.40% per month) within the three-‐month period following the sale of shares.
The option for the parent-‐subsidiary regime is available when the parent company controls at least 5% of the share capital and 5% of the voting rights of the subsidiary. It’ also a double condition, and the only detention of the capital or of the voting rights is not sufficient to opt for this regime.
14 ECJ, Case C-‐418/07, November 2008. 15 Articles 145 and 216 of French Code Général des Impôts.
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When those conditions are met, what are consequences? The French parent-‐subsidiary regime offers a tax exemption regime and more precisely, limits the taxable basis of the dividends at the level of the beneficiary company to a 5% service charge16 , with the service charge being neutralized — not taxed — when the companies are part of the same French tax group. As we will see just after (SECTION II), this regime has been recently modified, as well as consolidation tax regime;
SECTION II – Limitation of tax leverage: example in France, The Netherlands.
The general principle in the UK is that acquisition debt is entirely deductible for tax purposes. By way of contrast, Germany (with the interest barrier), France, the Netherlands and other States are seeking to restrict tax deductions for acquisition debt.
I – Example in France.
Both the consolidation and parent-‐subsidiary regime have been modified in order to restrict incentives tax effects.
A) The “Charasse amendment” followed by the “Carrez amendment”.
In France, the deduction of interest expenses must comply with general principles that govern the right to deduct business expenses. The general rule is that business expenses are tax deductible; firstly if they are paid in the corporate interest, secondly are actually incurred and properly documented, and thirdly, reduce the net worth of the company.
Concerning interest expenses, the deduction is also authorized as soon as the relevant loan is extended for the business purpose of the borrowing company and if the borrower can prove in its books, the existence of the loan and of the interest expenses.
But additional restrictions, specific to the deduction of interest expenses, apply for corporate income tax purposes.
At first, if interests are paid to shareholders and related companies, the deduction is limited to interest paid at a rate not exceeding the annual average rate of interest charged by financial institutions17.
Second, if interests are only paid to a related company18, the deduction is denied in regard to any portion of the interest that does not comply with a three-‐stage leverage test (thin-‐capitalization rule).
16 This service charge is called in French “réintégration d’une quotepart pour frais et charges”. 17 In French, this is the « taux effectif moyen ».
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Third, within the framework of a group benefiting from a consolidation tax regime, the deduction of interest related to the purchase of a new company is limited if this company was acquired from a shareholder that controls the group. This is the “Charasse Amendment” and it concerns directly LBO transactions.
1 – Charasse amendment.
Indeed, in an LBO transaction shares acquisition of the target to be included in the tax group from a related party may be subject to the Charasse amendment limitation19. This rule provides the fact that, when shares of the target that becomes a member of the tax group (created specially for the LBO transaction) are purchased from shareholders who directly or indirectly control the group, or from non-‐group companies that are controlled by non-‐group parents, a part of interest expenses incurred by the tax group will be non deductible from the group profits during a 15 year period. In order to calculate the amount that has to be reintegrated, you have to multiply annual interest expenses of the tax group by the purchases prices of the target shares and divide the result by the average amount of the group’s debt during the tax year. However, this Charasse amendment doesn’t apply in three cases. Firstly, if the target shares are acquired in exchange for newly issued shares that is to say, a capital increase equal to the value of the shares that has been acquired. Secondly, if the target shares are acquired from members of the tax group. Thirdly, if target shares are acquired by related companies from unrelated companies with in the order to transfer the target shares shortly afterwards to a member of the French tax group. This rule applies to a stock acquisition even if the acquisition wasn’t financed by a loan granted by a bank.
However, some attenuations of this restrictive law have been adopted since 2006. On the one hand, the concept of “control” has been précised. the Administrative Supreme Court indicates20 that, for the aplication of the amendment Charasse, the concept of control should be appreciated at the time of the sale of shares and not before. Judges have invalidated a French administrative doctrine which provided that control has to be appreciated during the 12 months preceding the acquisition of target shares.
In this same decision, the Court precised that the notion of “control” must be restricted to situations of detention of more than 40% share capital against 33% previously. In addition to this, the reintegration must be stopped when the holding company is no longer controlled by persons who control it at the time of acquisition of the target.
18 Article 39 .12 of the French Code Général des Impôts. 19 Article 223B of the French Code Général des Impôts. 20 Administrative Supreme Court, July 13, 2011, n°312285
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On the other hand, a second decision allowed to reduced the Charasse amendment effects21 . Indeed, the Administrative Supreme Court rendered a decision which states, for the first time, that LBO transactions are not purely artificial for tax purposes and, thus, consistent with the general anti-‐avoidance rule. In this case, the shares of a company providing IT services (the target) were divided between two shareholders. The target had a lot of cash in reserve, which were converted into equity shortly before the shares in that company were sold to a holding company. The shareholders established the Newco for the specific purpose of acquiring the target. Just after the acquisition, the target distributed a significant amount of dividends to its new shareholder. The acquisition made by the Newco was principally financed by dividend distribution, and by debt. The LBO lasted over a year, and eventually enabled the holding vehicle to reimburse the acquisition price of the target to its shareholders, and retain its accounts some cash. After a tax control of the target, the French tax authorities took the position that the LBO transaction constituted an artificial arrangement that permitted the two shareholders to avoid, for individual income tax purposes, the progressive rates applicable to dividends. Consequently, the shareholders were liable to tax on the capital gains derived from the disposal of the shares and subject to a lower flat rate of 16%. Therefore, the French tax authorities applied the anti avoidance rule (GAAR) and imposed on the shareholders a fine equal to 80% of the avoided tax. The Court ruled in favour of the shareholders, and held that the LBO structure described above was not purely artificial.
2 – Carrez amendment.
Until 2011, interest on loans exposed in order to acquire a participation in another company was tax deductible in France even where dividends issued from those shares were exempt under the French participation exemption regime. This derogation deemed to represent non-‐deductible expenses under the participation exemption regime.
But in order to follow other interest expenses restrictions recently adopted, the “Carrez Amendment” adopted in the Finance Amendment Law for 2011 limits the deduction of interest regarding to acquisitions of participation shares.
The rule targets leveraged acquisitions where the French Newco is only the formal legal owner of the participation shares, whereas another company situated abroad exercises effective control and management of the shares.
In this situation, the deductibility of a percentage of the acquisition related interest expenses is denied and added back to the company’s tax base.
Surprisingly, the aim of this reintegration mechanism is not clear. Leveraged acquisitions that are controlled and managed from France, even where the French
21 Administrative Supreme Court, January 27, 2011, n°320313, « Bourdon ».
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Newco is also a formal legal owner interposed between the target company and the real buyer, may benefit of a safeguard clause. This recapture mechanism is aimed at preventing interest deductions in situations where the participation shares are effectively managed from abroad. We can take the example of a US company using a French Newco as a Special Purpose Acquisition Vehicle (SPV) to purchase an operating target company situated in Germany.
The Carrez Amendment bans interest expenses deduction for participations acquired by a French company if this company can’t demonstrate two cumulative conditions. First, decisions relating to these participations are effectively made by the acquiring French company, or by a company that is established in France and that directly or indirectly has the control of the acquiring company and where control or influence is exercised over the target company, the acquiring company effectively exercises this control or influence.
B) Parent-‐subsidiary regime: a new French tax on dividend distributions.
Indeed, a new tax has just been created since 2012 on dividend distributions. It’s levied at the level of the distributing company also in an LBO transaction, of the target that distributes dividends to the Newco in order to reimburse the debt borrowed.
The target must be subject to French corporate income tax. The tax on dividends is not deductible from the taxable income of the target company.
The 3% rate applies to the amount of the dividends that are really distributed. The tax also targets incomes which are realized in France by foreign companies through permanent establishments, and which are deemed to be distributed to a non resident shareholder, where such incomes aren’t reinvested in the French company. The tax is applicable to distributions made from August 17, 2012.
The bill of the Amended Finance Law initially provided for an exemption regarding distributions made to corporate shareholders likely to benefit from the parent-‐subsidiary regime that we has just studied before. But this exemption has been eliminated.
Since January 1st 2013, a new limitation of interest expenses deductibility exists in France. In the Financial Law for 2013 the Parliament has limited the deduction of net interest expenses for companies. Those companies will be allowed to deduct 85% of the total amount of deductible interest paid in 2012 and 2013, and 75% of the total amount of deductible interest paid as from 2014.
In order to apply this new measure, all loans will be taken into account, whatever the quality of lender (it could be a related or an unrelated undertaking company, French or foreign), and concerning the allocation of granted funds (it could be used either for acquisition of capital assets, or financing of activity).
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The amount of net financial expenses will be calculated by the difference between the financing amount granted to the company and the income received by this company in consideration for financing granted by it.
If the company is a member of a consolidation tax group, this measure will not applied to companies that are members of the same tax group, with the exception of financial charges relating to operations realised with companies outside the group. The net financial expense must be defined at the tax consolidated group's level and not at the level of each company in the group.
II – The Netherlands.
Interest expenses are generally deductible from basis for Dutch corporate income tax purposes. This also applies to interest relating to a participation to which the participation exemption applies, irrespective of whether the shareholding is in a resident or non-‐resident company.
But the Netherlands, as the other members of the European Union, recently restricted the regime of interest expenses.
In the Bosal case22, the European Court of Justice affirmed that the interdiction of the deductibility of the interest expenses suffered by the Dutch corporation in connection to foreign participation was in contradiction to the right by virtue of the European Treaty to establish a company under the European law. The decision decreed that interest expenses related to debts incurred in order to finance a foreign subsidiary are deductible at the level of Dutch entity.
Regarding this decision, the government has just after adopted a law in order to restrict the tax deduction of interest expenses.
The new law that has been enacted in June 2012 contains a principle that limits the deduction of excessive interest which are paid by a Dutch corporate company related to interest expenses that are incurred with debts financed to generate income that is exempt under the Dutch participation exemption.
Under the new law, the notion of “excessive interest” is defined as the amount of interest and costs paid by a Dutch corporate company for debt, this amount being multiplied by its average amount of participation debt and divided by its average amount of total debt.
The participation debt is considered as present if the cost price of a company’s participation exceeds its equity for tax purposes. The participation debt can exceed neither the total amount of debt nor the total cost price of the participations. The participation debt is also lowered with the debt that is subject to other interest deduction limitations. 22 European Court of Justice, September 18, 2003, Bosal Holding, case C-‐168/01.
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Interest expenses on the acquisition debt also are deductible up to the amount of the acquirer’s own profit before the deduction of the acquisition interest expenses (own profit). If the acquisition interest exceeds the own profit and the excess amount is less than one million euros, then the interest deduction will not be limited on the basis of the new rule.
Moreover, if there is no excess acquisition interest, the interest will also remain deductible in full. We should also mention the fact that all acquisition interest that is non deductible in any year will be reported to the following year, where it will again be assessed to see if it falls under the interest deduction limitation.
There is another tax issue to study more precisely, the capital gains eventualluy made by investors through the LBO transaction. But this aspect will be studied at the last chapter of this research report that concerns with differents strategies for exiting an LBO deal.
CHAPTER II – EXIT ROUTES IN LBO TRANSACTIONS. A leveraged buyout is the acquisition financed primarily with debt by a small group of equity investors of a public or private company. The equity holders service the heavy interest and principal payments of debt with cash from operations and/or asset sales. The shareholders generally hope to reverse the LBO within three to seven years through a public offering or company sale.
SECTION I – Exit planning considerations.
When a private equity firm decides to invest in an LBO transaction, the fund has to invest in portfolio companies and at the end of a certain period, has to take profits and also, recovering its initial investment. There are mainly two different strategies for exiting an LBO transaction, the initial public offering (IPO) and the sale of the portfolio company another party, another investor.
I – Initial public offering; “Reverse LBO”.
When a fund exits its investment through an IPO, it does so through an offering of shares to the public of either: the portfolio company or the parent holding company that wholly owns the portfolio company and through which the fund made its investment and owns equity.
An IPO is a financial transaction conducted by a company and its various counsels (lawyer, banks etc.) that allows the listing of shares of this company on a stock market.
In increasing numbers and at ever shrinking spans of time, companies that have gone private through leveraged buyouts are again going public.
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A leveraged buyout involves the merger of a public company with a private one, financed primarily with borrowed funds, with the public company's assets as collateral and the process in which a company that has gone private through an LBO and then sells shares to the public has been called a reverse leveraged buyout. It is a process that produces enormous profits for investors in the original buyout and helps the company selling the shares reduce onerous debt.
A lot of studies were conducted to examine the long term stock price performance of firms that undergo a reverse leveraged buyout.
A reverse LBO occurs when either a publicly traded firm or a division within one converts to private ownership by means of an LBO and subsequently goes public. When the performance returns of firms that had a reverse LBO are compared with those of a portfolio of comparable companies, reverse LBO firms outperform the others. That reveals the fact that takeover premiums may certainly cause these positive returns after a reverse LBO.
Reverse leveraged buyouts represent also a special class of initial public offering. In contrast to original IPOs, reverse LBOs refer to the reentry into the equity markets of once publicly traded firms or subsidiaries of publicly traded firms. These firms were previously taken private in a leveraged buyout and, after a period of restructuring, seek to obtain the same benefits as original IPOs.
During the restructuring period, LBO firms sell off unwanted assets, renegotiate contracts and reduce debt levels. Whereas original IPOs involve firms during the growth phase of the firm life cycle, reverse LBOs involve firms that have recently reduced the scale of their operations.
Although both are classified as initial public offerings, original IPO firms and reverse LBO firms are fundamentally different with respect to the level of information available to investors and the stage of the firm life cycle. It is hypothesized that differences in the characteristics of original IPOs and reverse LBOs lead to differences in the level of underpricing in early trading and the factors affecting early returns.
Once IPO is realized, sponsor typically can’t liquidate fully the fund’s investment in a portfolio company in the company’s IPO. To complete a full exit after the IPO, a fund can sell shares in unregistered sales.
Making a reverse LBO can present several advantages. Firstly, the IPO allows to the investor a future liquidity. Second, the private equity firm which invested in the LBO transaction generally prefers an IPO because it results in a higher valuation for portfolio company’s equity than other possible exits as sale to a third party.
But reverse LBO has some disadvantageous. The main disadvantage is that the private equity firm doesn’t fully liquidate its investment through the portfolio company’s equity. Indeed, the private equity fund’s investment, with the shares the
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company sells in the IPO, is generally too large to be sold into the market at one time at the desirable price.
II – Alternative ways for exiting an LBO .
“The credit quality of many LBOs is threat from private equity investors' propensity to take out dividends early in the life of such transactions”, says a report published in 2010 by Standard & Poor's Ratings Services.
Indeed, private equity funds generally envisage an exit from their investments within a three to four years period. Failure to show an exit way at that point may reflect a possible decline in the enterprise value of the company.
Private equity sponsors typically use one of three routes to exit all or part of their equity investment. Firstly and as we have just said, an initial public offering. Secondly, a secondary and why not, a tertiary LBO which is a highly leveraged acquisition by another private equity firm. Thirdly, a trade sale that is to say an acquisition by another operating company in the same industry.
IPOs and secondary LBOs can share a common point in that there are expected to be significant unrealized equity gains due to favourable regulatory or market trends at the point of sale. These gains should be visible and attractive enough to an investor with limited or no involvement in the industry.
Trade sales may be, but not necessarily, more successful than either an IPO or a secondary buyout because business synergies may be available to the trade buyer that are not available to the general investor. As a result, the trade buyer should be able to generate higher returns on the same price paid for the LBO company.
In secondary and tertiary buyouts, the LBO fund sells the company to other financial investors. Such transactions usually lead to a renewed rise in the leverage effects. Exits of this kind have recently been occurring at shorter and shorter intervals. In this connection, it seems justified to ask if a secondary buyouts really lead to further improvements in the operational ability or the efficiency of the capital structure or if there is only a significant increase in risk through the increased use of debt to finance the company.
However, secondary buyouts are important for individual LBO funds because these funds have been created to exist only over a given life span and therefore have to sell their shares after no more than a few years.
For example in France, the company “LBO France” has acquired building materials company “Materis” in a secondary buyout transaction. The transaction provides an exit for Advent International, The Carlyle Group and CVC Capital Partners, generating a return of over two times the money invested… LBO France, managed by LBO France
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Gestion, now owns 86% of Materis and Lafarge and management each retain a 7% stake.
Another strategie for exiting an LBO is the dividend recap. Since 2006, some leveraged buyout firms have rushed to embrace recapitalizations in order to monetize quickly their investments. Classically, buyout firms put together dividend-‐paying recaps three to five years after the original LBO and after the buyout firms had proven the company’s ability to deliver strong earnings, cash flow and revenues in good times and bad. LBO firms are also recapitalizing deals they negotiated only months earlier or using the recaps as a way to pull out the whole of their equity in an old deal that has gone stale.
SECTION II – Capital gain, carried interest and tax aspects.
The process of an LBO transaction is simple. The Newco, in order to reimburse its debt and interest payments, has to improve its profitability. The Newco increases generally its value, and after few years, investors so private equity firms, sell their participation in order to obtain a significant capital gain. That’s like it as general partners can hope capital gain and enrich their limited partners.
Last year, secondary buyout, which is a possibility for exiting an LBO, was a more common exit for private equity investors than sale of businesses back to the public by an IPO. This fact is surprising because we know that the goal of any LBO is to extract the maximum value and streamline the company.
Also, if a second group of private equity firms step in to do another LBO transaction of a target that has been through the process once, that likely means either that the first group has failed or that the second group has made a faulty analysis.
Then, there is the rather interesting way in which the industry has structured compensation, enabling it to claim that its employees aren't just earning salaries but rather capturing long term capital gains called "carried interest".
I – Concept of carried interest.
Carried interest can be defined as the right that entitles the general partner of a private equity firm to a share of the fund’s profits.
Generally in a private equity fund, the general partner is a partnership and is controlled by investment managers and contributes 1 to 5% of the fund’s initial capital. The general partner must engage to manage the fund’s assets. The general partner obtains an annual fee of 2% of the fund’s assets and a "carried interest" of 20% of the fund’s profits that exceed a certain "hurdle" rate of return.
The individual partners of the general partner, not the general partner itself, are taxed on these payments.
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Carried interests conflate generally three tax problems. Firstly, the classification of income as capital gains or ordinary income. Secondly, the determination of partners' income at the partnership, or entity, level, and thirdly, the dependence of the tax system on realizable events.
Whether carried interests produce ordinary income or capital gains has attracted the most controversy, particularly in the USA and in France the last year. Logically, the profit from the sale of assets must be defined as the essence of a capital gain, and carried interests do give general partners a right to future capital gains generated by the sale of partnership assets.
The profit from an asset sale must be also thought to belong to the owner of the asset, who pays the applicable capital gains tax.
But general partners pay effectively the capital gain tax rate on their carried interest income, even though they don’t own the assets whose sale generated the income.
By contrast, the limited partners have a "capital interest," which gives them the shared and sole right to the liquidation value of the partnership. Indeed, limited partners hope to realize a capital gain on their initial private equity investment, but risk losing this capital. General partners so the private equity firms, risk only their “time” and effort…
Carried interest constitutes approximately one-‐third of the payments that private equity general partners obtain, and the management fee the remainder. Under current law, the management fee is taxed like a simple salary income, with a top income tax rate of 45% in France, whereas the carried interest is currently taxed as investment profit, also with a lower tax rate.
In particular, any portion of the carried interest that represents qualified dividends or long term capital gains of the fund is taxed at a top rate of 20% plus a 3.8% surtax. Many commentators believe it would be fairer and more efficient for carried interest to be taxed like wage and salary income, like the current French Government.
II – Comparison between the USA and in France.
In the US, legislators are currently debating whether carried interest qualifies as capital gains, or should be taxed as ordinary income instead.
France's Parliament decided four or five years ago that carried interest qualified as capital gains, and recent clarifications from the last government indicate that carry's tax status is not in danger.
But today some analysts and lawyers explain that the French view carried interest as being "at risk", while the US seems to see carry more and more as a fee for services rendered.
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Before the new legislation, the carried interest of a private equity fund could receive a capital gain tax treatment if the fund managers fulfill two main conditions: they should receive a normal income, a salary, and they should also invest a certain amount in the fund, which wasn't clearly determined by the tax administration. Those were the only rules that were applied.
But things have changed since the Financial law for 200923.
With the new legislation, several new rules have been enacted. One is that the amount the manager must invest in the fund has been more clearly determined. The amount is now 1% of the total commitments of the fund for a carried interest with a rate of 2%, except in the cases of venture capital funds that invest in innovative companies or in European “PME”.
The capital gain tax treatment of carried interest is the result of the risk taken by the managers of the funds.
The last year, there has been a bad time for French private equity funds. Most obviously, it has found itself in the firing line of hefty tax increases, wanted by the new socialist government and President François Hollande. These include a special 75% tax for people earning more than € 1 million per year.
The government has, to the relief of buyout firms, softened its stance on the taxation of carried interest, after initially saying it would be classified as income and, therefore, potentially attracting the 75% rate.
Instead, carried interest will always benefit from capital gains tax, meaning owners will receive a 20% tax exemption on shares held between two and four years, increasing to 40% for assets held for more than six years.
About the taxation regime abroad, the Belgian tax ruling service has recently concluded that carried interests paid to managers of a private equity fund were liable to tax as ordinary income that is to say in Belgium, 53,5%.
To conclude, it has been estimated that there are between 1,500 to 2,000 French companies under leveraged buyout financing in 2011, of which some 25% have not been able to respect one or more of their financial covenants to lenders. The breach of financial covenants by a company under LBO is often the first warning sign to lenders that all is not well.
This may indicate a temporary problem resulting from a downturn in current market conditions or, when linked to an immediate or pending liquidity problem, a more serious structural problem requiring a restructuring of the capital and debt financing structure of the company and its subsidiaries.
23 Article 150-‐0-‐A II, 8°) of the French Code Général des Impôts.