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Management & Leveraged Buyouts

Mark Fielding-Pritchard

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LBO = Definition

Buyout: The purchase of a company or a controlling interest of a company's shares.

Leverage buyout: The acquisition of a company using debt and equity finance. As the word leverage implies, more debt than equity is used to finance the purchase, e.g. 90% debt to 10% equity. Normally, the assets of the company being acquired are put up as collateral to secure the debt. (Beatrice Foods by Esmark, Levis Strauss, etc.)

Going Private: Refers to transformation of a public corporation into a privately held firm.

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MBOs

Management buy-out (MBO) - A private equity firm will often provide financing to enable current operating management to acquire at least 50% of the business they manage. In return, the private equity firm usually receives a stake in the business.

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Characteristics LBOs are a way to take a public company

private, or put a company in the hands of the current management, MBO.

LBOs are financed with large amounts of borrowing (leverage), hence its name. Debt:Equity ratio can go more than 90:10

LBOs use the assets or cash flows of the company to secure debt financing, bonds or bank loans, to purchase the outstanding equity of the company.

After the buyout, control of the company is concentrated in the hands of the LBO firm and management, and there is no public stock outstanding.

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Methods of achieving an MBO?

Asset Purchase Stock Purchase

The choice is dictated by balancing Legal, Financial, Tax and Accounting advantages and disadvantages.

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Asset Purchase

Suitable for Small and Medium sized transactions. Allows selection or rejection of assets and

liabilities. Leads directly to price allocation and stepped up

asset value, that are part of Tax and Accounting aspects of transactions.

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Stock Purchase

In Stock purchase , the target shareholders simply sell their stock and all their interest in target corporation to the buying group and then the two firms may be merged.

This method cannot be used if one or more minority share holders refused to sell.

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Successful Strategy Finding cheap assets – buying low and selling

high (value arbitrage or multiple expansion)

Targeting firms with low Q-Ratio (Market Value/Asset Value)

Unlocking value through restructuring: Financial restructuring of balance sheet –

improved combination of debt and equity Operational restructuring – improving

operations to increase cash flows

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Scanning target Company History of profitability.

Predictable cash flows to service financing.

Low current debt and high excess cash.

Strong management team - risk tolerant.

Known products, strong market position.

Little danger of technological change (high tech?).

Low-cost producers with modern capital.

Take low risk business, layer on risky financing.

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LBO Financing

LBO sponsors have equity funds raised from institutions like pensions & insurance companies

Balance from commercial banks (bridge loans, term loans, revolvers).

Banks concentrate on collateral of the company, cash flows, level of equity financing from the sponsor, coverage ratios, ability to repay (5-7 yr)

Some have “Mezzanine Funds” as well that can be used for junior subordinated debt and preferred

Occasionally, sponsors bring in other equity investors or another sponsor to minimize their exposure

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LBO ‘s are undertaken at high premium price. The premium paid is 40% or more than average

stock value of last two months.

What are the sources of these gains? Tax Savings.

Management Incentives.

Asymmetric Information and under pricing.

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Where do we create value

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Tax Savings

Most of the premium paid is financed by Tax savings.

New company can operate Tax free for as long as 4-5 years.

In this time period the debt/equity ratio is pulled down from 10 to 1.

Often the LBO is sold after this time horizon or reverse LBO is done.

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Management Incentives

Control and hence stakes are with few people.

Incentives of Management increases.

Dividends are not necessary.

Debt payment is effective substitute for dividend payment.

To save company from the Bankruptcy.

Restructuring of the acquired firm saves substantial amount of costs.

Changes in marketing strategies.

Employee reduction

Economies of Scale.mefielding

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Underpricing Investors have more information on the value

of firm than public shareholders. Investors buy firms that have low Q-Ratio. Net value of the firm may still be higher than

LBO price paid. Such firms are generally resold at much

higher price after the new management brings the firm to its true value by restructuring activities. Example, Kohlberg Kravis Roberts and Thomas H

Lee Company started in 1970’s, seas opportunity in inefficient and undervalued corporate.

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