prof. ian giddy new york university structured finance: leveraged buyouts

Prof. Ian GiddyNew York University

Structured Finance:Leveraged Buyouts

Copyright ©2002 Ian H. Giddy Structured Finance 2

Structured Finance

Asset-backed securitization Corporate financial

restructuring Structured financing

techniques


Leveraged Financing

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

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

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

a third party (a leveraged acquisition).


Case Study

The John Case LBO Proposal Devise a recommended financing plan

John Case (owner)

Buyers VC Investors


Corporate Restructuring

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

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


Divestitures

Divestiture: the sale of a segment of a company to a third party

Spin-offs—a pro-rata distribution by a company of all its shares in a subsidiary to all its own shareholders

Equity carve-outs—some of a subsidiary' shares are offered for sale to the general public

Split-offs—some, but not all, parent-company shareholders receive the subsidiary's shares in return for which they must relinquish their shares in the parent company

Split-ups—all of the parent company's subsidiaries are spun off and the parent company ceases to exist.


Divestitures Add Value

Shareholders of the selling firm seem to gain, depending on the fraction sold:

Total value created by divestititures between 1981 and 1986 = $27.6 billion.

% of firm sold Announcement effect

0-10%10-50%50%+

0+2.5%+8%


Going Private

A public corporation is transformed into a privately held firm

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

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

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

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

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

Leveraged Buy-Out (LBO)


Leveraged Buy-Outs

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

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

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

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


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

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

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

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


M&A and Leverage

Leveraged buyout?

Company has

unused debt

capacity Leveraged

recapitalization?

Takeover?


Typical LBO Sequence

Company gets bloated or slack and stock price falls

LBO offer made

LBO completed

Restructuring Efficiencies Divestitures Financial

? years 3-9 months 5-7 years

IPO or sale of company


Case Study: John M. Case Company

Bank debt and equity-linked structured financing in the context of leveraged buyout financing, including valuation and exit strategies. Convertibles and bridge financing.

What financial structure enables the acquiring group to retain control?

What is the cost of financing? “How much equity should/must our client give

up in order to get the funding we need?”


The John M Case Leveraged Buy-Out

1. What are the most important operating and financial characteristics of the Case Company?

2. Is the company worth Mr Case's $20 million asking price?

3. Can the $20 million purchase be financed so that management can retain at least 51% ownership? What sources should management tap? In what amounts? Is the return being sought by the venture capital reasonable?


4. How compelling a buyout opportunity is this proposition for the four managers?

5. Would you, as a commercial banking lender, provide the loan needed to finance the seasonal buildup in accounts receivable and inventory? On what terms?

6. Would you, as the venture capital firm, provide the balance of the funds needed? If so, on what terms?

The John M Case Leveraged Buy-Out


Bank Loan Loan from Mr Case Venture Capitalists' Investment

Financing Sources


POSITIVES :

The company has a stable product The company enjoys good profit

margins There are important barriers to

competitor entry The business is not too asset-intensive The four key managers know the

business well


NEGATIVES :

Sales growth is probably quite limited This low-tech product has no patent

protection Even if outsiders find it difficult to

penetrate the market, that may not apply to vendors already in the industry, most particularly, the Watts Company


Simplified Balance Sheetfor a restructured J.M.Case Company

Cash $5762 Current Liab $1266Other current 3236 Bank loan 6000Fixed & other 2184 Case loan 4000

Good will 10084 Plug figure 9500

Managers’ equity

500

Total 21,266 Total 21,266

Assets Liabilities


WACC

John M. Case LBOHow is the acquisition to be financed?Answer: let's work out what we have to pay the VCs in order to fill the gap

Assets Liabilities Nominal Effective Weight ProductCash 5,762$ Current $1,266 0% 0.00% 5.95% 0.00%Other current 3,236$ Bank loan $6,000 12% 8.40% 28.21% 2.37%Long term 2,184$ Seller note $4,000 4% 8.17% 18.81% 1.54%Goodwill 10,084$ VC plug $9,500 9% 21.40% 44.67% 9.56%

Managers' equity $500 30% 2.35% 0.71%Total 21,266$ $21,266 14.17%

johncaselbo.xls


Feasibility of the Price

Book Value Basis Stock Market Valuation Basis Comparable Company Value Discounted Cash Flow Basis


Book Value Basis :

Asking price : twice the value of the company’s equity

Why would anyone pay this ?

If the profitability of the company justifies it

- in this case, it appears to – ROE around 20 % or $ 2 million in 1984


Stock Market Valuation

If a company is publicly traded, the valuation accorded its outstanding market shares can be a starting point for valuation

In this case, the company is not publicly traded, so no opportunity is available here


Comparable Company Value

Common practice to compare its value with those accorded to publicly traded companies in a similar business

After comparisons made, it is seen that the Case asking price is in line with the market value of a publicly traded competitor


John Case Valuation

John Case Analysis 1 2 3 4 5 6Year 1985 1986 1987 1988 1989 1990

Principal Repayment 9500Coupon payments 855 855 855 855 855 855Total Repayments 855 855 855 855 855 10355Return @ 25% 25% 25% 25% 25% 25% 25%NPV 684 547.2 437.76 350.208 280.1664 2714.501NPV @ yr0 5014Equity 4486Total VC 9500

I) FCF#1: Original Core BusinessFCF after financing: 1448 1702 1920 2114 1982 2002NPV of FCF after financing 1268.257 1305.681 1290.083 1244.113 1021.639 903.8505NPV of FCF @ yr 0 7034NPV of VC Equity 4486 39%Total Equity 11520

II) FCF#2: Expansion PlanTurnover 1000 1400 1960 2744 3073.28 3442.074Profit (margin of 6%) 60 84 117.6 164.64 184.3968 206.5244NPV of FCF after financing 52.55209 64.44019 79.01755 96.89255 95.04891 93.24036NPV of FCF @ yr 0 481

III) Total Equity Valuation 12,000,980$


Case Study: Le Meridien

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

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

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

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

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prof. ian giddy new york university structured finance: leveraged buyouts

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