Leveraged Buyouts
Characteristics
Evidence on LBOs
An LBO (Private Equity) Model
Reverse LBOs
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Definition of an LBO
• No precise definition -- different forms
• Transaction in which a group of private
investors uses debt financing to purchase a
corporation or a corporate division. Equity
securities of the company are no longer
publicly traded, though the debt and preferred
stock may be publicly traded. Uses entire
borrowing structure
• Often involves a financial sponsor who
contributes capital and expertise (KKR, Bass
Brothers, Blackstone, etc.) and management
team.
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Copyright, Robert Holthausen, 2010
Distinct Features of an LBO
• Significant increase in financial leverage
– Average debt/total capital increases substantially
• Management ownership interest increases
– Median ownership of a Fortune 500 U.S.
Corporation is 0.5%, for Value Line 1000 is 5%
– After an LBO the ownership is 10% - 35%
• Non-mgmt equity investors join the board
– Before an LBO, non-management directors have
almost no ownership. After, non-management
directors may represent 40%-60% of
equityholders
– Typical board of 5 individuals, 2-3 from the LBO
sponsor
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Historical Characteristics of Potential
LBO Candidates
•
•
•
•
•
•
•
History of profitability
Predictable cash flows to service financing
Low current debt and high excess cash
Readily separable assets or businesses
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
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Typical LBO Structure
• Varies tremendously over time with market conditions
• Debt Financing
– Total debt sometimes 60-80% of entire deal (4-5 x LTM
EBITDA, but depends on industry, cash flow, and time
period etc.
– 40% - 60% senior bank debt (repayment in 5-7 years)
– 0-15% senior subordinated (repayment in 8-12 years)
– 0-20% junior subordinated (repayment in 8-12 years)
– 0 - 15% preferred stock
– 10% - 50% common equity
• Equity Ownership
– 10% - 35% management/employee owned
– 40% - 60% investors with board representation
– 20% - 25% owned by investors not on board
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LBO Financing
• Financial sponsors have equity funds raised from
institutions like pensions & insurance companies
• 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
• Balance from commercial banks (bridge loans, term
loans, revolvers) & other mezzanine sources
• Banks concentrate on collateral of the company, cash
flows, level of equity financing from the sponsor,
coverage ratios, ability to repay (5-7 yr)
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•
•
•
•
•
•
•
•
LBO Financing – Senior Bank Debt
Senior bank debt which is secured with assets like receivables,
inventory, PP&E is often priced at T-Bills, LIBOR or prime + 400 to
700 basis points (three years ago spreads were much lower).
Often in tranches where first tranche is repaid quickly and other
tranches are not due until maturity (7-8 year maturity with average
life of 4-5 years)
2.5 – 3.5 x LTM EBITDA (varies by industry and rating and with
credit market conditions)
Lend up to X % (40%-65%) of receivables less than Y (90) days,
over certain $ amount, at T-Bill, LIBOR or Prime, plus a risk
premium
Inventory usually 20% to 60%
Securities 10% to 90% (US Govt Bonds @ 90%)
PP&E (Cars (60%), Computers (25%), Building (60% to 70%,
unique factories (10% to 30%)
Bankers historically like to see 25% to 35% equity for protection
(now much more)
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LBO Financing – Unsecured Debt
• Unsecured debt (senior and junior)
• Potentially many different pieces (cash pays are senior and
senior subordinated while junior subordinated may be zero
coupon issued by holding company)
• Longer maturity than bank debt
• Covenants not to pay dividends, increase debt or sell assets
• Supported by cash flows and operations of the business.
• High-yield a favorite (senior subordinated), but hard to sell high
yield for less than $150 million and high-yield market not always
viable.
• High-yield is typically non-callable for about five years and then
have call penalties for 3-5 years.
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Junior Subordinated and
Preferred
• Below the high-yield bonds (or below the bank debt if the deal
isn’t big enough to support high-yield bonds) but above the
common would be junior subordinated and preferred stock.
• Junior subordinated may be PIK (zeros) for some time period.
May be issued by a holding company of the operating company
and may be issued with warrants. Holding company notes
almost always PIK because there is no cash flow into the
holding company for some time.
– In transactions of this type, the PIK interest may not be
deductible until it is paid in cash or the bond matures and is
paid off (so called AHYDO rules)
• Preferred can be PIK as well, so dividends accrue but are not
paid and at sale of the company the preferred holders get their
investment plus accrued dividends (often called the liquidation
preference) -- often sold with warrants. Alternatively, can issue
convertible preferred instead of including warrants.
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Common Equity
• Typically 20% - 45% of capital structure
historically, but varies over time (at high end
or more right now).
• Typically seeking a 20%-40% IRR but
depends on how levered the capital structure
• Often assume exit and entry multiples are the
same, but not necessarily a good assumption
– rarely expect multiple expansion
• Ask what the exit strategy is likely to be.
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Management Ownership
• Management puts up 60% to 70% of wealth
(excluding residence)
• Management share of equity (sometimes called
management promote) usually increases year by
year as they meet targets (e.g., revenue and EBITDA
and non-financial targets) through performance
vesting options. Strike price usually at equity buy-in
price at time of deal.
• Managers are sometimes offered chance to buy
stock with a mixture of recourse and non-recourse
notes.
• Managers often already own shares in a company
that does an LBO and they do not necessarily cash
out those shares – that equity goes into the new
entity – called rollover equity.
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Financial Sponsors
• Typically won’t put more than certain percentage of a
fund in one company and another percentage of a
fund in one industry. Increases in % of financing that
is equity has caused deal sharing.
• Razor edge margins because of the high risk profiles.
Shooting for 20% - 30% on every deal, some earn
100%, some 4%, some -80%, etc.
• Sponsor takes funds from pension funds only when
required, a draw down notice (LBO sponsors do not
want to be generic portfolio managers).
• Typically assume will take 3-5 years to invest a fund
and then another 3-5 years to cash out (monetize)
the investments.
• Expertise in layering risk, financial structure
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Financial Sponsors
• Normally get a management fee that is
1% to 1.5% of fund size.
• In addition, they split returns between
investors and themselves and often get
a percentage in the capital gain of the
fund (so called carried interest).
• In addition, they invest their own money
in the fund.
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Financial Sponsor M&A
Activity
1998 – 2010 Global Sponsor
M&A Activity
$ in billions
% of Total Value
$1,200
30%
$1,001
$1,000
25%
$898
$800
20%
$600
$162
$180
$118
10%
$204
$187
$119
$145
2001
2002
$423
$388
$357
$400
$200
15%
$506
5%
$0
0%
1998
1999
2000
2003
Global Sponsor Activity Volume
2004
2005
2006
2007
2008
2009
2010
(1)
% of Total Global M&A Volume
___________________________
Source: Thomson Financial based on rank date excluding equity carveouts, exchange offers and open market repurchases. As of 12/31/10.
(1)
Total Global M&A Volume includes government interventions, defined as deals in which a government entity is the acquiror, excluding SWF transactions.
18
Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2010
Financial Sponsor M&A Activity 2007-2010
Sponsor Volume has reemerged, steadily gaining more share of Global M&A Volume


2009 Sponsor volume was off 47% from 2008 year-over-year average; Strategic volume was down 30%
2010 Sponsor volume was up 107% from 2009 volume; Strategic volume was up 14%
Global
Sponsor Quarterly M&A Activity
$ in billions
Sponsor % of Market
50%
$1,417
$1,400
45%
$1,200
$1,000
40%
35%
$972
1,028
$897
$893
$874
30%
$798
$800
$733
$668
$600
707
686
739
$400
$519
$476
$443
20%
$520
$471
723
563
594
471
404
450
$200
$564
$591
732
500
422
459
463
211
15%
10%
515
390
265
25%
$637
5%
135
104
161
75
$0
48
26
39
49
90
61
100
123
139
0%
Q1 2007 Q2 2007 Q3 2007Q4 2007 Q1 2008 Q2 2008Q3 2008 Q4 2008 Q1 2009 Q2 2009Q3 2009 Q4 2009 Q1 2010Q2 2010 Q3 2010 Q4 2010
Sponsor Volume
Strategic Volume
Sponsor % of Market(1)
___________________________
Source: Thomson Financial based on rank date excluding equity carveouts, exchange offers and open market repurchases. As of 12/31/10.
(1)
Total Global M&A Volume includes government interventions, defined as deals in which a government entity is the acquiror, excluding SWF transactions.
20
Corporate Valuation -- Chapter 18
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Strategics are Driving the M&A
Market
Risk right-sizing in credit markets will continue to allow Strategics to be more competitive
buyers of assets, but Sponsor volume has reemerged
Strategics
Financial Sponsors
 Harder time getting to DCF range, cheap
credit subsidy gone
 Leveraged finance market recovered,
although still below pre-2008 levels
 Reemerged due to opening of credit
markets
 2010 tax-driven transactions
 Portfolio backlog waiting to be
monetized
 High acquisition appetite
 Search for assets where they have a
comparative advantage as buyer
 Deal size sweet spot for Financial
Sponsors moves to the midcap market
 Reemergence of large LBOs, $5+ billion
21
 MBO a less viable path for CEOs
 No longer getting out-bid – ability to push the
strategic agenda
 Synergies > financing subsidy
 Resurgence of cash as an acquisition
currency
 Historically high cash levels on balance
sheets that needs to “go to work”
 Investment grade corporates “rule” with
maximum financial flexibility
Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2010
Risk Profile Questions
• Is cash flow consistent (no cyclical
industries)?
• Is a turnaround required to meet projections?
• Any outside threats to long-term
performance?
• Are there larger, better capitalized
competitors?
• Does the firm have high quality
management?
• Are there other successful LBOs in that
industry?
• Can the company grow with the leverage
increase?
Corporate Valuation -- Chapter 18
17
• Wharton
What isSchool
the exit strategy?
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U.S. LBO Acquisition Financing Market Trends
Sample Capital Structure Terms for Leveraged Deals
Average Debt Multiples (1)
6.7x
6x
3.3
3x
3.4
6.0x
5.4x 5.0x 5.2x 5.3x 5.2x 5.8x 5.7x 5.2x
0.6 4.7x
4.6x
4.5x 4.1x
4.0x 4.2x 4.4x 4.4x
4.0x
3.8x
3.7x
2.3
2.1
2.0
0.6
1.7
1.9
1.2 1.2
0.2 0.6
2.4 2.5 2.5
1.3 1.1
1.5 1.4 1.7 1.5
5.4
4.1 3.8 4.0
3.4 2.6 2.7 2.8 3.3 3.5 3.6 3.5 3.3 2.9
3.3
3.1
2.7
2.2 2.4 2.3
0x
1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Senior Debt/EBITDA
Junior Debt/EBITDA
Average Equity Contribution to LBO (2)
52%
50%
25%
0%
25% 26% 24% 23%
21% 22%
43%
43%
41% 40% 40%
36% 38%
35% 32% 33% 33%
32%
30%
34% 35% 37% 35% 32% 30% 31% 31% 39%
27% 28% 32%
26%
25%
24% 23%
21% 22%
3% 4% 4% 6% 3% 5% 3% 2% 2% 2% 4%
3%
13%
46%
13%
6%
41%
2%
1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Rollover Equity
________________
Source: S&P Leveraged Commentary & Data. As of 12/31/10.
1) Excludes media loans. Too few deals in 1991 to form a meaningful sample.
2) Rollover equity prior to 1996 is not available. Too few deals in 1991 to form a meaningful sample.
41
Contributed Equity
Corporate Valuation -- Chapter 18
Copyright, Robert Holthausen, 2010
Current State of the Market
•
•
•
•
•
•
•
Driven by the recovery of the leveraged finance market, as well as the
return of the corporate buyer, the M&A market has recovered to a “new
normal”. There have been several $1B+ LBOs including Del Monte at
$5.3 billion.
The size of LBOs that can get done is a function of size, industry,
quality of asset, quality of sponsor, quality of management team.
As equity valuations have rebounded and stabilized, sellers are more
comfortable with valuations and believe they are not selling at impaired
values and are no longer constrained by 2009 “trough” financial results.
The robust and recovering leveraged finance market is causing
valuations and structures to change monthly.
Right now, Sponsors can easily do deals up to about $3-5 Billion,
perhaps larger for just the right target characteristics.
Deals greater than $5 billion still require a number of attributes
including stable earnings, world-class management and a top-tier
Sponsor. These larger deals will test depth of the market and will be
constrained by the size of the accompanying equity check (majority of
deals are 30%-50% equity).
Recent large deals include Del Monte, Burger King, Syniverse,
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and other $1+ billion
LBOs. Copyright, Robert Holthausen, 2010
Current State of the Market
•
•
•
•
•
•
Access to high yield market is strong, however underwriters’ capacity is
a constraint (multi-billion full commitment is now a couple of banks, not
one.
Leverage loan market (5 to 7 year term loans) with some amortization
(from banks and senior loan funds), has rebounded.
Deal action seen mainly in industries with stable cash flows and less
cyclicality. Some industries that have had highly levered deals in the
past (e.g., media) are lagging because the leverage terms do not yet
fully support valuations that are considered attractive.
A typical capital structure now is 30%-50% equity, senior secured or
first lien debt of about 40%-50 and subordinated debt/mezzanine at
20%-30%.
Senior debt yielding less than 6% with High Yields yielding anywhere
from around 6% to 9% now and the mezzanine debt in the low-double
digits (coupon rates) but depends on credit risk.
Sponsor firms hope to earn low- to mid-20s IRR on equity. However, in
the interest of putting money to work and against the backdrop of lower
benchmark returns, sponsors will invest at a lower calculated rate (high
upper teens) on a “base case” with the hope of getting to the target
Corporate
Valuation
-- Chapter
20 acquisitions
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IRRs through
the “upside case”,
or other
improvements
in 18
Copyright, Robert Holthausen, 2010
cash flows.
Exit Strategies
• Exit strategies include:
–
–
–
–
IPO
Buyout by a strategic buyer
Buyout by another financial buyer
Leveraged recapitalization --- not really an exit,
but essentially after the debt is paid down to a
reasonable level, the entity issues a new round of
debt and pays a large dividend to equityholders
(or repurchases shares). Some, but not all,
equityholders may be taken out.
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Potential Motivations for an LBO
• Increase in debt and concentrated
ownership increase incentives to
maximize value.
• Non-management on board with
significant equity stakes increases
board effectiveness
• Advantage to being private (filings, etc.)
• Beneficial tax consequences (debt,
step-up)
• Wharton
Transfer
wealth
from
other
stakeholders
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Valuation -- Chapter 18
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Copyright, Robert Holthausen, 2010
in the firm such as employees
&
Performance of LBOs
• Evidence indicates that the median
premium paid to existing shareholders
is 42% .
• What are the potential sources of
value?
– Improved operating performance
– wealth transfers from employees
– reduction of taxes
– wealth transfers from pre-buyout
debtholders
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– overpayment by post-buyout
investors
Changes in Median Performance
• In three year period after the buyout relative
to the year before the buyout
–
–
–
–
–
–
–
–
–
EBIT increases by 42%
EBIT/assets increases by 15%
EBIT/sales increases by 19%
EBIT-CAPEX increases by 96%
EBIT-CAPEX/assets increases by 79%
EBIT-CAPEX/sales increases by 43%
working capital management improves
no decline in advertising, maintenance or R&D
CAPEX falls by 33% relative to industry
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Transfers from Employees
• No evidence that investor wealth gains
can be attributed to wage reductions or
layoffs
– median change in number of employees is
0.9% among all LBOs and is 4.9% among
LBOs that did not engage in divestitures
– significant increase in average annual
compensation for non-management
employees
– there is evidence that LBOs are not adding
to their payrolls at the same rate as the
industry
(12%
declines
for
all,
6.2%
decline
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Valuation
-- Chapter 18
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Copyright, Robert Holthausen, 2010
for those with no divestitures)
Tax Effect of LBOs
• Firms’ interest deductions increase
substantially after an LBO. Depending on
how you value them & how long you think the
highly levered structure will be in place, 21%
to 70% of the premium is attributable to the
interest
• Additional depreciation (pre-1986 Tax Reform
Act accounted for at least 30% of the
premium
• Ratio of federal taxes/EBIT falls from 20%
pre-buyout to 1% for 2 yrs. after buyout.
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Copyright, Robert Holthausen, 2010
Transfers from Bondholders
• If leverage increases dramatically, prebuyout debtholders with no protection
could experience wealth losses
– on average, pre-buyout debtholders lost
2.1%
– represents 3% of the premium paid
– wealth losses accrue only to those
bondholders not safeguarded by protective
covenants (limitations on debt issuance,
etc.)
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Copyright, Robert Holthausen, 2010
Overpayment by Post-Buyout
Investors
• Evidence indicates over three years
subsequent to the buyout, post-buyout
equity investors earned a mean excess
return of 45%.
• Evidence for debtholders is less clear
as it is difficult to track bonds that
default. Default rates on low grade
bonds were roughly 2.5% per year, but
returns are less easily quantified
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John Harland -- An LBO?
• Typical LBO Model
• Model cash flows -- see how it supports
the debt financing structure
• Treat exit year as a choice variable to
determine sensitivity of IRR to exit date.
• Determine the IRR for the mezzanine
and equity providers and see if it hits
target
• Models don’t typically assess value
Corporate
Valuation
-- Chapter
exceptSchool
as exit multiple
(can
do
DCF
of 18
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Copyright, Robert Holthausen, 2010
LBO Models as an Alternative
Valuation
• LBO models can serve as an alternative
valuation.
• Take the cash flow forecasts, determine the
amount of financing available in the market
place currently and the IRR that LBO
sponsors would target for this company.
Based on all that, determine the maximum
amount that could be paid as an LBO
transaction that satisfies the required IRR.
• Triangulate with DCF and Market Multiple
Valuations
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LBO Model Logic
• Create a sources (debt, equity contribution)
and uses (purchase price, fees, debt payoff)
statement for inception of LBO
• Debt schedules
• Proforma balance sheet, income statement
and statement of cash flows based on
operating assumptions
• Cash flows pay down the debt (senior first
and then mezzanine)
• Perform valuations at alternative exit dates
and determine IRR to equity holders
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Reverse Leveraged Buyouts
• Reverse LBO occurs when an LBO goes
public
• Constituted roughly 10% of IPO market in
1980s
• Leverage and ownership changes at time of
reverse LBO that moves them back toward
pre-LBO structure
• Leverage falls from 83% to 56% (debt/capital)
• Inside ownership falls from 75% to 49%
(management and board -- includes sponsor).
• Board size increases from 5 to 7, roughly 1/3
each of operating management,
non
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Valuation -- Chapter 18
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Holthausen, 2010
management capital providers
and
external
Financial Performance
OCF Before Interest and Taxes
•
Year
–
-1
–
0
– +1
– +2
– +3
– Avg +1 to +3
Firm
19.3%
14.6%
11.9%
14.3%
13.5%
13.9%
Industry-Adjusted
9.2%
4.7%
1.5%
4.1%
2.4%
2.9%
• Doing much better than their industry, but
evidence of deterioration relative to prior
performance
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Discretionary Expenditures
• Discretionary expenditures defined as capital
expenditures, advertising and R&D.
– Spending as much as their industry prior to the
reverse LBO and increases subsequently
(discretionary expend./sales) 2% greater than
industry
– CAPEX low before reverse LBO and normal after
– Advertising above industry before and after
– R&D tracks industry before and after
• Employees/sales same as industry both
before and after the reverse LBO
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Effect of ownership and leverage
• No evidence that changes in leverage affect
performance
• Significant correlation between decline in
performance and decline in ownership.
– 10% additional decline in percentage equity
owned by managers results in an additional 3.6%
fall in OCF/assets over three subsequent years
– 10% additional decline in percentage equity
owned by non-management insiders results in an
additional 4.1% fall in OCF/assets over three
subsequent years
• Suggests important role for ownership
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incentive
Copyright, Robert Holthausen, 2010
Stock Market Performance
• Evidence of a large increase in stock
prices of the reverse LBO firms over the
next four years.
• Large increase in stock prices exactly
tracks the stock market. As such, there
is no evidence of positive or negative
excess returns
• Very different from IPOs in general.
Strong evidence of negative excess
returns
Corporate Valuation -- Chapter 18
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