12 - 1
Leveraged Buyout
Structures and Valuation
12 - 2
M&A and Other
Restructuring
Activities
M&A
Environment
M&A Process
Deal
Structuring
Alternative
Restructuring
Strategies
Motivations
for M&A
Business &
Acquisition Plans
Public &
Private Company
Valuation
Divestitures,
Spin-Offs, &
Carve-Outs
Common Takeover
Tactics and
Defenses
Search Through
Closing Activities
Financial
Modeling
Techniques
Bankruptcy &
Liquidation
Alternative
Structures
Tax & Accounting
Issues
Learning Objectives
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
Primary Learning Objective: To provide students with a knowledge of how
to analyze, structure, and value highly leveraged transactions.

Secondary Learning Objectives: To provide students with a knowledge of
• The motivations of and methodologies employed by financial buyers;
• Advantages and disadvantages of LBOs as a deal structure;
• Alternative LBO models;
• The role of junk bonds in financing LBOs;
• Pre-LBO returns to target company shareholders;
• Post-buyout returns to LBO shareholders, and
• Alternative LBO valuation methods
• Basic decision rules for determining the attractiveness of LBO
candidates
Financial Buyers
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In a leveraged buyout, all of the stock, or assets, of a public
corporation are bought by a small group of investors
(“financial buyers”), usually including members of existing
management. Financial buyers:

Focus on ROE rather than ROA.

Use other people’s money.

Succeed through improved operational performance.

Focus on targets having stable cash flow to meet debt service
requirements.
• Typical targets are in mature industries (e.g., retailing,
textiles, food processing, apparel, and soft drinks)
LBO Deal Structure

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Advantages include the following:
• Management incentives,
• Tax savings from interest expense and depreciation from asset writeup,
• More efficient decision processes under private ownership,
• A potential improvement in operating performance, and
• Serving as a takeover defense by eliminating public investors

Disadvantages include the following:
• High fixed costs of debt,
• Vulnerability to business cycle fluctuations and competitor actions,
• Not appropriate for firms with high growth prospects or high business
risk, and
• Potential difficulties in raising capital.
Classic LBO Models:
Late 1970s and Early 1980s
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
Debt normally 4 to 5 times equity. Debt amortized over no
more than 10 years.

Existing corporate management encouraged to participate.

Complex capital structure: As percent of total funds raised
• Senior debt (60%)
• Subordinated debt (26%)
• Preferred stock (9%)
• Common equity (5%)

Firm frequently taken public within seven years as tax benefits
diminish
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Break-Up LBO Model (Late 1980s)

Same as classic LBO but debt serviced from
operating cash flow and asset sales

Changes in tax laws reduced popularity of this
approach
• Asset sales immediately upon closing of the
transaction no longer deemed tax-free
• Previously could buy stock in a company
and sell the assets. Any gain on asset sales
was offset by a mirrored reduction in the
value of the stock.
Strategic LBO Model (1990s)
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
Exit strategy is via IPO

D/E ratios lower so as not to depress EPS

Financial buyers provide the expertise to grow earnings
• Previously, their expertise focused on capital structure

Deals structured so that debt repayment not required until 10
years after the transaction to reduce pressure on immediate
performance improvement

Buyout firms often purchase a firm as a platform for leveraged
buyouts of other firms in the same industry
Role of Junk Bonds in Financing LBOs 12 - 9

Junk bonds are non-rated debt.
• Bond quality varies widely
• Interest rates usually 3-5 percentage points above the prime rate

Bridge or interim financing was obtained in LBO transactions to close the
transaction quickly because of the extended period of time required to issue
“junk” bonds.
• These high yielding bonds represented permanent financing for the
LBO

Junk bond financing for LBOs dried up due to the following:
• A series of defaults of over-leveraged firms in the late 1980s
• Insider trading and fraud at such companies a Drexel Burnham, the
primary market maker for junk bonds

Junk bond financing is highly cyclical, tapering off as the economy goes
into recession and fears of increasing default rates escalate
Factors Affecting Pre-Buyout Returns
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
Premium paid to target firm shareholders consistently
exceeds 40%

These returns reflect the following (in descending order of
importance):
• Anticipated improvement in efficiency and tax benefits
• Wealth transfer effects
• Superior Knowledge
• More efficient decision-making
Factors Determining Post-Buyout Returns12 - 11

Empirical studies show investors earn abnormal postbuyout returns

Full effect of increased operating efficiency not reflected
in the pre-LBO premium.

Studies may be subject to “selection bias,” i.e., only LBOs
that are successful are able to undertake secondary public
offerings.

Abnormal returns may also reflect the acquisition of many
LBOs 3 years after taken public.
Valuing LBOs
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
A LBO can be evaluated from the perspective of common
equity investors or of all investors and lenders

LBOs make sense from viewpoint of investors and lenders if
present value of free cash flows to the firm is greater than or
equal to the total investment consisting of debt and common
and preferred equity

However, a LBO can make sense to common equity investors
but not to other investors and lenders. The market value of
debt and preferred stock held before the transaction may
decline due to a perceived reduction in the firm’s ability to
• Repay such debt as the firm assumes substantial amounts of
new debt and to
• Pay interest and dividends on a timely basis.
Valuing LBOs: Variable Risk Method
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Adjusts for the varying level of risk as the firm’s
total debt is repaid.

Step 1: Project annual cash flows until
target D/E achieved

Step 2: Project debt-to-equity ratios

Step 3: Calculate terminal value

Step 4: Adjust discount rate to reflect
changing risk

Step 5: Determine if deal makes sense
Variable Risk Method: Step 1
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
Project annual cash flows until target D/E ratio
achieved

Target D/E is the level of debt relative to equity at
which
• The firm will have to resume payment of
taxes and
• The amount of leverage is likely to be
acceptable to IPO investors or strategic
buyers (often the prevailing industry
average)
Variable Risk Method: Step 2

Project annual debt-to-equity ratios

The decline in D/E reflects
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• the known debt repayment schedule and
• The projected growth in the market value of
the shareholders’ equity (assumed to grow at
the same rate as net income)
Variable Risk Method: Step 3
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
Calculate terminal value of projected cash flow to
equity investors (TVE) at time t, i.e., the year in
which the initial investors choose to exit the
business.

TVE represents the PV of the dollar proceeds
available to the firm through an IPO or sale to a
strategic buyer at time t.
Variable Risk Method: Step 4
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
Adjust the discount rate to reflect changing risk.

The firm’s cost of equity will decline over time as debt is repaid and equity grows,
thereby reducing the leveraged ß. Estimate the firm’s ß as follows:
ßFL1 = ßIUL1(1 + (D/E)F1(1-tF))
where ßFL1
ßIUL1
= Firm’s levered beta in period 1
= Industry’s unlevered beta in period 1
= ßIL1/(1+(D/E)I1(1- tI))
ßIL1
= Industry’s levered beta in period 1
(D/E)I1 = Industry’s debt-to-equity ratio in period 1
tI
= Industry’s marginal tax rate in period 1
(D/E)F1 = Firm’s debt-to-equity ratio in period 1
tF

= Firm’s marginal tax rate in period 1
Recalculate each successive period’s ß with the D/E ratio for that period, and using
that period’s ß, recalculate the firm’s cost of equity for that period.
Variable Risk Method: Step 5

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Determine if deal makes sense
• Does the PV of free cash flows to equity
investors (including the terminal value)
equal or exceed the equity investment
including transaction-related fees?
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Evaluating the Variable Risk Method

Advantages:
• Adjusts the discount rate to reflect
diminishing risk as the debt-to-total capital
ratio declines
• Takes into account that the deal may make
sense for common equity investors but not
for lenders or preferred shareholders

Disadvantage: Calculations more burdensome than
Adjusted Present Value Method
Valuing LBOs: Adjusted Present Value12 - 20
Method (APV)
Separates value of the firm into (a) its value as if it were debt free and (b)
the value of tax savings due to interest expense.

Step 1: Project annual free cash flows to equity investors and interest
tax savings

Step 2: Value target without the effects of debt financing and discount
projected free cash flows at the firm’s estimated unlevered cost of
equity.

Step 3: Estimate the present value of the firm’s tax savings discounted
at the firm’s estimated unlevered cost of equity.

Step 4: Add the present value of the firm without debt and the present
value of tax savings to calculate the present value of the firm including
tax benefits.

Step 5: Determine if the deal makes sense.
APV Method: Step 1

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Project annual free cash flows to equity investors and interest
tax savings for the period during which the firm’s capital
structure is changing.
• Interest tax savings = INT x t, where INT and t are the
firm’s annual interest expense on new debt and the
marginal tax rate, respectively
• During the terminal period, the cash flows are expected to
grow at a constant rate and the capital structure is expected
to remain unchanged
APV Method: Step 2

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Value target without the effects of debt financing and discount
projected cash flows at the firm’s unlevered cost of equity.
• Apply the unlevered cost of equity for the period during
which the capital structure is changing.
• Apply the weighted average cost of capital for the terminal
period using the proportions of debt and equity that make
up the firm’s capital structure in the final year of the period
during which the structure is changing.
APV Method: Step 3

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Estimate the present value of the firm’s annual
interest tax savings.
• Discount the tax savings at the firm’s
unlevered cost of equity
• Calculate PV for annual forecast period
only, excluding a terminal value, since the
firm is sold and any subsequent tax savings
accrue to the new owners.
APV Method: Step 4

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Calculate the present value of the firm including
tax benefits
• Add the present value of the firm without debt
and the PV of tax savings
APV Method: Step 5

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Determine if deal makes sense:
• Does the PV of free cash flows to equity
investors plus tax benefits equal or exceed
the initial equity investment including
transaction-related fees?
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Evaluating the Adjusted Present Value Method

Advantage: Simplicity.

Disadvantages:
• Ignores the effect of changes in leverage on the
discount rate as debt is repaid,
• Implicitly ignores the potential for bankruptcy of
excessively leveraged firms, and
• Unclear whether true discount rate should be the
cost of debt, unlevered cost of equity, or
somewhere between the two.
Things to Remember…
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
LBOs make the most sense for firms having stable cash flows, significant
amounts of unencumbered tangible assets, and strong management teams.

Successful LBOs rely heavily on management incentives to improve
operating performance and a streamlined decision-making process resulting
from taking the firm private.

Tax savings from interest expense and depreciation from writing up assets
enable LBO investors to offer targets substantial premiums over current
market value.

Excessive leverage and the resultant higher level of fixed expenses makes
LBOs vulnerable to business cycle fluctuations and aggressive competitor
actions.

For an LBO to make sense, the PV of cash flows to equity holders must
equal or exceed the value of the initial equity investment in the transaction,
including transaction-related costs.