Financing the Deal:
Private Equity, Hedge Funds, and
Other Sources of Financing
No one spends other people’s money
as carefully as they spend their own.
—Milton Friedman
Exhibit 1: Course Layout: Mergers,
Acquisitions, and Other
Restructuring Activities
Part I: M&A
Environment
Part II: M&A Process
Part III: M&A
Valuation and
Modeling
Part IV: Deal
Structuring and
Financing
Part V: Alternative
Business and
Restructuring
Strategies
Ch. 1: Motivations for
M&A
Ch. 4: Business and
Acquisition Plans
Ch. 7: Discounted
Cash Flow Valuation
Ch. 11: Payment and
Legal Considerations
Ch. 15: Business
Alliances
Ch. 2: Regulatory
Considerations
Ch. 5: Search through
Closing Activities
Ch. 8: Relative
Valuation
Methodologies
Ch. 12: Accounting &
Tax Considerations
Ch. 16: Divestitures,
Spin-Offs, Split-Offs,
and Equity Carve-Outs
Ch. 3: Takeover
Tactics, Defenses, and
Corporate Governance
Ch. 6: M&A
Postclosing Integration
Ch. 9: Financial
Modeling Techniques
Ch. 13: Financing the
Deal
Ch. 17: Bankruptcy
and Liquidation
Ch. 10: Private
Company Valuation
Ch. 14: Valuing
Highly Leveraged
Transactions
Ch. 18: Cross-Border
Transactions
Learning Objectives
• Primary Learning Objective: To provide students with a
knowledge of how M&A deals are financed and the role
of private equity and hedge funds in this process.
• Secondary Learning Objectives: To provide students
with a knowledge of
– Advantages and disadvantages of LBO structures;
– How LBOs create value;
– Leveraged buyouts as financing strategies;
– Factors critical to successful LBOs; and
– Common LBO capital structures.
How are M&A Transactions
Commonly Financed?
• Borrowing Options:
– Asset based or secured
lending
– Cash flow or unsecured
lenders (senior and
junior debt)
– Long-term financing
(junk bonds, leveraged
bank loans, convertible
debt)
– Bridge financing
– Payment-in-kind
Financing M&As: Borrowing Options
Alternative Forms of Borrowing
Type of Security
Backed By
Lenders Loan Up to Lending Source
Secured Debt
Short-Term (<1Yr.)
Liens generally on
receivables and
inventory
Liens on Land
and Equipment
50-80% depending
on quality
Intermediate Term
(1-10 Yrs.)
Unsecured Debt
(Subordinated incl.
seller financing)
Bridge Financing
Payment-in-Kind
Cash generating
capabilities of the
borrower
Up to 80% of
appraised value of
equipment; 50% of
real estate
Banks, finance and
life insurance
companies; private
equity investors;
pension and hedge
funds
Life insurance
companies,
pension funds,
private equity and
hedge funds;
target firms
Financing M&As: Equity Options
Alternative Forms of Equity
Equity Type
Backed By
Investor Types
Common Stock
Cash generating
capabilities of the firm
Life insurance
companies, pension
funds, hedge funds,
private equity, and
angel investors
Preferred Stock
--Cash Dividends
--Payment-in-Kind
Cash generating
capabilities of the firm
Same as above
Financing M&As: Seller Financing
• Seller defers a portion of the purchase price
• Advantages to seller:
– Buyer may be willing to pay seller’s asking price since
deferral will reduce present value
– Makes sale possible when bank financing not
available (e.g., 2008-2009)
• Advantages to buyer:
– Shifts operational risk to seller if buyer defaults on
loan
– Enables buyer to put in less cash at closing
Financing M&As: Cash on Hand and Selling
Redundant Assets
• “Cash on hand” represents cash in excess of
normal operating requirements on the acquirer
or target’s balance sheet.
• Target’s excess cash can be used to buy target
firm’s outstanding shares.
• Redundant assets are those owned by the
acquirer or target firm that are not considered
germane to the acquirer’s business strategy.
Financial Buyers/Sponsors
In a leveraged buyout, all of the stock, or assets, of a public
or private corporation are bought by a small group of
investors (“financial buyers aka financial sponsors”),
often including members of existing management and a
“sponsor.” Financial buyers or sponsors:
• Focus on ROE rather than ROA.
• Use other people’s money.
• Succeed through improved operational performance, tax
shelter, debt repayment, and properly timing exit.
• 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)
Role of Private Equity and Hedge Funds in
Deal Financing
•
•
•
Financial Intermediaries
– Serve as conduits between investors/lenders and borrowers
– Pool resources and invest/lend to firms with attractive growth prospects
Lenders and Investors of “Last Resort”
– Buyers of about one-half of private placements
– Source of funds for firms with limited access to credit markets
Providers of Financial Engineering1 and Operational Expertise for Target Firms
– Leverage drives need to improve operating performance to meet debt service
– Improved operating performance enables firm to increase leverage
– Private equity owned firms survive financial distress better than comparably
leveraged firms
– Pre-buyout announcement date shareholder returns often exceed 40% due to
investor anticipation of operational improvement and tax benefits
– Post-buyout returns to LBO shareholders exceed returns on S&P 500 due to
improved operating performance (better controls, active monitoring, willingness
to make tough decisions)
1Financial
engineering describes the creation of a viable capital structure that magnifies financial returns to equity investors.
Leveraged Buyouts (LBOs)
• Finance a substantial portion of the
purchase price using debt.
• Frequently rely on financial sponsors for
equity contributions
• Target firm management often equity
investors in LBOs
• Management buyouts (MBOs) are LBOs
initiated by management
LBOs As Financing Strategies
• LBOs are a commonly used financing strategy employed by private
equity firms to acquire targets using mostly debt to pay for the cost
of the acquisition
• Target firm assets used as collateral for loans
– Most liquid assets collateralize bank loans
– Fixed assets secure a portion of long-term financing
• Post-LBO debt-to-equity ratio substantially higher than pre-LBO ratio
due to debt incurred to buy shares from pre-buyout private or public
shareholders
– Debt-to-equity ratio also may increase even if pre-and post-LBO
debt remains unchanged if the target’s excess cash and the
proceeds from sale of target assets used to buy out target
shareholders (Why? Assets decline relative to liabilities shrinking
the target’s equity)
Impact of Leverage on
Financial Returns
Impact of Leverage on Return to Shareholders
All-Cash
Purchase
($Millions)
1Tax
50% Cash/50%
Debt
($Millions)
20% Cash/80%
Debt
($Millions)
Purchase Price
$100
$100
$100
Equity (Cash Investment by Financial
Sponsor)
$100
$50
$20
Borrowings
0
$50
$80
Earnings Before Interest and Taxes (EBIT)
$20
$20
$20
Interest @ 10%1
0
$5
$8
Income Before Taxes
$20
$15
$12
Less Income Taxes @ 40%
$8
$6
$4.8
Net Income
$12
$9
$7.2
After-Tax Return on Equity (ROE)2
12%
18%
36%
shelter in 50% and 20% debt scenarios is $2 million (I.e., $5 x .4) and $3.2 million (i.e., $8 x .4), respectively.
EBIT = 0 under all three scenarios, income before taxes equals 0, ($5), and ($8) and ROE after tax in the 0%, 50% and 80% debt scenarios = $0 / $100,
[($5) x (1 - .4)] / $50 and [($8) x (1 - .4)] / $20 = 0%, (6)% and (24)%, respectively. Note the value of the operating loss, which is equal to the interest expense, is
reduced by the value of the loss carry forward or carry back.
2If
LBO’s Impact of Target Firm Employment,
Innovation, and Capital Spending
• Net reduction in employment at firms several years after
undergoing LBOs is 1%
– Employment at target firms declines about 3% in
existing operations compared to other firms in the
same industry
– But employment at new ventures increases about 2%
– Employment at private firms may increase
• LBOs often increase R&D and capital spending relative
to peers
• Operating performance particularly for private firms
undergoing LBOs improves significantly due to increased
access to capital
Discussion Questions
1. Define the financial concept of leverage.
Describe how leverage may work to the
advantage of the LBO equity investor?
How might it work against them?
2. What is the difference between a
management buyout and a leveraged
buyout?
3. What potential conflicts might arise
between management and shareholders
in a management buyout?
LBO Advantages and Disadvantages
• Advantages include the following:
– Management incentives,
– Better alignment between owner and manager objectives (reduces
agency conflicts),
– Tax savings from interest expense and depreciation from asset
write-up,
– 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 raise the firm’s break-even point,
– 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.
How LBOs Create Value
Factors Contributing to
LBO Value Creation
Buyouts of Public
Firms
Buyouts of Private
Firms
Key Factor: Alleviating
Agency Problems
Key Factor: Provides
Access to Capital
•
•
•
•
Factors Common to
LBOs of Public and
Private Firms
Deferring Taxes
Debt Reduction
Operating Margin
Improvement
Timing of the Sale
of the Firm
LBOs Create Value by Reducing Debt and Increasing Margins
Thereby Increasing Potential Exit Multiples
Firm
Value
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Debt Reduction & Reinvestment Increases Free Cash Flow and In turn Builds Firm Value
Debt
Reduction
Adds to Free
Cash Flow by
Reducing
Interest &
Principal
Repayments
Debt Reduction
Reinvest in Firm
Free Cash Flow
Reinvestment
Adds to Free
Cash Flow by
Improving
Operating
Margins
Tax Shield Adds to Free Cash Flow
Tax
Shield1
Year 1
1Tax
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
shield = (interest expense + additional depreciation and amortization expenses from asset write-ups) x marginal tax rate.
LBO Value is Maximized by Reducing Debt, Improving
Margins, and Properly Timing Exit
Case 1:
Debt Reduction
Case 2:
Debt Reduction + Margin
Improvement
Case 3:
Debt Reduction + Margin
Improvement + Properly
Timing Exit
LBO Formation Year:
Total Debt
Equity
Transaction/Enterprise Value
$400,000,000
100,000,000
$500,000,000
$400,000,000
100,000,000
$500,000,000
$400,000,000
100,000,000
$500,000,000
Exit Year (Year 7) Assumptions:
Cumulative Cash Available for
Debt Repayment1
Net Debt2
EBITDA
EBITDA Multiple
Enterprise Value3
Equity Value4
$150,000,000
$250,000,000
$100,000,000
7.0 x
$700,000,000
$450,000,000
$185,000,000
$215,000,000
$130,000,000
7.0 x
$910,000,000
$695,000,000
$185,000,000
$215,000,000
$130,000,000
8.0 x
$1,040,000,000
$825,000,000
Internal Rate of Return
24%
31.2%
35.2%
Cash on Cash Return5
4.5 x
6.95 x
8.25 x
1Cumulative
cash available for debt repayment increases between Case 1 and Case 2 due to improving margins and lower interest and
principal repayments reflecting the reduction in net debt.
2Net Debt = Total Debt – Cumulative Cash Available for Debt Repayment = $400 million - $185 million = $215 million
3Enterprise Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year
4Equity Value = Enterprise Value in 7th Year – Net Debt
5The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return, because it
accounts for the time value of money.
Common LBO Deal Structures
• Direct merger: Target firm merged directly into the firm
controlled by the financial sponsor
• Subsidiary merger: Target firm merged into a acquisition
subsidiary wholly-owned by the parent firm which in turn
is controlled by the financial sponsor
• A reverse stock split: Used when a firm is short of cash
to reduce the number of shareholders below 300 which
forces delisting of the firm from public exchanges.
Majority shareholders retain their shares after the
reverse split reduces the number of shares outstanding;
minority shareholders receive a cash payment.
Direct Merger
Financial Sponsor
(Limited Partnership
Fund)
Equity
Contribution
Acquirer
(Controlled by
Financial Sponsor)
Loan
Lender
Target Merges
with Acquirer
Target Firm
Target Stock
Acquirer Cash
and Stock
Target Firm
Shareholders
Subsidiary Merger
Financial Sponsor
Limited Partnership Fund
Equity
Contribution
Parent
(Controlled by Financial
Sponsor)
Equity
Contribution
Lender
Loan
Guarantee
Loan
Target Firm
Merger Sub
Shares
Merger Sub
Merger Sub Merges
Into Target
Merger Sub
Cash & Shares
Target Firm Shares
Target Firm
Shareholders
Typical LBO Capital Structure
Common
Equity (10%)
Equity (25%)
Preferred
Equity (15%)
Revolving
Credit (5%)
Purchase
Price
Term Loan A
Debt (75%)
Senior
Secured Debt
(40%)
Term Loan B
Term Loan C
Sub
Debt/Junk
Bonds (30%)
2nd Mortgage
Debt
Mezzanine
Debt & PIK
Case Study: Cox Enterprises Takes Cox
Communications Private
In an effort to take the firm private, Cox Enterprises announced a proposal to buy the remaining 38% of Cox
Communications’ shares not currently owned for $32 per share. Valued at $7.9 billion (including $3 billion in
assumed debt), the deal represented a 16% premium to Cox Communication’s share price at that time. Cox
Communications is the third largest provider of cable TV, telecommunications, and wireless services in the U.S,
serving more than 6.2 million customers. Historically, the firm’s cash flow has been steady and substantial.
Cox Communications would become a wholly-owned subsidiary of Cox Enterprises and would continue to
operate as an autonomous business. Cox Communications’ Board of Directors formed a special committee of
independent directors to consider the proposal. Citigroup Global Markets and Lehman Brothers Inc. committed
$10 billion to the deal. Cox Enterprises would use $7.9 billion for the tender offer, with the remaining $2.1 billion
used for refinancing existing debt and to satisfy working capital requirements.
Cable service firms have faced intensified competitive pressures from satellite service providers DirecTV
Group and EchoStar communications. Moreover, telephone companies continue to attack cable’s high-speed
Internet service by cutting prices on high-speed Internet service over phone lines. Cable firms have responded
by offering a broader range of advanced services like video-on-demand and phone service. Since 2000, the
cable industry has invested more than $80 billion to upgrade their systems to provide such services, causing
profitability to deteriorate and frustrating investors. In response, cable company stock prices have fallen. Cox
Enterprises stated that the increasingly competitive cable industry environment makes investment in the cable
industry best done through a private company structure.
Discussion Questions:
1. What is the equity value of the proposed deal?
2. Why did the board feel that it was appropriate to set up special committee of independent board directors?
3. Why does Cox Enterprises believe that the investment needed for growing its cable business is best done
through a private company structure?
4. Is Cox Communications a good candidate for an LBO? Explain your answer.
5. How would the lenders have protected their interests in this type of transaction? Be specific.
Things to Remember…
• M&As commonly are financed through debt, equity, and available
cash on balance sheet or some combination.
• 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 and depreciation expense 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.