Notes on Leveraged Buyouts
1
What Is a Leveraged Buyout?
• The acquisition by a small group of investors
of a public or private company, financed
primarily with debt.
– “Taking the company private.”
• This financing technique can be used by a
variety of entities, including the managers of
a corporation (MBO), or outside groups, such
as other corporations or investment groups
(Kohlberg Kravis Roberts, Blackstone,
Thomas H. Lee etc.).
2
1
Advantages of LBOs
• Tax shields associated with heavy debt
financing.
• Freedom of being a private firm – long-term
orientation.
• Better incentive alignment of management.
• Efficiency improvement.
3
LBOs in the 1980s
Kaplan (1989)
• 76 LBOs from 1979 – 1986.
– Average size: BV of total assets = $535M.
• Shareholders receive a premium of 45% (on average).
• Leverage increases from 20% pre-buyout to 86% postbuyout.
• Management ownership.
– % equity stake go up (9% to 30% on average for all
managers).
– $ ownership declines (from $25M to $16M on average)
• Managers cash out on average!!!
• 48 of 76 LBOs go public before 1989.
– These successful MBOs had large increases in
operating performance and reductions in CAPX.
4
2
The Evolution of the LBO Market
• LBO boom in the late 1980s and bust in early 1990s.
– Buyout volume raises from $1 billion in 1980 to
$60 billion in 1988.
– It drops dramatically to $4 billion in 1990.
• Default rates increase over time.
– 2% for LBOs done between 1980-1984 and 30%
for 1985-1989.
• The use of junk bonds to finance LBOs increases
over time.
– Only one pre-1985 LBO uses junk bonds (55% of
post-1985 LBOs).
• Managerial participation in LBOs.
– Managers cash-out more in the post-1985 LBOs.
LBOs in the 1990s to Present
5
Cao and Lerner (2009)
• The buyout industry is far larger and deals are getting
larger.
– Fundraising by US buyout funds in 2005 is nine times
of 1987 level.
• The returns for these investments deteriorated.
– LBO funds in the 1980s earned annual return of 47%.
– LBO funds in the 1990s earned just over 10%.
• There is increased competition for transactions.
– Auctions by sellers.
– Consortium by potential buyers.
– Higher risk of securing a deal.
• Higher equity contribution by buyout firms.
6
3
Market Trends in Private Equity Buyouts
Axelson et al. (2009)
7
Market Trends in Private Equity Buyouts
Axelson et al. (2009)
8
4
Sources of Funds for LBOs
• Typically, the merchant bank invites
Targetco’s management to purchase some of
the stock of Shellco.
• LBOs are generally friendly transactions.
• Some debt will be bank loans, most senior.
• The rest will come from private placements
with other lenders, or from public debt issues
(non-investment grade).
9
An LBO Financing Example
• Wavell Corp, a manufacturer of glassware was bought by
Eastern Pacific, a conglomerate in the 1970s.
• In 1983, Wavell management considered an MBO.
• Sales $7 million, EBIT $650k, Net Income $400k.
• The purchase price was $2 million.
– Banks supplied $1.2 million of senior debt at an
interest rate of 13%, secured by Wavell’s inventory and
PPE.
– An insurance company made a loan of $.6 million,
subordinate debt.
– The same insurance company had an equity position
of $.1 million.
– The Wavell management team put up $.1 million as
their own equity position.
10
5
11
Interest Rates on LBO Debt Funding
Axelson et al. (2009)
Note: The spread is relative to LIBOR.
12
6
Debt Service on LBO Debt Funding
Axelson et al. (2009)
13
Which Companies Are Good LBO Candidates?
• Steady and predictable cash flow – Free Cash Flow.
• Clean balance sheet with little debt and strong asset
base.
• Strong market position.
• Divestible assets.
• Strong management team.
• Potential for expense reduction.
• Viable exit strategy.
14
7
Potential Problems with LBOs
• Bankruptcy risk.
• Leverage can induce firms to choose overly risky
projects.
• Underinvestment.
• Passing up good projects.
15
Strategic Effects of LBOs
• A firm’s capital structure can affect its
operations and investment decisions.
– High leverage can increase costs of
financial distress, impact firm’s ability to
invest.
• Debt (and capital structure more generally)
can also affect the way competing firms
interact.
16
8
Leverage and Competitive Strategy
• Several possibilities may arise:
– High debt firms may invest less.
– Increasing leverage may cause a firm to
pursue more aggressive pricing strategies in
order to capture a larger market share.
– But if leverage is too high, it may also
encourage competitor firms to react
aggressively.
17
In a Nutshell
• Synergy-related explanation:
– If a conglomerate is inefficient, then taking
a division private and making it
independent of the parent creates value.
• Leverage-related explanations:
– Tax advantage of debt financing.
– Wealth transfers from creditors to
shareholders (the LBO increases the risk
of debt).
18
9
Valuation of LBOs
• Free Cash Flow: Calculate FCF and discount by the
WACC.
• Problem: LBO’s are highly leveraged transactions in
which we expect the capital structure to change
rapidly.
• Investors are usually expected to pay off
outstanding principal according to a specific
timetable ==> The firm’s debt/equity ratio falls
over time, in a predictable way.
• WACC approach is better for valuing situations
where the debt/equity ratio remains constant.
19
Valuation of LBOs
• Adjusted Present Value Approach (APV):
Calculate NPV of the all-equity financed firm
and add the value of the tax benefits of debt.
• Advantage: This method calculates
separately the value created by the project
and the value created by the financing.
• For this reason, it is easy to apply to a
firm whose capital structure is changing
over time.
20
10
The LBO Formula
• Take a firm private.
• Fund by borrowing against assets.
• Sell off pieces to pay down debt.
• Exit.
– Sale.
– Re-capitalization.
– Come full circle with an IPO of the core –
Reverse LBOs (RLBOs).
LBOs and RLBOs
Year
RLBOs
LBOs
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Total
3
1
0
10
3
11
26
34
3
5
12
39
67
40
28
18
26
37
28
33
29
22
21
496
17
15
15
46
112
153
235
212
298
299
191
181
218
180
178
209
194
202
177
183
296
167
154
3915
VC-Backed
IPOs
31
77
30
138
58
46
99
75
39
40
42
113
124
176
121
178
253
127
71
261
219
44
32
2,394
Total IPOs
73
189
73
475
190
198
456
305
116
113
97
227
299
473
340
389
565
417
272
440
349
75
71
6,202
RLBO as fraction of
LBOs
17.65%
6.67%
0.00%
21.74%
2.68%
7.19%
11.06%
16.04%
1.01%
1.67%
6.28%
21.55%
30.73%
22.22%
15.73%
8.61%
13.40%
18.32%
15.82%
18.03%
9.80%
13.17%
13.64%
12.67%
21
Cao and Lerner (2009)
RLBO Share of VCBacked IPOs
9.68%
1.30%
0.00%
7.25%
5.17%
23.91%
26.26%
45.33%
7.69%
12.50%
28.57%
34.51%
54.03%
22.73%
23.14%
10.11%
10.28%
29.13%
39.44%
12.64%
13.24%
50.00%
65.63%
20.72%
RLBO Value Share of
All IPO Value
1.43%
2.45%
0.00%
0.73%
9.78%
16.17%
9.87%
2.15%
6.94%
13.87%
60.21%
40.47%
14.41%
4.15%
9.49%
10.96%
10.74%
15.96%
17.26%
12.28%
2.99%
11.24%
16.12%
13.17%
RLBO Share of
All IPOs
4.11%
0.53%
0.00%
2.11%
1.58%
5.56%
5.70%
11.15%
2.59%
4.42%
12.37%
17.18%
22.41%
8.46%
8.24%
4.63%
4.60%
8.87%
10.29%
7.50%
8.31%
29.33%
29.58%
8.00%
22
11
RLBOs versus IPOs
RLBOS
1980
1981
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
AVG
Gross
Procee
ds
(Million
)
15.00
23.40
53.11
21.03
19.40
37.79
44.61
55.23
46.24
38.79
59.94
65.60
77.57
66.23
89.05
118.20
112.72
134.54
147.01
163.89
148.13
202.62
79.09
Underpricing
(Percentag
e)
Total
Debt/Capitali
zation After
IPOs
4.09
10.39
-0.14
3.21
16.37
14.00
9.08
10.44
9.37
5.81
13.48
11.92
42.72
54.21
31.67
15.06
10.30
15.41
20.01
49.21
33.17
56.38
53.98
53.28
61.73
46.29
59.28
58.06
45.79
49.08
47.16
44.01
32.05
54.93
39.65
40.72
51.18
34.29
38.58
36.52
47.87
Cao and Lerner (2009)
Non-Buyout backed IPOs
Total
UnderGross
Debt/Cap
pricing
Proceeds
italization
(Perce
(Million)
After
ntage)
IPOs
13.70
29.30
12.76
23.32
23.06
33.95
13.94
37.29
33.59
39.13
30.59
70.77
41.53
31.38
32.76
37.90
34.57
49.91
40.76
33.72
56.24
31.45
40.95
28.50
25.60
43.87
32.44
24.76
49.14
13.64
26.20
59.33
14.91
27.38
56.27
13.86
30.33
56.55
28.27
22.81
54.81
20.29
23.15
70.92
15.16
22.54
62.30
22.04
24.60
80.26
73.00
13.77
64.77
61.25
9.41
142.38
15.34
20.34
145.53
9.24
27.52
52.47
32.80
27.84
23
Characteristics of RLBOs
Cao and Lerner (2009)
Mean
Median
Standard
Deviation
Min
Max
6.87
3.08
3.55
0.17
27.25
2876.18
1258.40
4426.83
2.8
27582.4
14.22
13
7.95
1
41
55.3%
52.6%
26.4%
5%
100%
37.9%
36.2%
20.5%
0%
85.1%
44.0%
42.9%
20.6%
0%
100%
Director/Management
Ownership Before IPO
66.2%
68.5%
23.2%
6.9%
100%
Director/Management
Ownership After IPO
36.0%
35.1%
26.8%
0%
86.9%
29.19%
0
46.56%
0
1
14.09%
0
24.81%
0
1
Years of staying
private after LBO
Buyout Group Capital
Managed Prior to
RLBO ($ Million)
Buyout Group Age
Before RLBO
Buyout Group
Ownership Before IPO
Buyout Group
Ownership
After IPO
Board Share of Buyout
Group
Chairman from Buyout
group
CEO, President, and
Chairman from Buyout
Group
24
12
RLBO Performance
Cao and Lerner (2009)
Average Monthly Excess Return (Equal Weighted)
0.60%
0.40%
0.20%
0.00%
1
-0.20%
2
3
4
5
-0.40%
-0.60%
25
RLBO Performance
Cao and Lerner (2009)
Average Monthly Excess Return (Value Weighted)
2.00%
1.50%
1.00%
0.50%
0.00%
1
2
3
4
5
26
13
Summary of RLBO Performance
Cao and Lerner (2009)
• RLBOs appear to consistently outperform other IPOs
and the market as a whole.
• No evidence of a deterioration of returns appears over
time.
• RLBOs sharply outperform the market in the first,
fourth, and fifth year after going public.
• Much of the outperformance seems associated with the
larger RLBOs.
• There is no evidence that more leveraged RLBOs
perform more poorly than their peers.
27
Appendix:
Kohlberg Kravis Roberts &
Co.
28
14
Who we are?
• KKR, one of the world’s largest and most successful private equity
firms, has completed buyout transactions that are among the most
complex in history. The firm’s investment approach, however, is
fundamentally simple: KKR acquires industry-leading companies
and works with management to grow and improve them and
thereby create shareholder value.
• Established in 1976 and led by co-founding members Henry
Kravis and George Roberts, KKR has completed more than 150
transactions with an aggregate enterprise value of over $279
billion. As of December 31, 2006, KKR’s equity investments were
valued at over $74 billion on over $30 billion of invested capital, a
multiple of 2.5 times. Our investors include corporate and public
pension plans, financial institutions, insurance companies, and
university endowments.
29
Our principles
• KKR operates as an investment firm, not as a conglomerate or a
holding company. Each company in our portfolio is independently
managed and financed. Each has its own board of directors, which
includes KKR representatives. There are no cross-holdings. Cash
flow from one company cannot be used in another company.
• We are "involved," patient investors, not traders. The average time
period we own a company is eight years, although a number of
investments have exceeded ten years.
• We take a long-term view of a company's performance. We are
never concerned with quarter-to-quarter results, but rather focus on
cash flow and look at results over a number of years.
• Management is our partner in creating value. Our portfolio
company managers have a significant amount of their personal net
worth invested in their companies because we believe strongly that
the best managers think like - and are - owners.
30
15
A time-tested approach to build value
• KKR’S goal since its founding has been to achieve high rates of return for
the KKR Funds by investing large amounts of capital for long-term
appreciation.
• KKR has executed management buyouts of large, mature companies; taken
leveraged "build-ups" from having no assets at all into the Fortune 500;
made acquisitions in traditional growth industries; pioneered leveraged
investments in such novel fields as reinsurance and resort properties;
created stand-alone, independent companies from large corporate parents;
and made equity infusions to restructure highly leveraged public companies,
setting new standards for creativity, innovation and flexibility in the process.
• ….KKR’s long-standing recognition of the fact that the closing of an
acquisition is only the beginning of the process of delivering value. For KKR,
success in private equity investing depends not only on identifying and
consummating acquisitions, but also cultivating and nurturing them.
• ….. after a deal is done and the headlines are gone, KKR embarks on years
of diligent work along with the managements of its portfolio companies to
realize the full potential of its acquisitions.
31
Deal origination
• KKR evaluates hundreds of potential investments each
year. Once an opportunity has been identified, KKR
employs a number of strategies to secure a transaction.
Whenever possible, KKR works with companies and
managers on an exclusive basis to develop transactions, as
it has done with several of its portfolio companies.
• Management teams at existing KKR companies often
provide pivotal assistance by lending their expertise and
judgment in identifying and assessing opportunities.
Together, these capabilities enable KKR to analyze large,
multi-faceted, multi-billion dollar enterprises that few others
would be able to review adequately.
32
16
Structuring and financing transactions
• ……KKR’s transactional capabilities are enhanced by
its significant presence in the capital markets.
Throughout its history, KKR has been able, regardless
of prevailing market conditions or available financing
sources, to engineer the largest, most complex and
most advantageous financings in the marketplace. No
buyout group has more experience raising bank debt,
high-yield debt or equity in the marketplace, and
because of the scope of its activities, KKR has typically
been able to receive the best possible financing terms.
33
Overseeing portfolio companies (I)
• Over the years, KKR’s involvement in helping its companies
enhance shareholder value has become widely recognized,
and the manner in which KKR executives fulfill their roles as
active directors has been viewed, by many, as a model of
effective corporate governance. The expertise KKR brings to
its portfolio companies includes
• Attracting Strong Management
• Management and Employee Incentivization -- In addition to
attracting talented executives, KKR has been an innovator in
its work to structure management incentives and
compensation plans that align the interests of management
and shareholders. A requirement of engagement for all
managers of KKR companies is that they make a significant
investment in their businesses, sharing directly in both the
rewards and risks of equity ownership.
34
17
Overseeing portfolio companies (II)
• Helping Portfolio Companies Arrange Financings -KKR continually seeks to optimize the capital structure
of each portfolio company. With KKR’s assistance,
virtually every one of its portfolio companies has been
able to access efficient sources of capital over time. At
the appropriate time, KKR has taken a number of
companies public, generally using proceeds to
deleverage and reduce the inherent risk for KKR and its
investors. KKR’s level of involvement does not change
after the offering; KKR typically remains a controlling
shareholder and continues its oversight role, assisting
in the formulation of strategy and evaluating
management. Such efforts tend to translate into
superior results, with many of KKR’s companies
outperforming their industry peers after they go public. 35
Overseeing portfolio companies (III)
• Providing Effective Oversight -- The core oversight role that
KKR plays on a day-to-day basis through its position on the
Boards of Directors of its portfolio companies is vitally
important. KKR works closely with each management to put
into place a rigorous infrastructure to monitor corporate
results on a consistent and continual basis. The objective is
to instill a discipline that translates into predictable and
superior performance.
• Maximizing Value When Exiting Investments -- The duration
of the average KKR investment is typically five to ten years,
with the firm’s exit strategy being the final step in generating
value. KKR seeks to maximize the value it can obtain
through its exit strategy by carefully selecting the timing and
method of sale.
36
18