Characteristics of Potential
LBO Candidates
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 an LBO sponsor who contributes
capital and expertise (KKR, Bass Brothers,
Blackstone, etc.) and management team.
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•
•
•
•
•
•
•
•
•
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 financing
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Typical LBO Structure
• Varies over time with market conditions
• Debt Financing
– Total debt often 60-80% of entire deal (4-5 x LTM EBITDA, but
depends on industry, cash flow, 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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Distinct Features of an LBO
• Significant increase in financial leverage
– Average debt/total capital increases from 20% to 70%
• 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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Corporate Valuation -- Chapter 19
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LBO Financing
• LBO 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 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.
• 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)
• 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 like to see 25% to 35% equity for protection
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Common Equity
• Typically 25% - 35% of capital structure
now, but varies over time.
• Typically seeking a 20%-25% IRR
• Often assume exit and entry multiples are
the same, but not necessarily a good
assumptions
• Ask what the exit strategy is likely to be.
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Corporate Valuation -- Chapter 19
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LBO Financing – Unsecured Debt
Management Ownership
• 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, usually outstanding
• 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.
• 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 nonfinancial 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 – potential
tax advantages for managers.
• 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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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 call the liquidation preference) -- often sold
with warrants. Alternatively, can issue convertible preferred instead of
including warrants.
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Corporate Valuation -- Chapter 19
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LBO 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 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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LBO Acquisition Financing
Market Trends
LBO 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.
Sample Capital Structure Terms for Leveraged Deals
6.7x
6x
3.3
3x
3.4
0x
Average Debt Multiples
5.4x 5.0x 5.2x 5.3x 5.2x 5.8x 5.7x 5.2x
4.5x 4.1x 3.7x 3.8x 4.0x 4.2x 4.4x 4.4x
2.0 2.4 2.5 2.5 1.9 2.3 2.1 1.7 1.2
1.2 1.5 1.4 1.7 1.5 1.3 1.1
3.4 2.6 2.7 2.8 3.3 3.5 3.6 3.5 3.3 2.9 2.2 2.4 2.3 2.7 3.1 3.3
1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Bank Debt/EBITDA
Non-Bank Debt/EBITDA
Average Equity Contribution to LBO
50%
25%
0%
43% 45%
40% 42% 41%
38% 34% 34%
33% 36%
25% 26% 24% 23%
40%
22% 22%
38%
35%
40%
35% 32% 31%
30% 32% 36%
10% 13% 21% 22% 25% 26% 24% 23%
3% 4% 4% 4% 6% 3% 5% 3% 2% 3%
10% 13%
1988 1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Rollover Equity
Contributed Equity
________________
Source: Portfolio Management Data. Excludes media loans. Too few deals in 1991 to form a meaningful sample.
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Corporate Valuation -- Chapter 19
Copyright, Robert Holthausen, 2006
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Financial Sponsor M&A Activity
1998 – 2006 Global Sponsor M&A Activity
$ in billions
% of Total Value
20%
$1,000
$900
$759
$800
15%
$700
$600
10%
$500
$400
$300
$232
$200
$50
5%
$151
$103
$87
$100
$92
$95
2002
2003
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Corporate Valuation -- Chapter 19
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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.
$64
0%
$0
1998
___________________________
Source: SDC.
1999
2000
2001
Total $ Value of Sponsor Deals
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2004
2005
2006
% of Total Value of M&A Deals
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Risk Profile Questions
Potential Motivations for an LBO
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?
• What is the exit strategy?
• 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)
• Transfer wealth from other stakeholders in
the firm such as employees & bondholders
•
•
•
•
•
•
•
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Performance of LBOs
Tax Effect of LBOs
• Evidence indicates that the median premium
paid to existing shareholders is 42% (1980’s
data).
• What are the potential sources of value?
• 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% prebuyout to 1% for 2 yrs. after buyout.
–
–
–
–
–
Improved operating performance
wealth transfers from employees
reduction of taxes
wealth transfers from pre-buyout debtholders
overpayment by post-buyout investors
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Corporate Valuation -- Chapter 19
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Changes in Median Performance
• In three year period after the buyout relative to the
year before the buyout (1980s data)
–
–
–
–
–
–
–
–
–
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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Corporate Valuation -- Chapter 19
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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 for those
with no divestitures)
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Corporate Valuation -- Chapter 19
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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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Corporate Valuation -- Chapter 19
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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% (again, 1980s data).
• 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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Corporate Valuation -- Chapter 19
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John Harland -- An LBO?
Reverse Leveraged Buyouts
• 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 except
as exit multiple (can do DCF of course)
• 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 preLBO 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 management
capital providers and external board members
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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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Corporate Valuation -- Chapter 19
Copyright, Robert Holthausen, 2006
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Copyright, Robert Holthausen, 2006
Financial Performance
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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OCF Before Interest and Taxes
•
Year
–
-1
–
0
– +1
– +2
– +3
– Avg +1 to +3
Firm
Industry-Adjusted
19.3%
14.6%
11.9%
14.3%
13.5%
13.9%
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 incentive
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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
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