Structured Finance:
Leveraged Buyouts
Prof. Ian Giddy
New York University
Structured Finance
Asset-backed
securitization
 Corporate financial
restructuring
 Structured financing
techniques

Copyright ©2002 Ian H. Giddy
Structured Finance 2
Leveraged Financing
Leveraged Finance is the provision of
bank loans and the issue of high yield
bonds to fund acquisitions of companies
or parts of companies by
 an existing internal management team
(a management buy-out),
 an external management team (a
management buy-in), or
 a third party (a leveraged acquisition).
Copyright ©2002 Ian H. Giddy
Structured Finance 3
Case Study
The John Case LBO Proposal
 Devise a recommended financing plan

John Case (owner)
Buyers
Copyright ©2002 Ian H. Giddy
VC Investors
Structured Finance 4
Corporate Restructuring
Divestiture—a reverse acquisition—is
evidence that "bigger is not necessarily
better"
 Going private—the reverse of an IPO
(initial public offering)—contradicts the
view that publicly held corporations are
the most efficient vehicles to organize
investment.

Copyright ©2002 Ian H. Giddy
Structured Finance 5
Divestitures
Divestiture: the sale of a segment of a company to a
third party
 Spin-offs—a pro-rata distribution by a company of all
its shares in a subsidiary to all its own shareholders
 Equity carve-outs—some of a subsidiary' shares are
offered for sale to the general public
 Split-offs—some, but not all, parent-company
shareholders receive the subsidiary's shares in return
for which they must relinquish their shares in the
parent company
 Split-ups—all of the parent company's subsidiaries
are spun off and the parent company ceases to exist.
Copyright ©2002 Ian H. Giddy
Structured Finance 6
Divestitures Add Value
Shareholders of the selling firm seem to
gain, depending on the fraction sold:
 Total value created by divestititures
between 1981 and 1986 = $27.6 billion.

% of firm sold
0-10%
10-50%
50%+
Copyright ©2002 Ian H. Giddy
Announcement effect
0
+2.5%
+8%
Structured Finance 7
Going Private
A public corporation is transformed into a privately
held firm
 The entire equity in the corporation is purchased by
management, or managment plus a small group of
investors
 These account for about 20% of public takeover
activity in recent years in the United States.
 Can be done in several ways:



"Squeeze-out"—controlling shareholders of the firm buy up
the stockholding of the minority public shareholders
Management Buy-Out—management buys out a division or
subsidiary, or even the entire company, from the public
shareholders
Leveraged Buy-Out (LBO)
Copyright ©2002 Ian H. Giddy
Structured Finance 8
Leveraged Buy-Outs
LBO is a transaction in which an investor group acquires
a company by taking on an extraordinary amount of
debt, with plans to repay the debt with funds generated
from the company or with revenue earned by selling off
the newly acquired company's assets
 Leveraged buy-out seeks to force realization of the
firm’ potential value by taking control (also done by
proxy fights)
 Leveraging-up the purchase of the company is a
"temporary" structure pending realization of the value
 Leveraging method of financing the purchase permits
"democracy" in purchase of ownership and control--you
don't have to be a billionaire to do it; management can
buy their company.
Copyright ©2002 Ian H. Giddy
Structured Finance 9
LBOs, Agency Costs
and Free Cash Flow
"Free cash flow" is cash-cow type
earnings in excess of amounts required
to fund all positive-NPV projects
 Payout of free cash flow, to stockholders,
reduces the amount of resources under
managment's discretion. Forces
management to go out into the markets
and justify raising funds
 Thus debt has a disciplining role. “Safe”
managers choose less debt.

Copyright ©2002 Ian H. Giddy
Structured Finance 10
M&A and Leverage
Company
has
unused
debt
capacity
Copyright ©2002 Ian H. Giddy

Takeover?

Leveraged
buyout?

Leveraged
recapitalization?
Structured Finance 11
Typical LBO Sequence
IPO or sale of
company
Company gets bloated
or slack and stock
price falls
LBO offer made
LBO completed
Restructuring

Efficiencies

Divestitures

Financial
? years
Copyright ©2002 Ian H. Giddy
3-9 months
5-7 years
Structured Finance 12
Case Study: John M. Case Company




Bank debt and equity-linked structured
financing in the context of leveraged buyout
financing, including valuation and exit
strategies. Convertibles and bridge financing.
What financial structure enables the acquiring
group to retain control?
What is the cost of financing?
“How much equity should/must our client give
up in order to get the funding we need?”
Copyright ©2002 Ian H. Giddy
Structured Finance 13
The John M Case Leveraged Buy-Out
1. What are the most important operating and
financial characteristics of the Case
Company?
2. Is the company worth Mr Case's $20 million
asking price?
3. Can the $20 million purchase be financed
so that management can retain at least 51%
ownership? What sources should
management tap? In what amounts? Is the
return being sought by the venture capital
reasonable?
Copyright ©2002 Ian H. Giddy
Structured Finance 14
The John M Case Leveraged Buy-Out
4. How compelling a buyout opportunity is this
proposition for the four managers?
5. Would you, as a commercial banking lender,
provide the loan needed to finance the seasonal
buildup in accounts receivable and inventory?
On what terms?
6. Would you, as the venture capital firm, provide
the balance of the funds needed? If so, on what
terms?
Copyright ©2002 Ian H. Giddy
Structured Finance 15
Financing Sources
Bank Loan
 Loan from Mr Case
 Venture Capitalists' Investment

Copyright ©2002 Ian H. Giddy
Structured Finance 16
POSITIVES :
The company has a stable product
 The company enjoys good profit
margins
 There are important barriers to
competitor entry
 The business is not too asset-intensive
 The four key managers know the
business well

Copyright ©2002 Ian H. Giddy
Structured Finance 17
NEGATIVES :
Sales growth is probably quite limited
 This low-tech product has no patent
protection
 Even if outsiders find it difficult to
penetrate the market, that may not
apply to vendors already in the industry,
most particularly, the Watts Company

Copyright ©2002 Ian H. Giddy
Structured Finance 18
Simplified Balance Sheet
for a restructured J.M.Case Company
Assets
Cash
$5762
Other current
3236
Fixed & other 2184
Good will
10084
Total
Copyright ©2002 Ian H. Giddy
21,266
Liabilities
Current Liab $1266
Bank loan
Case loan
Plug figure
Managers’
equity
Total
6000
4000
9500
500
21,266
Structured Finance 19
WACC
John M. Case LBO
How is the acquisition to be financed?
Answer: let's work out what we have to pay the VCs in order to fill the gap
Assets
Cash
Other current
Long term
Goodwill
$
$
$
$
5,762
3,236
2,184
10,084
Total
$
21,266
Liabilities
Current
Bank loan
Seller note
VC plug
Managers' equity
$1,266
$6,000
$4,000
$9,500
$500
$21,266
Nominal Effective
0%
0.00%
12%
8.40%
4%
8.17%
9%
21.40%
30%
Weight Product
5.95% 0.00%
28.21% 2.37%
18.81% 1.54%
44.67% 9.56%
2.35% 0.71%
14.17%
johncaselbo.xls
Copyright ©2002 Ian H. Giddy
Structured Finance 20
Feasibility of the Price
Book Value Basis
 Stock Market Valuation Basis
 Comparable Company Value
 Discounted Cash Flow Basis

Copyright ©2002 Ian H. Giddy
Structured Finance 21
Book Value Basis :
Asking price : twice the value of the
company’s equity
 Why would anyone pay this ?

If the profitability of the company
justifies it
 - in this case, it appears to – ROE
around 20 % or $ 2 million in 1984

Copyright ©2002 Ian H. Giddy
Structured Finance 22
Stock Market Valuation

If a company is publicly traded, the
valuation accorded its outstanding
market shares can be a starting point
for valuation

In this case, the company is not publicly
traded, so no opportunity is available
here
Copyright ©2002 Ian H. Giddy
Structured Finance 23
Comparable Company Value

Common practice to compare its value
with those accorded to publicly traded
companies in a similar business

After comparisons made, it is seen that
the Case asking price is in line with the
market value of a publicly traded
competitor
Copyright ©2002 Ian H. Giddy
Structured Finance 24
John Case Valuation
John Case Analysis
Year
Principal Repayment
Coupon payments
Total Repayments
Return @
NPV
NPV @ yr0
Equity
Total VC
1
1985
25%
II) FCF#2: Expansion Plan
Turnover
Profit (margin of 6%)
NPV of FCF after financing
NPV of FCF @ yr 0
Copyright ©2002 Ian H. Giddy
855
855
25%
547.2
3
1987
855
855
25%
437.76
4
1988
5
1989
6
1990
855
855
855
855
25%
25%
350.208 280.1664
9500
855
10355
25%
2714.501
5014
4486
9500
I) FCF#1: Original Core Business
FCF after financing:
NPV of FCF after financing
NPV of FCF @ yr 0
NPV of VC Equity
Total Equity
III) Total Equity Valuation
855
855
25%
684
2
1986
1448
1702
1920
2114
1982
2002
1268.257 1305.681 1290.083 1244.113 1021.639 903.8505
7034
4486
11520
39%
1000
1400
1960
2744 3073.28 3442.074
60
84
117.6
164.64 184.3968 206.5244
52.55209 64.44019 79.01755 96.89255 95.04891 93.24036
481
$
12,000,980
Structured Finance 25
Case Study: Le Meridien




What kind of financing package would enable Royal
Bank to beat other commercial and investment banks
in the Meridien deal? Who are potential rivals, and
what strengths might give them a competitive edge?
If RBS offers sale-and-leaseback financing, what
should be the structure and terms of the deal, terms
that make sense for the client as well as for the
bank?
If RBS offers equity participation, what form should
this take? Common stock or mezzanine finance? Or
should the bank avoid the risks of an equity
investment?
Would asset-backed securities be suitable as a
financing source for this acquisition?
Copyright ©2002 Ian H. Giddy
Structured Finance 26
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