Lecture 15
Leveraged Buy Outs
LBO
• Acquisition of a company or division of a company
with a substantial portion of borrowed funds.
• The goal of an LBO is to use the target company to
finance the purchase. LBO analysis is based on cash
flow projections and takes a company’s leveraged
capital structure into consideration.
• The buyer, which is known as the LBO sponsor,
equity sponsor or financial sponsor, uses debt to pay
the majority of the purchase price of the company.
The rest of the purchase price is funded with equity
by the LBO sponsor.
LBOs
• LBOs are a way to take a public company private, or
put a company in the hands of the current
management, MBO.
• LBOs are financed with large amounts of borrowing
(leverage), hence its name.
• LBOs use the assets or cash flows of the company to
secure debt financing, bonds or bank loans, to
purchase the outstanding equity of the company.
• After the buyout, control of the company is
concentrated in the hands of the LBO firm and
management, and there is no public stock
outstanding.
The leverage is the key
Higher returns %
Tax
deductions
Debt
…”
Fewer
longterm
investments
Characteristics of 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 equity
holders
– Typical board of 5 individuals, 2-3 from the LBO
sponsor
LBOs
• Many variations are found
• Converting equity to debt requires shareholder
approval
• Private equity firm restructures the target and plans
to sell at a substantial profit
• Increased leverage leads to an increase in default
risk
Motivations for LBO
• 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
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
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
or another sponsor 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)
Management Ownership
• 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 non-financial 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.
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 earn
100%, some 4%, some -80%, etc.
• 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
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.
LBO Strategies
• Finding cheap assets – buying low and selling high
(value arbitrage or multiple expansion)
• Unlocking value through restructuring:
– Financial restructuring of balance sheet – improved
combination of debt and equity
– Operational restructuring – improving operations to increase
cash flows
LBO Candidates
•
•
•
•
•
•
•
•
•
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
Risk Profile Questions
•
•
•
•
•
•
•
•
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?
Valuation of LBO
• Cash Flow determines what the LBO sponsor would
be willing to pay for an asset based on target
investment returns.
• The interaction of the following two factors drives
valuation:
– Debt Capacity: Maximizing the leverage or debt capacity of
the company will allow the equity sponsor to maximize the
purchase price and contribute as little equity as possible.
– Equity Return: Once the debt capacity has been determined,
the initial equity investment will be determined by assumed
equity returns and exit proceeds. Target returns are usually
around 20-30% IRR.
Average Debt Multiples
6x
3.3
0.6
2.0
3x
3.4
3.4
2.4
2.6
2.5
2.5
2.7
2.8
1.9
3.3
2.3
3.5
2.1
3.6
1.7
3.5
1.2
1.2
3.3
2.9
1.5
2.2
1.4
2.4
1.7
2.3
1.5
1.3
1.1
2.7
3.1
3.3
5.4
0x
1989 1990 1992
1993 1994 1995 1996 1997 1998 1999 2000 2001
Bank Debt/EBITDA
2002 2003 2004 2005 2006 2007
Non-Bank Debt/EBITDA
50%
25%
0%
38% 35% 40% 40% 35%
32% 31% 33%
30% 32% 36%
26%
25%
24%
23%
22%
21%
3% 4% 4% 4% 6% 3% 5% 3% 2% 3% 2%
10% 13%
1988 1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Rollover Equity
Contributed Equity
________________
Source: S&P Leveraged Commentary & Data. Excludes media loans. Too few deals in 1991 to form a meaningful sample.
Average Equity Contribution
• An LBO effectively trades equity for debt
• A private equity firm partners with financial
institutions to buy a public company
• 25% of deal is provided by the private equity
firm, which becomes an equity stake in the
target company
• Financial institutions provide the other 75%
which becomes debt in the target company
Value Creation in LBO
• Management incentives and agency cost effects
– Increased ownership stake may provide increased incentives
for improved performance
• Better aligns manager / shareholder interests
• Lower agency costs of free cash flows: debt from LBO
commits cash flows to debt
• Debt puts pressure on managers to improve firm
performance to avoid bankruptcy
Value creation in LBO
• Wealth transfer
– Wealth transfer from current employees to new investors –
low management turnover (but sometimes new mgmt. team),
slower growth in number of employees
– Tax benefits in LBO constitute subsidy from public and loss
of revenue to government – LBO premiums positively related
to tax benefit
• Net effect of LBO on government tax revenues may be
positive due to gains to shareholders and increased
profitability
• Many of tax benefits could be realized without LBOs
Value Creation in LBO
• Asymmetric information and underpricing
– Managers, investor groups have better information on value
of firm than shareholders
– Large premium signals that future operating income will be
larger than expectations – investor group believes new
company is worth more than purchase price
• Other efficiency considerations
– More efficient decision process as private firm
– Influence of favorable economic environment
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.