Financing the Deal: Private Equity, Hedge Funds, and Other Sources of Financing

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Financing the DealPrivate Equity, Hedge Funds,
and Other Sources of Financing
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No one spends other peoples money as carefully
as they spend their own.

Milton Friedman
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(No Transcript)
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Learning Objectives

• Primary Learning Objective To provide students
  with a knowledge of how MA 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.

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How are MA 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

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Financing MAs Borrowing Options
Alternative Forms of Borrowing Alternative Forms of Borrowing Alternative Forms of Borrowing Alternative Forms of Borrowing
Type of Security Backed By Lenders Loan Up to Lending Source
Secured Debt Short-Term (lt1Yr.) Intermediate Term (1-10 Yrs.) Liens generally on receivables and inventory Liens on Land and Equipment 50-80 depending on quality 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
Unsecured Debt (Subordinated incl. seller financing) Bridge Financing Payment-in-Kind Cash generating capabilities of the borrower Life insurance companies, pension funds, private equity and hedge funds target firms
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Financing MAs Equity Options
Alternative Forms of Equity Alternative Forms of Equity 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

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Financing MAs Seller Financing

• Seller defers a portion of the purchase price
• Advantages to seller
• Buyer may be willing to pay sellers 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

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Financing MAs Cash on Hand and Selling
Redundant Assets

• Cash on hand represents cash in excess of
  normal operating requirements on the acquirer or
  targets balance sheet.
• Targets excess cash can be used to buy target
  firms outstanding shares.
• Redundant assets are those owned by the acquirer
  or target firm that are not considered germane to
  the acquirers business strategy.

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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 peoples 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)

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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 SP 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.

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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

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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
  targets excess cash and the proceeds from sale
  of target assets used to buy out target
  shareholders (Why? Assets decline relative to
  liabilities shrinking the targets equity)

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Impact of Leverage on Financial Returns
Impact of Leverage on Return to Shareholders Impact of Leverage on Return to Shareholders Impact of Leverage on Return to Shareholders Impact of Leverage on Return to Shareholders
All-Cash Purchase (Millions) 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 _at_ 101 0 5 8
Income Before Taxes 20 15 12
Less Income Taxes _at_ 40 8 6 4.8
Net Income 12 9 7.2
After-Tax Return on Equity (ROE)2 12 18 36
1Tax 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. 2If 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.
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LBOs 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 RD and capital spending
  relative to peers
• Operating performance particularly for private
  firms undergoing LBOs improves significantly due
  to increased access to capital

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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?

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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 firms
  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.

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How LBOs Create Value
Factors Contributing to LBO Value Creation
Buyouts of Private Firms
Buyouts of Public 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

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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
Reinvest in Firm
Debt Reduction Adds to Free Cash Flow by Reducing
Interest Principal Repayments
Reinvestment Adds to Free Cash Flow by Improving
Operating Margins
Free Cash Flow
Tax Shield Adds
to Free Cash Flow
Tax Shield1
Year 1 Year 2 Year 3
Year 4 Year 5 Year 6
Year 7
1Tax shield (interest expense additional
depreciation and amortization expenses from asset
write-ups) x marginal tax rate.
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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. 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. 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. 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.
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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.

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Direct Merger
Financial Sponsor (Limited Partnership Fund)
Equity Contribution
Target Merges with Acquirer
Acquirer (Controlled by Financial Sponsor)
Target Firm
Loan

• Target Stock

Lender
Target Firm Shareholders
Acquirer Cash and Stock
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Subsidiary Merger
Financial Sponsor Limited Partnership Fund
Equity Contribution
Target Firm
Parent (Controlled by Financial Sponsor)
Merger Sub Merges Into Target
Merger Sub Shares
Equity Contribution
Loan Guarantee
Merger Sub Cash Shares
Target Firm Shareholders
Lender
Merger Sub
Target Firm Shares
Loan
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Typical LBO Capital Structure
Common Equity (10)
Equity (25)
Preferred Equity (15)
Purchase Price
Revolving Credit (5)
Term Loan A
Debt (75)
Senior Secured Debt (40)
Term Loan B
Term Loan C
2nd Mortgage Debt
Sub Debt/Junk Bonds (30)
Mezzanine Debt PIK
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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
  Communications 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 firms 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 cables 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?
• Why did the board feel that it was appropriate to
  set up special committee of independent board
  directors?
• Why does Cox Enterprises believe that the
  investment needed for growing its cable business
  is best done through a private company structure?
• Is Cox Communications a good candidate for an
  LBO? Explain your answer.
• How would the lenders have protected their
  interests in this type of transaction? Be
  specific.

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Things to Remember

• MAs 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.