Leveraged Buyout Structures and Valuation

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Leveraged Buyout Structures and Valuation
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Learning Objectives

• Primary Learning Objective To provide students
  with a knowledge of how to analyze, structure,
  and value highly leveraged transactions.
• Secondary Learning Objectives To provide
  students with a knowledge of
• The motivations of and methodologies employed by
  financial buyers
• Advantages and disadvantages of LBOs as a deal
  structure
• Alternative LBO models
• The role of junk bonds in financing LBOs
• Pre-LBO returns to target company shareholders
• Post-buyout returns to LBO shareholders, and
• Alternative LBO valuation methods
• Basic decision rules for determining the
  attractiveness of LBO candidates

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Financial Buyers

• In a leveraged buyout, all of the stock, or
  assets, of a public corporation are bought by a
  small group of investors (financial buyers),
  usually including members of existing management.
  Financial buyers
• Focus on ROE rather than ROA.
• Use other peoples money.
• Succeed through improved operational performance.
• 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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LBO Deal Structure

• Advantages include the following
• Management incentives,
• 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,
• 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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Classic LBO Models Late 1970s and Early 1980s

• Debt normally 4 to 5 times equity. Debt amortized
  over no more than 10 years.
• Existing corporate management encouraged to
  participate.
• Complex capital structure As percent of total
  funds raised
• Senior debt (60)
• Subordinated debt (26)
• Preferred stock (9)
• Common equity (5)
• Firm frequently taken public within seven years
  as tax benefits diminish

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Break-Up LBO Model (Late 1980s)

• Same as classic LBO but debt serviced from
  operating cash flow and asset sales
• Changes in tax laws reduced popularity of this
  approach
• Asset sales immediately upon closing of the
  transaction no longer deemed tax-free
• Previously could buy stock in a company and sell
  the assets. Any gain on asset sales was offset by
  a mirrored reduction in the value of the stock.

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Strategic LBO Model (1990s)

• Exit strategy is via IPO
• D/E ratios lower so as not to depress EPS
• Financial buyers provide the expertise to grow
  earnings
• Previously, their expertise focused on capital
  structure
• Deals structured so that debt repayment not
  required until 10 years after the transaction to
  reduce pressure on immediate performance
  improvement
• Buyout firms often purchase a firm as a platform
  for leveraged buyouts of other firms in the same
  industry

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Role of Junk Bonds in Financing LBOs

• Junk bonds are non-rated debt.
• Bond quality varies widely
• Interest rates usually 3-5 percentage points
  above the prime rate
• Bridge or interim financing was obtained in LBO
  transactions to close the transaction quickly
  because of the extended period of time required
  to issue junk bonds.
• These high yielding bonds represented permanent
  financing for the LBO
• Junk bond financing for LBOs dried up due to the
  following
• A series of defaults of over-leveraged firms in
  the late 1980s
• Insider trading and fraud at such companies a
  Drexel Burnham, the primary market maker for junk
  bonds
• Junk bond financing is highly cyclical, tapering
  off as the economy goes into recession and fears
  of increasing default rates escalate

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Factors Affecting Pre-Buyout Returns

• Premium paid to target firm shareholders
  consistently exceeds 40
• These returns reflect the following (in
  descending order of importance)
• Anticipated improvement in efficiency and tax
  benefits
• Wealth transfer effects
• Superior Knowledge
• More efficient decision-making

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Factors Determining Post-Buyout Returns

• Empirical studies show investors earn abnormal
  post-buyout returns
• Full effect of increased operating efficiency not
  reflected in the pre-LBO premium.
• Studies may be subject to selection bias, i.e.,
  only LBOs that are successful are able to
  undertake secondary public offerings.
• Abnormal returns may also reflect the acquisition
  of many LBOs 3 years after taken public.

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Valuing LBOs

• A LBO can be evaluated from the perspective of
  common equity investors or of all investors and
  lenders
• LBOs make sense from viewpoint of investors and
  lenders if present value of free cash flows to
  the firm is greater than or equal to the total
  investment consisting of debt and common and
  preferred equity
• However, a LBO can make sense to common equity
  investors but not to other investors and lenders.
  The market value of debt and preferred stock
  held before the transaction may decline due to a
  perceived reduction in the firms ability to
• Repay such debt as the firm assumes substantial
  amounts of new debt and to
• Pay interest and dividends on a timely basis.

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Valuing LBOs Variable Risk Method

• Adjusts for the varying level of risk as the
  firms total debt is repaid.
• Step 1 Project annual cash flows until
• target D/E achieved
• Step 2 Project debt-to-equity ratios
• Step 3 Calculate terminal value
• Step 4 Adjust discount rate to reflect
  changing risk
• Step 5 Determine if deal makes sense

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Variable Risk Method Step 1

• Project annual cash flows until target D/E ratio
  achieved
• Target D/E is the level of debt relative to
  equity at which
• The firm will have to resume payment of taxes and
• The amount of leverage is likely to be acceptable
  to IPO investors or strategic buyers (often the
  prevailing industry average)

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Variable Risk Method Step 2

• Project annual debt-to-equity ratios
• The decline in D/E reflects
• the known debt repayment schedule and
• The projected growth in the market value of the
  shareholders equity (assumed to grow at the same
  rate as net income)

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Variable Risk Method Step 3

• Calculate terminal value of projected cash flow
  to equity investors (TVE) at time t, i.e., the
  year in which the initial investors choose to
  exit the business.
• TVE represents the PV of the dollar proceeds
  available to the firm through an IPO or sale to a
  strategic buyer at time t.

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Variable Risk Method Step 4

• Adjust the discount rate to reflect changing
  risk.
• The firms cost of equity will decline over time
  as debt is repaid and equity grows, thereby
  reducing the leveraged ß. Estimate the firms ß
  as follows
• ßFL1 ßIUL1(1 (D/E)F1(1-tF))
• where ßFL1 Firms levered beta in
  period 1
• ßIUL1 Industrys unlevered
  beta in period 1
• ßIL1/(1(D/E)I1(1-
  tI))
• ßIL1 Industrys levered
  beta in period 1
• (D/E)I1 Industrys
  debt-to-equity ratio in period 1
• tI Industrys
  marginal tax rate in period 1
• (D/E)F1 Firms debt-to-equity
  ratio in period 1
• tF Firms marginal tax
  rate in period 1
• Recalculate each successive periods ß with the
  D/E ratio for that period, and using that
  periods ß, recalculate the firms cost of equity
  for that period.

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Variable Risk Method Step 5

• Determine if deal makes sense
• Does the PV of free cash flows to equity
  investors (including the terminal value) equal or
  exceed the equity investment including
  transaction-related fees?

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Evaluating the Variable Risk Method

• Advantages
• Adjusts the discount rate to reflect diminishing
  risk as the debt-to-total capital ratio declines
• Takes into account that the deal may make sense
  for common equity investors but not for lenders
  or preferred shareholders
• Disadvantage Calculations more burdensome than
  Adjusted Present Value Method

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Valuing LBOs Adjusted Present Value Method (APV)

• Separates value of the firm into (a) its value as
  if it were debt free and (b) the value of tax
  savings due to interest expense.
• Step 1 Project annual free cash flows to equity
  investors and interest tax savings
• Step 2 Value target without the effects of debt
  financing and discount projected free cash flows
  at the firms estimated unlevered cost of equity.
• Step 3 Estimate the present value of the firms
  tax savings discounted at the firms estimated
  unlevered cost of equity.
• Step 4 Add the present value of the firm without
  debt and the present value of tax savings to
  calculate the present value of the firm including
  tax benefits.
• Step 5 Determine if the deal makes sense.

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APV Method Step 1

• Project annual free cash flows to equity
  investors and interest tax savings for the period
  during which the firms capital structure is
  changing.
• Interest tax savings INT x t, where INT and t
  are the firms annual interest expense on new
  debt and the marginal tax rate, respectively
• During the terminal period, the cash flows are
  expected to grow at a constant rate and the
  capital structure is expected to remain unchanged

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APV Method Step 2

• Value target without the effects of debt
  financing and discount projected cash flows at
  the firms unlevered cost of equity.
• Apply the unlevered cost of equity for the period
  during which the capital structure is changing.
• Apply the weighted average cost of capital for
  the terminal period using the proportions of debt
  and equity that make up the firms capital
  structure in the final year of the period during
  which the structure is changing.

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APV Method Step 3

• Estimate the present value of the firms annual
  interest tax savings.
• Discount the tax savings at the firms unlevered
  cost of equity
• Calculate PV for annual forecast period only,
  excluding a terminal value, since the firm is
  sold and any subsequent tax savings accrue to the
  new owners.

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APV Method Step 4

• Calculate the present value of the firm including
  tax benefits
• Add the present value of the firm without debt
  and the PV of tax savings

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APV Method Step 5

• Determine if deal makes sense
• Does the PV of free cash flows to equity
  investors plus tax benefits equal or exceed the
  initial equity investment including
  transaction-related fees?

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Evaluating the Adjusted Present Value Method

• Advantage Simplicity.
• Disadvantages
• Ignores the effect of changes in leverage on the
  discount rate as debt is repaid,
• Implicitly ignores the potential for bankruptcy
  of excessively leveraged firms, and
• Unclear whether true discount rate should be the
  cost of debt, unlevered cost of equity, or
  somewhere between the two.

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Things to Remember

• 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 expense and
  depreciation 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.
• For an LBO to make sense, the PV of cash flows to
  equity holders must equal or exceed the value of
  the initial equity investment in the transaction,
  including transaction-related costs.