Leverage Buyouts

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Leverage Buyouts

• Arzac, Chapter 13

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How To Go Private

• four commonly used techniques for going private
  transactions
• shell corporation that combines with firm via
  merger
• asset sales
• tender offer
• reverse stock split

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Going Private

• leverage transaction of public firm into
  privately held company
• LBO
• MBO
• often associated with improvement in performance

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LBOs

• peak from 1986 to 1989
• largest was RJR Nabisco in 1988 with price of
  24.6b and then Beatrice in 1985 at 5.4b
  (Mergerstat)
• buying group generally includes current mgt
• expectation at some point that reverse
  transaction will occur

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Why Pay Premiums?

• premiums paid for firms in LBOs average 40 of
  market price 1-2 months prior to announcement of
  buyout
• gains do occur and are achieved through stock
  price performance
• sources of gains
• taxes
• management incentives
• wealth transfer effects
• asymmetric information and underpricing
• efficiency considerations

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Strip Financing

• LBOs sometimes structured to use strip financing
• nonequity financing like senior debt,
  subordinated debt, convertible debt, and
  preferred stock often used
• others below senior and above common are
  mezzanine level
• strip says buyer who purchases X of any
  mezzanine level security must purchase X of all
  mezzanine level securities and some equity too

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Ownership Structure Changes

• most complete form of ownership change when take
  a public firm private through an LBO
• purchase control using a high debt component with
  mgt often part of equity base
• fundamental operating changes generally made in
  attempt to increase profitability and firm value

10
Financing

• firms with valuations less than about 400 will
  not generally have access to public high yield
  market to raise funds for LBO
• used secured debt from bank private placement
  of subordinated debt and equity participation
• typical financial structure for smaller firms
  prior to 1980s
• debt about 5X EBITDA
• equity about 1-1.5X EBITDA
• everything changed in 1980s for larger firms
  because of high-yield debt market
• secured financing about 3X EBITDA
• high-yield financing about 2.5-3X EBITDA
• equity about 1.5X EBITDA
• sales about 7-8X EBITDA
• problem when high-yield debt market is not as
  active
• mezzanine financing fills in gap

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Example 1

• Let the LBO purchase price be 210 million, of
  which 60 million is secured debt. 100 million
  is subordinated debt with a below-market coupon
  interest of 6 plus 27 of the equity, and 50
  million is invested by the sponsor for 73 of the
  equity. Assume the FCFs generated during the
  first 5 years go to pay interest and amortize the
  secured debt in its entirety and that cash
  balances are negligible. Furthermore, let
  expected year-5 EBITDA equal 49.5 million and
  assume that the company is expected to be sold
  for 8 times EBITDA or 396 million net of fees
  and expenses. Then, the cash flows and the return
  to subordinated holders are as follows

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LBO Financing

• determine debt capacity
• determine equity needed from sponsor
• find total financing amount
• find purchase price in terms of EBITDA
• determine if lenders equity requirement
  satisfies return required by sponsor

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Debt Capacity

• need to find in order to determine affordable
  price for LBO
• example 3 (Arzac) Consider a target with
  1st-year pro-forma EBITDA of 150m, growth rate
  of sales and EBITDA of 7, initial cash balance
  of 1.9m, and senior secured debt making up 73
  of total borrowing to be amortized in 7 years.
  (Firm has debt capacity of about 4.74x EBITDA or
  4.74150m 710.8m, amortize 322.8m of it, and
  be left with the 388m of subordinated debt at
  the end of year 5 and a cash balance of 2.6m.
  See Exhibit 7.5.) Assume that the LBO sponsor
  expects to exit the investment in 5 years at 7x
  forward EBITDA. What is residual equity at the
  end of the 5th year? If the sponsor requires 30
  return, what is the max equity that can be used
  and an affordable purchase multiple? Fees and
  expenses are .15x EBITDA.

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Peregrine Coatings

• Peregrine Coatings was a small specialty chemical
  company engaged in the manufacturing and
  distribution of coatings, paints, and related
  products primarily in the United States. In the
  spring of 2005, its owner, a diversified chemical
  company decided to sell Peregrine Coatings. As is
  customary in this type of transaction, Peregrine
  was to be sold with no cash and no outstanding
  debt. Assume that lenders are willing to lend on
  a secured basis up to 60 of total debt and
  required 25 of the purchase price to be equity.
  They would be charged 6.7 cash interest and
  require the term loan to be paid down with all
  available pre-loan amortization cash flow over 7
  years. Subordinated lenders would provide 40 of
  the total debt at 8 cash interest with principal
  due in 7 years. Both loans would be callable
  after 12/31/2010 without penalty. The sponsor
  needed to supply the remaining 25 of the capital
  and required a 25 IRR. Fees and expenses
  associated with the transaction would be about 2
  of the purchase price.

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