Leveraged Buyouts

Characteristics Evidence on LBOs An LBO (Private Equity) Model Reverse LBOs

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Definition of an LBO
No precise definition -- different forms Transaction in which a group of private investors uses debt financing to purchase a corporation or a corporate division. Equity securities of the company are no longer publicly traded, though the debt and preferred stock may be publicly traded. Uses entire borrowing structure Often involves a financial sponsor who contributes capital and expertise (KKR, Bass Brothers, Blackstone, etc.) and management team.
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Distinct Features of an LBO

Significant increase in financial leverage Average debt/total capital increases substantially 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 equityholders Typical board of 5 individuals, 2-3 from the LBO sponsor Corporate Valuation -- Chapter 18 Wharton School 3

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Historical Characteristics of Potential 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 Corporate Valuation -- Chapter 18 Wharton School 4 financing Copyright, Robert Holthausen, 2010

Typical LBO Structure

Varies tremendously over time with market conditions Debt Financing
Total debt sometimes 60-80% of entire deal (4-5 x LTM EBITDA, but depends on industry, cash flow, and time period 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

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LBO Financing
Financial 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)

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LBO Financing Senior Bank Debt

Senior bank debt which is secured with assets like receivables, inventory, PP&E is often priced at T-Bills, LIBOR or prime + 400 to 700 basis points (three years ago spreads were much lower). Often in tranches where first tranche is repaid quickly and other tranches are not due until maturity (7-8 year maturity with average life of 4-5 years) 2.5 3.5 x LTM EBITDA (varies by industry and rating and with credit market conditions) Lend up to X % (40%-65%) of receivables less than Y (90) days, over certain $ amount, at T-Bill, LIBOR or Prime, plus a risk premium Inventory usually 20% to 60% Securities 10% to 90% (US Govt Bonds @ 90%) PP&E (Cars (60%), Computers (25%), Building (60% to 70%, unique factories (10% to 30%) Bankers historically like to see 25% to 35% equity for protection (now much more)

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LBO Financing Unsecured Debt

Unsecured debt (senior and junior) Potentially many different pieces (cash pays are senior and senior subordinated while junior subordinated may be zero coupon issued by holding company) Longer maturity than bank debt Covenants not to pay dividends, increase debt or sell assets Supported by cash flows and operations of the business. High-yield a favorite (senior subordinated), but hard to sell high yield for less than $150 million and high-yield market not always viable. High-yield is typically non-callable for about five years and then have call penalties for 3-5 years.

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Junior Subordinated and Preferred

Below the high-yield bonds (or below the bank debt if the deal isnt big enough to support high-yield bonds) but above the common would be junior subordinated and preferred stock. Junior subordinated may be PIK (zeros) for some time period. May be issued by a holding company of the operating company and may be issued with warrants. Holding company notes almost always PIK because there is no cash flow into the holding company for some time. In transactions of this type, the PIK interest may not be deductible until it is paid in cash or the bond matures and is paid off (so called AHYDO rules) Preferred can be PIK as well, so dividends accrue but are not paid and at sale of the company the preferred holders get their investment plus accrued dividends (often called the liquidation preference) -- often sold with warrants. Alternatively, can issue convertible preferred instead of including warrants.

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Common Equity
Typically 20% - 45% of capital structure historically, but varies over time (at high end or more right now). Typically seeking a 20%-40% IRR but depends on how levered the capital structure Often assume exit and entry multiples are the same, but not necessarily a good assumption rarely expect multiple expansion Ask what the exit strategy is likely to be.

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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. 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.
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Financial Sponsors
Typically wont 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. Sponsor takes funds from pension funds only when required, a draw down notice (LBO sponsors do not want to be generic portfolio managers). 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
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Financial 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.

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Financial Sponsor M&A Activity 1998 2010 Global Sponsor M&A Activity
$ in billions % of Total Value

$1,200 $1,001 $1,000 $898 $800

30%

25%

20%

$600

$506 $357 $388 $423

15%

$400 $180 $119 $145 $187

10% $204 5%

$200

$162 $118

$0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
(1)

0%
2010

Global Sponsor Activity Volume

% of Total Global M&A Volume

___________________________ Source: Thomson Financial based on rank date excluding equity carveouts, exchange offers and open market repurchases. As of 12/31/10. (1) Total Global M&A Volume includes government interventions, defined as deals in which a government entity is the acquiror, excluding SWF transactions.

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Financial Sponsor M&A Activity 2007-2010

Sponsor Volume has reemerged, steadily gaining more share of Global M&A Volume

2009 Sponsor volume was off 47% from 2008 year-over-year average; Strategic volume was down 30% 2010 Sponsor volume was up 107% from 2009 volume; Strategic volume was up 14%
Sponsor % of Market
50% 45% 40% $972 1,028 $897 $874 $893 $798 $733 $668 707 686 739 563 $591 $519 723 471 404 450 390 265 $0 211 135 104 161 75 48 26 39 49 90 61 100 123 139 0% 500 422 459 463
515

Global Sponsor Quarterly M&A Activity $ in billions

$1,417 $1,400 $1,200

$1,000

35% 30% 25% 20% 594 15% 10% 5%

$800 $564 $520 $637

$600

732

$476

$443

$471

$400

$200

Q1 2007 Q2 2007 Q3 2007Q4 2007 Q1 2008 Q2 2008Q3 2008 Q4 2008 Q1 2009 Q2 2009Q3 2009 Q4 2009 Q1 2010Q2 2010 Q3 2010 Q4 2010
___________________________ Source: Thomson Financial based on rank date excluding equity carveouts, exchange offers and open market repurchases. As of 12/31/10. (1) Total Global M&A Volume includes government interventions, defined as deals in which a government entity is the acquiror, excluding SWF transactions.

Sponsor Volume

Strategic Volume

Sponsor % of Market (1)

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Strategics are Driving the M&A Market

Risk right-sizing in credit markets will continue to allow Strategics to be more competitive buyers of assets, but Sponsor volume has reemerged Financial Sponsors
Harder time getting to DCF range, cheap credit subsidy gone Leveraged finance market recovered, although still below pre-2008 levels Reemerged due to opening of credit markets 2010 tax-driven transactions Portfolio backlog waiting to be monetized High acquisition appetite Search for assets where they have a comparative advantage as buyer Deal size sweet spot for Financial Sponsors moves to the midcap market Reemergence of large LBOs, $5+ billion

Strategics
MBO a less viable path for CEOs No longer getting out-bid ability to push the strategic agenda Synergies > financing subsidy Resurgence of cash as an acquisition currency Historically high cash levels on balance sheets that needs to go to work Investment grade corporates rule with maximum financial flexibility

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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? Corporate Valuation -- Chapter 18 School 17 Wharton What is the exit strategy? Copyright, Robert Holthausen, 2010

U.S. LBO Acquisition Financing Market Trends

Sample Capital Structure Terms for Leveraged Deals

Average Debt Multiples (1)

6.7x

6x 3x

3.3 3.4

6.0x 5.4x 5.0x 5.2x 5.3x 5.2x 5.8x 5.7x 5.2x 0.6 4.7x 4.6x 4.5x 4.1x 4.0x 4.2x 4.4x 4.4x 4.0x 3.8x 3.7x 2.3 2.1 2.0 0.6 1.7 1.9 1.2 1.2 0.2 0.6 2.4 2.5 2.5 1.3 1.1 1.5 1.4 1.7 1.5 5.4 4.1 3.8 4.0 3.4 2.6 2.7 2.8 3.3 3.5 3.6 3.5 3.3 2.9 3.3 3.1 2.7 2.2 2.4 2.3

0x
1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Senior Debt/EBITDA

Junior Debt/EBITDA

Average Equity Contribution to LBO (2)

52%

50% 25% 0%
25% 26% 24% 23% 21% 22% 13%

43% 41% 40% 40% 36% 38% 35% 32% 33% 33% 32% 30% 46% 6%

43%

34% 35% 37% 35% 32% 30% 31% 31% 39% 27% 28% 32% 26% 25% 24% 23% 21% 22% 3% 4% 4% 6% 3% 5% 3% 2% 2% 2% 4% 3% 13%

41% 2%

1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
________________ Source: S&P Leveraged Commentary & Data. As of 12/31/10. 1) Excludes media loans. Too few deals in 1991 to form a meaningful sample. 2) Rollover equity prior to 1996 is not available. Too few deals in 1991 to form a meaningful sample.

Rollover Equity

Contributed Equity

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Current State of the Market

Driven by the recovery of the leveraged finance market, as well as the return of the corporate buyer, the M&A market has recovered to a new normal. There have been several $1B+ LBOs including Del Monte at $5.3 billion. The size of LBOs that can get done is a function of size, industry, quality of asset, quality of sponsor, quality of management team. As equity valuations have rebounded and stabilized, sellers are more comfortable with valuations and believe they are not selling at impaired values and are no longer constrained by 2009 trough financial results. The robust and recovering leveraged finance market is causing valuations and structures to change monthly. Right now, Sponsors can easily do deals up to about $3-5 Billion, perhaps larger for just the right target characteristics. Deals greater than $5 billion still require a number of attributes including stable earnings, world-class management and a top-tier Sponsor. These larger deals will test depth of the market and will be constrained by the size of the accompanying equity check (majority of deals are 30%-50% equity). Recent large deals include Del Monte, Burger King, Syniverse, Corporate Valuation -- Chapter 18 Wharton 19 GymboreeSchool and other $1+ billion LBOs. Copyright, Robert Holthausen, 2010

Current State of the Market

Access to high yield market is strong, however underwriters capacity is a constraint (multi-billion full commitment is now a couple of banks, not one. Leverage loan market (5 to 7 year term loans) with some amortization (from banks and senior loan funds), has rebounded. Deal action seen mainly in industries with stable cash flows and less cyclicality. Some industries that have had highly levered deals in the past (e.g., media) are lagging because the leverage terms do not yet fully support valuations that are considered attractive. A typical capital structure now is 30%-50% equity, senior secured or first lien debt of about 40%-50 and subordinated debt/mezzanine at 20%-30%. Senior debt yielding less than 6% with High Yields yielding anywhere from around 6% to 9% now and the mezzanine debt in the low-double digits (coupon rates) but depends on credit risk. Sponsor firms hope to earn low- to mid-20s IRR on equity. However, in the interest of putting money to work and against the backdrop of lower benchmark returns, sponsors will invest at a lower calculated rate (high upper teens) on a base case with the hope of getting to the target Corporate Valuation -- Chapter Wharton School 20 acquisitions IRRs through the upside case, or other improvements in 18 Copyright, Robert Holthausen, 2010 cash flows.

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.

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Potential Motivations for an 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) Wharton Transfer wealth from other stakeholders Corporate Valuation -- Chapter 18 School 22 Copyright, Robert Holthausen, 2010 in the firm such as employees &

Performance of LBOs
Evidence indicates that the median premium paid to existing shareholders is 42% . What are the potential sources of value?
Improved operating performance wealth transfers from employees reduction of taxes wealth transfers from pre-buyout debtholders Corporate Valuation -- Chapter 18 Wharton School 23 Copyright, Robert Holthausen, 2010 overpayment by post-buyout investors

Changes in Median Performance

In three year period after the buyout relative to the year before the buyout
EBIT increases by 42% EBIT/assets increases by 15% EBIT/sales increases by 19% EBIT-CAPEX increases by 96% EBIT-CAPEX/assets increases by 79% EBIT-CAPEX/sales increases by 43% working capital management improves no decline in advertising, maintenance or R&D CAPEX falls by 33% relative to industry
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 No evidence that investor wealth gains can be attributed to wage reductions or layoffs
median change in number of employees is 0.9% among all LBOs and is 4.9% among LBOs that did not engage in divestitures significant increase in average annual compensation for non-management employees there is evidence that LBOs are not adding to their payrolls at the same rate as the industry (12% declines for all, 6.2% decline Corporate Valuation -- Chapter 18 Wharton School 25 Copyright, Robert Holthausen, 2010 for those with no divestitures)

Transfers from Employees

Tax Effect of LBOs

Firms interest deductions increase substantially after an LBO. Depending on how you value them & how long you think the highly levered structure will be in place, 21% to 70% of the premium is attributable to the interest Additional depreciation (pre-1986 Tax Reform Act accounted for at least 30% of the premium Ratio of federal taxes/EBIT falls from 20% pre-buyout to 1% for 2 yrs. after buyout.
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Transfers from Bondholders

If leverage increases dramatically, prebuyout debtholders with no protection could experience wealth losses
on average, pre-buyout debtholders lost 2.1% represents 3% of the premium paid wealth losses accrue only to those bondholders not safeguarded by protective covenants (limitations on debt issuance, etc.)
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Overpayment by Post-Buyout Investors

Evidence indicates over three years subsequent to the buyout, post-buyout equity investors earned a mean excess return of 45%. Evidence for debtholders is less clear as it is difficult to track bonds that default. Default rates on low grade bonds were roughly 2.5% per year, but returns are less easily quantified
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John Harland -- An LBO?

Typical LBO Model Model cash flows -- see how it supports the debt financing structure Treat exit year as a choice variable to determine sensitivity of IRR to exit date. Determine the IRR for the mezzanine and equity providers and see if it hits target Models dont typically assess value Corporate Valuation -- Chapter except as exit multiple (can do DCF of 18 Wharton School 29

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LBO Models as an Alternative Valuation

LBO models can serve as an alternative valuation. Take the cash flow forecasts, determine the amount of financing available in the market place currently and the IRR that LBO sponsors would target for this company. Based on all that, determine the maximum amount that could be paid as an LBO transaction that satisfies the required IRR. Triangulate with DCF and Market Multiple Valuations
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LBO Model Logic

Create a sources (debt, equity contribution) and uses (purchase price, fees, debt payoff) statement for inception of LBO Debt schedules Proforma balance sheet, income statement and statement of cash flows based on operating assumptions Cash flows pay down the debt (senior first and then mezzanine) Perform valuations at alternative exit dates and determine IRR to equity holders
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 Reverse LBO occurs when an LBO goes public Constituted roughly 10% of IPO market in 1980s Leverage and ownership changes at time of reverse LBO that moves them back toward pre-LBO structure Leverage falls from 83% to 56% (debt/capital) Inside ownership falls from 75% to 49% (management and board -- includes sponsor). Board size increases from 5 to 7, roughly 1/3 each of operating management, non Corporate Valuation -- Chapter 18 Wharton School 32 Copyright, Robert Holthausen, 2010 management capital providers and external

Reverse Leveraged Buyouts

Financial Performance
OCF Before Interest and Taxes
Year
-1 0 +1 +2 +3 Avg +1 to +3

Firm
19.3% 14.6% 11.9% 14.3% 13.5% 13.9%

Industry-Adjusted
9.2% 4.7% 1.5% 4.1% 2.4% 2.9%

Doing much better than their industry, but evidence of deterioration relative to prior performance
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Discretionary Expenditures
Discretionary expenditures defined as capital expenditures, advertising and R&D.
Spending as much as their industry prior to the reverse LBO and increases subsequently (discretionary expend./sales) 2% greater than industry CAPEX low before reverse LBO and normal after Advertising above industry before and after R&D tracks industry before and after

Employees/sales same as industry both before and after the reverse LBO
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Effect of ownership and leverage

No evidence that changes in leverage affect performance Significant correlation between decline in performance and decline in ownership.
10% additional decline in percentage equity owned by managers results in an additional 3.6% fall in OCF/assets over three subsequent years 10% additional decline in percentage equity owned by non-management insiders results in an additional 4.1% fall in OCF/assets over three subsequent years

Suggests important role for ownership Corporate Valuation -- Chapter 18 Wharton School 35 incentive Copyright, Robert Holthausen, 2010

Stock Market Performance

Evidence of a large increase in stock prices of the reverse LBO firms over the next four years. Large increase in stock prices exactly tracks the stock market. As such, there is no evidence of positive or negative excess returns Very different from IPOs in general. Strong evidence of negative excess returns Corporate Valuation -- Chapter 18
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