chp. 9 leveraged buyout

7/29/2019 Chp. 9 Leveraged Buyout

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Introduction

Leveraged buyout (LBO) is a financial

engineering product of the takeover

and corporate restructuring wave of

1980s in the US .

For domestic acquisition in India

LBOs are not practiced.

However, Indian companies have been

successfully resorting to the LBOs for

the overseas acquisition.


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LBO-Leveraged Buyout Acquisition of another company involving significant

amount of borrowed money to meet the cost of

acquisition

Without having to commit a lot capital


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Occurs when a financial sponsor gains control of amajority of a target company's equity equity through

the use of borrowed money or debt .

A leveraged buyout is a strategy involving the

acquisition of another company using a significant

amount of borrowed money (bonds or loans) to meet

the cost of acquisition.

The purpose of leveraged buyouts is to allow

companies to make large acquisitions without having

to commit a lot of capital


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Leveraged Buyout And Going Private

Leveraged buyout (LBO) simplistically means mobilizingborrowed funds based on the security of assets and cash flows ofthe target company (before its takeover) and using those fundsto acquire the target company.

This debt financing maturity period is 10 or more years where itis raised by issuing normally junk bond

Junk bond means with high interest rate bonds havingspeculative in nature. Normally small group of individual

investors or institutional investors like commercial banks,investing banks, financial institutions & mergers specialist firminvesting in such debt financing.

These are four characteristics/steps in a typical or classicalleveraged buyout.


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LBO Characteristics Investors are outside financial group or managers or

executives of company Results in significant increase of equity share

ownership by managers

Turnaround in performance is usually associated with

formation of LBO Typical LBO operation

Financial buyer purchases company using high levelof debt financing

Financial buyer replaces top management New management improves operations

Financial buyer makes public offering of improvedfirm


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Characteristics/steps in a

typical or classical leveraged

buyout.


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Incorporation of a

privately/wholly ownedcompany to act as a special

purpose vehicle (SPV) for

acquisition of a target

company.

1


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Mobilization of borrowed

funds in the SPV, based onthe security of assets and

cash flows of the target

company (before its

takeover).

2


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Acquisition of the entire or

near entire share capital of

the target company.

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Merger of the target company into the

SPV. This last move, which is also a

critical step in the leveraged buyout, has

two effects:

It brings the assets of the target

company and the loans

It makes the target company goprivate, i.e., the target company gets

unlisted.

4


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Criticisms of LBO Risk of solvency

Overall increase in market interest rate will make

borrowing costly for other borrowers Fear of remove in the minds of efficient & experience

employees

There will be clash between short term and long term

objective


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Process/stages in LBO Raising of finance more than 50% borrowed capital

Conversion in private

Restructuring of business activity

Reverse LBO


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Types of LBO

Sponsored LBOs

Non Sponsored LBOs


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The first major LBO by an Indian companywas acquisition of Tetley by Tata Tea in

early 2000. in this case, Tata Tea set up a

SPV in the UK in the form ofTata Tea (GB)

Limited.

The SPV, in turn mobilized GBP 235 million

by way of long-term debt on the security of

the assets and cash flows of the Tetley and

acquired 100 per cent of Tetley at the cost

of the GBP 271 million, taking it private.

The acquisition of Corus Plc by Tata Steel

Limited is also a case of leveraged buyout.


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Management Buyout

When the professional management or non-promoter

management of a company carries out a leveraged

buyout of the company from its promoters, the same is

called as Management buyout or MBO.

Partners in growth


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Example

As on 31 March 2005, the balance sheet of XYZ Corporation

The paid-up capital consisted of 5 crore shares of Rs 10 each. The companys

sales were very stablerather stagnantbut the profitability was very good.

Its pre-tax cost of borrowing was just 10 per cent per annum. It used to charge

depreciation on straight line basis in its books. The current average rate of

book depreciation was 10 per cent. With regard to depreciation for income tax

purpose for the year 200405, the same worked out to Rs 3 crore only.


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Thus, earning per share (EPS) in 2004-05 worked out to Rs.4.4 per

share, with a healthy return on net worth (RONW) of 22 per cent. Thecompanys professional management team and particularly its MD

were rearing to go for leveraged investments in the new lines of

business.

However, its seventy-three-year old promoter was not interested in

taking any risk.


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The management team decided that it would itself take overthe company and take it to the next higher path of growth andapproached an investment banker to help them.

The investment banker estimated that the promoter, who washolding 40 per cent stake (2 crore shares) would be happy toexit at a price of Rs 35 per share which he had never seen in

last so many years. Public offer for 35 per cent and delistingoffer for balance 25 per cent will go through for Rs 40 and Rs44 per share respectively.

The investment banker confirmed that he can arrange forborrowed funds at the debt equity ratio of roughly 3:1 by

securing the debt on the assets of XYZ Limited.This meant that management team had to invest Rs 50 crores,whereas, Rs 145 crores would come in the form of long-termloans. The management team had decided to go ahead.


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The balance sheet of XYZ Holdings Limited


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After this, the management team decided to merge XYZLimited with XYZ Holdings Limited and change the

name of the merged entity to XYZ Limited.

Management, now in the shoes of the owners, decidedto invests Rs 100 crores in a new but synergistic line of

business that promised Rs 100 crore turnover in the

first year itself.


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The post merger balance sheet of XYZ Limited

chp. 9 leveraged buyout

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