Financing the Deal:Private Equity, Hedge Funds, and

Other Sources of Financing

No one spends other people’s money as carefully as they spend their own.

—Milton Friedman

Exhibit 1: Course Layout: Mergers, Acquisitions, and Other Restructuring Activities

Part IV: Deal Structuring and

Financing

Part II: M&A ProcessPart I: M&A Environment

Ch. 11: Payment and Legal Considerations

Ch. 7: Discounted Cash Flow Valuation

Ch. 9: Financial Modeling Techniques

Ch. 6: M&A Postclosing Integration

Ch. 4: Business and Acquisition Plans

Ch. 5: Search through Closing Activities

Part V: Alternative Business and Restructuring

Strategies

Ch. 12: Accounting & Tax Considerations

Ch. 15: Business Alliances

Ch. 16: Divestitures, Spin-Offs, Split-Offs,

and Equity Carve-Outs

Ch. 17: Bankruptcy and Liquidation

Ch. 2: Regulatory Considerations

Ch. 1: Motivations for M&A

Part III: M&A Valuation and

Modeling

Ch. 3: Takeover Tactics, Defenses, and Corporate Governance

Ch. 13: Financing the Deal

Ch. 8: Relative Valuation

Methodologies

Ch. 18: Cross-Border Transactions

Ch. 14: Valuing Highly Leveraged

Transactions

Ch. 10: Private Company Valuation

Learning Objectives

• Primary Learning Objective: To provide students with a knowledge of how M&A 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.

How are M&A 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

Financing M&As: Borrowing Options

Alternative Forms of Borrowing

Type of Security Backed By Lenders Loan Up to Lending Source

Secured Debt Short-Term (<1Yr.) Intermediate Term (1-10 Yrs.)

Liens generally on receivables and inventoryLiens 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 FinancingPayment-in-Kind

Cash generating capabilities of the borrower

Life insurance companies, pension funds, private equity and hedge funds;target firms

Financing M&As: Equity Options

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

Financing M&As: Seller Financing

• Seller defers a portion of the purchase price• Advantages to seller:

– Buyer may be willing to pay seller’s 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

Financing M&As: Cash on Hand and Selling

Redundant Assets

• “Cash on hand” represents cash in excess of normal operating requirements on the acquirer or target’s balance sheet.

• Target’s excess cash can be used to buy target firm’s outstanding shares.

• Redundant assets are those owned by the acquirer or target firm that are not considered germane to the acquirer’s business strategy.

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 people’s 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)

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 S&P 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.

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

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

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 @ 10%1 0

$5 $8

Income Before Taxes $20 $15 $12

Less Income Taxes @ 40% $8

$6 $4.8

Net Income $12 $9

$7.2

After-Tax Return on Equity (ROE)2 12% 18% 36%

Impact of Leverage on Financial Returns

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.

LBO’s 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 R&D and capital spending relative to peers

• Operating performance particularly for private firms undergoing LBOs improves significantly due to increased access to capital

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?

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 firm’s 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.

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

LBOs Create Value by Reducing Debt and Increasing Margins Thereby Increasing Potential Exit Multiples

Firm Value

Debt Reduction Reinvest in Firm

Free Cash Flow

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

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

Tax Shield Adds to Free Cash Flow

Debt Reduction

Adds to Free Cash Flow by

Reducing Interest & Principal

Repayments

Reinvestment Adds to Free Cash Flow by

Improving Operating Margins

Tax Shield1

1Tax shield = (interest expense + additional depreciation and amortization expenses from asset write-ups) x marginal tax rate.

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 million3Enterprise Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year4Equity Value = Enterprise Value in 7th Year – Net Debt5The 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.

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.

Direct Merger

Acquirer (Controlled by

Financial Sponsor)

Target Firm Shareholders

Target Firm

Lender

Target Merges with Acquirer

Target Stock

Acquirer Cash and Stock

Loan

Financial Sponsor (Limited Partnership

Fund)

Equity Contribution

Subsidiary Merger

Financial Sponsor Limited Partnership Fund

Parent (Controlled by Financial

Sponsor)

Lender

Target Firm

Target Firm ShareholdersMerger Sub

Equity Contribution

Merger Sub Cash & Shares

Target Firm Shares

Merger Sub Merges Into Target

Merger Sub SharesEquity

Contribution

Loan

Loan Guarantee

Typical LBO Capital Structure

Purchase Price

Equity (25%)

Debt (75%)

Common Equity (10%)

Preferred Equity (15%)

Revolving Credit (5%)

Senior Secured Debt

(40%)

Sub Debt/Junk

Bonds (30%)

Term Loan A

Term Loan B

Term Loan C

2nd Mortgage Debt

Mezzanine Debt & PIK

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 Communication’s 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 firm’s 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 cable’s 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.

Things to Remember…

• M&As 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.