lbo powerpoint

5/27/2018 LBO Powerpoint

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Corporate Valuation -- Chapter 18Copyright, Robert Holthausen, 2010Wharton School1

Leveraged Buyouts

Characteristics

Evidence on LBOs

An LBO (Private Equity) ModelReverse LBOs


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Definition of an LBO

No precise definition -- different forms Transaction in which a group of privateinvestors uses debt financing to purchase acorporation or a corporate division. Equity

securities of the company are no longerpublicly traded, though the debt and preferredstock may be publicly traded. Uses entireborrowing structure

Often involves a financial sponsor whocontributes capital and expertise (KKR, BassBrothers, Blackstone, etc.) and managementteam.


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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-managementdirectors may represent 40%-60% ofequityholders

Typical board of 5 individuals, 2-3 from the LBOsponsor


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Historical Characteristics of PotentialLBO 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 (hightech?)

Low-cost producers with modern capital

Take low risk business, layer on risky

financing


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Typical LBO Structure Varies tremendously over time with market conditions

Debt Financing Total debt sometimes 60-80% of entire deal (4-5 x LTMEBITDA, but depends on industry, cash flow, and timeperiod 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 beused for junior subordinated debt and preferred

Occasionally, sponsors bring in other equity investorsor another sponsor to minimize their exposure

Balance from commercial banks (bridge loans, termloans, revolvers) & other mezzanine sources

Banks concentrate on collateral of the company, cashflows, level of equity financing from the sponsor,coverage ratios, ability to repay (5-7 yr)


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LBO FinancingSenior 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 averagelife of 4-5 years)

2.53.5 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 riskpremium

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 FinancingUnsecured Debt

Unsecured debt (senior and junior)

Potentially many different pieces (cash pays are senior andsenior subordinated while junior subordinated may be zerocoupon 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 highyield for less than $150 million and high-yield market not alwaysviable.

High-yield is typically non-callable for about five years and thenhave call penalties for 3-5 years.


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un or u or na e anPreferred

Below the high-yield bonds (or below the bank debt if the deal

isnt big enough to support high-yield bonds) but above thecommon 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 companyand may be issued with warrants. Holding company notesalmost always PIK because there is no cash flow into theholding 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 ispaid off (so called AHYDO rules)

Preferred can be PIK as well, so dividends accrue but are notpaid and at sale of the company the preferred holders get theirinvestment plus accrued dividends (often called the liquidationpreference) -- often sold with warrants. Alternatively, can issueconvertible preferred instead of including warrants.


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Common Equity

Typically 20% - 45% of capital structurehistorically, but varies over time (at high endor 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 calledmanagement promote) usually increases year byyear as they meet targets (e.g., revenue and EBITDAand non-financial targets) through performance

vesting options. Strike price usually at equity buy-inprice at time of deal. Managers are sometimes offered chance to buy

stock with a mixture of recourse and non-recoursenotes.

Managers often already own shares in a companythat does an LBO and they do not necessarily cashout those sharesthat equity goes into the newentitycalled rollover equity.


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Corporate Valuation -- Chapter 18Copyright, Robert Holthausen, 2010Wharton School 12

Financial Sponsors

Typically wont put more than certain percentage of afund in one company and another percentage of afund in one industry. Increases in % of financing thatis 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 notwant to be generic portfolio managers).

Typically assume will take 3-5 years to invest a fundand 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 is1% to 1.5% of fund size.

In addition, they split returns betweeninvestors and themselves and often get

a percentage in the capital gain of thefund (so called carried interest).

In addition, they invest their own money

in the fund.


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Corporate Valuation -- Chapter 18Copyright, Robert Holthausen, 2010

$357

$187$145$119

$180$162

$118

$506

$898

$1,001

$388

$204

$423

$0

$200

$400

$600

$800

$1,000

$1,200

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

0%

5%

10%

15%

20%

25%

30%

Global Sponsor Activity Volume % of Total Global M&A Volume

$ in billions % of Total Value

___________________________

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.

Financial Sponsor M&AActivity1998 2010 Global Sponsor M&A Activity

(1)

18


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Financial Sponsor M&A Activity 2007-2010

265390

211135 104

16148 39 49 90 61

100 123 139

707

1,028

563723

450422

500459

463

594

$972

$1,417

$897 $874

$668

$893

$798

$519$476

$443 $471

$591

$520

$637

$733

2675

739732

471 404 515

686

$564

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

Q1 2007 Q2 2007Q3 2007Q4 2007Q1 2008 Q2 2008Q3 2008Q4 2008Q1 2009 Q2 2009Q3 2009Q4 2009Q1 2010Q2 2010Q3 2010Q4 2010

$ in billions

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Sponsor % of Market

Sponsor Volume Strategic Volume Sponsor % of Market

Global Sponsor Quarterly M&A Activity

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%

___________________________

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.

(1)

20


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Harder time getting to DCF range, cheapcredit 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 bemonetized

High acquisition appetite

Search for assets where they have acomparative advantage as buyer

Deal size sweet spot for FinancialSponsors moves to the midcap market

Reemergence of large LBOs, $5+ billion

MBO a less viable path for CEOs

No longer getting out-bidability 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

Strategics are Driving the M&AMarket

Risk right-sizing in credit markets will continue to allow Strategics to be more competitivebuyers of assets, but Sponsor volume has reemerged

Financial Sponsors Strategics

21


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Risk Profile Questions

Is cash flow consistent (no cyclicalindustries)?

Is a turnaround required to meet projections? Any outside threats to long-term

performance?

Are there larger, better capitalizedcompetitors?

Does the firm have high qualitymanagement?

Are there other successful LBOs in thatindustry?

Can the company grow with the leverageincrease?

What is the exit strategy?


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0.2 0.6

6.7x5.4x 5.2x 5.3x 5.2x

5.8x 5.7x5.2x

4.5x 4.1x 3.7x 3.8x 4.0x 4.2x 4.4x 4.4x

6.0x4.7x

4.0x 4.6x

4.03.84.15.4

3.33.12.72.32.42.22.93.33.53.63.53.32.82.72.63.43.4

0.6

0.6

1.11.31.51.71.41.51.21.2

1.72.12.31.92.52.52.42.0

3.35.0x

0x

3x

6x

1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Senior Debt/EBITDA Junior Debt/EBITDA

________________

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.

41%13%

21% 25% 26% 24% 23%

30% 32% 36% 38%

41% 40% 40%35% 32% 33% 33%

43%

52%43%

2%3%5%3%6%4%4%3% 2%2% 4% 6%3% 2%13% 21% 22% 25% 26% 24% 23%

27% 28% 32% 34% 35% 37% 35% 32% 30% 31% 31% 39%

46%22%

0%

25%

50%

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

Rollover Equity Contributed Equity

Sample Capital Structure Terms for Leveraged Deals

U.S. LBO Acquisition Financing Market Trends

Average Debt Multiples (1)

Average Equity Contribution to LBO (2)

41


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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 newnormal. 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 morecomfortable 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 attributesincluding stable earnings, world-class management and a top-tierSponsor. These larger deals will test depth of the market and will beconstrained by the size of the accompanying equity check (majority ofdeals are 30%-50% equity).

Recent large deals include Del Monte, Burger King, Syniverse,

Gymboree and other $1+ billion LBOs.


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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, notone.

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 lesscyclicality. Some industries that have had highly levered deals in thepast (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 at20%-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-doubledigits (coupon rates) but depends on credit risk.

Sponsor firms hope to earn low- to mid-20s IRR on equity. However, inthe interest of putting money to work and against the backdrop of lowerbenchmark returns, sponsors will invest at a lower calculated rate (highupper teens) on a base case with the hope of getting to the target

IRRs through the upside case, acquisitions or other improvements incash flows.


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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 areasonable level, the entity issues a new round ofdebt 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 concentratedownership increase incentives tomaximize value.

Non-management on board withsignificant equity stakes increasesboard effectiveness

Advantage to being private (filings, etc.)

Beneficial tax consequences (debt,step-up)

Transfer wealth from other stakeholdersin the firm such as employees &


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Performance of LBOs

Evidence indicates that the medianpremium paid to existing shareholdersis 42% .

What are the potential sources ofvalue?

Improved operating performance

wealth transfers from employees

reduction of taxes

wealth transfers from pre-buyoutdebtholders

overpayment by post-buyout investors


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Corporate Valuation -- Chapter 18Copyright, Robert Holthausen, 2010Wharton School

24

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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Wharton School 25

Transfers from Employees No evidence that investor wealth gains

can be attributed to wage reductions orlayoffs

median change in number of employees is0.9% among all LBOs and is 4.9% amongLBOs that did not engage in divestitures

significant increase in average annualcompensation for non-management

employees there is evidence that LBOs are not adding

to their payrolls at the same rate as theindustry (12% declines for all, 6.2% decline

for those with no divestitures)


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Wharton School 26

Tax Effect of LBOs

Firms interest deductions increasesubstantially after an LBO. Depending onhow you value them & how long you think thehighly levered structure will be in place, 21%

to 70% of the premium is attributable to theinterest

Additional depreciation (pre-1986 Tax ReformAct 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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Wharton School 27

Transfers from Bondholders

If leverage increases dramatically, pre-buyout debtholders with no protectioncould experience wealth losses

on average, pre-buyout debtholders lost2.1%

represents 3% of the premium paid

wealth losses accrue only to those

bondholders not safeguarded by protectivecovenants (limitations on debt issuance,etc.)

O t b P t B t


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Wharton School 28

Overpayment by Post-BuyoutInvestors

Evidence indicates over three yearssubsequent to the buyout, post-buyoutequity investors earned a mean excessreturn of 45%.

Evidence for debtholders is less clearas it is difficult to track bonds thatdefault. Default rates on low gradebonds were roughly 2.5% per year, butreturns are less easily quantified


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Wharton School 29

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 todetermine sensitivity of IRR to exit date.

Determine the IRR for the mezzanine

and equity providers and see if it hitstarget

Models dont typically assess value

except as exit multiple (can do DCF of

LBO Models as an Alternative


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Wharton School 30

LBO Models as an AlternativeValuation

LBO models can serve as an alternativevaluation.

Take the cash flow forecasts, determine theamount of financing available in the marketplace currently and the IRR that LBOsponsors would target for this company.Based on all that, determine the maximumamount that could be paid as an LBOtransaction that satisfies the required IRR.

Triangulate with DCF and Market MultipleValuations


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Wharton School 31

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 statementand statement of cash flows based onoperating 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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Wharton School 32

Reverse Leveraged Buyouts Reverse LBO occurs when an LBO goes

public

Constituted roughly 10% of IPO market in1980s

Leverage and ownership changes at time of

reverse LBO that moves them back towardpre-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 1/3each of operating management, non

management capital providers and external

Financial Performance


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Wharton School 33

Financial PerformanceOCF Before Interest and Taxes

Year Firm Industry-Adjusted -1 19.3% 9.2% 0 14.6% 4.7%

+1 11.9% 1.5%

+2 14.3% 4.1% +3 13.5% 2.4%

Avg +1 to +3 13.9% 2.9%

Doing much better than their industry, butevidence of deterioration relative to priorperformance


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Wharton School 34

Discretionary Expenditures

Discretionary expenditures defined as capitalexpenditures, advertising and R&D.

Spending as much as their industry prior to thereverse LBO and increases subsequently

(discretionary expend./sales) 2% greater thanindustry

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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Wharton School 35

Effect of ownership and leverage

No evidence that changes in leverage affectperformance

Significant correlation between decline inperformance and decline in ownership.

10% additional decline in percentage equityowned 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 anadditional 4.1% fall in OCF/assets over threesubsequent years

Suggests important role for ownership

incentive


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Corporate Valuation -- Chapter 18C i ht R b t H lth 2010

Wharton School 36

Stock Market Performance

Evidence of a large increase in stockprices of the reverse LBO firms over thenext four years.

Large increase in stock prices exactlytracks the stock market. As such, thereis no evidence of positive or negativeexcess returns

Very different from IPOs in general.Strong evidence of negative excessreturns

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