Corporate Restructuring

• Corporate restructuring is a process of expanding

or contracting business activities either by asset
restructuring or ownership restructuring.

• On the other hand financial restructuring refers

to changing only debt-equity mix of the firm
• The process of restructuring may involve
regrouping companies of the same group or
regrouping the various divisions/departments or
merging some companies or hiving off some
departments/ divisions and building some new
ones.
•FORMS OF RESTRUCTURING

•EXPANSION ORINTED RESTRUCTURING:

•These activities result in expansion of size, increase in product portfolio,
market reach of the firm

•CONTRACTION ORINTED RESTRUCTURING:

•Contraction leads reduction in the size of the firm either to have manageable
size or core competitiveness.

•CORPORATE CONTROL ORINTED RESTRUCTURING:

Restructuring for corporate control refers to a process by which control over
management is established

•CHANGE IN OWNERSHIP STRUCTURE:

These activities will result in the changes in the ownership pattern of a company.
Rather than the regular capital structure other variables are used to try out new
operating strategy, new capital structure, and different cash flow pattern.
What are the FORMS OF RESTRUCTURING ?
EXPANSION ORINTED RESTRUCTURING:
These activities result in expansion of size, increase in product portfolio, market reach of the firm
1.Mergers
-in the form of consolidation
-in the form of an acquisition
1.Tender offers
2.Asset Acquisition
3. Joint ventures

CONTRACTION ORINTED RESTRUCTURING:

Contraction leads reduction in the size of the firm either to have manageable size or core competitiveness.
1.Spin-offs
2.Split-offs
3.Split-ups
4.Divestitures
5.Equity Carve outs

CORPORATE CONTROL ORINTED RESTRUCTURING:

Restructuring for corporate control refers to a process by which control over management is established.
1.Premium buy backs
2.Stand still agreements
3.Anti takeover amendments
4.Proxy contests

CHANGE IN OWNERSHIP STRUCTURE:

These activities will result in the changes in the ownership pattern of a company. Rather the regular capital structure other
variables are used to try out new operating strategy, new capital structure, and different cash flow pattern.
1.Leveraged Buy Outs
2.Exchange offers
3.Going Private
4.ESOPs and MLPs
5.Share repurchase
•EXPANSION oriented restructuring

•Merger forms and types

•Merger is a combination of two or more companies into a single company.
A merger can be either in the form of amalgamation (Consolidation) or
absorption (Acquisition).

•Amalgamation
•This type of merger leads to the formation of a new company. The
merging companies lose their individual legal entity. This form of
amalgamation takes place between equal size firms.

Glaxo Smithkline beecham

Both the Cos lose their legal

Entity and form a new company

Glaxo Smithkline beecham

 Absorption or Acquisition

When a bigger company absorbs the smaller company it is called absorption. After the
merger smaller company ceases to exist.

Only one merging co or acquired Co

HUL Loses the legal entity

Acquires Ponds India Ltd

HUL
 MERGER
MERGER
TYPES
TYPES

CONGLOMERAT
CONGLOMERAT
HORIZONTAL
HORIZONTAL VERTICAL
VERTICAL
MERGER MERGER EE
MERGER MERGER MERGER
MERGER

MARKET
MARKET
PRODUCT
PRODUCT BASEDON
BASED ON BASEDON
BASED ON
FORWARD
FORWARD BACKWARD
BACKWARD
EXTENSION
EXTENSION EXTENSION
EXTENSION OBJECTIVE
OBJECTIVE FUNCTIONS
FUNCTIONS
MERGER INTEGRATION
INTEGRATION INTEGRATION
INTEGRATION
MERGER MERGER
MERGER

PURE
PURE FINANCIAL
FINANCIAL
CONGLOMERA
CONGLOMERA CONGLOMERA
CONGLOMERA
TEMERGER
TE MERGER TES
TES

MIXED
MIXED MARKETING
MARKETING
CONGLOMERA
CONGLOMERA CONGLOMERAT
CONGLOMERAT
TEMERGER
MERGER ES
ES
TE

MANAGERIAL
MANAGERIAL
CONGLOMERAT
CONGLOMERAT
ES
ES

CONCENTRIC
CONCENTRIC
CONGLOMERAT
CONGLOMERAT
ES
ES
 Horizontal merger
• This occurs when two companies that are in direct competition with each other in the same
product lines and markets decide to merge. Horizontal merges involves of firms operating in

the same kind of business activities .

• Product extension merger : Whilst a product-extension merger is designed to increase
the types/range of products a company sells in a particular market, so this will occur when
two companies selling different but related products in the same market merge together.

Merges with Smith Kline Glaxo Smith Kline

Glaxo Beecham
Beecham

Both are competing firms in the same industry

 Market-extension merger:
As the name suggests, this is a merger between two companies that sell the same
products in different markets.

ICICI ICICI
BANK OF
BANK BANK
MADURA

FORAY OF ICICI
BANK INTO
SOUTH INDIAN
MARKET
 Vertical merger
• This occurs when a supplier company, mergers with a company that they supply
goods or services to ie supplier firm and customer decide to merge. It is either
forward integration or backward integration to improve the value chain.
• Those companies involved in different stages of production operations combine
together, such merges are also called as rational mergers.

A-Oil exploration Co

B-Oil processing Co

Merger of A with B improves the value chain for both the firms. For A it
is forward integration and for B it is backward integration

AB
• Vertical integration is the extent to which an organization
controls either its inputs or the distribution network of its
products and services. There are two forms of vertical
integration: backward integration and forward integration. A
firm’s attempt to merge or acquire in order to control its
inputs or supplies is known as: backward integration.
• Eg: Coke Acquired many bottling units in India ; which can be
considered as backward integration.
• A firm’s attempt to merge or acquire in order to control its
distribution is known as: forward integration.
 Conglomerate merger is a merger of firms engaged in unrelated business
activities

• Mixed Conglomerate merger:

• They can be either in the nature of Product
expansions or market expansions in
remotely related products to the existing
product line of the acquirer.. This type of
merger adds new products to the portfolio
of the acquirer.
•
• Eg : Acquisition of Ponds India Ltd and Lakme Ltd By Hindustan Lever Ltd
added wide range of cosmetics to the product portfolio of HLL. The
acquirer had personal care products in health and hygiene segment and
the acquisitions added new varieties of products into their portfolio.
• Pure Conglomerate merger
• This merger involves the firms having nothing
in common. Merger leads to the complete
diversification of activities to the merging
firms

• Eg: The merger of American Online and Time Warner is a

merger which involved an Internet Service Provider(AOL) and
media major (Time Warner) giving a new dimension to the
merging firms. Here AOL acquired Time Warner and the new
company was called as AOL Time Warner
 Based on functions conglomerate merges can be
classified as follows :
a) Financial conglomerates
•Financial Conglomerates provide a flow of funds to each
segment of the target operations, exercise control and
are the ultimate financial risk takers.
•In theory financial conglomerate undertake strategic
planning but do not participate in operating decisions.

b) Marketing conglomerates:
•The acquirer not only assumes the financial
responsibility but also play role in operating division and
provide staff expertise and service
• c) Managerial conglomerates
• Managerial conglomerates carry the attributes of Financial conglomerates
still further by providing managerial counsel & interaction on decisions.
Managerial Conglomerates increase the potential for improving
performance.

• d) Concentric Companies
• The difference between managerial conglomerate and concentric company
is based on the distinction between the general and specific management
functions. If the activities of merged segments are so related that there is a
carry over of
• specific management functions namely –
• Research and development
• Manufacturing facilities
• Finance / Marketing/ Personnel etc
• as complementarily in relative strengths among these specific management
functions, the merger should be termed as concentric rather than
conglomerate.
 Tender Offers
• In a tender offer generally an acquirer makes
an open offer to the shareholders of the target
firm to seek control in the target
To
Tender offer to purchase the shareholders
Acquirer Shares Of the target
Firm

Sell shares in response

To the offer
• Tender offer is an attempt to takeover
• It provides an opportunity to replace the existing BODs
• These offers will not affect the legal entity of the acquirer or target

Affect on Acquirer Co Affect on Target Co

•The purchased shares are •The shareholding pattern

shown as investments in B/S
•The dividends earned on
these shares are shown as
dividends received in P&L
statement
undergoes a change
•BOD is restructured; directors
representing the acquirer’s
block is nominated
•The acquirer will control the
activities of the target firm
Take Over – taking over the control of
management
• Share purchases or tender offers are generally known as takeover.
Substantial acquisition of shares or voting Rights will enable the acquirer
to nominate the Directors on the Board, and there by controlling decisions
of the target. In theory the acquirer must buy more than 50% of the paid
up equity of the acquired company to enjoy control. In practice however
even 20% to 30% of the equity holding will enable the acquiring company
to exercise control.
• Types of Takeover
• TAKE OVER Friendly takeover
•
•
TAKE OVER Hostile takeover
•
• Bailout takeover
• Friendly Takeover
• Management of a company may face serious financial problems or threats
of hostile takeover then the target can invite a friendly management or an
existing promoter of the company to takeover. Such methods are used
when target is unable to ward off the takeover attempt. A friendly
corporate body or group of companies may come to the rescue by buying
shares of the company in the open market and/or by pumping resources
to help the management.

• Example: Sterlite Industries made a public offer to acquire Indal. In turn

Indal requested its foreign collaborator Alcan (US) to come to the rescue.
Alcan bought 36% of the share capital from Financial Institutions who
were the key holders in this case. Thus Indal warded of the hostile threat.
• Hostile Takeover
• The method of trying to take the control of the company without the
knowledge or consent of the existing management is known as “hostile
takeover”.
• Eg: India Cement’s attempt to takeover Raasi Cements was a hostile
takeover attempt
• Bailout Takeover
• Taking over of the management of loss making companies or weak
companies for nurturing them back in normal activities by an acquirer
having management expertise and resources is known as “Bailout
takeover”. In this case the takeover is inevitable for the target.
• Example: The takeover of Global Trust Bank (GTB) by Oriental bank of
Commerce (OBC) is a bailout takeover. GTB had huge accumulated loss
and at the same time could not adhere to the RBI norms in terms of
Capital adequacy, statutory liquidity requirement etc. Finally OBC acquired
GTB.
• Takeover of Mangalore Chemicals and Fertilisers Ltd by UB Group is
another instance of bailout takeover. MCF was a loss making firm, UB has
a proven track record and also resources to nurture the company.
 Joint ventures
• A JV is an agreement between two or more companies to provide certain
resources (capital, technical know how etc) towards the achievement of
common business goal. A JV can be for a limited duration and may have
separate legal entity apart from the JV partners.
• Eg: ICICI Bank and Prudential Plc UK set up ICICI Prudential Life Insurance
Co Ltd
• JVs are considered as market entry strategy by MNCs
• It pools resources and the best of the skills
• Joint venture is most suitable when resources
are to be shared for limited duration and does
not require complete merger.
•
Joint Ventures and Alliances can deliver more
shareholder value than M&A can, but getting
them off the ground can trip you up in
unpredictable ways”
-- Harvard Business Review
 MUL to Maruthi Suzuki Ltd
• Jv between Indian Government and Suzuki
Motor Corporation Japan
• Co was formed in 1981 but the first car hit the
market in 1983
• Car market size was just 30000 cars a year and
with only 2 players
• Today Maruthi Suzuki alone manufactures
500000 cars a year (50% of cars
manufactured)
• Suzuki had just 26% of equity
• In 2007 MUL was renamed as MAruthi Suzuki
Ltd, and Suzuki owns 54.2% of equity.
• Indian Govt has offloaded all its shares
through IPO to general public and financial
institutions & has no stake in MSL
• Now MSL is considered as a subsidiary of
Suzuki Motor Corporation Japan
 Range of Strategic Alliances
Equity Joint
Level of Interaction High

Ventures

Co-production Buy-back

R&D Consortia

Franchising

Licensing

Cooperation Agreement
Low

Competition Type of Arrangement

Cooperation
 Why make a Joint-Venture reasons for JV
 Globalisation of demand and supply
1. Emergence of major markets globally
2. Uniform demand
3. Shifting production facilities became simpler

 Rapid change in technology

 Pressures on individual COs
1. To protect market share
2. Accelerated product development
3. To be cost competitive and use latest technology

 Other reasons
1. Regulatory changes world wide
2. Access to resources and expertise
3. To explore the new markets
 Motives/rationale behind JV
• Pooling of complementary resources
• Access to raw materials
• Access to new markets
• Diversification of risks
• Economies of scale
• Cost reduction
• Tax shelter
• Equity exchanges
 What are the respective
contributions in the Joint-Ventures
 Financial contributions
 Knowledge of local market and and of local
business practices
 Commercial contacts and networks
 Know-how and technologies
 Qualified and/or cheap workforce
 Raw materials: facilitated access
 Contribution of trademarks
 The end of the Joint-Venture
 The joint-venture has a life cycle
 The joint-venture is transformed into subsidiary
 Merger & Acquisition
 Purchase of the joint-venture by the local partner
 Dissolution of the joint-venture
 Duration limited since the creation of the joint-venture
- R&D joint-venture
- “Project” joint-venture
Why do Joint Ventures Fail?
 Failure Joint-Ventures

Reasons for failures of Joint-Ventures

 Partners do not manage to get on well with

each other,
 Partners’ market are disappearing,
 Managers from each partner company do not
manage to work with one another in the Joint-
Venture,
 Managers of the Joint-Venture do not manage
to work with those of parent companies.
• Other Reasons cited are:
– Wrong Strategies
– Incompatible Partners
– Weak Management
– Unrealistic or inequitable Deals
– Regulatory changes
 Divorce??
• According to a recent survey, only 44% of
CEOs of JVs characterized their venture as
“very successful”*
• The most common causes of failure cited by
CEOs are:
– Cultural differences (49%)
– Poor or unclear leadership (30%)
– Poor integration process (21%)
 Strategic alliances v/s JV
• A strategic alliance is a business to business
collaboration where two or more corporates
share resources, capabilities or distinctive
competencies to achieve some business
purpose
• These alliances are made for joint marketing,
joint sales and distribution, joint production,
design collaboration, technology licensing
and R&D
• Strategic alliance is more flexible arrangement
• A JV is a separate entity or an organization set
up by 2 or more participants
• JVs are relatively rigid
• JVs are set up with a specific market objective
• JVs live longer compared to alliances
• JV is mostly used in cross border relationships.
 CONTRACTION
certain restructuring activities result in reduction in the size of the firm.

• Spin-off
• A Spin-off is setting up a subsidiary through distribution of all equity
shares held by the parent company in the subsidiary to the shareholders
of the parent company, on pro-rata basis.

• The new subsidiary will have separate management and is run

independently from the parent company. A spin-off does not result in any
fresh cash inflow

• Eg: Air India has formed a separate company named Air India Engineering
Services Ltd by spinning –off its engineering division
• Why Spin-off?
– To give operational autonomy to a division which requires special attention
– To tap the potential of the division which is spun-off
 Air India Engineering
Services Ltd
Air India Assume a capital
Assume a capital base of 30
base of 100

The shareholders of Air India will get shares in Air India

Engg Ltd in proportion to their holding in Air India.
Resultantly the shareholders will have the shares of both
the companies.
The spun-off company will have a separate legal entity
and a separate BOD
 Split-off
• A split-off also creates a separate entity for its subsidiary
through distribution of share held by the parent company to
its shareholders but in exchange of the shares held by them in
the parent company. Hence the capital base of the parent
company is reduced reflecting the downsizing of the firm. This
activity does not result in any fresh cash inflow.

A Co A Co AB Co
Capital of 100 A Co is split into 80 20
2 Cos

If the shareholders wishes to obtain the shares in AB Co they will have to

Surrender the shares in A Co and in exchange obtain the shares in AB Co
 Split-ups

• A single company is divided into separate entities and the parent entity
ceases to exist. A fresh class of shares for the new entities is created and
the shareholders can exchange their shares in any of the split companies.
A split-up is also considered as a series of Spin-offs.

A Co AB Co AC Co

A co ceases to exist. A fresh class of shares are issued to the shareholders of

A co in either AB Co or AC Co in exchange of their share holding in A.
The APSEB was Split into APGENCO & APTRANSCO and the APSEB ceases
To exist.
 Divestiture ( sell off )
• The sale of a portion of the firm to an outside party is called
divestiture.
• It results in Fresh cash inflow to the business
• Is carried out when a division is no more suitable with the
main activity carried out.
• Divestiture of intangible assets like an established brand is
also possible for fresh cash inflow.
• . Thus it helps in right sizing of the firm. For the buyer this
results in purchase and expansion of his activity.

• A sell off can be

– opportunistic : to gain the benefits of a very high price offered
Eg: the sale of Thums-up by Parle to Coca cola. The acquisition of Thums
Up brought some of the leading national soft drinks like Thums Up,
Limca, Maaza, Citra and Gold Spot under its umbrella. Price $60
million
 – planned or
– forced
• Eg: Tata Steel Sold its cement division as a part
of its turnaround startegy; as they wanted to
focus only on steel. This sell off resulted in
fresh cash inflow to the Tata Steel.
 Thums up sale
• In 1970s The Coco Cola company was
abandoned from India
• Chouhan brothers (Ramesh & Prakash
Chouhan) bought the stake and launched
Thums up, gold spot and Limca
• In 1990s market was again opened for foreign
investors
• Pepsi was the first to enter the market
• In 1993 Coke reenterd Indian Market buying
Thums up and the bottling units
 Factors driving a divestiture
• Economic
• Psychological
• Operational
• Strategic and
• Governmental or legislative
 Economic
• Low rewards on investment
– Whatever the efforts put in the ROI is not up to the desired levels
• Continual failure to meet the goals
– Either continuous down fall in profits, failure to meet the set
milestones
• Tax considerations:
– The loss making units could be eyed by the heavy tax payers As the
accumulated losses can be set-off against the profits
• Shrinking Margins:
– Pressure on margins due to heavy competition. Sell-off may lead to
reduction in the number of rival firms and contribute to the
improvement in margin
• Profits:
– Lack of profits is the most noted reason behind sell-offs
 Psychological
• To avoid being a loser:
– It is depressing to be a loser as it may lead to
moving away of all the stakeholders. It can act as a
demotivating factor
• Bad apple theory
– As one rotten apple spoils the entire basket of
apples, the inefficiency in one unit may spill over
other units
Hence management always desires to keep
performing units
 Operational
• Lack of inter company synergy
– Product lines should assist in synergy benefits. If management is
unable to consolidate the operations to increase profitability
liquidation or sell-off is an alternative
• Labor considerations
– Such as labor unrest, increasing wage, lack of skilled employees may
force the sell-off of a unit
• Competitive reasons
– When the competition is intense it is better to withdraw before the
drastic affects of competition is experienced
• Management deficiency
– Inability of the management to run a business efficiently may force a
sell-off
• Eliminating inefficiency
– Before marginally earning firms turn into sick units a sell-off can take
place
 Strategic
• Change in corporate goals
– The effort to sell-off a loss making unit is often masked by the statement of
change in corporate goals
• Change in corporate image
– If there is an attempted shift in the image, it may require divestment of certain
divisions which does not add to the effort of being lean.
• Technological reasons
– Many companies undertake divestment programs to technologically upgrade
operations.
• Poor business fit
– As a result of an attempt to focus only on core competency, the firm may find
certain divisions unfit. This might result in a sell-off of such units which no
longer match with their core business activity
• Market saturation
– It is a situation where a cash cow is turning into a dog and is a perfect
candidate for divestiture
• Takeover defense
– If the unit is considered as a crown jewel (major attraction for the acquisition
of a company) the unit can be divested to make the company less attractive
 Governmental or legislative
• If the merger of firms result in anti-trust
problems, in order to avoid litigation some of
the firms could be divested under the
restrictive trade policies
 Advantages of sell-off
• Generation of cash
• Strategic business fit
• Tax benefits to the buyer
• Efficiency gain and refocus
• Change in investment strategy positively
 Equity Carve-out
• Equity carve out also involves the selling of a portion of the
business for cash inflow through fresh issue of shares to the
outsiders. Thus the ownership is transferred to the new class
of shareholders and parent company does not have any say in
the management.

A Co B Co

A Co creates B Co through fresh issue of shares to the public which in turn

Will determine the BOD. B Co will obtain the cash inflow to sustain its operations and
the parent Co is not responsible for it.
 Corporate Control changes
• Restructuring to bring changes in corporate
control refers to obtaining the control over the
management of firm to influence the
organisational strategies. Hence this exercise
mainly focuses on restructuring the Board to
influence the performance of the company.
• This restructuring exercise is mainly carried
out when there is a takeover threat.
 Premium buy backs
• It refers to the repurchase of a substantial
stock holders’ ownership interest at a
premium above the market price. Thus the
control of the promoters will increase in the
share capital.
• The bought back shares are retired.
• Eg: out of 100 shares if 25 shares are bought
back; the promoters holding 25 shares will
represent 33% of the holding after the
buyback against 25% prior to this exercise.
• It is a process of buying back own shares by a company from
the existing shareholders.
• This leads to reduction in the equity capital of the company
• Increases the promoters’ stake in the capital structure of the
company
• This exercise is carried out by the cash rich companies to pay
back the equity shareholder
• It can also be used as a takeover defense
• Share repurchases affects only equity holding on the liability
side and the cash on the asset side
• If the borrowed funds are used to repurchase then equity is
reduced & debt is increased on the liability side and the cash
is reduced on the asset side
 Stand still agreements
• This represent the voluntary contract in which
the stock holder who has bought out the
shares of a firm agrees not to make further
attempts to takeover the company in future.
This would put the buyer of the shares in an
effective control position.
• This is a restructuring exercise to keep the
control intact
 Anti takeover amendments
• Bring changes in corporate bylaws to make an
acquisition of the company more difficult or more
expensive. These include

– Super majority voting provisions requiring a higher

percentage of stockholders to approve of merger
– Staggered terms for directors which can delay change
of control for a number of years
– Golden Parachutes, which will pay heavy compensation
to the BOD for loss of office in an event of acquisition
Thus the corporate control is held with the firm through
the above mentioned restructuring exercises
 Proxy contests
• A proxy contest is an attempt by a single
shareholder or a group of shareholders to take
control or bring about other changes in a
company through the use of proxy mechanism
of corporate voting
• In a proxy fight the bidder may attempt to use
his or her voting right and garner the support
from other shareholders to expel the
incumbent board or management
• Through this exercise the corporate control is
obtained
Changes in ownership structure
 Leveraged Buyout
• A leveraged buyout is a takeover of a company, or of a controlling interest
in a company, using borrowed money, usually amounting to 70% or more
of the total purchase price (with the remainder being equity capital).
• In this scenario, a company is provided with a combination of equity and
debt capital.
– The debt capital is used to build the critical mass the company needs
for a successful exit.
• This can be achieved through acquisitions, product
development, operational improvements, leverage, etc.,
all of which serve to create economies of scale in terms
of overhead, procurement, distribution, marketing,
manufacturing, etc.
– The buyer will typically seek a 25% - 35% return on its equity over a
three to five year horizon.
 Leveraged Buyout
• In a leveraged buildup, this critical mass is achieved solely
through acquisitions.
• In a management buyout, either current management partners
with a private equity provider to perform a buyout on an
existing company.
– Managers must have excellent credibility and are
expected to invest their personal cash in the
success of the business, no matter the amount
(generally no more than 10% of the deal value).
• In a management buy-in, a new management team takes over
the management of an existing company, with similar
financing expectations.
 Leveraged Buyouts (LBO)
• LBOs are a way to take a public company private, or put a
company in the hands of the current management, MBO.

• LBOs are financed with large amounts of borrowing

(leverage), hence its name.

• LBOs use the assets or cash flows of the company to secure

debt financing, bonds or bank loans, to purchase the
outstanding equity of the company.

• After the buyout, control of the company is concentrated in

the hands of the LBO firm and management, and there is no
public stock outstanding.
What are the stages of an LBO operation?

LBO Stages

3rd Stage
1 Stage
st
2 Stage
nd
4th Stage
Strategic &
Resource Going Private Again Going
Operational
mobilisation Public
Changes
• The first stage :Resource mobilisation

• Raising the cash required for Buy out & devising

the management incentive system
• 10% of BO is usually contributed by the firm’s top
managers and buyout specialists
• The incentive for the management is equity
participation. Hence their contribution will be
around 30%
• 60 to 70% of the required money is raised
through debt using the assets of the firm
• At this stage they also identify the venture capital
firms, banks, FIs who can finance the BO
 Second Stage: Going Private
• This stage is also termed as Structuring LBO
• It involves making the firm private.
• It can happen either in the stock purchase format (Cash flow
LBOs) or asset purchase format (Bust up LBOs)
• In case of asset purchase format the buying group forms a
new privately held corporation.
• This is seen in Acquisitions of diversified public companies
where the equity markets may not reflect the full value of the
Company
• The finances of the Bust-up transaction depend upon the
values of the assets of the various individual units the
acquirer can subsequently sell off the units to generate cash
and retire the debt.
• These forms of LBO are rare
• Cash flow LBO is most common most common in
management led transaction that requires repayment of
acquisition financing through operating cash flows.
• Equity investors receive returns through the replacement of
debt capital with equity
• Debt is retired from the operating income of the company
• Selective Bust-up/Cash flow LBO deals (Hybrid)
• It uses both the techniques
• Involves the purchase of a fairly diversified company and the
subsequent divestiture of selected units to retire a portion of
the acquisition debt. The acquirer gets the control of a smaller
group of assets which are best suited for longer term leverage
and have captured a premium on the assets which have been
sold. The remaining assets form the operations of a cash flow
leveraged buyout.
 Third stage: Strategic & operational
Changes
• The management tries to increase the profits
and cash flows by cutting operating costs and
changing marketing strategies. Some of the
suggested changes that can be brought in are:
– Strengthening or restructuring production facilities
– Change product quality
– Change in product mix
– Customer service
– Reconsidering the pricing
– Improving inventory management &
– Accounts receivable management
 Fourth stage
• The investor group may again take the
company public if the goals of the LBO are
achieved.
• This process is called a reverse LBO
• This is termed as SIPO ie. Secondary IPO
• The whole purpose is to provide liquidity to
the existing shareholders.
 Successful LBO Strategies
• Finding cheap assets – buying low and
selling high (value arbitrage or multiple
expansion)

• Unlocking value through restructuring:

– Financial restructuring of balance sheet
– improved combination of debt and
equity
– Operational restructuring – improving
operations to increase cash flows
 Leverage Buyout: Ultimate Goal
• Buy low, sell high!
• An equity investor expects that the Company will grow in
value.
• How does Private Equity Firm create value?
– Cost cutting (outsource )
– Selecting operating executives and boards of directors
– Industry consolidation or acquisition strategies
 Power of Leverage
• Why borrow capital (debt) to fund buyout transaction?
Cash Purchase LBO
Transaction Structure:

Purchase Price Today: $100 million $100 million

Equity $s Invested: $100 million $30 million (30%)

$125 million $125 million

Selling Price (1 year later):

$25 million $25 million

Profit:

Simple Return Calc: $25 (profit) / $100 (invested $25 (profit) / $30 (invested
amount) = 25% amount) = 83%
 Who are LBO Targets
• Firms with large cash flows
• Firms in less risky industries with stable profits
• Firms with unutilized debt capacity
• What are the advantages and
disadvantages of LBO deals?
 1.Value Creation
• Management incentives and agency cost effects
– Increased ownership stake may provide
increased incentives for improved
performance
• Better aligns manager / shareholder interests
• Lower agency costs of free cash flows: debt from
LBO commits cash flows to debt
• Debt puts pressure on managers to improve firm
performance to avoid bankruptcy
 Value Creation
• Wealth transfer
– Wealth transfer from current employees to new
investors – low management turnover (but
sometimes new mgmt. team), slower growth in
number of employees
– Tax benefits in LBO constitute subsidy from
public and loss of revenue to government – LBO
premiums positively related to tax benefit
• Net effect of LBO on government tax revenues may
be positive due to gains to shareholders and
increased profitability
• Many of tax benefits could be realized without LBOs
 Value Creation
• Asymmetric information and under pricing
– Managers, investor groups have better
information on value of firm than shareholders
– Large premium signals that future operating
income will be larger than expectations –
investor group believes new company is worth
more than purchase price
Other efficiency considerations
– More efficient decision process as private firm
– Influence of favorable economic environment
 Problems
• The problem is that we cannot separate the
effect of good insider information from the
other benefits such as the reduction in agency
costs
• Accordingly, research has focused on whether
minority shareholders win or lose
• High level of exposure to business risk and
interest rate risk
 Minority Shareholders
• For offers that are subsequently withdrawn,
prices Spring by 9%
• Clearly, even minority shareholders benefit
from LBOs
• The division of the gains is still an open
question
 Financing an LBO

Senior Debt

Subordinate Debt

Mezzanine Convertible Debt

Financing

Preferred Stock

Common Stock
 Sources of Financing
• Mezzanine:
• Third-party financiers, holding strips and
maybe equity as well.
• Here it is asset based lending.
• The debts will have a maturity ranging
between 1-5 years.
• In large deals there could be different layers of
lending.
• LBO financing is considered as Mezzanine
hence the financier looks for a return between
20 & 30%
• Senior Debt: Usually by banks which are
secured by liens on assets of the company
• Lein is against physical assets such as land,
plant, equipment, stock etc
• Usually 85% of the value is lent
• Subordinate debt or Intermediate term debt
is normally after the senior debt where the
loan amount is determined based on the
auction value of the assets. If the auction
value is greater than the book value the firm
can raise higher loans. The same asset class is
considered to lend
• Convertible debts are the debt instruments attached with an
option of convertibility after the maturity of debt on
predetermined terms.
• The Convertible debt can be used to enhance the proportion
of debt in LBO financing.
• Apart from the above sources a very small % of Equity and
preferred stock is used to finance LBO. The % is normally
below 25%.
 Management Buy outs:
• A MBO is a special type of LBO where the
management decides that it wants to take its
publicly traded company or a division of the
company private.
• Since large sums are necessary for such
transactions the management has to usually
rely on borrowing to accomplish such
objectives
• There should be a premium to be given above
the MPS to convince the shareholders to sell
their shares
 The pros and cons of MBO
• The advantages of MBO
1. The risks are high the potential rewards are also high
2. MBOs are less risky than starting a new company altogether
3. The firms bought out operate at a high level of efficiency as
the shareholding employees takes the decision to benefit
both
• The disadvantages:
1. The MBOs are risky for the buying management as it may
result in loss of personal wealth as well as established jobs
2. The new problems may arise post MBO. For eg: there are
chances of loosing the customers if they consider the
existing firm to be too risky
 Management Buy-ins
• A Management buy-in occurs when a group of
outside managers buys a controlling interest in a
business
• MBI is effective when the existing management
is weak and need to be replaced with the more
efficient managers.
• The main disadvantage of an MBI is the
resistance from the existing employees
• The new management may focus on the short
term gains instead of the long term prosperity of
the business
 Master Limited Partnerships
• MLPs are limited partnerships in which the
units of partnerships are publicly traded
GP runs the business and bears
General partner Unlimited liability

Ltd partner 2
Ltd partner 1

The Units of partnership that is money contributed by these partners can be

Distributed as units which can be actively traded on an exchange
 Features of MLP
• Unlimited life
• Unlimited liability to general partners and
limited liability to limited partners and unit
holders
• Centralized management
• MLPs do not have separate legal entity
• MLPs typically specify the limited liability of
100 years
 Types of MLP
• Roll up MLP:
– It is formed by a combination of two or more partnerships into one
publicly traded partnership
• Liquidation MLP
– It is formed by a complete liquidation of a corporation into MLP

• Roll out MLP:

– It is formed by a corporation’s contribution of operating assets in
exchange for general and limited partnership interests in the MLP
• Start up MLP:
– It is an MLP formed by a partnership that is initially privately held but
later offers its interest to the public in order to finance internal growth
 Advantages of MLP
• Best of Both:
– It has the benefits of both a Corporation and a
partnership firm
• Tax benefits
– It is superior to Corporation as income is
distributed as cash distribution to the unit holders
on a pro-rata basis and this is taxed at individual
tax rates , not at corporate tax rates. Corporate tax
rates are higher than the individual tax rates
• Limited liability
– The unit holders enjoy limited liability
 Disadvantages
• Non-suitability to all type of business :
– Master Limited Partnerships are limited by US
Code to only apply to enterprises that engage in
certain businesses, mostly pertaining to the use of
natural resources, such as petroleum and natural
gas extraction and transportation. Some real
estate enterprises may also qualify as MLPs.
• Unlimited liability
– General partner runs the business and his liability
is unlimited
• Rigidity of management:
– General partner cannot be changed even if he is
ineffective. He can only be removed under the
charges of fraud
 Going private
• Going private refers to the transformation of a
public company into a privately held company.
• The small group of investors buy the entire
equity which are publicly traded in the market
• Going private may involve either MBO ( when
bought by the incumbent management) or
LBO ( when bought by the third parties) or
MBI
• The process of going private can be
deliberately done or it can be one stage of LBO
• When a company goes private a substantial
debt is raised to pay back the shareholders
and thus restructures the debt to equity
proportion
 REVERSE MERGERS
• What happens in a reverse merger? "A private company
merges into a public one,".

• "The private company purchases control of a public one,

merges into it, and when the merger is complete it becomes a
publicly traded company in its own right." Where the public
company has minimal operations, it is called a shell.

• It results in a privately held company becoming a publicly

held company without going the traditional route of filing a
prospectus and undertaking an initial public offering (IPO).
Rather, it is accomplished by the shareholders of the private
company selling all of their shares in the private company to
the public company in exchange for shares of the public
company.
 DEMERGERS
• Demerger is the reverse of a merger or
acquisition. It describes a form of restructure
in which shareholders or unit holders in the
parent company gain direct ownership in a
subsidiary (the ‘demerged entity’). Underlying
ownership of the companies and/or trusts that
formed part of the group does not change.
The company or trust that ceases to own the
entity is known as the ‘demerging entity’.
• Eg: demerger of Reliance Industries Ltd