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Leveraged Buyout Structures and Valuation

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Learning Objectives
Primary Learning Objective: To provide students with a knowledge of how to analyze, structure, and value highly leveraged transactions. Secondary Learning Objectives: To provide students with a knowledge of The motivations of and methodologies employed by financial buyers; Advantages and disadvantages of LBOs as a deal structure; Alternative LBO models; The role of junk bonds in financing LBOs; Pre-LBO returns to target company shareholders; Post-buyout returns to LBO shareholders, and Alternative LBO valuation methods Basic decision rules for determining the attractiveness of LBO candidates

Financial Buyers
In a leveraged buyout, all of the stock, or assets, of a public corporation are bought by a small group of investors (financial buyers), usually including members of existing management. Financial buyers: Focus on ROE rather than ROA. Use other peoples money. Succeed through improved operational performance. 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)

LBO Deal Structure


Advantages include the following: Management incentives, 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, 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.

Classic LBO Models: Late 1970s and Early 1980s


Debt normally 4 to 5 times equity. Debt amortized over no more than 10 years. Existing corporate management encouraged to participate. Complex capital structure: As percent of total funds raised Senior debt (60%) Subordinated debt (26%) Preferred stock (9%) Common equity (5%) Firm frequently taken public within seven years as tax benefits diminish

Break-Up LBO Model (Late 1980s)


Same as classic LBO but debt serviced from operating cash flow and asset sales Changes in tax laws reduced popularity of this approach Asset sales immediately upon closing of the transaction no longer deemed tax-free Previously could buy stock in a company and sell the assets. Any gain on asset sales was offset by a mirrored reduction in the value of the stock.

Strategic LBO Model (1990s)


Exit strategy is via IPO D/E ratios lower so as not to depress EPS Financial buyers provide the expertise to grow earnings Previously, their expertise focused on capital structure Deals structured so that debt repayment not required until 10 years after the transaction to reduce pressure on immediate performance improvement Buyout firms often purchase a firm as a platform for leveraged buyouts of other firms in the same industry

Role of Junk Bonds in Financing LBOs


Junk bonds are non-rated debt. Bond quality varies widely Interest rates usually 3-5 percentage points above the prime rate Bridge or interim financing was obtained in LBO transactions to close the transaction quickly because of the extended period of time required to issue junk bonds. These high yielding bonds represented permanent financing for the LBO Junk bond financing for LBOs dried up due to the following: A series of defaults of over-leveraged firms in the late 1980s Insider trading and fraud at such companies a Drexel Burnham, the primary market maker for junk bonds Junk bond financing is highly cyclical, tapering off as the economy goes into recession and fears of increasing default rates escalate

Factors Affecting Pre-Buyout Returns


Premium paid to target firm shareholders consistently exceeds 40% These returns reflect the following (in descending order of importance): Anticipated improvement in efficiency and tax benefits Wealth transfer effects Superior Knowledge More efficient decision-making

Factors Determining Post-Buyout Returns


Empirical studies show investors earn abnormal postbuyout returns Full effect of increased operating efficiency not reflected in the pre-LBO premium. Studies may be subject to selection bias, i.e., only LBOs that are successful are able to undertake secondary public offerings. Abnormal returns may also reflect the acquisition of many LBOs 3 years after taken public.

Valuing LBOs
A LBO can be evaluated from the perspective of common equity investors or of all investors and lenders LBOs make sense from viewpoint of investors and lenders if present value of free cash flows to the firm is greater than or equal to the total investment consisting of debt and common and preferred equity However, a LBO can make sense to common equity investors but not to other investors and lenders. The market value of debt and preferred stock held before the transaction may decline due to a perceived reduction in the firms ability to Repay such debt as the firm assumes substantial amounts of new debt and to Pay interest and dividends on a timely basis.

Valuing LBOs: Variable Risk Method


Adjusts for the varying level of risk as the firms total debt is repaid. Step 1: Project annual cash flows until target D/E achieved Step 2: Project debt-to-equity ratios Step 3: Calculate terminal value Step 4: Adjust discount rate to reflect changing risk Step 5: Determine if deal makes sense

Variable Risk Method: Step 1


Project annual cash flows until target D/E ratio achieved Target D/E is the level of debt relative to equity at which The firm will have to resume payment of taxes and The amount of leverage is likely to be acceptable to IPO investors or strategic buyers (often the prevailing industry average)

Variable Risk Method: Step 2


Project annual debt-to-equity ratios The decline in D/E reflects the known debt repayment schedule and The projected growth in the market value of the shareholders equity (assumed to grow at the same rate as net income)

Variable Risk Method: Step 3


Calculate terminal value of projected cash flow to equity investors (TVE) at time t, i.e., the year in which the initial investors choose to exit the business. TVE represents the PV of the dollar proceeds available to the firm through an IPO or sale to a strategic buyer at time t.

Variable Risk Method: Step 4


Adjust the discount rate to reflect changing risk. The firms cost of equity will decline over time as debt is repaid and equity grows, thereby reducing the leveraged . Estimate the firms as follows: FL1 = IUL1(1 + (D/E)F1(1-tF)) where FL1 IUL1 = Firms levered beta in period 1 = Industrys unlevered beta in period 1 = IL1/(1+(D/E)I1(1- tI)) IL1 = Industrys levered beta in period 1 (D/E)I1 = Industrys debt-to-equity ratio in period 1 tI = Industrys marginal tax rate in period 1 (D/E)F1 = Firms debt-to-equity ratio in period 1 tF = Firms marginal tax rate in period 1

Recalculate each successive periods with the D/E ratio for that period, and using that periods , recalculate the firms cost of equity for that period.

Variable Risk Method: Step 5


Determine if deal makes sense Does the PV of free cash flows to equity investors (including the terminal value) equal or exceed the equity investment including transaction-related fees?

Evaluating the Variable Risk Method


Advantages: Adjusts the discount rate to reflect diminishing risk as the debt-to-total capital ratio declines Takes into account that the deal may make sense for common equity investors but not for lenders or preferred shareholders Disadvantage: Calculations more burdensome than Adjusted Present Value Method

Valuing LBOs: Adjusted Present Value Method (APV)


Separates value of the firm into (a) its value as if it were debt free and (b) the value of tax savings due to interest expense. Step 1: Project annual free cash flows to equity investors and interest tax savings Step 2: Value target without the effects of debt financing and discount projected free cash flows at the firms estimated unlevered cost of equity. Step 3: Estimate the present value of the firms tax savings discounted at the firms estimated unlevered cost of equity. Step 4: Add the present value of the firm without debt and the present value of tax savings to calculate the present value of the firm including tax benefits. Step 5: Determine if the deal makes sense.

APV Method: Step 1


Project annual free cash flows to equity investors and interest tax savings for the period during which the firms capital structure is changing. Interest tax savings = INT x t, where INT and t are the firms annual interest expense on new debt and the marginal tax rate, respectively During the terminal period, the cash flows are expected to grow at a constant rate and the capital structure is expected to remain unchanged

APV Method: Step 2


Value target without the effects of debt financing and discount projected cash flows at the firms unlevered cost of equity. Apply the unlevered cost of equity for the period during which the capital structure is changing. Apply the weighted average cost of capital for the terminal period using the proportions of debt and equity that make up the firms capital structure in the final year of the period during which the structure is changing.

APV Method: Step 3


Estimate the present value of the firms annual interest tax savings. Discount the tax savings at the firms unlevered cost of equity Calculate PV for annual forecast period only, excluding a terminal value, since the firm is sold and any subsequent tax savings accrue to the new owners.

APV Method: Step 4


Calculate the present value of the firm including tax benefits Add the present value of the firm without debt and the PV of tax savings

APV Method: Step 5


Determine if deal makes sense: Does the PV of free cash flows to equity investors plus tax benefits equal or exceed the initial equity investment including transaction-related fees?

Evaluating the Adjusted Present Value Method


Advantage: Simplicity. Disadvantages: Ignores the effect of changes in leverage on the discount rate as debt is repaid, Implicitly ignores the potential for bankruptcy of excessively leveraged firms, and Unclear whether true discount rate should be the cost of debt, unlevered cost of equity, or somewhere between the two.

Things to Remember
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 expense and depreciation 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. For an LBO to make sense, the PV of cash flows to equity holders must equal or exceed the value of the initial equity investment in the transaction, including transaction-related costs.