M&A and Valuation

Dr. Buhui Qiu

Department of Finance
RSM Erasmus University

Module 4
Leveraged Buyouts (LBO)

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Today’s Program

 Overview of Leveraged Buyouts

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Leveraged Buyouts (LBOs)

 LBO: Transactions financed mainly with debt

whereby a public company goes private
(sometimes the target can be private firm or a
division of public firm)
 Management buyout (MBO) – where the buyouts
are led by managers and managers are (part of) the
buyers

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 Value of Worldwide LBOs
1980-2011
$ Millions
The Value of Worldwide LBO, 1980 - 2011

900,000

800,000

700,000

600,000

500,000

400,000

300,000

200,000

100,000

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Source: Thomson Securities Financial Data 4

 Number of Worldwide LBOs
1980-2011
Number of deals
The Volume of Worldwide LBO, 1980 - 2011

2,500

2,000

1,500

1,000

500

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Source: Thomson Financial Securities Data 5

Value of Worldwide LBOs by
Regions 1995-2011

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Deal Size of Worldwide LBOs
2003-2011

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Basic Structure of LBOs

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The private equity cycle
closing of fund
year 0
first capital call

screen evaluate negotiate

2-3 years investment and deals and
additional invest
capital calls funds
candidates due diligence financing

Value creation and monitoring

board service performance evaluation follow-on financing

4-5 years

recruitment management assist with external relationships

Exit investment Distributing proceeds

2-3 years
IPO secondary buyout cash other
trade sale liquidation public shares (IPO)

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Largest Worldwide LBOs in History

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Buyouts in the Netherlands

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Look Back at the 1980s’ Merger Wave
LBOs
 The 1980s’ merger wave was the period that
made LBOs famous
 However, those deals, while considered mega-
deals then, are generally smaller compared to
the mega-deals of the 2000s (except the deal of
RJR Nabisco)

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 Top Ten LBO Deals of the 1980s
Purchase Average Premium
Year Company
Price ($ mil) P/E Offered (%)
1988 RJR Nabisco 24,561 19.5 92.1
1985 Beatrice 5,361 10.7 14.9
1986 Safeway Stores 4,198 18.4 43.8
1987 Borg-Warner 3,798 20.4 30.6
1987 Southland 3,732 13.8 14.1
1986 Owens-Illinois 3,632 19.6 36.0
Hospital Corp. of
1988 3,602 N/A 44.7
America
1988 Fort Howard Paper 3,574 22.6 35.3
1989 NWA, Inc. 3,525 18.5 12.6
1985 R.H. Macy 3,485 18.4 54.4
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 LBO Fundamentals
 Key Participants
 Financial Sponsors
 Traditional private equity firms, merchant banking divisions
of IBs, hedge funds, venture capital funds, and special
purpose acquisition companies
 Investment Banks – plays a key role in LBOs
 As a provider of financing & as a strategic M&A advisor

 Bank and Institutional Lenders

 Capital providers for the bank debt in an LBO financing
structure
 Bond Investors: purchasers of high-yield bonds issued
 High yield mutual funds, hedge funds, pension funds,
insurance companies, distressed debt funds, and CDOs
 Target Management:
 crucial role in the marketing of target;

 often holds a meaningful equity interest in the post-LBO firm14

 Kohlberg Kravis & Roberts (KKR)
 KKR was a leader in the LBO business in the 1980s’ merger
wave
 KKR’s first LBO (1979) taking Houdaille Industries for $355
million
 KKR’s biggest deal: $25 billion LBO of RJR Nabisco ($31
billion with assumed debt)
 2007: KKR has 35 portfolio companies with $95 billion in total
revenues
 However, today KKR is but one of a number of very large
private equity firms that are active in LBOs (the largest PE
firms include The Carlyle Group, KKR, Goldman Sachs
Principal Investment Group, The Blackstone Group, Bain
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Capital and TPG Capital)
Characteristics of LBOs

 LBOs are cash purchases rather than stock

purchases

 The cash is borrowed using the target’s assets and

expected cash flows

 The end result of an LBO is that the target becomes

a private company

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Characteristics of LBOs
• Acquisitions financed primarily with debt
• Debt is secured with assets of the enterprise being acquired
- This is why the financing is called asset-based lending
• Originally many LBOs were in Capital Intensive industries as
opposed to high-tech and service industries
- Capital Intensive industries have assets which can be used as collateral
for debt

• Most LBOs involve a purchase of a division of a firm or sub-

unit rather than the whole firm
Example: Corporation decides that the division does not fit into its plans

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Characteristics of a Strong LBO
Candidate
 Strong cash flow generation
 Leading and defensible market positions
 Growth opportunities
 Efficiency enhancement opportunity
 Low Capex requirement
 Strong asset base
 Proven management team

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Economics of LBO
 Return Analysis – Internal Rate of Return (IRR)
 Primary metric by which sponsors gauge the attractiveness of a
potential LBO; meeting acceptable IRR thresholds is critical
(historically, a 20%+ threshold)
 IRR measures the total return on a sponsor’s equity investment,
including any additional equity contribution made, or dividend
received, during the investment horizon
 r: NPV=0
 Primary IRR drivers: target’s projected financial performance,
purchase price, financing structure, exit multiple and year
 Example: A sponsor contributes $250 mil of equity at the end
of year 0 and receives equity proceeds upon sale of $750 mil at
the end of year 5. What is IRR (assuming no interim div.)? 19
Economics of LBO (cont’d)
 Return Analysis – Cash Return
 Sponsors also examine returns on the basis of a
multiple of their cash investment
 Unlike IRR, the cash return approach does not factor
in the time value of money
 Example: A sponsor contributes $250 mil of equity at
the end of year 0 and receives equity proceeds upon
sale of $750 mil at the end of year 5 (assuming no
additional investments or dividends during the
period)
 The cash return is 3x 20
Primary Exit Strategies

 Most sponsors aim to exit their investments

within a 5-year holding period in order to provide
timely returns to their LPs
 Exit strategies
 Sale
 sale to another company (“strategic sale”)
 sale to another sponsor (2nd LBO)
 IPO (i.e., reverse LBO)
 May extract return prior to exit through a
Dividend Recapitalization
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Reverse LBOs

 Taking a company private then taking it public

later on

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 Successful Reverse LBO Case:
Hertz Rent-A-Car
 Acquired by the Carlyle Group, Clayton Dubilier &
Rise and Merrill Lynch Global Private Equity in 2005
from cash-strapped Ford Motor Co. for $5.6 billion
(PE firms contributed $2.3 billion in equity – each firm
$765 million; deal size $15 billion incl. debt)
 Extracted a $1 billion special dividend
 They took the company public again (29%) after 6
months for $1.32 billion
 Buyout firm still owns 70% of the company
 As of early 2007 Carlyle estimates it earned 54% on
its $765 million investment
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LBO Value Creation

Literature review of Eckbo and Thorburn (2008):

Premiums paid to target shareholders in LBOs average

37%

Announcement (2-day) CARs average 16–17%

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Realized Returns of LBO Funds

Kaplan and Schoar (2005): Study the realized returns net of

costs for 169 LBO funds raised between 1980 and 2001

The median fund underperforms the stock market index,

generating 80% (mean 97%) of the return on the S&P500

However, for the subset of sponsors that have been around

for at least five years, the median performance exceeds the
S&P500 by 50% (mean 80%). Moreover, this performance
is persistent

• Conclusion: LBO sponsors may have different skills in

managing portfolio companies

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 Realized Returns of LBOs of Recent
Wave 1996-2006

LBOs of 1996-2006 Cash Return S&P adjusted return

# of
# of positive positive
Outcome N Mean Median returns Mean Median returns
1. IPO 28 152.0% a 87.4% a 27 127.2% a 72.8% a 26
2. Acquired 15 68.9% b 51.0% b 12 48.8% c 29.2% b 11
3. 2nd LBO 13 102.1% a 76.0% a 12 73.5% a 64.9% a 11
4. Chapter 11 14 -48.8% a -53.5% a 3 -57.9% a -60.7% a 1
5. Still private 20 111.3% 74.3% a 19 57.2% a 28.1% a 18
Total (1-5) 90 90.7% a 65.5% a 73 62.0% a 29.9% a 67
Total(1-4) 70 84.8% a 64.5% a 54 63.4% a 31.1% a 49

Source: Guo, Hotchkiss, and Song (2011)

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 Reverse LBOs Research

Muscarella and Vetsuypens (1990): Analyzed 72 reverse LBOs

Found ownership structure was quite concentrated with
management retaining a larger percentage of the equity
Profitability was improved
 Improvement was due to cost reductions rather than
increases in revenues
 More of the cost reductions came from reduction in
capital expenditures rather then staffing cuts
Leverage, while initially increased after the original LBO,
was decreased after the LBO by management

• Conclusion: Reverse LBO firms were in better shape after the

LBO which is why the market pays more for these firms when
they go public again (potential moral hazard problem here?)
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Reported Success of LBOs and
Irrelevance of Capital Structure
• LBO proponents cite the success of LBOs as
evidence that LBOs generate gains and enhance
efficiency

• Implications: Chicago school view is that capital

structure does not matter in determining the value
of the firm

- However, if LBOs generate gains then capital

structure does matter

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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
• Why capital structure may cause greater efficiencies:
 Management equity typically higher than (10%) greater
incentive to generate gains
 Buyout firms hold 90% equity in Bank America database
 Both have greater incentives to monitor more closely
versus a widely distributed equity base
 More focus on the cash flow no longer need to focus on
EPS for securities market reporting to outside shareholders
Reason: Cash flow is what is needed to service debt as
opposed to earnings per share to pay dividends
- Firms even try to minimize taxable income
which increases after-tax cash flows 29
Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
• Baker and Wruck (JFE 1989): A case study which describes the
organizational changes at O.M. Scott after its LBO in 1986
 The board had five members, of which one was a manager
and three represented the buyout sponsor. All board
members owned stock
 The board met quarterly, and an executive committee
monthly
 One of the private equity partners served as a liaison
between the LBO sponsor and the firm’s managers

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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
• Baker and Wruck (JFE 1989): ct’d.
 The operating partner, which functioned as an advisor and
a consultant, spent several weeks at O.M. Scott after the
buyout closed and was thereafter in telephone contact with
the CEO daily
 The close monitoring by the LBO sponsor, combined
with the restrictions imposed by the high leverage and
significant managerial shareholdings and bonus plans,
led to a substantial improvement in O.M. Scott’s
operating performance and investment efficiencies

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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
• Cornelli and Karakas (2008, WP)
investigate the evolution of board
size and composition surrounding
88 UK private equity backed going
private deals from 1998-2003
• Boards are drastically restructured:
reduction in outside directors and
increase in directors from private
equity house
• Private equity investors prefer to
use their own employees rather than
outside experts
• They are likely to step in and fire
CEOs in case of poor peformance

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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)

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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)

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Better monitoring: less private benefits

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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
• Jensen (1989):
 Active governance by buyout sponsors and high-powered
managerial incentives, combined with the pressure from
high leverage, provides an incentive structure that is
superior to that of public firms with dispersed ownership
and weak governance
 The LBO organizational form may ”eclipse” the traditional
corporate form to become the dominant organizational
form (at least for firms in low-growth industries)
 There will be long-lived LBO companies

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LBO Exits
• Stromberg (2007): Studies exits for 21,000 buyout transactions
in 1970–2007. Of these buyouts 17,000 (80%) were backed by a
financial sponsor. The value of firms acquired in LBOs between
1970 and 2007 as a total of $3.6 trillion, three-quarters of which
represent LBOs undertaken after 2000
 Only 40% of the firms in his sample have exited
 39% of the exits are in the form of a sale to a strategic
buyer. One quarter of the exits are a secondary buyout, i.e.,
a sale to another LBO fund (which has increased in
importance over the last decade)
 IPOs account for 13% of the exits
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Exit Strategies of Worldwide LBOs
2007-2011

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LBO Exits
• Stromberg (2007):
 Despite the significant leverage used in buyouts, only 6% of
exiting firms file for bankruptcy or initiates a financial
restructuring
 The median firm stays in LBO ownership for nine years,
and only 8% of the firms are sold within two years of the
buyout
 Overall, the evidence suggests that leveraged buyouts are
a long-term organizational form for many firms
(potentially supporting Jensen’s (1989) prediction)

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LBO Financing: Structure
 In a traditional LBO, debt has typically comprised
60% - 70% of the financing structure, with the
remainder of the purchase price funded by equity
contribution from a sponsor (or group of
sponsors) and rolled/contributed equity from
management
 General Ranking of Financing Sources in an LBO
capital structure
Debt Financing Equity Financing
Equity
Bank Debt High Yield Bonds Mezzanine Debt Contribution
Higher Ranking <------------------------> Lower Ranking
Lower Flexibility <------------------------> Higher Flexibility
Lower cost of capital <------------------------> Higher cost of capital
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LBO Debt Financing: Key Terms

Summary of Selected Key Terms of Debt Financing

Debt Financing
Bank Debt High Yield Bonds Mezzanine Debt
Secured <--------- Security ------------> Unsecured
Senior <--------- Seniority ------------> Junior
Shorter <--------- Maturity ------------> Longer
Lower <--------- Coupon ------------> Higher
More Prepayability <--------- Call Protection ------------> Negotiated
More Restrictive <--------- Covenants ------------> Less Restrictive

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LBOs of the 1990s versus the 1980s
• Senior Debt: shorter term
Bank of America averages: 3-4 years (1990s) vs. 6-7 years (1980s)
• Debt/Cash Flow Ratios: lower
Bank of America averages: senior debt 2.5 times EBITDA (1990s)
versus 3-4 times EBITDA (1980s)
• More Equity:
Bank of America averages: sponsor controlled equity capital of 35%
of the capital structure in the 1990s versus 20 to 25% in the 1980s
• Buyout Prices Lower
5-6 times EBITDA (1990s) versus 7-10 times EBITDA (1980s)
Conclusion: 1990s deals had:
Reduced debt; Shorter maturities; Greater cash flow requirements;
More equity; Buyout prices lower
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 Comparison of Two Largest LBO’s:
RJR versus HCA
RJR Nabisco HCA Inc.*
Date April 1989 (closed) Nov. 2006 (closed)
Deal Value ($ bill.) $31.3 $33.0
including assumption of debt
Equity invested ($ bill.) $2.0** $5.8
EV/EBITDA $10.9 $7.7
Debt/ EV 94% 84%
Blended average interest rate 13.8% 7.9%
EBITDA/interest 1.1 1.9
Advisory fees to sponsors ($ mill.) $75 $150
* Debt terms and fees are estimates
Source: The Deal ** Included $500M of junior debentures
October 2 – October 8, 2006 43
• Thank you for your attention!

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