Leveraged Buyouts Definition/Description
Ø A leveraged buyout (or LBO, or highly
leveraged transaction (HLT) occurs when an investor, typically a financial
sponsor acquires a controlling interest in a company's equity and where a
significant percentage of the purchase price is financed through leverage
(Debt).
Ø The Debt raised (by issuing bonds or
securing a loan) is ultimately secured upon the acquisition target and also
looks to the cash flows of the acquisition target to make interest and
principal payments.
Ø Acquisition debt in an LBO is usually
non-recourse to the financial sponsor and to the equity fund that the financial
sponsor manages.
Ø The amount of debt used to finance a
transaction as a percentage of the purchase price for a leverage buyout target,
varies according to the financial condition and history of the acquisition
target, market conditions, the willingness of lenders to extend credit.
Typically the debt portion of a LBO ranges from 50%-85% of the purchase price,
but in some cases debt may represent upwards of 95% of purchase price.
Ø To finance LBO's, private-equity firms usually
issue some combination of syndicated loans and high yield bonds.
•
Small group of investors borrows money
to buy the stock of a public corporation.
•
LBO transaction is expected to be
reversed with a public offering within three to five years.
Sometimes only a
segment, a division or subdivision of the firm is bought
•
Buyout:
An LBO where management
plays a significant role.
•
Buyin:
An
LBO where outside management plays a significant role.
Leveraged Buyouts History & Market
Evolution
Ø The
first leveraged buyout may have been the purchase of two companies:
Pan-Atlantic and Waterman companies
(steamship companies) in 1955 by McLean Industries.
§ McLean borrowed $42 million and raised an
additional $7 million through an issue of preferred stock.
§ When the deal closed, $20 million of
Waterman cash and assets were used to retire $20 million of the loan debt.
§ The Debt raised (by issuing bonds or
securing a loan) is ultimately secured upon the acquisition target and also
looks to the cash flows of the acquisition target to make interest and
principal payments.
Ø The use of publicly traded holding
companies as investment vehicles to acquire portfolios of investments in
corporate assets was a relatively new trend in the 1960s, popularized by the
likes of Warren Buffett via Berkshire Hathaway and Victor Posner via DWG
Corporation.
Ø The leveraged buyout boom of the 1980s was
conceived by a number of corporate financiers, most notably Jerome Kohlberg,
Jr. and later his protégé Henry Kravis and his cousin George Roberts – both
working for Bear Stearns – to create KKR.
Ø In 1989, KKR closed in on a $31.1 billion
dollar takeover of RJR Nabisco. It was,
at that time and for over 17 years, the largest leverage buyout in history. The
event was chronicled in the book (and later the movie), Barbarians at the
Gate: The Fall of RJR Nabisco.
Ø Drexel Burnham Lambert was the investment
bank most responsible for the boom in private equity during the 1980s due to
its leadership in the issuance of high-yield debt.
Ø Mega Deals of 2005-2007: The combination of decreasing interest rates,
loosening lending standards, creation of CLOs and regulatory changes for
publicly traded companies (specifically the Sarbanes-Oxley Act.) would set the
stage for the largest boom private equity had seen.
Ø Capital
Markets: Types of Financing
Ø Ranks
ahead of all other debt and equity capital in the business
Ø Bank loans are typically structured in up to
three tranches: Revolver, TL A and TL B.
Ø The debt is usually secured on specific assets
of the company, which means the lender can automatically acquire these assets
if the company breaches its obligations under the relevant loan agreement;
therefore it has the lowest cost of debt.
Ø Typical Maturity 5-7 years
Ø Senior Debt represent 45-60% of total Capital
Ø Senior Debt Multiples represent 3.0x – 4.0x
of historic EBITDA
Ø Revolver and TL A (called Pro-rata facilities)
are provided by traditional banks
Ø Term Loan B (called institutional facility) is
provided by non-banking institutions (CLOs, Insurance Co., Funds)
Ø Capital
Markets: Types of Financing
Subordinated Debt (Mezzanine)
Ø Ranks behind senior debt in order of priority
on any liquidation.
Ø The terms of the subordinated debt are
usually less stringent than senior debt.
Ø Repayment is usually required in one ‘bullet’
payment at the end of the term.
Ø Typical maturity is 8-10 years
Ø Since subordinated debt gives the lender less
security than senior debt, lending costs are typically higher.
Ø An increasingly important form of
subordinated debt is the high yield bond, often listed on US markets.
Ø They are fixed rate, publicly traded,
long-term securities with a looser covenant package than senior debt though
they are subject to stringent reporting requirements.
Ø High yield bonds are not prepayable for the
first five years and after that, they are prepayable at a premium (Call
premiums)
Ø SEC requires the Issuer of these bonds to be
rated by two independent agencies (Moody’s and S&P)
Ø Subordinated Debt represent 15-25% of total
Capital
Total Debt
(including both the Senior and Sub debt represent 5.0x – 6.0x of historic
EBITDA.
Private Equity
Ø Ranks at the bottom of the “waterfall” in
order of priority on any liquidation.
Ø Equity represent 20-35% of total Capital
Ø Capital
Markets: Types of Financing
Estimate Debt Capacity
Ø The next step is to estimate the amount of
debt that the company can take on.
Ø The financial statements should make
provisions for interest and debt costs.
Ø The company can only bear debt to the extent
that it has available cash flows. Note that all existing debt will need to be
refinanced. When modelling (Equity or
Debt investors) the financing assumptions
used are according to market conditions, industry characteristic and
company specific issues. Set out below are some parameters that will influence
financing considerations for the model:
§ Minimum interest cover (times)
§ Total debt/EBITDA (times)
§ Senior debt repayment (in years)
§ Mezzanine debt repayment (in years)
§ Senior debt interest rate
§ Subordinated interest rate
§ Mezzanine finance exit IRR
Buyout
Benefits
•
Tax savings
–
Stepped up asset base.
•
Approximately half of the companies
involved in LBOs stepped up their asset base in 1980's (Kaplan, Journal of
Financial Economics, 1989)
–
Tax shields from interest payments.
•
One should realize, however, that these
benefits should be relatively low when all of the costs and benefits are
factored in. Most likely the LBO companies do not have the optimal capital
structure in the first few years after the LBO - why would they otherwise not
keep those high debt levels?
Advantages include the
following:
•
Management incentives,
•
Better alignment between owner and
manager objectives,
•
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 raises 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.
