LBO Guide: Leveraged Buyouts Explained

Leveraged Buyouts
Merger and Acquisition Modelling
Feb 8, 2015
Leveraged Buyout Discussion

A group takes over control sometimes with hostile takeovers.
Use high level of leverage and multiple debt layers to take control
Once in control
Improve Operations
Divest Unrelated Businesses
Re-sell the New Company for a Profit
Feb 8, 2015
Leveraged Buyout
Leverage ranges from 6:1 to 12:1
Investors seek returns of 25 to 40 percent
Average life of 6.7 years, after which investors take the firm public
Characteristics
Strong and stable cash flows
Low level of capital expenditures
Strong market position
Low rate of technological change
Relatively low market valuation
Feb 8, 2015
LBO Statistics
3% to 6% of M&A activity in number of transactions
Peak in 1980s
Significant increases in efficiency
Late 1980s, 27 percent of LBOs defaulted
Opportunities to transfer wealth between groups
Feb 8, 2015
LBO Example
MediMedia
Revolver and senior debt

Amount $32 million
Term 7 years
Rate LIBOR + 2.25%
Mezzanine Debt
Amount $15 million
Term 8 years
Rate LIBOR + 3.25%
Vendor Note
Amount $11 Million
Equity
Amount $11 Million
Feb 8, 2015
LBO Example - Revco

Sources
Bank Term Loans
455,000
Senior Subordinated
400,000
Subordinated
210,000
Junior Subordinated
91,145
Common Stock
93,750
Exchangable Preferred
130,200
Convertible Preferred
85,000
Junior Preferred
30,098
Investor Common
34,276
Cash of Revco
10,655
Total Sources
1,448,799
Purchase of Common Stock
1,253,315
Repayment of Debt
117,484
Fees and Expenses
78,000
Uses
Total Uses
1,448,799
Feb 8, 2015
The Deal Decade, 1981-1989 (the fourth movement)

Motivating forces
Surge in the economy and stock market beginning in mid-1982
Impact of international competition on mature industries such as steel and

auto
Unwinding diversified firms
New industries as a result of new technologies and managerial innovations

Decade of big deals
Ten largest transactions

Exceeded $6 billion each
Summed to $126.1 billion
Top 10 deals reflected changes in the industry

Five involved oil companies increased price instability resulting from OPEC
actions
Two involved drug mergers increased pressure to reduce drug prices
Two involved tobacco companies diversified into food industry
Feb 8, 2015
1980s LBO Wave
Prior to 1980 managers were

loyal to the firm, not shareholders
Little managerial share

ownership, stock
compensation
Little external threat of

takeover
Characteristics
Highly levered deals: cash

payment funded by
borrowing
Hostile
Industry clusters
Non Investment Grade Bond Volume

As a % of Average Total Stock Market Capitalization
1977 - 1999
Going Private Volume

As Percent of Average Total Stock Market Value
1979 - 1999
Feb 8, 2015
The Deal Decade, 1981-1989 (Continued)

Financial innovations
High yield bonds provided financing for aggressive acquisitions by

raiders
Financial buyers
Arranged going private transactions
Bought segments of diversified firms
"Bustup acquisitions"
Buyers would seek firms whose parts as separate entities were worth
more than the whole
After acquisitions, segments would be divested
Proceeds of sales were used to reduce the debt incurred to finance the
transaction
Rise of wide range of defensive measures as a result of increased hostile

takeovers
Feb 8, 2015
LBO Greed or Efficiency Gains
LBOs shifted corporate governance
Managers had high equity stakes
Debt disciplined manager decision making
Close monitoring from LBO investors, stong

boards
First half of 1980s
Improved operating profits
Few defaults
Contested Tender Offers as % of Total

1974 - 1999
Last half of 1980s
1/3 defaulted
But, operating profits improved from pre-LBO

levels, just not enough
Prices paid in LBO deals were too high
By the end of the 1980s corporate raiders

and LBOs were despised
Securities fraud
Junk bond market collapsed
Feb 8, 2015
10
Lasting Results from 1980s Takeovers
Managers are more shareholder focused
More shares are owned by institutional investors (1980 <30 % to 2000

>50%)
Hostile takeovers not as necessary
More monitoring and activism from shareholders
Management stock ownership and stock compensation has increased
More interested in creating stockholder value
CEO option grants increased x7 from 1980 1994
Equity compensation = 50% in 1994, <20% in 1980
Boards are more active
Feb 8, 2015
11
Value Created by LBOs
Feb 8, 2015
12
Productivity Study of LBOs
Feb 8, 2015
13
LBO Modelling Issues

Perspective of Alternative Parties
Cash Flow Waterfall
Sources and Uses of Funds
Pro-Forma Analysis
IRR on Alternative Financial Instruments
Feb 8, 2015
14
Cash Flow Waterfall
Waterfall Issues
Defaults and subsequent repayments of defaults before
dividend distributions
Model different priorities of debt
Model cash flow trap mechanisms
Evaluate Pre-payments from covenant violations
Compute Debt service reserve injections and withdrawls
Accumulation of debt service reserve after construction
period
Feb 8, 2015
15
Modelling Defaults on Debt
Modelling defaults on debt is important in credit analysis. Through

modelling defaults, the probability of default and the loss given
default can be evaluated through break-even analysis and through
Monte Carlo simulation.
The following process shows how to model defaults:

Set up the debt balance to incorporate defaults and repayment of defaults
The default comes from an if statement in the cash flow
statement
The re-payment of default is the previous year default
amount. This means the model attempts to fully repay the
default in the year immediately following the default. If there
is no cash flow to repay the default, the default increases by
the amount of the default.
Feb 8, 2015
16
Modelling Defaults on Debt - Procedure
The following illustrates the modelling process for defaults.

Note how the default comes from the cash flow statement
The if statement in the cash flow statement
The repayment of default from the prior default
Feb 8, 2015
17
Maximum Default
When modelling the defaults on debt, it is possible that the cash
flow is less than the total debt service.
In this case, the default is only the debt service that was not
covered, not the negative of the cash flow.
Therefore, the default formula should be:
If(cash<0,min(-cash,debt service),0)
Notes:
Cash is cash flow to tranche
Debt service includes the repayment of defaults
Feb 8, 2015
18
Analysis with Defaults
Once defaults are modeled, one can evaluate the IRR earned
on debt instruments and the amount of debt outstanding.
The amount of debt outstanding is the loss given default.
The IRR allows you to compute a probability distribution
for the loan facility
Feb 8, 2015
19
Computing Cash Flow for the Waterfall

To model priorities in a cash flow waterfall the first step is setting up a the cash flow
statement in a model that reflects the actual ordering of cash flow:
Begin with the cash flow after capital expenditures and after all new financing
and acquisitions
Add back interest expense that was deducted because the interest will be
accounted for on an issue by issue basis
Add the beginning balance of cash. Even though it seems odd to add the
cash balances, these cash balances are available to pay off debt.
The sum of these items gives the cash flow for the waterfall as illustrated
below.
Cash Flow After Capital Expenditures
Add: New Debt Issues
Add: New Equity Issues
Cash Flow before waterfall adjustments
Add: Total Interest Expense
Add: Beginning Cash Balance
Cash Flow for Waterfall
Feb 8, 2015
20
Cash Flow Priorities
Once the cash flow for the waterfall is computed, you can compute the defaults on senior and
junior debt.
Subtract scheduled interest payments and maturities from the cash flow for waterfall
Also subtract attempts to re-pay earlier defaults
The difference is cash flow after senior debt that determines default defaults are the driven by an
if statement driven by whether there is negative cash flow.
Any defaults are added to cash flow to determine the cash flow to junior debt
This step of the waterfall is illustrated below:

Cash Flow for Waterfall
Less: Scheduled Repayment
Less: Interest on Senior
Less: Repayment of earlier defaults
Cash Flow after Senior Debt
Add: Default on Senior Debt
Cash Flow to Junior Debt
Less: Scheduled Repayment
Less: Interest on Junior
Less: Repayment of earlier default
Feb 8, 2015
21
Cash Flow Traps and Dividends

After junior debt is evaluated, traps on cash and distributions can be
evaluated.
You must subtract the cash balance that was added at the beginning of the
waterfall
Cash Traps can be evaluated at this point that prevent excess cash going
dividends before debt is paid
This step of the waterfall is illustrated below:

Cash Flow after Junior Debt
Add: Default on Junior Debt
Less: Cash Balance Added Above
Net Cash Flow
Switch for Trapping Cash
Less: Cash Trapped
Add: Cash Withdrawn from Account
Dividend Distributions
Feb 8, 2015
22

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Leveraged Buyouts

Merger and Acquisition Modelling

Leveraged Buyout Discussion

Divest Unrelated Businesses

Re-sell the New Company for a Profit

Merger and Acquisition Modelling

Strong and stable cash flows

Low level of capital expenditures

Strong market position

Low rate of technological change

Relatively low market valuation

Merger and Acquisition Modelling

Merger and Acquisition Modelling

Revolver and senior debt

Merger and Acquisition Modelling

LBO Example - Revco

Bank Term Loans

Purchase of Common Stock

Fees and Expenses

Merger and Acquisition Modelling

The Deal Decade, 1981-1989 (the fourth movement)

Surge in the economy and stock market beginning in mid-1982

Impact of international competition on mature industries such as steel and

Unwinding diversified firms

New industries as a result of new technologies and managerial innovations

Ten largest transactions

Top 10 deals reflected changes in the industry

Merger and Acquisition Modelling

1980s LBO Wave

Prior to 1980 managers were

Little managerial share

Little external threat of

Highly levered deals: cash

Merger and Acquisition Modelling

Non Investment Grade Bond Volume

Going Private Volume

The Deal Decade, 1981-1989 (Continued)

High yield bonds provided financing for aggressive acquisitions by

Rise of wide range of defensive measures as a result of increased hostile

Merger and Acquisition Modelling

LBO Greed or Efficiency Gains

LBOs shifted corporate governance

Managers had high equity stakes

Debt disciplined manager decision making

Close monitoring from LBO investors, stong

First half of 1980s

Improved operating profits

Contested Tender Offers as % of Total

Last half of 1980s

But, operating profits improved from pre-LBO

Prices paid in LBO deals were too high

By the end of the 1980s corporate raiders

Junk bond market collapsed

Merger and Acquisition Modelling

Lasting Results from 1980s Takeovers

Managers are more shareholder focused

More shares are owned by institutional investors (1980 <30 % to 2000

Hostile takeovers not as necessary

More monitoring and activism from shareholders

Management stock ownership and stock compensation has increased

More interested in creating stockholder value

CEO option grants increased x7 from 1980 1994

Equity compensation = 50% in 1994, <20% in 1980