LBO = Definition

Buyout: The purchase of a company or a controlling interest of a company's shares. Leverage buyout: The acquisition of a company using debt and equity finance. As the word leverage implies, more debt than equity is used to finance the purchase, e.g. 90% debt to 10% equity. Normally, the assets of the company being acquired are put up as collateral to secure the debt.

Example of LBO in Daily life
Mortgaging a Home. Buying a Car/Taxi, financed by bank.

Special purpose Vehicle
Whose operations are limited to the acquisition and financing of specific assets. The SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt.

Tata tea-Tetley
The first major LBO by an Indian company was acquisition of Tetley by Tata in early 2000.In this case, Tata Tea set up a SPV in the UK in the form of Tata Tea (GB) Limited. This SPV had equity capital of GBP 71 million contributed by Tata Tea Limited. The SPV, in turn mobilized GBP 235 million by way of long-term debt on the security of the assets and cash flows of Tetley and acquired 100 percent of Tetley at the cost of GBP 271 million, taking it private.

Corus-Tata Steel
Acquisition of Corus by Tata steel ltd is also a case of Leveraged buyout. In case of Tetly, Tatas used only one SPV, i.e, Tata Tea (GB) Limited. In case of Corus they used a chain of SPVs-Tata Steel Asia Pt was set up as a wholly owned Singapore based subsidiary of Tata Steel limited and Tata Steel UK Limited was set up as wholly owned subsidiary of TATA steel Asia Pt.

Debt mobilization was also done by both the SPVs. $5.6bn through a LBO ($3.05bn through senior term loan, $2.6bn through high yield loan)

Essential characteristics of an Ideal LBO
Efficient and experienced management team: In order to motivate the lenders as well as investors for providing borrowed or loan capital to a considerable extent and with a view to make the LBO programme successful, a strong management body comprising of experienced as well as professionally highly qualified chief financial services, CEO·s, directors, senior managers, etc. is quite a essential. The management should have long track record in the history and also should have long track record in the industry and also should have desirable experience of handling large projections effectively and efficiently.

Assurance of sufficient and stable cash flow: With a view to service the debt borrowed for the acquisition and in order to ensure the smooth ongoing operations of the firm, the existence of sufficient, strong and secure cash flow is considered indispensable for a successful LBO programme. A LBO candidate having strong and stable cash flow can easily impress the lenders to provide huge amount loan capital required for the purpose of acquisition under the LBO programme and also to produce highest borrowing capacity of the firm.

Lower degree of operating risk: in a LBO programme, the financial risk is very high since it is mostly based on leveraged capital or debt capital. Thus, in order to sustain in the market, the degree of operating risk arising out of normal business activities should be as less as possible. Companies with strong market positions, diversified products portfolio, strong customer base and new innovative power to cope with the changing business world, etc.

Limited amount of debt There should have been limited amount of debt in the firm·s balance sheet compared to the value of the tangible assets of the firm that can be used as collateral securities for raising the loan capital required to finance the LBO programme. The lower the amount of existing debt relative to the collateral value of such assets, the greater will be the borrowing capacity of the firm. On the other side, if the balance sheet of the acquiring company is already over-burdened by debt capital, the acquiring firm may have to face difficulties in financing the acquisition through the option of LBO.

Other factors: Apart from the above mentioned factors, lenders or investors may look for some other important factors depending upon the nature of the business of the LBO candidate. For instance the existence of strong asset base in the balance sheet of the company is one of the most important tangible factors because, such assets are used as collateral for financing the LBO programme. A LBO candidate having strong asset base can easily raise capital to finance the LBO. On the other hand timing is another important factor to make a LBO programme successful. Proper timing is very much important to maximize the probability of making the LBO transaction successful.

Sources of LBO financing
There are a number of types of financing which can be used in an LBO. These include: Senior Debt: This is the debt which ranks ahead of all other debt and equity capital in the business. The debt is usually secured on specific assets of the company, which means the lender can automatically acquired these assets if the company breaches its obligations under the relevant loan agreement, therefore it has the lowest cost of debt. Typically, the terms of senior debt in an LBO will require repayment of the debt in equal annual installments over a period of app. 7 years.

Senior debt is prepayable and has a floating rate of interest. From the lender·s perspective, this is the most secured form of financing. A financial buyer will usually want the LBO to be financed by as much senior debt as possible as it provides the platform for the debt financing, since it is the lowest cost form of financing. -However, the providers of senior debt will be reluctant to accept very high levels of senior debt or may impose conditions which are unacceptable to the equity investor. As a result senior debt will often only from about 50% of the total financing.

Subordinated debt
This debt is less secured as compared to senior debt and repayment is usually required in one bullet payment at the end of the term. A high yield, or "junk", bond is a bond issued by a company that is considered to be a higher credit risk. The credit rating of a high yield bond is considered "speculative" grade . This means that the chance of default with high yield bonds is higher than for other bonds.

Cash-pay bonds ² The high-yield market·s ´plain vanillaµ bonds, they offer investors a fixed coupon rate of interest, paid in cash, until maturity or an earlier stated redemption date. Step-coupon bonds ² Offer one interest (coupon) rate in the early years of the bond·s life, followed by a second, higher interest rate at a specified time (the step-up date) in later years. Most of these bonds are callable at a premium on the stepup date.

Mezzanine Financing
A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full. Since mezzanine financing is usually provided to the borrower very quickly on the part of the lender and little or no collateral on the part of the borrower, this type of financing is aggressively priced with the lender. .

Preference Shares
This forms of a company·s share capital and usually gives preference shareholders a fixed dividend.

Advantages of LBO
With the help of LBO , the acquiring company can expand its business network in the international market based on leveraged capital i.e. without occurring huge amount of outlay from the internal resources of the firm.

Benefit of SPV: Since in the LBO system, a new company is created to procure the debt capital as well as other sources of finance required for the acquisition, the volatility of earnings of that new created company, does not affect the business of the acquiring company.

Tax benefits: The newly created company can enjoy tax benefits in operating the business for a considerable time period of five to six years. Due to the existence of high amount of leveraged or debt capital, in the capital structure of the company, tax benefits can be achieved in respect of payment of interests. Moreover, higher amount of assets setup will provide greater amount of tax savings in the form of depreciation expense.

Discipline on management High payments in the form of interests tends to be a discipline on management, since a company·s cash flow is usually quite tight due to the necessary paydown of interest and debt.

Limitations
High degree of financial risk: The LBO programme is subject to high degree of financial risk since, it is mostly based of borrowed capital. On he other hand, if the degree of operating risk of the LBO candidate is also high, it may be difficult for the firm to service the debt properly which, in turn, may lead to the firm into bankruptcy in near future. In addition to that, the fluctuation in interest rate is another important point to be considered here. The rise in interest rate may create genuine problem for firm that has more variable debt rate.

In case of Less assets: A LBO candidate should have strong asset base that can be used as collateral for financing the acquisition. Moreover, an experienced as well as efficient team of management is also important.

Financing of Merger
Equity Debt

Equity
(a)

Internal Accruals: For most of the domestic acquisition, the primary source of funding is internal accruals. Acquisition is a game that is normally played by the cash-rich companies who are looking at growth opportunities through acquisitions using surplus cash. In october 2002, when Hindalco made an open offer for acquisition of 25.5 percent of the voting capital of Indal, the entire cost of Rs. 218.19 cr was funded purely through internal accruals. Dec 2008, Dabur india ltd acquired Fem Care Pharma ltd at the total cost of over Rs. 250 crore which was funded entirely through internal accruals.

(b)IPO/FPO
IPO (Initial public offering): Funds can be raised by IPO or FPO. But it has some limitations: -Its not suitable for companies whose performance in the market is not good. -Time consuming and expensive process -Market perceives acquisitions as risky investments and would not have much appetite for such issues.

(c) Right Issue
Right Issue is an effective post-acquisition route to mobilize funds for repayment of loans taken from the banks and financial institutions for acquisition. In oct 2008, Tata Motors came out with a right issue of Rs 4145 cr for prepayment of part of the short-term loan availed by jaguar Land Rover Ltd., a subsidiary of Tata Motors, to partially fund the purchase consideration for the the acquisition of Jaguar Land Rover from Ford.

(d) Private Placements/PE funds
The sale of securities to a relatively small number of select investors as a way of raising capital. Investors involved in private placements are usually large banks, mutual funds, insurance companies and pension funds. Private placement is the opposite of a public issue, in which securities are made available for sale on the open market.

(e) ADRs/GDRs
Use of funds mobilized through American Depository receipts and Global Depository Receipts is not permitted for acquiring a company or a part thereof in India except that the ADRs/GDRs proceeds can be utilized for the acquisition of shares in the disinvestment process of public sector undertakings.

Borrowed funds
(a) Banks and FIs When in May-june 2007, Kingfisher acquired Deccan Airways, the transaction consisted of Air Deccan first making a preferential allotment of 26%. The funding of the Preferential allotment was done through two medium-term loans-400 cr term loan of 3 year tenure from IDFC and Rs 100 cr term loan of 3 year tenure from HDFC.

A management buyout (MBO) is a form of acquisition where a company's existing managers acquire a large part or all of the company. Management buyouts are similar in all major legal aspects to any other acquisition of a company. The particular nature of the MBO lies in the position of the buyers as managers of the company, and the practical consequences that follow from that. In particular, the due diligence process is likely to be limited as the buyers already have full knowledge of the company available to them.

The Purpose of an MBO
The purpose of such a buyout from the managers' point of view may be to save their jobs, either if the business has been scheduled for closure or if an outside purchaser would bring in its own management team. They may also want to maximize the financial benefits they receive from the success they bring to the company by taking the profits for themselves. This is often a way to ward off aggressive buyers.

Financing a Management Buyout
Debt Financing The management of a company will not usually have the money available to buy the company outright themselves. They would first seek to borrow from a bank, provided the bank was willing to accept the risk. Management buyouts are frequently seen as too risky for a bank to finance the purchase through a loan.

Private Equity Financing
If a bank is unwilling to lend, the management will commonly look to private equity investors to fund the majority of buyout. A high proportion of management buyouts are financed in this way. The private equity investors will invest money in return for a proportion of the shares in the company, though they may also grant a loan to the management.

Seller Financing
In certain circumstances it may be possible for the management and the original owner of the company to agree a deal whereby the seller finances the buyout. The price paid at the time of sale will be nominal, with the real price being paid over the following years out of the profits of the company. The timescale for the payment is typically 3²7 years. This represents a disadvantage for the selling party, which must wait to receive its money after it has lost control of the company. It is also dependent on the returned profits being increased significantly following the acquisition, in order for the deal to represent a gain to the seller in comparison to the situation presale. This will usually only happen in very particular circumstances. The vendor may nevertheless agree to vendor financing for tax reasons, as the consideration will be classified as capital gain rather than as income. It may also receive some other benefit such as a higher overall purchase price than would be obtained by a normal purchase. The advantage for the management is that they do not need to become involved with private equity or a bank and will be left in control of the company once the consideration has been paid.

Examples of MBOs
A classic example of an MBO involved Springfield Remanufacturing Corporation, a former plant in Springfield, Missouri owned by Navistar (at that time, International Harvester) which was in danger of being closed or sold to outside parties until its managers purchased the company. In the UK, New Look was the subject of a management buyout in 2004 by Tom Singh, the founder of the company who had floated it in 1998. An earlier example of this in the UK was the management buyout of Virgin Interactive from Viacom which was led by Mark Dyne The Virgin Group has undergone several management buyouts in recent years. On September 17, 2007, announced that the UK arm of Virgin Megastores was to be sold off as part of a management buyout, and from November 2007, will be known by a new name, Zavvi. On September 24, 2008, another part of the Virgin group, Virgin Comics underwent a management buyout and changed its name to Liquid Comics. In the UK and Ireland, Virgin Radio also underwent a similar process and became Absolute Radio

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