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Hertz A + B

Hertz A + B


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Published by: Linus Vallman Johansson on Jan 18, 2011
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Many fleet cars were bought with an option to sell them back to the manufacturer.

Such vehicles were called “program cars”, as distinct from “risky cars” which were not covered by a put option. Roughly 85 % of Hertz’ domestic fleet and 74 % of its international fleet were program cars. Program cars will become more expensive in the future due to the fact that Ford and GM adopted new market strategies that deemphasized lower-margin sales of program cars Risk cars exposed the company to residual value risk. Generally less expensive than program cars. What could be the possible motivations for CD&R to buy (syndicated) Hertz? • Under exploiting of the firm’s potential due to mismanagement. Hertz managers were overconfident. The senior guys were absolutely convinced that they were running the most efficient, most productive, well-organized, well-oiled machine in the industry. • The room for increasing the operational efficiency. Value creation through cost savings. • Potential improvement of the capital structure. Lower cost of capital through extensive securitization. • Hertz was undervalued. • Unique strong brand • On airport market leadership • Good historical performance Operational Efficiency Improvements • U.S. RAC on airport operating expenses CD&R estimated that labor per transaction, administrative, and other costs had increased 41 %, 65 % and 30 %. • U.S. RAC off-airport strategy CD&R proposed to slow expansion, focus selectively on profitable growth, and close locations that failed to achieve positive contribution. • European operating SG&A expenses Hertz’ operational SG&A expenses as a percentage of revenue were nearly three times higher than those in the U.S. • U.S. RAC fleet costs Despite its scale advantages, Hertz historically had higher fleet costs than those of key competitors. • U.S. RAC nonfleet capital expenditures Reduce future capital spending to a level more in line with competitors • HERC, Return On Invested Capital (ROIC) HERC managers earned maximum bonuses year after year, despite the low returns on capital. CD&R expected to realize significant savings by changing managers’ incentives to focus on ROIC. Risks with the investment? • Hertz’ business was mature and capital intensive • The industry was highly exposed to cyclical changes in travel activity and to severe disruptions such as the September 11 attack. (Operational Risk) • Well established competition in all its major markets. • New complex financing structure • Hertz would be required to implement many changes in its operations in order to thrive as independent, privately owned company. • Hertz’ managers were afraid that the deal would be followed by layoffs and possibly even a breakup.

Stability CD&R wanted Hertz to be able to survive a severe business downturn without having to restructure. OpCo would own the rest of Hertz’ assets. 2.Value drivers in Hertz case • Higher operating margins due to lower costs (operational improvements) • Lower WACC (extensive use of ABS) Hertz Vehicle Financing and Hertz International would own the domestic and international RAC fleets. Flexibility The structure had to provide flexibility to accommodate the large volumes in car purchases and sales that enable Hertz to manage seasonal. CD&R expected most of the value created by the transaction to come from improvements in Hertz’ existing operations rather than expansion into new markets. The structure was designed to achieve 4 primary goals 1. 4. Liquidity The structure was intended to provide sufficient liquidity to enable Hertz to exploit for future growth and expansion. respectively. again. Securitization • Higher transaction cost (creation of SPE) • Reducing agency problems through increased external monitoring • Raising large amount of debt that is off the consolidated balance sheet (hidden average) • Liquidity enhancement (transforming illiquid assets into liquid securities) Convertible Debt • Higher cost of capital • Lower transaction costs • Reducing agency problems through preventing managers from opportunistic behavior • Limits company’s ability to issue additional debt due to on-balance sheet increase of leverage (potential underinvestment problem) • Doesn’t put any restrictions on fleet management Benefits of ABS • Makes otherwise illiquid assets tradable • Lower costs • Bankruptcy remotes reduces the specific corporate credit risk for investors • ABSs have usually higher credit rating • Reduces asymmetric information costs • ABSs usually over-collaterized → alleviates adverse selection and moral hazard • Lower cost of capital due to increased debt capacity . without refinancing. including HERC and its equipment fleet. 3. cyclical and other fluctuations in rental activity. Lower cost of capital CD&R intended to obtain funds at substantially lower cost than under Hertz’ existing structure.

4 billion ABL revolver sized against pool of assets in OpCo.25 billion senior unexpected notes (9.75% interest). Maturity 5 years.3 billion in equity • Three members of CCM would have identical financial interest in Hertz TOTAL: $9 billion D/E = 6.8 billion D/E ratio = 9/1.8 = 5 WACC calculation: x 4.Proposed Capital Structure FleetCo Debt ($9 billion) • $5. 3-7 years • $2.3 billion) • $2. to fund expansion and cyclical swings.5 billion of equity from Hertz • $200 million 5 year letter of credit • ABS and insurance agreement require FleetCo to hold $100 million in cash • Equity was owned by OpCo TOTAL: $10.7 million) • $1. Equity ($1.91 x 7. 8-10 years Equity ($2.8 billion) • $1.3 = 2. 3-7 years • Seek additional $1.0 billion hybrid ABS/ABL structure internationally.85 billion conventional loan 7 years to institutional investors • $2.3 billion ABS debt in US. • $1.25 = 5.89 % .50% interest) and $800 million senior subordinated notes (10.7/2.7 billion committed but unfunded ABS capacity in US & Europe.74 + OpCo Debt ($6. CD&R expected to draw only $400 million at closing.

data driven analyses of the ABS market and wholesale used car markets would convince the agencies that no matter what happened to ford and GM. How the SPE works • The SPE would buy the rental cars and lease them to the parent. • The same exposure affected OEM receivables held by the rental car companies – amounts on the OEMs owed for program cars they had bought back but not yet paid for in cash. • Although OEM had no obligation with respect to such cars. for primary 3 reasons 1. One week later. • The SPE financed itself by issuing notes – Asset Backed Securities – that were secured by the cars and associated repurchase agreements negotiated with car manufacturers. so did the value of their promise to repurchase program cars in the future. 2.S. credit analysts reasoned that used cars might lose considerable value following the bankruptcy of the company that made them.Hertz B In September 2005. The latter represented a binding promise by the underwriter to deliver the full amount on specified terms and pricing. the notes typically would be guaranteed as to principal and interest by a highly rated insurance company. Deutsche Bank. CD&R believed that Hertz could purchase a guarantee for the notes – an “insurance wrap” – that would bring their rating up to AAA. This credit enhancement boosted the rating of the notes and lowered the interest rate paid by the issuer. However. 3. portion alone was twice as large as the existing market. The issuer in turn paid a fee to compensate for the guarantee. the value of Hertz’ fleet would not fall dramatically. and Lehman Brothers. • Cash received by the SPE was then used to pay interest and principal on the notes. This in turn would further diminish the collateral securing an ABS issue. Benefits of an SPV/SPE • Don’t have to be consolidated on the originator’s balance sheet. a consortium of private equity firms led by CD&R signed a contract with Ford to buy Hertz for $5. Ford. (off balance sheet) • Mitigate adverse selection and moral hazard • Lower discount rate • Reduces firm’s borrowing costs The Hertz deal would be more complicated than usual ABS deals. to tap as large a market for the ABS notes as possible.3 billion.. • The SPE received lease payments from the parent in exchange for the use of the cars and additional payments when the cars were sold at the end of the lease term. S&P downgraded GM from BB to BB-. • Hertz owned more cars built by Ford than any other manufacturer. The simple goal was to obtain a BBB rating. This caused to a meeting between Hertz. Though the structure had been used successfully in the U. CCM. • Whether the notes received an investment-grade rating depended on how much equity the parent contributed and how many cars served as collateral for a given amount of debt. They hoped that sound. The required amount of cash was called the “liquidity level”. CCM would need another $15 billion to close the deal. it had not been done on a large scale outside of U. • Finally. In May Moody’s and S&P downgraded Ford to BB+ and GM to BB. • As OEMs creditworthiness declined. The contemplated ABS issue was very large – at $5. Previous rental car ABS issues had been underwritten on a “best effort” basis rather than as firm commitments fully underwritten.S. the U. Ford and Gm accounted for more than 60 % of Hertz’ fleet In October 2005S&P placed both Ford and GM on negative Credit Watch. The downgrading affected the ABS issuing in several ways. If a BBB target could be met. and Moody’s placed GM on negative Credit Watch.S. MBIA and Ambac would do the “wrapping” – thus selling the papers as AAA which means that they take the . Together.6 billion.

cars) b. Hertz new enhancement level would be almost 30% on a pre-tax basis. Failure in production process c. Instead of upgrading OEMs ratings. as CD&R sought to lock in terms for Hertz’s complex capital structure. which needs to be financed at OpCo. Failure in computer systems. Firm which one has no direct dealings with defaults or. With the new enhancement level this would be much more expensive and would thus reduce corporate EBITDA. But neither side had anticipated how large the problem would become in the end of October. 6. In this case the increase was somewhere around 10%. fluctuations e. The private equity sponsors had simultaneously agreed to put in another $200 million of equity. the measure of operating CF against which OpCo planned to borrow. Risk-Map Market risk a.6 million is probably more than they could receive in an IPO 1. Indirect I. Downturn in economy → demand on secondary market down d. • The old enhancement level of Hertz would have been somewhere around 12%.g. Natural disasters which might lead to unexpected large losses Financial risk 2. fluctuation in currency Funding risk a. Hard to sell notes. Downturn in economy. Why should Ford accept the deal? • They needed the money • $5. liquidity in market Liquidity risk b. Structural inflows is not interest bearing but out-flows is. Changes in asset prices (downgrade in Ford. 8. Interest rate risk. Firm/customer which one has an arrangement with c.risk between BBB and AAA in exchange for 30 basis points. • A 1% increase in enhancement level would lead to $80M more equity needed in FleetCo. e. 3. They also threatened the LBO financing for the OpCo. fleet with its heavy component of Ford and GM would require an enhancement level of more than 25 % with liquidity of 4. GM might not be able to buy back program cars Operational risk a. . supervision and control b. securitizing Hertz’ U. Currency risk. 7. was computed after fleet debt service. house bubble which decreased the purchase power among consumers Legal risk a. MBIA and Ambac had mixed incentives. Direct I. But since the rating agencies change the model used for assessing the enhancement level. which means $800M more equity at FleetCo that needs to be financed. Ford → value of fleet decreases c. 5. However. GM etc for Hertz. • This new enhancement level posed a serious problem for the ABS financing. the problem would get still worse if Ford and GM deteriorated further in the eyes of the rating agencies.5 %. Legal problems in every department b. Bad as it was. 4. a change was made in the rating system which boosted the enhancement levels for all the OEMs. Under the new system. interest rates were rising. Even Lehman Brothers and Deutsche Bank had mixed incentives.S. Corporate EBITDA. Customers can’t make payments b. less consumption of durable goods (cars) → downgrade for GM. If further downgrading. Cash in-flow doesn’t mach cash out-flow Market liquidity risk a. when LIBOR etc goes up → out-flows might exceed in-flows Credit risk a. Ford acknowledged some responsibility for the problems and agreed at signing a contribute $200 million letter of credit to boost FleetCo’s equity base. Finally. Late payments (cash flow mismatch) c.

Synthetic transactions only transfer unwanted risk exposure of a specifically defined asset pool without placing assets under the control of investors through a transfer of legal title. 1.g. Protective Cell Company Same idea as rent-a-captive but every company belongs to separate legal entity. Issuers lower their financing cost (cost of capital) from issuing securities by the performance of segregated credit exposures. Synthetic securitization SPVs may also support synthetic securitizations. 4. term structures or liquidity issues can be met . where issuers create generic debt securities. Rent-a-captive Owners of rent-a-captives are usually reinsurance companies. All companies belong to the same legal entity→give rise to lemon problem→solution Protective Cell Company. Reduce both economic cost of capital and regulatory minimum capital requirements Diversify asset exposures Curtail balance sheet growth Overcome agency costs of asymmetric information in external finance (e. Business risk are those that the firm must bear in order to operate its primary business (core) The following models are a result of dissatisfaction with prices of terms of insurance companies. 2. The issuers also retain much of the earning power of securitized assets. leading to price information/market valuation of a specific loan portfolio. By going straight to the capital market the issuer bypasses commercial banks that could have financed the same assets through secured bank loans. 5. optimization of the overall balance sheet’s risk structure in case of new investments using the newly generated liquidity • Balance sheet management Generation of liquidity. 3. The seller does not only receive cash flows from servicing fees.a. repackage and sale of risk • Other Transforming formerly illiquid assets such as mortgage loans into liquid instruments (ABS bonds). out of derivative structured claims on securitized assets to reduce economic cost of capital and raise cash from borrowing against existing assets and receivables. 9. reduction of risk weighted assets/increase of ratio. underinvestment and assetsubstitution problems) Improve asset-liability management. Financial risk are those that a firm is not in the business of bearing (non core) Business risk a. Securitization allows issuers to raise funds and improve their liquidity position without increasing their onbalance sheet liabilities. and hence ratings. increase in profitability by investing newly generated liquidity in higher yield assets • Arbitrage Purchase. positive rating implication Drivers (investor perspective) • Benefiting from investments in new asset classes • Benefiting from the flexibility of ABS structure in that the investors’ specific needs in terms of risk profiles. Cedant should all not be exposed to the same risk. diversification of funding sources • Portfolio/-Risk Management Transfer/sale of risk (without resource). but also holds an equity claim on any residual revenue of the SPV. so called creditlinked notes (CLN). asset liability management. Drivers (originator/seller perspective) • Fund/-Profit Management Cheaper funding. Traditional securitization The securitized assets are refinanced by various notes/bonds with different risk and maturity profiles. as the issuance of securitized debt funds assets whose future cash flows are matched to the repayment schedule of the debt investors Corporate issuers also greatly benefit from limited information disclosure and the retention of capital control.

• Regulatory Capital Arbitrage • Optimizing the regulatory capital charge facing the originator is another powerful motivation underlying a lot of bank balance sheet CDO activity to date. balance sheet CDOs are usually comprised of loan assets. CDOs allow investors to hold highly specific risks associated with firms. The originator is often a bank. • . • Monetization of Assets • Because the original assets are sold for cash. An Arbitrage CDO. • Funded Credit Protection • The up-front cash flow associated with the securitization of assets in a balance sheet CDO not only has a financing impact on the originator. the corporate financing objectives of the owner of the original assets are not a driving consideration. ABS bonds offered higher coupons/spreads compared to corporate bonds as well as a relatively high rating stability Cash Collateralized Debt Obligations (CDO) A CDO is an ABS structure. What are the reasons for banks to undertake such a strategy? • Customized Credit Risk Transfer • CDOs allow a firm to sell a single portfolio of assets to different groups of investors who may have specific risk appetites for particular loss exposures within the portfolio • From the investor standpoint. • Reducing Adverse Selection Costs • Another benefit of securitization can be reduced adverse selection costs for the originateor leading to a lower WACC. Instead. but it also affects the credit risk of the originator. As such. is undertaken primarily as an investment management tool. The difference concerns the sources of funds to feed the interest and principal waterfalls and the associated coverage triggers Of particular concern to an arbitrage CDO manager is the so-called CDO funding-gap. in which the securitized products issued have principal and interest backed by a pool of debt instruments collateral Cash CDOs are CDOs in which securitization is employed to convey credit sensitive assets to an SPV that in turn issues securities backed by those credit-sensitive assets Synthetic CDOs are structures in which a SPV engages in a synthetic securitization instead of an actual asset acquisition by selling credit protection using credit derivatives CDOs backed entirely with loans as collateral are called collateralized loan obligations (CLOs) whereas bondbacked CDOs are called collateralized bond obligations (CBOs) A Balance sheet CDO is undertaken specifically because the owner of an asset portfolio seeks to divest itself of some or all of those assets. the risk management and corporate financing impacts of the CDO structure cannot be divorced. by contrast. which is the difference between the yield on the asset portfolio and the yield on the CDO liabilities. Arbitrage CDOs can be Cash Flow CDOs or Market Value CDOs. thus enabling them to diversify away firm-specific risks and better diversify across loss layers and trigger points. and structuring agents to combine the tools of asset management with financial engineering to try to offer investors a new and superior investment product. Balance sheet CDOs generally do not have independent collateral managers. In other words. the higher the interest rate can be for the CDOs highly subordinated debt and the higher the expected return on equity. The higher the funding gap.Benefiting from the fact that the performance of ABS bonds is generally independent from the originator’s/seller’s credit risk • Higher yield. arbitrage CDOs represent the efforts of collateral managers.

External Credit Enhancement External credit enhancements in a structure represent credit risk transfer from the SPE to another firm. O/C is a way of increasing the value of equity in the structure Direct Equity Issue An obvious way to create O/C in a structure is for the SPE to issue debt with a smaller notional or par amount than the amount of collateral acquired to back those securities. A CCA serves a cash reserve against losses and provides a credit enhancement to all the securities issued by the SPE. (The first $20 million in losses would be absorbed by the subordinated debt tranche or perhaps the internal credit enhancements in the structure.Internal Credit enhancement Internal credit enhancements are credit enhancements that are provided by a participant inside the structure. That is. The CDS would then provide complete credit insurance to the SPE for losses above $20 million. A structure is overcollateralized when the assets exceed the fixed liabilities or debt. Holdback is the difference between the price actually paid by the SPE to acquire assets from the originator and the true value of those assets. The SPE might issue $80 of debt and $1 of equity and then spend $81 on assets that have a true value of $100. A financial guarantee could accomplish the same thing. it redistributes the total credit risk of the underlying asset pool across investors in securitized products. In the event that the underlying assets have a market value below $80 million. Credit Default Swap The SPE could also enter into a senior/sub basket credit default swap (CDS) with the $100 million in collateral assets serving as the reference portfolio and a $20 million deductible. If the SPE has $100 in assets and issues only $80 in debt. Wraps and Guaranties Suppose the full P&I of the $80 million in senior debt is wrapped. But from where did the $20 come? .) . Apart from subordination. The SPE would simply obtain a $80 million LOC from a bank. the surplus $20 would indeed constitute O/C. but does not change the total amount of credit risk born by investors in the securitized products in aggregate. Holdback Another way to easy create O/C is through holdback. Insurance. Excess Spread The gross excess spread internal to a structure is the difference between interest earned on the collateral assets and interest paid on the debt liabilities of the SPE. the wrapper will assume the responsibility and making up the difference so that senior bondholders are fully repaid. Choosing multiple levels of subordination is an internal credit enhancement. Cash Collateral Account Another easy way to get O/C funded by the originator is for the originator to deposit money in a cash collateral account (CCA). That would of course create a problem for the SPE. Letter of Credit An alternative to credit insurance product is a letter of credit (LOC). where the bank is writing the LOC as it would a financial guarantee. The SPE would simply buy a guaranty of the underlying $100 million in collateral assets with a deductible of $20 million and a policy limit of $100.One possible answer is to issue $20 in equity to an inside or outside investor. the most common form of internal C/E is overcollateralization (O/C. The net excess spread is the gross excess spread minus senior fees and expenses. This would create a $19 O/C as a credit enhancement.

2. 3. the ABCP only issue a single type of securities. . ABCP issues neither trade in an active secondary market nor have long maturities. Asset Backed Commercial Paper (ABCP) There are mainly 3 differences between ABS and ABCP. In a typical ABCP program. 1. The securities in an ABCP program are short-term commercial paper (CP). Unlike ABSs. multi-class structures. the paper is typically held to maturity by end investors for holding periods of often only a few months. ABS conduits usually involve a one-time conveyance of assets to the SPV. Instead. and the SPV then winds down after the receivables are repaid and the securities fully paid off. While ABS issues generally are senior-sub.Put Option on Assets A put enables the SPE to sell the collateral assets to the put counterparty for a fixed price. the put can be exercised and the collateral sold for a fixed cash amount. In the event that the underlying collateral defaults and reduces the market value of the collateral assets. by contrast. and all holders of the CP issued by the SPV have equal seniority in the SPV’s capital structure. the SPV continually purchases new assets or receivables and rolls over outstanding commercial paper issues.

Decreased credit rating What will the credit downgrade have on the bond issuance? • Downgraded to non-investment grade • Increased interest rate → decreased liquidity • Market price of the bond ↓ Why issuing convertible debt? • Control the asset substitution problem • Resolve the overinvestment problem • Mitigate the adverse selection problem • Lower cash yield requirement • Flexible capital • Rating agency equity content • Tax deductibility of coupon payments • Rapid access to market Macroeconomic Risks • Exchange rate • Interest rate • Foreign loans • Joint venture • MUST analysis Synergies • Softbank paid premium for Vodafone • Economies of scope • Diversification • Soft Bank paid too much? • → empire building? .Case Soft Bank What effects will the credit downgrade have on the bond issuance? • Debt claims against focal firm’s assets • Defense against hostile takeover • Effects of the LBO • Increased TFP (Total Factor Productivity) • Increased operating income & net cash flow • Significant increase in operating returns Negative aspects • Decreased tax shield – Trade-off Theory • Financial distress costs • Debt overhang • Already shows signs of first-stage financial distress • Negative net cash flow and earnings • Financial distress costs • Loss of competiveness  Limited access to capital markets • Forced to sell assets • Become financially squeezed • Probability of default ↑ Softbank is planning to issue fixed-rate long term bonds.

• Prop 2 The expected return on a firm’s equity is an increasing function of the firm’s leverage . Miller & Modigliani • Prop 1 The market value of a firm is constant regardless of the amount of leverage that the firm uses to finance its assets.Conclusion • Fixed-rate instrument not recommended • We recommend convertible debt • We think they should commence the acquisition due to synergies and changes in the telecom market The Takeover of Manchester United Advantages with LBO • Maximizes the value of the firm • Tax benefits • Force effective self-monitoring Disadvantages • Costs higher than benefits • Over-leveraged • Underinvestment • Debt overhang Financial structure before LBO • Financial flexibility • Financial Slack • High Cash Load Financial structure after LBO • Increased monitoring • Risk of debt overhang • Problems to raise new financing in the credit market. • Underinvestment problem Financial flexibility best explain the Optimal Capital Structure for a sports club Less debt on balance sheet than traditional is “optimal” → better for a sports club.

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