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Structuring

LBO Financing
Prof. Ian Giddy
New York University

Leveraged Buy-Outs
LBO is a transaction in which an investor group acquires
a company by taking on an extraordinary amount of
debt, with plans to repay the debt with funds generated
from the company or with revenue earned by selling off
the newly acquired company's assets
Leveraged buy-out seeks to force realization of the
firm potential value by taking control (also done by
proxy fights)
Leveraging-up the purchase of the company is a
"temporary" structure pending realization of the value
Leveraging method of financing the purchase permits
"democracy" in purchase of ownership and control--you
don't have to be a billionaire to do it; management can
buy their company.
Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 2

Leveraged Financing
Leveraged Finance is the provision of
bank loans and the issue of high yield
bonds to fund acquisitions of companies
or parts of companies by
an existing internal management team
(a management buy-out),
an external management team (a
management buy-in), or
a third party (a leveraged acquisition).
Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 3

M&A and Leverage

Company
has
unused
debt
capacity

Copyright 2002 Ian H. Giddy

Takeover?

Leveraged
buyout?

Leveraged
recapitalization?

Corporate Financial Restructuring 4

Corporate Restructuring
Divestiturea reverse acquisitionis
evidence that "bigger is not necessarily
better"
Going privatethe reverse of an IPO
(initial public offering)contradicts the
view that publicly held corporations are
the most efficient vehicles to organize
investment.

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 5

Going Private
A public corporation is transformed into a privately
held firm
The entire equity in the corporation is purchased by
management, or managment plus a small group of
investors
These account for about 20% of public takeover
activity in recent years in the United States.
Can be done in several ways :

"Squeeze-out"controlling shareholders of the firm buy up


the stockholding of the minority public shareholders
Management Buy-Outmanagement buys out a division or
subsidiary, or even the entire company, from the public
shareholders
Leveraged Buy-Out (LBO)

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 6

LBOs, Agency Costs


and Free Cash Flow
"Free cash flow" is cash-cow type
earnings in excess of amounts required
to fund all positive-NPV projects
Payout of free cash flow, to stockholders,
reduces the amount of resources under
managment's discretion. Forces
management to go out into the markets
and justify raising funds
Thus debt has a disciplining role. Safe
managers choose less debt.
Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 7

Seagate
1.

2.
3.

Show, with a diagram, the


restructuring that resulted in the
Seagate LBO
How would the buyers create value?
How would they realize that value?

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 8

Seagate

1998
SEAGATE

40% for $1.8b

VERITAS

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 9

Seagate

2000

Seagate
shareholders
100% worth $16b

SEAGATE

Distribution
taxable at
39.2%?

40% worth $22b

VERITAS

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 10

Seagate

Nov 2000

Seagate
shareholders

$2b cash

NEWCO
Cost $1.65b
after tax

Management,
Chase,
Goldman

Copyright 2002 Ian H. Giddy

109m Veritas
shares
(worth $18.7b)

SEAGATE

Disk drive
business

128m Veritas
shares
(worth $22b)

VERITAS

Silver Lake
Partners

Corporate Financial Restructuring 11

Seagate
NEWCO

Disk
drive
business

Copyright 2002 Ian H. Giddy

Debt $1b

Equity $1b

Management,
Chase,
Goldman

Corporate Financial Restructuring 12

Typical LBO Sequence

IPO or sale of
company

Company gets bloated


or slack and stock
price falls
LBO offer made
LBO completed

Restructuring

Efficiencies

Divestitures

Financial
? years
Copyright 2002 Ian H. Giddy

3-9 months

5-7 years
Corporate Financial Restructuring 13

Can the Financing Work?


LBO Leverage Analysis
10
8
6
4
2
0
1

Debt ($m)

Debt ($m)
Equity ($m)
EBITDA
Interest
Coverage Ratio
Copyright 2002 Ian H. Giddy

Equity ($m)

1
5.5
1

2
5
1.09

3
4.5
1.273

1080000
550000
1.96

1401000
500000
2.80

1761150
450000
3.91

Coverage Ratio
4
5
4
3.5
1.55845 1.957218
2166323
400000
5.42

2623271
350000
7.50

6
3
2.4818
2835434
300000
9.45

Corporate Financial Restructuring 14

Can the Financing Work?


Free Cash Flow Analysis of LBO
600000
400000
200000
0
-200000

-400000
-600000
-800000
FCFF

FCFF
- Interest*(1-T)
- Principal repayment
= FCFE
Copyright 2002 Ian H. Giddy

Interest*(1-T)
1
220000
330000
500000
-610000

Principal repayment

2
253000
300000
500000
-547000

FCFE

3
4
5
6
290950 334592.5 384781.4 404020.4
270000
240000
210000
180000
500000
500000
500000
0
-479050 -405408 -325219 224020.4

Corporate Financial Restructuring 15

LBO Financing
NEWCO

Disk
drive
business

Senior
debt $1b
Mezzanine

What securities?
What returns?
What investors?

Equity $0.25b

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 16

The Financing Spectrum

Expected Return

Equity
Equity
Preferred
Preferred equity
equity
Convertible
Convertible debt
debt
Subordinated
Subordinated debt
debt
Senior
Senior unsecured
unsecured debt
debt
Senior
Senior secured
secured debt
debt
Risk
Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 17

What Are The Alternatives?


Asset-backed or cash flow-backed debt
Senior debt
Subordinated debt
Subordinated debt with upside
participation
Subordinated debt with equity option
Preferred equity
Restricted shares
Common stock

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 18

Subordinated High Yield Debt

Junk bonds like equity, but allow increased


financial leverage
Tax advantage over equity
Big market in USA (institutional investors) and
increasing in Europe
Leveraged loans favored by certain
commercial banks
Often used in connection with M&A and LBOs
Behave like equity and often have equity
participation

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 19

Sub Debt -- Motivations


Optimization of financial leverage
Regulatory-driven capital requirements
Rated asset securitizations (senior-sub
structure in asset-backed securities)
Insider or supplier-credit subordination
(eg in project finance)
Work-outs and restructurings (existing
borrowers agree to seniority of new
loans, to buy time)

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 20

Sub Debts Big Problem: High Interest!


Solutions
Deep discount subordinated debt
Subordinated debt with equity warrants
Convertible subordinated debt
Participating subordinated debt
Puttable subordinated debt

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 21

Convertibles
V
a
l
u
e
o
f
C
o
n
v
e
r
t
i
b
l
e

Conversion
Value
Market
Value
Market Premium

Straight
Bond Value

B
o
n
d
($) 0
Price Per Share of Common Stock
Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 22

Warrants
V
a
l
u
e
o
f
W
a
r
r
a
n
t

Market
Value
Market Premium

Theoretical
Value

($)
0

Copyright 2002 Ian H. Giddy

Price Per Share of Common Stock ($)

Corporate Financial Restructuring 23

Preferred Equity
Legally a form of equity
Claim senior to ordinary equity
May have fixed dividend, or may be
participating
But cannot trigger liquidation if payment
missed
Par value determines liquidation claim

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 24

Convertible Preferred
Used by venture capital firms
Permit investors to participate in growth
But give preference in liquidation if the
venture fails
And disguise share value (tax!)
A variant PERCS* give issuer right to
convert into common stock

*Preferred equity redemption cumulative stock


Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 25

Preferred Stock: Pros and Cons


Advantages
No dilution of control
Dividends
conditional on
availability of
earnings
Omission cannot
force liquidation

Copyright 2002 Ian H. Giddy

Disadvantages
Higher after-tax cost
than debt
Lower return on
equity
Limited investor
interest

Corporate Financial Restructuring 26

Motivations for Issuing Hybrid Bonds


Company has a view
There are constraints on what the
company can issue
The company can arbitrage to save
money
Always ask: given my goal, is there an
alternative way of achieving the same
effect (e.g., using derivatives?)

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 27

Why Use a Hybrid?


Motivations for Hybrids
Linked to
business risk
Linked to
market risk
Cannot hedge
with derivatives

Copyright 2002 Ian H. Giddy

Driven by investor
needs
Company
hedges

Company
does not
hedge
Debt or
equity are
Not good enough
Corporate Financial Restructuring 28

Case Study: Le Meridien

What kind of financing package would enable Royal


Bank to beat other commercial and investment banks
in the Meridien deal? Who are potential rivals, and
what strengths might give them a competitive edge?
If RBS offers sale-and-leaseback financing, what
should be the structure and terms of the deal, terms
that make sense for the client as well as for the bank?
If RBS offers equity participation, what form should
this take? Common stock or mezzanine finance? Or
should the bank avoid the risks of an equity
investment?
Would asset-backed securities be suitable as a
financing source for this acquisition?

Copyright 2002 Ian H. Giddy

Corporate Financial Restructuring 29

Case Study
The John Case LBO Proposal
Devise a recommended financing plan

John Case (owner)

Buyers

Copyright 2002 Ian H. Giddy

VC Investors

Corporate Financial Restructuring 30

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