Leveraged Buyouts andManagement Buyouts Using OPM to Buy a Firm (Other People’s Money)
Leveraged Buyout • 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.
Management • Buyout: • An LBO where management plays a significant role. • Buyin: • An LBO where outside management plays a significant role.
LBO and MBO Sponsors • Leveraged buyout specialist (KKR) • Venture capitalists • Investment bankers
THE 25 LARGEST LBOs, Jan 2000 - Dec 2003Source: Securities Data Corporation
LBO Financing • Secured Debt • Secured debt is also called asset-based lending, and it can be either senior or intermediate term debt. • Senior Debt • Comprises loan secured by liens on particular assets of the company. • The collateral includes physical assets such as land, plant and equipment, accounts receivable, and inventories. • Lenders will usually advance 85% of the value of the accounts receivable and 50% of the value of the target inventories. • The process of determining the collateral value of the LBO candidate's assets is sometimes called qualifying the assets.
Private companies outperform relative to the market.Source: McKinsey Quarterly, 2001, n. 2.
Financial Acquirers (LBOs) negotiate better than Corporate Acquirors (Mergers & Tender Offers).
Intermediate Term Debt • Is usually subordinate, and often backed up by fixed assets such as land and plant and equipment. • The collateral value of theses assets is usually based on their liquidation value. • Debt backed up by equipment typically has a term of six months to one year. • Loans backed up by real estate tend to have a one- to two-year term.
Unsecured Debt Financing • It is usually referred to as subordinated and junior subordinated debt. • The term mezzanine layer financing is often applied to this financing because it has both debt and equity characteristics: it is equity like in that lenders typically receive warrants that may be converted into equity in the target. • When the warrants are exercised, the share of ownership of the previous equity holders is diluted. It is important to be aware of the role of the warrants in computing the return to the providers of mezzanine layer financing.
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? The next two tables are from Kaplan, S. (1989), “Management Buyouts: Evidence on Taxes as a Source of Value”, Journal of Finance, 611-632.
Buyout Benefits Continued • Managerial incentives and other agency issues. • Managers own a larger fraction of the equity. • Separation of ownership and control has been reduced. As a result managers have larger incentives to worry about shareholders value. • Often they also get a larger fraction of their compensation tied to company performance. • Monitoring benefits. • Fewer and larger external shareholders (institutional investors) have an incentive to monitor managerial behavior. • Debt-bonding effect. • The debt payments reduce managerial discretion in the spending of free cash flows. “Debt provides discipline.”
Buyout Benefits Continued • Expropriation of “old” bondholders • LBOs increase riskiness of old debt without increasing their promised interest payments. • A bond with covenants to protect against this are said to have “event risk protection.” • Bonds with event risk protection were common in the early 1990’s. • Response to several large investment grade bond issues that were reduced to high yield status overnight via leveraged buyouts. • Few bonds now carry event risk protection.
Buyout Benefits Continued • Expropriation of employees • Anecdotal evidence: easier layoffs and reduction in over-funded pension plans.
Buyout Benefits Continued • Exploiting undervaluation. • Management has more information about future cash-flows than outside owners. Although selling shareholders are receiving high premiums, managers are possibly paying a too low price. • Evidence: • Median annualized rate of return on equity to post-buyout shareholders in a firm that goes public again was 286% in 1980-1987. • This gain was positively related to managerial ownership. • However, there also exists evidence that stock prices fall back to their pre-buyout levels in failed MBOs.
Buyout Benefits Continued • Reducing costs of being a public company. • These costs include administrative costs inside the company as well as regulatory costs to the stock exchange.
Buyout Costs • Cost of financial distress. • Managers become undiversified and may be less willing to take risks. • Inappropriate investment policy (underinvestment) because of high leverage.
Good LBO Candidates • High potential benefits: • Potentially high agency costs: • Small managerial ownership currently • Large excess cash • High marginal tax rate and stable earnings. • Makes debt financing attractive. • Low current leverage. • No need for new equity financing.
Good LBO Candidates Continued • Low potential costs: • Low investment needs - underinvestment and non risk-taking behavior do not pose a threat. • Parts of the assets can be sold if necessary.