MERGER and ACQUISITION

MF0011

Q.1 Define LBO. What are the different modes of LBO?

A leveraged buyout (LBO) is an acquisition (usually of a company but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt. As the debt usually has a lower cost of capital than the equity, the returns on the equity increase with increasing debt. The debt thus effectively serves as a lever to increase returns which explain the origin of the term LBO. LBOs are a very common occurrence in today's M&A environment. The term LBO is usually employed when a financial sponsoracquires a company. However, many corporate transactions are part-funded by bank debt, thus effectively also representing an LBO. LBOs can have many different forms such as Management Buy-out (MBO), Management Buy-in (MBI), secondary buyout and tertiary buyout among others and can occur in growth situations, restructuring situations and insolvencies just like in companies with stable performance. LBOs mostly occur in private companies, but can also be employed with public companies (in a so called PtP transaction, Public to Private). As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition. This has in many cases led to situations, in which companies were "overlevered", meaning that they did not generate sufficient cash flows to service their debt, which in turn led to insolvency or to debt-to-equity swaps in which the equity owners lose control over the business and the debt providers assume the equity. LBOs have become attractive as they usually represent a win-win situation for the financial sponsor and the banks: The financial sponsor can increase the returns on his equity by employing the leverage; banks can make substantially higher margins when supporting the financing of LBOs as compared to usual corporate lending. The amount of debt banks are willing to provide to support an LBO varies greatly and depends among other on The quality of the asset to be acquired (stability of cash flows, history, growth prospects, hard assets, ) The amount of equity supplied by the financial sponsor The history and experience of the financial sponsor The economic environment

For companies with very stable and secured cash flows (e.g., real estate portfolios with rental income secured with long term rental agreements), debt volumes of up to 100% of the purchase price have been provided. In situations of "normal" companies with normal business risks, debt of 4060% of the purchase price are normal figures. The debt ratios that are possible vary also significantly between the regions and between the industries of the target. Depending on the size and purchase price of the acquisition, the debt is provided in different tranches Senior debt: This debt is secured with the assets of the target company and has the lowest interest margins Junior debt (usually mezzanine): This debt usually has no securities and bears thus a higher interest margins

In larger transactions, sometimes all or part of these two debt types is replaced by high yield bonds. Depending on the size of the acquisition, debt as well as equity can be provided by more than one party. In larger transactions, debt is often syndicated, meaning that the bank who arranges the credit sells all or part of the debt in pieces to other banks in an attempt to diversify and hence reduce its risk. Another form of debt that is used in LBOs are seller notes (or vendor loans) in which the seller effectively uses parts of the proceeds of the sale to grant a loan to the purchaser. Such seller notes are often employed in management buyouts or in situations with very restrictive bank financing environments. Note that in close to all cases of LBOs, the only securities available for the debt are the assets and cash flows of the company. The financial sponsor usually is not willing to provide other securities outside of the acquisition target as securities. As a rule of thumb, senior debt usually has interest margins of 35% (on top of Libor or Euribor) and needs to be paid back over a period of 57 years, junior debt has margins of 716%, and needs to be paid back in one payment (as bullet) after 710 years. Junior debt often additionally has warrants and its interest is often all or partly of PIK nature. Q2.Write a note on joint Venture Strategy Business Plan 1. What are your goals for the company in 1 year, 5 years, 10 years, possibly 15 years? Clearly, the further you go out, the less solid those plans will be. However, it is important to be on the same page. 2. How many people (employees) will that take? Where will the clients come from and how will you get them? What additional space, technology, and expenses will there be? 3. What would be the proposed budget for each such year? 4. How much time will each of you commit to this venture? 5. Do you have the same values and commitment? E.g., one may say that it is amount of time you put in that matters whereas another may say it is results that matter. Neither is right or wrong. However, if this were true, the conflict is obvious. And there may be a further conflict that you have not thought about --the one who says results are the key may not be willing to put in full time because they believe they are already performing. 6. What job duties would be filled by each of you? How might that change over time? How might your commitments change over time? 7. What is the proposed time when each of you might depart the business i.e., selling out as an owner?2 Governance 1. How many people on the Board? 2. How will they be selected? 3. Who can remove Board members and why (e.g., for cause only)? 4. What decisions will be made by the Board? What decisions will be reserved to the owner? What decisions will be allowed to be made by the Officers and other operating personnel? 5. How will the Board act on decisions? If it is one person one vote and there are two Board members then it is really unanimous agreement.

6. Are some decisions so key that each shareholder must agree or that you take a majority (or other) vote by ownership? 7. Will there be committees of the Board? E.g., compensation committee, budget committee, audit committee? These are often used for more complex structures and may not apply to you. 8. How often will Board meetings be held? How often are meetings of the owners held? Funding 1. What capital will be contributed by each to the company? 2. Will the capital be contributed in the same ratio as rights to profits and losses? If you want the rights to profits and losses to be shared other than on the same basis as ownership, then a more complicated structure is required (either by additional compensation or via some other entity structure than an S Corporation). 3. What additional capital should be provided for as being mandatory? How will the need to actually call that capital be determined? 4. What vote will be required for further additional capital calls? And who must vote on that? 5. If additional capital is provided other than on a pro rata basis, is additional ownership given and the non-contributing shareholders interest diluted? Is there an extra dilution (i.e., more than just pro rata) due to failure to contribute? 6. If additional money is provided by a loan from an owner to the company, what interest rate and payback terms and collateral will be given? 7. What approval is required to borrow money (from an owner or from a third party)? Is there a limit under which limited or no Board approval is required? Is there an amount that will require a supermajority approval?3 8. Will guarantees of debt (e.g., bank loans, credit cards) be required? Will each owner carry the same risk (e.g., full 100% liability, or liability based on ownership percentage)? Will an owner providing more than his pro rata share of guarantee risk receive some additional payment? Financial Matters 1. How are additional budgets and business plans set? Who provides the initial draft? What vote of the Board (assuming that the Board approves the budget) is required? 2. What approval is required to exceed the budget? Is this on a line item basis or by categories? 3. What approval is required to change the business plan? What items require that approval and what items can be modified by Officers with limited or no approval? 4. How quickly / how often will financial statements be circulated? What types of financial and business information should be circulated? 5. Will there be a committee of the Board to concentrate on financial matters and business plans? Again, this may apply more when there are complex structures. Distributions 1. How will distributions of profits be allocated? Will losses be allocated in the

same manner as profits? Again, if you want this to be different than ownership, then a more complicated structure is required (either by additional compensation or via some other entity structure than an S Corporation). 2. Is there some preferred return of capital or preferred return on capital? Is there some preferred requirement to pay loans made to the company by an owner first? Once again, if you want this to be different than ownership, then a more complicated structure is required (either by additional compensation or via some other entity structure than an S Corporation). 3. Will there be mandatory distributions to pay taxes on income allocated to owners? If so, can the company borrow money to make those distributions if necessary? Note that in an S Corporation and in an LLC taxed as a partnership, taxes on company income are paid by the owners even if they do not receive any distributions. Officers 1. What Officers will be appointed? 2. How will Officers be selected by the Board? What vote will be required? Will this be done by a Board Committee or the full Board?4 3. What vote will be required to remove an Officer? 4. What method will be used to review Officers (e.g., a Board Committee, the full Board)? 5. What is the role and duty of each Officer? What will an Officer have the power and authority to do, what actions can they take, without Board approval? Operations 1. See re: Officer roles and duties above. 2. How will customers be accepted and fired? Is owner or Board or Officer approval required? Will an owner have the ability to push acceptance or nonacceptance, or firing of a customer? 3. What type of customer contracts will be used? 4. What insurance should be obtained? 5. What approval will be required for hiring, reviewing and firing employees? Dispute Resolution 1. If the owners disagree on matters, will there be some required mediation and/or arbitration of the dispute? Will there be a required face-to-face meeting? 2. If the owners disagree on matters that are not otherwise resolved, will there be some exit plan (see below)? Dissolution / Sale 1. What vote would be required to dissolve the company or to sell the companys business? 2. In dissolution, what happens to the companys intellectual property? Can any owner use it? 3. In dissolution, what happens to the companys name, phone numbers, website? Exit Plan 1. First, what is the expected departure time for each owner? 2. Second, in terms of a buy-sell agreement, are the terms the same for all owners

or do some provisions apply to one owner but not all? For example, often a minority owner has fewer rights under a buy-sell agreement than a majority owner. Sometimes this is obvious because of the language, such as when a termination of employment causes a redemption of stock from a minority owner but not from a majority owner. Other times it is not obvious but is the practical 5 result (e.g., the same termination of employment language applies, but the majority owner cannot be fired). 3. Can any owner assign their equity rights - note that this is not common and usually there is some type of buy-sell arrangement? Is there an exception to non-assignment for assignment to family or affiliates (and what is the definition of affiliate)? Do the other owners have a first right of refusal to match the offer or to buy at some other price and terms of payment (other than for family and affiliates, if applicable)? Do you want a tag along/drag along provision? This allows a minority owner to tag along in a sale with a majority owner, and allows a majority owner to force a minority owner to sell along with the majority owner. 4. Should a mandatory or optional purchase of stock occur on any of the following events: (a) death, (b) disability - and in that case, how long must a disability continue (to allow for a recovery period), and (c) termination of employment (and does it matter whether that is voluntary or involuntary?). 5. Is there some type of texas shoot-out or other method to split up if this does not work out and no one wants to or can force a separation some other way --- i.e., a business prenuptial agreement? A texas shoot-out allows one shareholder to require that the other shareholder sell their interest or buy the interest from the shareholder who triggered the event. What is the price and how is that price paid? 6. If an owner lost their interest in an involuntary transfer, e.g., bankruptcy or divorce, should the other owners have the right to buy? What are the price and terms of payment? Q.3What are the steps in valuing synergy A merger is a combination of two or more corporations in which only one corporation survives and the merged corporations go out of business. Statutory merger is a merger where the acquiring company assumes the assets and the liabilities of the merged companies A subsidiary merger is a merger of two companies where the target company becomes a subsidiary or part of a subsidiary of the parent company Types of Mergers Horizontal Mergers - between competing companies Vertical Mergers - Between buyer-seller relation-ship companies Conglomerate Mergers - Neither competitors nor buyer-seller relationship

 Motives and Determinants of Mergers Synergy Effect Financial Synergy Diversification Economic Motives Horizontal Integration Vertical Integration Tax Motives Equity Valuation Models - Balance Sheet Valuation Models Book Value: the net worth of a company as shown on the balance sheet. Liquidation Value: the value that would be derived if the firms assets were liquidated. Replacement Cost: the replacement cost of its assets less its liabilities.

D3 D1 D2 V0 = + + 2+ 1 +k + k)+ (1 k) (1
We e hr Vo Di k =v lu o th fir a e f e m =d id n iny a I iv e d er =d c u t r te is o n a

.......

Drives Cash Flow and Value - Fundamentally to increase its value a company must do one or more of the following: . Increase the level of profits it earns on its existing capital in place (earn a higher return on invested capital). . Increase the return on new capital investment. . Increase its growth rate but only as long as the return on new capital exceeds WACC. . Reduce its cost of capital. Analyzing Historical Performance Economic Profit
R tu no I v s e t C p l = e r n n e tmn a ita

NOPLAT

NPA OL T I v s dC p l n e te a ita

(Invested

Capital x WACC)
FCF = Gross Cash Flow Gross Investments

Forecast Performance

Evaluate the companys strategic position, companys competitive advantages and disadvantages in the industry. This will help to understand the growth potential and ability to earn returns over WACC. Develop performance scenarios for the company and the industry and critical events that are likely to impact the performance. Forecast income statement and balance sheet line items based on the scenarios. Check the forecast for reasonableness.