IM12Y011

Name

Natt Niljianskul / NATT,

Topics in Finance II: Corporate Restructuring Term 4 2013 Due date: July 9, 2013 (Tuesday) Assignment 6

ICS Recovery Fund (Help Me Company)

You are the Managing Director of the ICS Recovery Fund, a private equity fund specializing in the investment into troubled companies. You already raised $300 million dollars from institutional investors two years ago. The target return was set at 20% annual IRR. But, you have not found any suitable investment opportunities since then. Institutional investors, who pay the ICS Recovery Fund an annual 2% management fee, are restless and demand that you find deals with a good return within the next six months. Luckily, two opportunities have emerged. Investment Opportunity 1: Help Me Corporation (HMC) Help Me Corporation is a family owned company engaged in the designing, manufacturing, and selling of fashion goods. HMC has two strengths: 1) A strong brand known as Shining Silver, a traditional fashion line targeting older ladies. 2) A strong fashion retail shop network in the Osaka region where it owns 10 shops. One weakness is the low operating profitability due to out-of-date designs in its fashion brands Musume, targeting young ladies, and Ojisan, for middle aged men. However, HMCs biggest weakness is its huge debt burden. It expanded aggressively in manufacturing plants and direct shops in Osaka by borrowing money from Go-Go Bank, a medium sized regional bank in Osaka. The drop in property values in that area forced HMC to realize a $50 million loss last year due to the new mark to market accounting rule. Consequently, HMC only has $10 million shareholders equity against $300 million in debt. The Debt/EBITDA ratio (300/20=15) and Debt/FCF ratio (300/14=21.5) indicate HMC is financial weak. The Go-Go Bank, which extended a $200 million loan to HMC, finally sought to turnaround the company through a Privately Arranged Restoration. Two options were proposed, and each requested the ICS Recovery Fund to participate as the principal equity investor.

IM12Y011 Option A: Privately Arranged Restoration

Name

Natt Niljianskul / NATT,

The owner/CEO of HMC, a 60-year-old third generation member of the founders family, approached you stating he believes he has a talent for fashion design and only he can lead HMC. He would like to use this turnaround opportunity to maximize debt forgiveness by the banks. His proposal to the ICS Recovery Fund is as follows: EBITDA can be quickly improved to $22M. Appropriate Enterprise Value is 7 times of EBITDA, which is estimated as $154M. Proper financial structure is $30M equity and $124M debt. Thus, asking bank to give up $176M in debt, 80% of this forgiveness by Go-Go Bank. Existing equity share holder (the CEO) will accept a 20% devaluation, Go-Go Bank may accept $5M of DES. Thus $17M of new capital injection from ICS Recovery Fund is needed. EBITDA in 2011 is reasonably estimated to be $24M. Half of the annual Free Cash Flow will be used to pay debt. IPO HMC in 2012. Market value is estimated by the Enterprise Value (EV=EBITDA x 8) minus the Debt. ICS Recovery Fund can sell its equity share to the market in two steps, $10M in 2012 and $7M in 2013. He will stay as the CEO, of course. ICS Recovery Fund will get two of the six seats in the Board of Directors.

IM12Y011 Option B: Privately Arranged Restoration

Name

Natt Niljianskul / NATT,

Coincidentally, you are also approached by the Smart Fashion Company (SFC), one of the leading companies in the fashion industry with an excellent reputation for operations management. SFC is interested in HMCs Osaka shop network where it can sell its own branded fashion goods. At the same time, SFC plans to license the Shining Silver brand and sell it using its existing distribution network. SFC is confident it can easily turnaround the companys operation if has full management control. SFC does not intend to consolidate HMC until it is comfortable the company can be integrated without risk. This is why SFC invited the ICS Recovery Fund as a co-investor. Naniwa Bank, the sub-main bank of HMC with an $80 million outstanding loan, supports SFC. SFCs proposal to the ICS Recovery Fund is as follows: EBITDA can be improved quickly to $24M. Enterprise Value is estimated as 8 times of EBITDA, which is $192M. Proper financial structure is $50M equity and $142M debt. Financial conservatism is important. Thus the request for debt forgiveness is $158M. Existing equity share is devalued by 50%, and the banks can swap $5M debt to equity. Thus, an injection of $40M in new capital is required. SFC invites the ICS Recovery Fund to invest jointly in HMC. It is asking for $20M from the ICS Recovery Fund. SFC will keep HMC as a minority owned subsidiary and establish a business collaboration. Brand license fees and sales fees will be charged to HMC. With the help of SFC, EBITDA by 2011 is anticipated to reach $30M. Half of the annual FCF will be used to pay debt. SFC will buy the equity share held by ICS Recovery Fund at the beginning of 2012. The price of this purchase will be calculated based on the EV (EV=EBITDA x 8) minus the debt at the end of the third year. SFC will send its own senior executive and managers to run HMC. SFC welcomes two of five Board of Directors to be appointed by ICS Recovery Fund.

IM12Y011 P/L of Help Me Corporation:

Name

Natt Niljianskul / NATT,

Privately Arranged Restoration Option A: Forecast by CEO 2008 Sales Operating Profit Depreciation EBITDA CAPEX Change of W/C FCF* 400 12 8 20 6 1 8.2 2008 400 14 8 22 6 -2 12.4 2009 405 14 8 22 7 -2 11.4 2010 410 15 8 23 7 0 10 2011 415 15 9 24 8 0 10 (current) (after restructuring)

*FCF=Operating Profit After Tax(Tax rate 40%) + Depreciation CAPEX-Increase of Working Capital.

Privately Arranged Restoration Option B: Forecast by SFC 2008 Sales Operating Profit Depreciation EBITDA CAPEX Change of W/C FCF 400 12 8 20 6 1 8.2 2008 400 16 8 24 6 -3 14.6 2009 410 17 9 26 7 -3 15.2 2010 420 18 9 27 8 -1 12.8 2011 430 20 10 30 9 0 13 (current) (after restructuring)

B/S of Help Me Corporation (2008) Asset Cash Current Asset Fixed Asset Total Asset 20 110 260 390 Liability Liability Debt Equity Total 80 300 10 390

IM12Y011

Name

Natt Niljianskul / NATT,

Comparison between the Two Privately Arranged Restoration Proposals Proposal by CEO Base EBITDA Enterprise Value Multiple Enterprise Value Proposed Debt - debt giving up Proposed Equity - existing equity - DES - New Capital by Fund - New Capital by SFC Expected EBITDA in 2011 Enterprise Multiple (EV/EBITDA) in 2012 Expected Enterprise Value (EV) in 2011 Estimated Reduction of Debt** Estimated Debt in 2011 Estimated Equity Value in 2011 Ways of realizing value 22 7 times 154 124 ( 176 ) 30 8 5 17 24 8 times 192 21.9 102.1 89.9 IPO in 2012 Proposal by SFC 24 8 times 192 142 ( 158 ) 50 5 5 20 20 30 8 times 240 27.8 114.2 125.8 Buy up by SFC

** Estimated Debt Reduction from 2008 to 2011 is half of the accumulated FCFs during the period Question 1: Fill the blank boxes in the above Exhibits

IM12Y011

Name

Natt Niljianskul / NATT,

Question 2: Compare the two private restoration options. Which one would you choose (Option A go with the CEO, or Option B - ally with SFC) and why? When deciding consider the following points: What will be the expected investment return of each option? How feasible is of the earnings turnaround? How will you persuade the banks to forgive debt? Who should manage the company?

Explain using 10 sentences (or 3-4 bullets) I would choose option B to ally with SFC for the following reasons (collectively judge from all the reasons below): Although the return on invested capital of option A is higher (calculation: vs ), it could be deceptive to make decision solely based on this because there is no guarantee that each proposal will achieved the promised EBITDA level. As this is a turnaround PE deal, we also have to worry about viability revitalisation for an exit, too. The earnings turnaround is more likely to be achievable under SFCs proposal because SFC can bring in their expertise to help HMC. This will reinforce confidence amongst all stakeholders as well. SFCs proposal also has support from Naniwa Bank. Naniwa Bank will be more incline towards such proposal as the amount of debt forgiveness proposed was much lower than in option A. SFC should manage the company but to ensure that there is no information asymmetry problems, Naniwa Bank and ICS fund should send in corporate governance personnel to keep eyes on day-to-day operations and to verify that the turnaround proposal go as planned.

IM12Y011 example, consider the following options: -

Name

Natt Niljianskul / NATT,

Question 3. Will you ask the CEO or SFC to protect your interests, if necessary? How and why? For Do you want to change the financial scheme? Do you want to add any covenant clauses? Do you want to send your own candidates as top management?

Explain using 5 sentences I have no intention to change the financial scheme because the amount of debt forgiveness is extremely high (towards 80%+ forgiveness) and at the same time, this investment is already risky enough (despite the outcome make justify it as a good risk) and I do not want to put more at stake. I would want to add an anti-dilution clauses and lock in SFC with some obligation to buy up our shares. However, I want to have it in a form so that we hold a put option for our stake because then there could be some other opportunities if the turnaround is extremely positive that we could strike the option at a higher in-the-money value. Ideally, I would nominate some of the capable people from ICS Fund Management Entity to HMC in preferably a CFO position but I would prefer to have the top guy (CEO) being from SFC because they are the one who had the expertise in this business. Nonetheless, as mentioned in answer to Q2, I would like to propose that the structure of the board of directors be modified a little bit. By introducing external directors and increase the number of seats in the board to 6+ and give 2 to SFC and us, 1 to the bank and another 1 to the one of the previous executives.

IM12Y011

Name

Natt Niljianskul / NATT,

Investment Opportunity 2: Company Spin Off (CSO) The Company Spin Off is an $8 billion dollar company consisting of widely diversified businesses. After several years of poor performance, CSO faced criticism from institutional investors and banks about its unfocused business strategy and it agreed to divest non-core business subsidiaries. The CEO of CSO was your classmate at Hitotsubashi University and the two of you have maintained a long-term friendship. Now he asks if you are interested in one of the two subsidiaries targeted for divestiture. If your offer is reasonable and competitive, the CEO promises to prioritize your proposal above others. He also asks that you first choose which subsidiary you want to bid on. Both subsidiaries are of similar sizes in terms of sales ($200 million) and assets ($160 million). However, they are very different in character. The Blue Subsidiary is a profitable and growing company with innovative technology. Its operating earning rate is as high as 8% and annual sales growth rate constantly exceeds 10%. EBITDA in 2008 is $24 million and ROE (net profit based) is 23%. But, due to the aggressive capital expenditure and high R&D, Blues reliance on bank loans has increased. Current debt is $110 million and equity is $30 million. Blues growth is attributed to the entrepreneurial leadership of its current CEO, who recently announced his intention to resign to protest the parent companys decision to divest Blue. The market values of equi valent listed companies have a PER of 16 to 20, or Enterprise Value (market value of equity plus debt outstanding) multiples of 8 to 11 times. CSO anticipates selling Blue at these levels. Blue can go for an IPO in year 2012 with an anticipated Enterprise Value multiple of 10 times. The future plan of Blue is shown below. P/L & Cash Flow of Blue 2008 Sales Operating Profit Depreciation EBITDA CAPEX Increase of W/C Free Cash Flow Interest payment Ordinary Profit Net Profit 200 16 8 24 12 1 4.6 4.4 11.6 7.0 2009 220 18 9 27 14 2 3.8 of Buyout 2010 250 22 10 32 16 2 5.2 2011 280 25 12 37 18 3 6.0

Depend Upon Financial Scheme

IM12Y011 B/S of Blue (2008) Asset Cash Current Asset Fixed Asset Total Asset 10 50 100 160 Liability Liability Debt Equity Total 20 110 30 160

Name

Natt Niljianskul / NATT,

The Red Subsidiary is a low growth company of average profitability in a saturated market where technology is commoditized. Although Red is competitive in the industry, its profitability is unattractive. The operating profit margin is 5% and net profit ROE is just 5.0%. Reds EBITDA in 2008 is $20 million. Obviously, Reds earning and growth potential is inferior to Blues, but since Red capital expenditure needs are limited, it has accumulated profits. It has $100 million in shareholders equity and only $40 million of debt. On the top of this, Red also has $50 million in cash it is a financially rich company. Because the market is fragmented among so many players, one security analyst anticipates industry consolidation will soon take place. This would be good because market growth is so low the only way to increase sales and profitability is through mergers and acquisitions. This stems from the nature of a high fixed cost industry, where economies of scale can reduce costs and improve profitability. According to the analyst, the M&A price of competitors is around 8 times of the enterprise multiple (EV/EBITDA) or a PER of 16. But, if anyone becomes the industry leader, that company may be able to IPO for 10 times the enterprise multiple. By the way, Reds CEO is a conservative person seconded from CSO. He is good at cost cutting, but will never take big risks. He is relatively new to the market and has a limited personal network with the CEOs of competitor companies. The Pro Forma of Red is below: P/L & Cash Flow of Red 2008 Sales Operating Profit Depreciation EBITDA CAPEX Increase of W/C FCF 200 10 10 20 8 0 8 2009 205 11 10 21 7 0 9.6 2010 210 11 10 21 7 0 9.6 2011 215 12 10 22 7 1 9.2

IM12Y011 B/S of Red (2008) Asset Cash Current Asset Fixed Asset Total Asset 50 20 90 160 Liability Liability Debt Equity Total 20 40 100 160

Name

Natt Niljianskul / NATT,

Question 4: Which subsidiary will you bid on? Why? I would bit on the Red Subsidiary. The reason is because Red has a huge debt capacity that we could exploit so that we can acquire them through LBO. Also because industrial consolidation is foreseeable in the near future, this opens the door to easy exit How much will you pay to buyout the subsidiary? Explain your rationale for this amount. (Explain using 4 sentences). I will pay $170 million. The amount is derived from EV Net debt (Calculation: = 20*8 (50 + 40) = 170) or 8.5 times multiple. The rationale of why I dont want to pay premium is because this is a spin-off deal from CSO, not an M&A deal. Hence, paying at the valuation price is already good enough. What is your proposed financial structure (equity and debt mix)? Explain your rationale for this structure. (2 sentences) I will use LBO and will increase the leverage to ~4 (less than 4) buy entering into a structure loan deal with the bank such that if proportion of debt is paid back sooner, I will get interest discount. The structure at buy-out will be equity of 60 (Financial Leverage = Total Asset / Equity) and debt of 110 (assuming short-term liability stays the same.) I will subsequently use excess cash to pay back some portion of debt as aforementioned. Below is a projected balance sheet: B/S of Red (2008 after acquisition) Asset Cash Current Asset Fixed Asset 50 20 Liability Liability Debt 90 20 40 Extra debt 110

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IM12Y011 Goodwill Total Asset -

Name 70 230

Natt Niljianskul / NATT, Equity Total 60 230

What will you do to the management structure? Why? (2 sentences)

I will maintain most of the management people but I will mostly ask the current CEO to step down from the CEO position to assume the Chairman position. I will then introduce good corporate governance structure but having board members and independent board members. I will also try to hire Blues CEO or make it a condition of this deal to my friend. If Blues CEO is already resigned, I will hire him straight away. What is your future strategy to maximize the enterprise value? (3 bullet points)

First of all I will use the excess cash to repay the existing debt and repay some portion of the new debt. I will use ~50% of FCF generating every year to repay some portions of yearend outstanding debt. If the earnings exceed expectations, I will use the excess amount to re-invest into the company (i.e. if EBITDA exceeds the projection, I will increase CAPEX) How much investment return do you expect? (1 sentence)

Assuming that the balance sheet structure evolve from post-acuisition and all the strategy explained above comes into fruition (equity = 60, cash = 15, debt = ~86.6), return is 247.33% (Calculation: )

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