Leveraged buy outs and buy ins

Dr Clive Vlieland-Boddy

Terminology
MBO = Management Buy-Out The purchase of a business by its existing management team MBI = Management Buy-In Similar, but the Entrepreneurs leading the transaction will be from OUTSIDE the company Leveraged = Using external financing, debt and equity LBO = Leveraged buy out normally be existing management LBI = Leveraged buy in. Normally by external parties. EBITDA = Earnings before Interest, Tax, Depreciation and amortisation

MBO / MBI s and Entrepreneurship

Entrepreneurship can involve the purchase of an existing business as well as the creation of a new one. Leading individuals in MBO/MBIs display similar characteristics and motivations to those of Entrepreneurs generally.

MBO Vs MBI
MBO Recent research shows the importance of innovative behaviour, and new product development, which may not otherwise have happened Significantly better performance over 35 years than comparable non-buy-outs

Why do MBO / MBIs Occur?

Typically, because of corporate restructuring activity, leading the parent company to want to divest a subsidiary. BOs are the most common method of privatisation Or, in the private arena, if an entrepreneur has no family to succeed him/her in the business Significant levels of business exist in 1999 this represented $50bn in value An increasing proportion is in private companies in the UK in 1998 half of all MBO/MBIs were in private organisations.

Why do Management teams do Buy-Outs?

Competitive reasons: To acquire additional skills and competencies To secure a source of supply, or distribution To acquire new technologies Plus: The entrepreneurial realisation of an opportunity To speed market entry To get assets cheaply To acquire an opportunity in the form of an enterprise which is not realising its full potential

WHY?
Opportunity to enhance performance (commonly for privatisations Retaining the management team gives additional stability Wealth Creation studies prove that in the short term after a buy-out there is substantial improvements in profitability, cash flow and productivity measures

Leveraged Buyout General Characteristics

Leverage ranges from 6:1 to 12:1. Debt to EBITDA ranges from 3.5 times to 6 times or even more. Investors seek equity returns of 20 percent or more focus is on equity IRR rather than free cash flow. Average life of 6.7 years, after which investors take the firm public. Bank amortizes senior debt over 3-7 years. Characteristics
Strong and stable cash flows Low level of capital expenditures Strong market position Low rate of technological change Relatively low market valuation

European buyout value

European buyout value: 72 billion in Q1-Q3 2008

MBO vs MBI
MBI
Typically involve extensive restructuring (traditional accusations of asset stripping) Performance generally less strong than MBOs Therefore pure MBIs (lacking in knowledge of this particular business) are often replaced by the hybrid BIMBO (Buy In Management Buy Out)

Leveraged Finance - Introduction

Leveraged Finance simply means funding a company or business unit with more debt than would be considered normal for that company or industry. Higher-than-normal debt implies that the funding may be riskier, and therefore more costly, than normal borrowing -higher credit spreads and fees. It is often also more complex with covenants and waterfalls. Hence leveraged finance is commonly employed to achieve a specific, often temporary, objective: to make an acquisition, to effect a buy-out, to repurchase shares or fund a one-time dividend, or to invest in a self sustaining, cash-generating asset.

Definition of an LBO
Transaction in which a group of private investors uses debt financing to purchase a corporation or a corporate division. Equity securities of the company are no longer publicly traded, though the debt and preferred stock may be publicly traded. Uses entire borrowing structure Often involves an LBO sponsor who contributes capital and expertise (KKR, Bass Brothers, Blackstone, etc.) and management team.

Leveraged Buyout Process

A group takes over control of a company (sometimes with hostile takeovers). Use high level of leverage and multiple debt layers to take control Once in control, improve operations increase EBITDA, divest unrelated businesses to generate cash for transaction, re-sell the new company for a profit. High amortization assures self-restraint on behalf of the borrower. In a typical LBO, capital expenditures do not exceed depreciation by much. By changing the relative participation of debt and equity in the capital structure, an LBO redistributes returns and risks among providers of capital.

Typical LBO Structure

4-6

Incremental Debt to EBITDA ratio

This totals 7-8 x EBITDA

Rewards

Because of the way deals are structured, the management team will often be given a larger percentage of the equity than is warranted just by their investment

Equity ownership gives increased entrepreneurial control and opportunity to develop their own strategy

Costs / Risks
Cost:
Is the cheapest disposal option for the existing owner

Risk for the Management team

Do they genuinely have the skills to make it work? Faced with an MBO opportunity, the management often have little idea what is involved (but have to learn quickly) Very hard work, doesnt always work out If external financing is involved (particularly VC) the banks will put the management team under a lot of pressure, and usually appoint their own FD, and nonexec Chairman.

Distinct Features of an LBO

Significant increase in financial leverage Average debt/total capital increases from 20% to 70% Management ownership interest increases Non-mgmt equity investors join the board Before an LBO, non-management directors have almost no ownership. After, non-management directors may represent 40%-60% of equity holders

Characteristics of Potential LBO Candidates

History of profitability Predictable cash flows to service financing Low current debt and high excess cash Readily separable assets or businesses Strong management team - risk tolerant Known products, strong market position Little danger of technological change (high tech?) Low-cost producers with modern capital Take low risk business, layer on risky financing

Typical LBO Structure

Varies over time with market conditions Debt Financing Total debt often 60-80% of entire deal (4-5 x LTM EBITDA, but depends on industry, cash flow, etc. 40% - 60% senior bank debt (repayment in 5-7 years) 0-15% senior subordinated (repayment in 8-12 years) 0-20% junior subordinated (repayment in 8-12 years) 0 - 15% preferred stock 10% - 50% common equity Equity Ownership 10% - 35% management/employee owned 40% - 60% investors with board representation 20% - 25% owned by investors not on board

LBO Financing
LBO sponsors have equity funds raised from institutions like pensions & insurance companies Some have mezzanine funds as well that can be used for junior subordinated debt and preferred Occasionally, sponsors bring in other equity investors or another sponsor to minimize their exposure Balance from commercial banks (bridge loans, term loans, revolvers) & other mezzanine sources Banks concentrate on collateral of the company, cash flows, level of equity financing from the sponsor, coverage ratios, ability to repay (5-7 yr)

LBO Financing Senior Bank Debt

Senior bank debt which is secured with assets like receivables, inventory, PP&E Often in tranches where first tranche is repaid quickly and other tranches are not due until maturity (7-8 year maturity with average life of 4-5 years) Bankers like to see 25% to 35% equity for protection

LBO Financing Unsecured Debt

Unsecured debt (senior and junior) Longer maturity than bank debt Covenants not to pay dividends, increase debt or sell assets Supported by cash flows and operations of the business.

Common Equity
Typically 25% - 35% of capital structure now, but varies over time. Typically seeking a 20%-30% IRR Often assume exit and entry multiples are the same, but not necessarily a good assumption rarely expect multiple expansion Ask what the exit strategy is likely to be.

Management Ownership
Management puts up 60% to 70% of wealth (excluding residence) Management share of equity (sometimes called management promote) usually increases year by year as they meet targets Managers are sometimes offered chance to buy stock Managers often already own shares in a company that does an LBO and they do not necessarily cash

Exit Strategies
Exit strategies include:
IPO Buyout by a strategic buyer Buyout by another financial buyer Leveraged recapitalization --- not really an exit, but essentially after the debt is paid down to a reasonable level, the entity issues a new round of debt and pays a large dividend to equity holders (or repurchases shares). Some, but not all, equity holders may be taken out.

Potential Motivations for an LBO

Increase in debt and concentrated ownership increase incentives to maximize value. Non-management on board with significant equity stakes increases board effectiveness Advantage to being private (filings, etc.) Beneficial tax consequences (debt, step-up) Transfer wealth from other stakeholders in the firm such as employees & bondholders

Changes in Financial Performance

In three year period after the buyout relative to the year before the buyout
EBIT increases by 42% EBIT/assets increases by 15% EBIT/sales increases by 19% EBIT-CAPEX increases by 96% EBIT-CAPEX/assets increases by 79% EBIT-CAPEX/sales increases by 43% working capital management improves no decline in advertising, maintenance or R&D CAPEX falls by 33% relative to industry

Simple Example Albert Enterprises

Simple Example Albert Enterprises

Albert Enterprises is a long established manufacturing enterprise. Run for over 40 years by the principal shareholder (100%) who is now approaching retirement. The key management want to buy the business but do not have any real capital. The business is successful. EBITDA for last 10 years is 5m before tax at 30%, and has not grown. The management want to grow the business but the owners dislikes risks. They estimate that profits could grow by 10% per annum

Simple Example Albert Enterprises

The business has been valued at 40m. It has a freehold factory valued at 15m. It has cash in the bank of 5m. It has no bank loans. A private Equity firm has offered to finance the MBO.

Simple Example Albert Enterprises

Suggestions ..

Simple Example Albert Enterprises

The company could borrow say 80-90% of the value of the freehold factory. This would generate say 12m at a low rate of say 5% per annum interest. The management could request that the owner takes out the cash in bank of 5m. That would leave a balance of 23m.

Simple Example Albert Enterprises

Private Equity has agreed to provide the following:
7 year loan of 20m at a rate of 8%. 2 year loan of 3m at a rate of 10% Equity kicker of 25% of the equity.

Lets look at the figures

Before LBO Profits were Less Tax 30% Post Tax
5.0m 1.5m 3.5m

After LBO (Year 1) Profits were 5.0m Add growth 0.5m New Profits 5.5m Less Interest
12m @ 5% 20m @ 8% 3m @ 10% 0.6m 1.6m 0.3m

Pre Tax Profit Less tax 30% Post Tax

3.0m 0.9m 2.1m

Vendor Financing

Reasons for Vendor Financing

Normally buyer cannot raise the capital. Vendor keen to sell.

Vendor Financing
The seller agrees that all or part of the agreed sale price will be financed by him. He knows the business he is selling and is in a good position to assess the risks. Often the consideration that the seller is to receive is larger than his requirements. The purchasers are also protected by knowing that if there turns out to be undisclosed issues then they have some redress.