Management And

Leveraged Buy-Out
Submitted to Prof. Rajan
Subject : Mergers,
Acquisitions and Corporate
Restructuring
B G IM S M M S III S e m e ste r Fin a n ce
B a tch : 2 0 0 9 -2 0 1 1
Group Members
TOPICS COVERED
Development Stage and
Sources of Finance
 Internal Rate of Return
In a private equity fund, the net return
earned by investors from the fund’s
activity from inception to a stated
date. The IRR is calculated as an
annualised effective compounded
rate of return, using monthly cash
flows and annual valuations.
•
 BUY OUT
 A transaction in which a business,
business unit or company is acquired
from the current shareholders (the
vendor).
•
 MANAGEMENT BUY OUT
• The purchase of a business by its
current management, in co-
operation with external financiers
to provide funding, followed by an
eventual sale of the business to
realise value
•
 MANAGEMENT BUY OUT
In essence management are purchasing the
future cash flows of the business, which they
will use to pay the interest and repay the
capital on the borrowed funds. Value is created
for the management team in two main ways:
• Firstly by paying off the debt used to finance
the deal.
• Secondly through growing the business and
increasing its absolute value.
This value is then realised when the business is

sold, or “exited”. Typically management teams

realise their value through an exit after three to
five years.
 MANAGEMENT BUY OUT
 Why Management Teams do Buy outs?
• Non-Core Divestments and Efficiency
Improvements
• Management Incentivisation
• Insolvency
• Succession
• Regulatory Requirement
• Bundled Business
 MANAGEMENT BUY OUT
Why Management Teams do Buy outs?


• 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
 MANAGEMENT BUY OUT
 The Risks 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, but doesn’t 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
Director, and non-exec Chairman.
• ‘Deal Fatigue’
 MANAGEMENT BUY OUT
When are MBO’s

Attractive
• Stable industry sector
• Reputable in its markets
• Good spread of
customers and
suppliers
• Defensible market
position
• Secure contracts
• Good visibility of profits
and cash flow
• Solid Exit Policy
When are MBO’s not

Attractive
• Highly cyclical
• Fashion orientated
• Rapid expansion
• Significant R&D and/or
capital investment
required
• High/volatile working
capital
• Too volatile to exit
with profits
MANAGEMENT BUY OUT
S p o ttin g a Po te n tia lM B O Ta rg e t
 MANAGEMENT BUY OUT

R e q u ire m e n ts fo r a S u cce ssfu lM B O

MANAGEMENT BUY OUT
M B O Pro ce ss – 3 to 6 m o n th s
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XT
MANAGEMENT BUY OUT
M B O Fin a n cin g
 MANAGEMENT BUY OUT
Sources of Funds Uses of Funds
Sources Rs. (in lakhs) Uses Rs. (in lakhs)
Debt Purchase Price 100.0
Long Term 50.0 Working 10.0
Working 10.0 Capital
Capital
Equity Fees and/or 5.0
Pref. 54.0 Expenses
(Institutions)
ORDs 0.7
(Institutions)
ORDs 0.3
(Management)
Total 115.0 Total 115.0
Illu stra tio n D e a
MANAGEMENT BUY OUT
M B O Fin a n cin g Le ve ra g e

Illu stra tio n D

MANAGEMENT BUY OUT
O th e r C o n sid e ra tio n s
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XT
 LEVERAGED BUY OUT
 LBO is a financing technique of purchasing a
private company with the help of borrowed
or debt capital. The leveraged buy outs
are cash transactions in nature where cash
is borrowed by the acquiring firm and the
debt financing represents 50% or more of
the purchase price.
LEVERAGED BUY OUT
LEVERAGED BUY OUT
D istin ct Fe a tu re s o f a n LB O
LEVERAGED BUY OUT
S p o ttin g a Po te n tia lLB O Ta rg e t
LEVERAGED BUY OUT
 LEVERAGED BUY OUT
LB O S e q u e n ce

? ye a rs 3 -9 m o n th s 5 -7 ye a rs
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XT
LEVERAGED BUY OUT
LB O D e a lS tru ctu re
LEVERAGED BUY OUT
LEVERAGED BUY OUT
LEVERAGED BUY OUT
D e b t S tru ctu re
 LEVERAGED BUY OUT
 JUNK BONDS/Non
Investment Grade
Bonds/Speculative
Bonds/HIGH YIELD
BONDS
• Same as Regular
Bonds
• Differ Due to Credit
Quality

LEVERAGED BUY OUT
 LEVERAGED BUY OUT
LBO Sponsor/Financial Sponsor


A Financial Sponsor or LBO Sponsor is a term

commonly used to refer to Private Equity

Investment Firms who bring in the
capital/debt for the LBO Deal.


 Also brings in expertise, contacts, strategies for

operational improvement and experience in
owning leveraged companies.

 LEVERAGED BUY OUT
 LBO Sponsor/Financial Sponsor
• Razor edge Margins
• Expertise in layering risk, financial structure
• Normally, get a Management fees of 1-1.5%
of the fund
• Plus, share in Carried Interest
• Plus returns on investment made by self.

 LEVERAGED BUY OUT
Global Financial Sponsor M&A Activity from 1999-2007
$ in billions % of Total
$1,200 50% Value
$1,100 45%
$1,000
40%
$900
35%
$800 $759
$700 30%

$600 25%

$500 20%
$400
15%
$300 $232

$103 $151 10%

$200 $50 $87 $92 $95
$64 5%
$100

$0 0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Total $ Value of Sponsor Deals % of Total Value of M&A Deals

 LEVERAGED BUY OUT
LBO Valuation


Showing 2 Methods

 Variable Risk Method



 Adjusted Present Value Method

 LEVERAGED BUY OUT
 Variable Risk Method
Adjusts for the varying level of risk as the firm’s
total debt is repaid.
• Step 1: Project annual cash flows until
 target D/E achieved
• Step 2: Project debt-to-equity ratios
• Step 3: Calculate terminal value
• Step 4: Adjust discount rate to reflect
changing risk
• Step 5: Determine if deal makes sense

 LEVERAGED BUY OUT
 Variable Risk Method
Step 1: Project Annual Cash Flows until Target

D/E achieved
• Target D/E is the level of debt relative to
equity at which
– The firm will have to resume payment of
taxes and
– The amount of leverage likely to be
acceptable to IPO investors or strategic
buyers (often the prevailing industry
average)

 LEVERAGED BUY OUT
 Variable Risk Method
Step 2: Project debt-to-equity ratios

• The decline in D/E reflects

– the known debt repayment schedule
and
– The projected growth in the market
value of the shareholders’ equity
(assumed to grow at the same rate
as net income)
 LEVERAGED BUY OUT
 Variable Risk Method
Step 3: Calculate terminal value

• Calculate terminal value of projected cash

flow to equity investors (TVE) at time t,
i.e., the year in which the initial investors
choose to exit the business.
• TVE represents the PV of the Rupee
proceeds available to the firm through
an IPO or sale to a strategic buyer at
time t.



 LEVERAGED BUY OUT
Variable Risk Method


Step 4: Adjust discount rate to reflect

changing risk


• Adjust the discount rate to reflect

changing risk.
• The firm’s cost of equity will decline over
time as debt is repaid and equity grows,
thereby reducing the leveraged ß.
Estimate the firm’s ß as follows:


 ßFL1 = ßIUL1 (1 + (D/E)F1 (1-tF))


 LEVERAGED BUY OUT
 Variable Risk Method
 ßFL1 = ßIUL1 (1 + (D/E)F1 (1-tF))
where ß = Firm’s leveraged beta in period 1
FL1
 ßIUL1 = Industry’s unlevered beta in
period 1
 = ßIL1 /(1+(D/E)I1 (1- tI))
 ßIL1 = Industry’s levered beta in
period 1
 (D/E)I1 = Industry’s debt-to-equity ratio in
period 1
 tI = Industry’s marginal tax rate in
period 1
 (D/E)F1 = Firm’s debt-to-equity ratio in
period 1
 LEVERAGED BUY OUT
 Variable Risk Method
Step 5: Determine if deal makes sense

 Does the PV of free cash flows to equity

investors (including the terminal value)
equal or exceed the equity investment
including transaction-related fees?



 LEVERAGED BUY OUT
 Variable Risk Method
• Advantages:
– Adjusts the discount rate to reflect
diminishing risk as the debt-to-total
capital ratio declines
– Takes into account that the deal may
make sense for common equity
investors but not for lenders or
preferred shareholders
• Disadvantage: Calculations more
burdensome than Adjusted Present Value
 LEVERAGED BUY OUT
 Adjusted Present Value Method
Separates value of the firm into (a) its value as if it were debt


free and (b) the value of tax savings due to interest

expense.
• Step 1: Project annual free cash flows to equity investors
and interest tax savings
• Step 2: Value target without the effects of debt financing
and discount projected free cash flows at the firm’s
estimated unleveraged cost of equity.
• Step 3: Estimate the present value of the firm’s tax savings
discounted at the firm’s estimated unleveraged cost of
equity.
• Step 4: Add the present value of the firm without debt and
the present value of tax savings to calculate the present
value of the firm including tax benefits.
• Step 5: Determine if the deal makes sense.
 LEVERAGED BUY OUT
 Adjusted Present Value Method
• Step 1: Project annual free cash flows to equity
investors and interest tax savings for the period
during which the firm’s capital structure is
changing
– Interest tax savings = INT x t, where INT
and t are the firm’s annual interest
expense on new debt and the marginal
tax rate, respectively
– During the terminal period, the cash flows
are expected to grow at a constant rate
and the capital structure is expected to
remain unchanged
 LEVERAGED BUY OUT
 Adjusted Present Value Method
• Step 2: Value target company without the effects
of debt financing and discount projected cash
flows at the firm’s unleveraged cost of equity
– Apply the unleveraged cost of equity for the
period during which the capital structure
is changing.
– Apply the weighted average cost of capital
for the terminal period using the
proportions of debt and equity that make
up the firm’s capital structure in the final
year of the period during which the
structure is changing.
 LEVERAGED BUY OUT
 Adjusted Present Value Method
• Step 3: Estimate the present value of the firm’s
annual interest tax savings.
– Discount the tax savings at the firm’s
unleveraged cost of equity
– Calculate PV for annual forecast period only,
excluding a terminal value, since the firm
is sold and any subsequent tax savings
accrue to the new owners
 LEVERAGED BUY OUT
 Adjusted Present Value Method
• Step 4: Calculate the present value of the
firm including tax benefits
– Add the present value of the firm
without debt and the PV of tax
savings
 LEVERAGED BUY OUT
 Adjusted Present Value Method
• Step 5: Determine if deal makes sense:
– Does the PV of free cash flows to
equity investors plus tax benefits
equal or exceed the initial equity
investment including transaction-
related fees?
LEVERAGED BUY OUT
LEVERAGED BUY OUT
Common Features of LBO and
MBO
Distinction Between LBO
and MBO
N EX
T