INVESTMENT BANKING

LESSON 5 LEVERAGED BUYOUTS (LBO’s):

How IB is Used in Leveraged Buyouts Investment Banking (2nd edition) Beijing Language and Culture

University Press, 2013

Investment Banking for Dummies, Matthew Krantz, Robert R. Johnson,Wiley & Sons, 2014

WHAT’S IN THE NEWS!

MORGAN STANLEY HOPS ON CHINA!

CHINA’S WORLD BANK GAINING STRENGTH!

LESSON 4 REVIEW

1. WHAT IS THE DIFFERENCE BETWEEN A MERGER AND AN ACQUISITION? CAN YOU GIVE AN EXAMPLE OF A CHINESE M & A DEAL?

2. WHAT ARE THE 3 TYPES OF MERGERS AND WHAT IS A REASON THAT IT MIGHT BE GOOD OR BAD FOR THE TARGET FIRM?

3. WHAT ARE 5 REASONS WHY IT IS BEST TO MERGE OR ACQUIRE A CO. THAN JUST GROW?

LESSON 4 REVIEW

4. WHAT IS A HOSTILE TAKEOVER AND WHAT ARE THE 2 WAYS TO HANDLE THE TAKOVER?

5. WHO HAS THE MOST IMPORTANT ROLE IN THE M & A, THE SELL-SIDE OR BUY-SIDE ANALYST AND WHAT ARE SOME OF THE TOOLS THEY USE TO HELP THEM MAKE THE DEAL?

6. WHAT ARE SOME REASONS M&A DEALS GO BAD? WHAT ARE SOME EXAMPLES OTHER THAN THE ONES IN THIS POWERPOINT?

LESSON 5 TOPICS

1. INTRODUCTION AND GOAL OF A LEVERAGED BUYOUT (LBO)

2. WHO ARE THE “PLAYERS” IN AN LBO?

3. WHO ARE THE RIGHT TARGETS FOR AN LBO?

4. HOW IMPORTANT IS CASH FLOW IN AN LBO?

5. FINDING THE EXIT FOR AN LBO

LESSON 5 1. INTRODUCTION LBO’s

LBO’s have been viewed as the mystery thriller of the financial world for the money made and players involved. The most famous LBO of all time was started by a private equity firm KKR & Co purchasing RJR Nabisco in 1988. There was a movie made called Barbarians at the Gate that you might want to see. Greed ruled the day as it can do in some of these deals!

LESSON 5 1. INTRODUCTION LBO’s (cont)

For a quick review, an LBO is a simple transaction - an undervalued co. or division of a co. is purchased by a private equity firm. The purchased co. is changed from a publicly held co. to one that is privately held by a small group of investors who hold LARGE, mostly illiquid (difficult to sell) ownership blocks. Leverage, or debt plays the major role, with an asset from the purchased co. serving as collateral.

LESSON 5 1. INTRODUCTION LBO’s (cont)

The goal of most all LBO sponsors is to purchase a co., make changes to improve the co., improving the profitability. Then the private equity firm (sponsor) can sell the new and improved co. to a buyer for a great price as the new co. now has a greater value.

Let’s now look at the key players! Investment Banks, Big Institutions, Management and Stock and Bond Investors

LESSON 5 2. WHO ARE THE PLAYERS?

A. INVESTMENT BANKS – Firms will look to IB when they have been seen as a target for a buyout or they want to be the target of a buyout. IB are always on the “lookout” for potential purchasers.

After the LBO has been successful, the private equity sponsor will call upon the IB to put a value on the co. for 1. an IPO,

2. A strategic buyer who will pay top dollar,

LESSON 5 2. WHO ARE THE PLAYERS? (cont)

Or, 3. an IB could help a firm go through a secondary LBO, to re-capitalize the firm a give ownership to another private equity sponsor.

B. BIG INSTITUTIONS – Sponsoring LBO’s is a major activity of private equity firms. Some IB like Goldman Sachs and JP Morgan Chase are also sponsors and have private equity partnerships that their clients can invest in.

Small investors will invest through these sponsors.

LESSON 5 2. WHO ARE THE PLAYERS? (cont)

How an LBO is organized is private equity sponsors set up their funds as limited partnerships. This form of business has at least one general partner who manages the business and assumes legal debts. The partnership has many limited partners – they are entitled to the cash flow but are also legally liable for the debts as much as their initial investment.

LESSON 5 2. WHO ARE THE PLAYERS? (cont)

The LBO sponsor serves as general partner and has ownership interest in the target firm. They share in the profits but assume the debts so they have much greater liability.

C. MANAGEMENT – The sponsoring private equity firm partners with the management of the target firm. Most LBO’s are not “hostile” but are called management buyouts (MBO’s). An MBO is a form of an LBO started by the management team and results in the team having a large portion of ownership in the target firm.

LESSON 5 2. WHO ARE THE PLAYERS? (cont)

MBO’s happen when the founder wants to exit, get a big payoff and the management of the co. want to buy it as they believe in the future of the co. In an MBO, the private equity sponsor does not allow the management team to control the firm but provides advise, more management expertise and helps make decisions. The management team is given equity options to help give them an incentive to make decisions that are best for the co.

LESSON 5 2. WHO ARE THE PLAYERS? (cont)

The stakes for management are high. Given the greater amount of leverage (debt) in an LBO the chance for failure is greater and that can cost the management teams their jobs and reputations, as well as equity.

LESSON 5 2. WHO ARE THE PLAYERS? (cont)

D. STOCK & BOND INVESTORS – Investing in LBO’s is common for large institutional investors such as insurance companies, pension funds and university foundations (like the SIAS foundation). They don’t invest directly but through the private equity companies.

LESSON 5 3. WHO ARE THE RIGHT TARGETS FOR AN LBO ?

The right target must be a firm that can create cash flow to make payments on the debts but also provide a return for the new equity investors.

Investors can benefit if they know ahead of time some of the potential companies for a buyout? Why do you think?

Then, they can buy a company that is going to be bought out and the investors can make money when the buyout is announced because the stock price of the target company will rise substantially.

LESSON 5 3. WHO ARE THE RIGHT TARGETS FOR AN LBO ?

WHAT ARE THE MAIN CHARACTERISTICS OF THE TARGET CO?

A. STRONG MANAGEMENT

B. LOW LEVERAGE (DEBT)

C. STRONG ASSET BASE

D. LOW BUSINESS RISK

E. STABLE CASH FLOW

F. OUT OF FAVOR

G.DIVISIONS THAT DON’T FIT THE FIRM

LESSON 5 3. WHO ARE THE RIGHT TARGETS FOR AN LBO ?

WHAT ARE THE MAIN CHARACTERISTICS OF THE TARGET CO?

A. STRONG MANAGEMENT – Need high quality management working with LBO sponsor to make high cash flows to pay both interest and debt.

B. LOW LEVERAGE - Targets for LBO’s should have little or no debt. Interest payments are tax-deductible expenses while dividends to shareholders are not. The US tax code encourages debt instead of equity.

C. STRONG ASSET BASE – For lenders to lend the money there must be a strong marketable asset, collateral for the loan, that can be sold quickly. Firms with a large amount of cash can also be a good target.

LESSON 5 3. WHO ARE THE RIGHT TARGETS FOR AN LBO ?

WHAT ARE THE MAIN CHARACTERISTICS OF THE TARGET CO?

D. LOW BUSINESS RISK – Companies with low risk, not high-tech co., tend to make the best targets.

E. STABLE CASH FLOWS – Target firms should have predictable revenues and stable cash flows to pay the debt.

F. OUT OF FAVOR – Private equity sponsors look for under-valued co. One way to identify them is to look at the P/E (Price to earnings) ratio. A high P/E ration means the market has high hopes for the co. A low P/E ration means the co is “out-of favor” with the market.

LESSON 5 3. WHO ARE THE RIGHT TARGETS FOR AN LBO ?

WHAT ARE THE MAIN CHARACTERISTICS OF THE TARGET CO?

G. DIVISIONS THAT DON’T FIT THE FIRM – Many LBO targets are not entire companies but part of a co. or a division of the firm. Conglomerates often sell unwanted divisions in LBO’s as they are under pressure by shareholders to get rid of the under-performing divisions.

Then the potential of the “new” company can get attention of investors and the potential of the target company can be realized.

LESSON 5 4. HOW IMPORTANT IS CASH FLOW FOR AN LBO?

“CASH IS KING” and this applies to LBO’s in order to make required interest and principle payments on debt.

So, private equity sponsors focus on the rate of return (the percentage return) they expect to receive on their investment, as well as do the limited partners.

Analysts have many ways to calculate cash flow but simply cash flow is :

Net income of a co. and add back all non-cash expenses.

LESSON 5 4. HOW IMPORTANT IS CASH FLOW FOR AN LBO?

Free cash flow which we will look at later in detail is:

Cash flow minus capital expenditures, which include the purchase of new machines to replace worn out machines. Investors calculate the value of a firm as the present value of all future free cash flows.

Lenders use multiples of a measure of cash flow to determine how much debt they are willing to provide in LBO deal. The most common measure is (EBITDA) – earnings before interest, taxes, depreciation and amortization. Lenders plan on how much to lend as a multiple such as 5 or 6 times EBITDA.

LESSON 5 4. HOW IMPORTANT IS CASH FLOW FOR AN LBO?

Rate of return is a basic concept in the investment world and investors compare their performance with other investors by comparing rates of return.

In the private equity world, rates of return are calculated by computing the internal rate of return (IRR) of an investment. The IRR is the discount rate (or rate of return) that gives you the present value of projected costs (cash outflows) of an investment with the present value of the cash inflows. Simply, IRR is the interest rate that equals the present value of all cash flows to zero. We will look at this in detail in a later lesson.

LESSON 5 5. FINDING THE EXIT FOR AN LBO?

Warren Buffett’s, (the richest man in the world you saw in the movie Too Big to Fail) preferred holding period, or keeping investments is “forever”. So, he looks for investments that will be profitable for a long time.

Private equity sponsors know before they purchase a company they are preparing to sell it!

Identifying the best exit strategy can make or break a private equity deal, an LBO.

LESSON 5 5. FINDING THE EXIT FOR AN LBO? (cont)

On average, the holding period for sponsors of an LBO is between 3 and 8 years.There are 3 main methods for sponsors to exit their positions: A. IPOB. SALE TO A STRATEGIC BUYERC. ANOTHER LBO BUYOUT

LESSON 5 5. FINDING THE EXIT FOR AN LBO? (cont)

A. IPO – The best exit for an LBO sponsor is a successful IPO. If it all works out, the IPO allows the sponsor to “cash in” on the investment in the target firm and gives a good cash flow to the limited partners in the private equity sponsor firm.

But, it also gives needed equity to the target firm that is still highly leveraged (debt), even years after the LBO.

LESSON 5 5. FINDING THE EXIT FOR AN LBO? (cont)

The LBO sponsor gets help from an IB to bring the co. to the public. The IB first determines the value of the company and the IPO share price. As we have learned this is the key to success of the IPO.

The typical price on the first day of trading after the IPO is typically 5% above the IPO offering price.

LESSON 5 5. FINDING THE EXIT FOR AN LBO? (cont)

The lead investment bank forms a syndicate, which consists of other investment banks helping to sell shares in the IPO.

The big disadvantage this exit strategy is high cost.

And the economy must be right for an IPO. After the 2008 crisis investors were much less likely to invest in an IPO due to the risks involved.

LESSON 5 5. FINDING THE EXIT FOR AN LBO? (cont)

B. SALE TO A STRATEGIC BUYER – This is the most common exit and most preferred because it is quick and simple.

This is a firm that believes the target company offers synergy (1+1 =3) to its business. As we have talked about before – product line expansion, geographic expansion or purchase of a supplier.

The strategic buyer will pay a higher price to the seller due to synergy it can gain.

LESSON 5 5. FINDING THE EXIT FOR AN LBO? (cont)

C. ANOTHER LBO – This is the least common exit strategy but involves selling the company to another private equity firm that will sponsor another LBO.

The big disadvantage in this exit is that the second sponsor will often drive a “hard bargain” and the price will be higher.

LESSON 5 COVERED IN YOUR TEXTBOOK

CHAPTER 10 PRIVATE EQUITY

Pages 165-167 Definitions and Agreement

10.1-10.2

Pages 169 Internal Rate of Return 10.3

Pages 179-183 LBO and valuation, debt capacity without the technical formulas 10.6