INVESTMENT BANKING

LESSON 7 STRUCTURING A LEVERAGED BUYOUT

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 OR WHAT’S THERE TO LEARN?

THE ACQUISITION THAT GOT AWAY!

LESSON 6 REVIEW

1. WHAT IS EDGAR AND HOW IS IT HELPFUL TO IB?

2. HOW CAN SOCIAL MEDIA, LIKE FACEBOOK, TWITTER, WE CHAT, etc HELP OR HURT IB ACTIVITIES?

REVIEW CHAPTER 5

1. DESCRIBE WHAT AN LBO IS IN 3-4 SENTENCES.

2. WHAT IS THE GOAL OF AN LBO?

3. WHO ARE THE 4 KEY PLAYERS IN AN LBO AND WHAT DO THEY DO?

4. NAME 5 TARGETS RIGHT AND READY FOR AN IPO AND WHY?

5. WHY IS CASH FLOW IMPORTANT IN AN LBO AND WHAT CALCULATION(S) IS IMPORTANT TO THE SPONSORS AND INVESTORS?

6. WHAT ARE THE OPTIONS FOR EXITING AN LBO

LESSON 7 TOPICS

1. INTRODUCTION

2. THE 4 MAIN TYPES OF FINANCING

3. SENIORITY AND MATURITY IN LBO’S

4. BUILDING A LBO MODEL

5. DECIDING ON METHODS OF FINANCING

6. WHAT CAN GO RIGHT AND WHAT CAN GO WRONG?

LESSON 7 1. INTRODUCTION

In one sentence what is an LBO?

An LBO is a deal in which a buyer borrows money (usually a lot!) and uses that money to buy a target.

An LBO is a favorite tool of an IB because the returns can huge! The income made relative to the amount of cash you put at risk can be very large.

LESSON 7 1. INTRODUCTION (cont)

In this lesson we will see how different types of debt can be used to make LBO’s successful. And we will see how IB put LBO’s together.The primary reason for using debt is that, in America, the interest payments on debt are tax deductible and reduce a company’s tax bill.

LESSON 7 1. INTRODUCTION (cont)

If the debt is used wisely, equity holders (investors who put money in) and the private equity sponsor (the co. that gets money from investors to buy out the firms) can get a very good return in its invested capital.

LESSON 7 2. THE TYPES OF FINANCING

There are four kinds:

A. BANK DEBT

1. REVOLVING CREDIT

2. TERM LOANS

B. JUNK BONDS

C. MEZZANINE DEBT

D. EQUITY

Let’s look at each of these!

LESSON 7 2. THE TYPES OF FINANCING (cont)

A. BANK DEBT – There are 2 types

1. Revolving Credit – Just like a credit card this is not used for large items like physical plant and equipment. More as a source of funds for working capital – to purchase inventory or raw materials. This debt is then paid off when cash is available.

The rate is based on the prime rate (rates banks give to their best customers) or Libor (the London Interbank offered rate) plus a % added to both of them.

LESSON 7 2. THE TYPES OF FINANCING (cont)

A. BANK DEBT

2. Term loans – Just like a car loan or mortgage a term loan is paid back over the term (time – 6 months 1, 3,5 years) in equal payments. The payment represents interest + repayment of principal. This is called amortization.

Some term loans can be interest only payments with a bullet or balloon payment at the end of the loan.

SAMPLE AMORTIZATION SCHEDULELoan Information

Loan amount-$200,000 Annual interest rate-5% No. of months-240

Monthly principal and interest payment $1,319.91

Year Beginning Balance Principal Interest Payment Ending Balance

1 $200,000 $5,975 $9,864 $15,839$194,025

2 194,025 6,280 9,559 15,839 187,745 3 187,745 6,602 9,237 15,839 181,143 4 181,143 6,939 8,900 15,839 174,204 5 174,204 7,294 8,545 15,839 166,910 6-

17………………………………………………………………………………………………..

18 44,040 13,954 1,885 15,839 30,086 19 30,086 14,668 1,171 15,839 15,418 20 15,418 15,418 421 15,839 0

LESSON 7 2. THE TYPES OF FINANCING (cont)

B. JUNK BONDS – Bonds of lower quality than investment-grade bonds. Bond ratings range from AAA to C & D, which refer to bonds already in default.

The purpose of bond ratings is to provide investors with an idea of creditworthiness. Will an investor receive his promised interest and principal payments?

Mostly used by large capitalized LBO’s.

LESSON 7 2. THE TYPES OF FINANCING (cont)

B. JUNK BONDS - Some individual investors will invest in junk bonds but the market is dominated by large investors such as mutual funds and foundations.

Why invest in junk bonds?

They pay a much higher interest rate and are considered high-yield bonds. Junk bonds become more attractive as the market rate for better bonds is low. As the crisis of 2008 gets farther away, junk bonds

Become an option funding LBO’s.

LESSON 7 2. THE TYPES OF FINANCING (cont)

C. MEZZANINE DEBT – A form of financing between debt and equity. Mostly used by mid-size capitalized LBO’s (below $1billion) and goes for 3-5 years.

It’s like a bond but with a warrant which allows an investor to buy stock in a company during the 3 to 5 year period at a price of $10/share.

LESSON 7 2. THE TYPES OF FINANCING (cont)

C. MEZZANINE DEBT – The current price of a stock may be $7/share. If the company is successful the stock could rise say from $7 to even $21/share which makes the purchase of the warrant at a beginning higher price of $10 a bargain.

This kind of debt allows an investor to become an owner should the company be successful. The warrants can also be sold and the holder can retain the bond (debt).

LESSON 7 2. THE TYPES OF FINANCING (cont)

C. MEZZANINE DEBT – An advantage of this debt, with warrants is that it can be issued at a lower interest rate. This type or financing helps with the cash flow limiting the amount of interest and principal to be paid.

Most common investors are insurance companies, commercial banks and other private equity firms.

LESSON 7 2. THE TYPES OF FINANCING (cont)

D. EQUITY – After the mound of debt are the equity holders (stockholders). These are the people that own the company and are entitled to the returns after the debt has been paid back. This is mainly the private equity partnership – the firm that sponsored the LBO and put the deal together. Some of the equity will be held by the management so there is an incentive to help make the deal work.

LESSON 7 3. SENIORITY & MATURITY IN LBO’S

WHAT DOES SENIORITY MEAN?

Simply, seniority means, who gets paid back first?

FIRST - Revolving bank debt is the least risky form of financing with also the lowest expected return.

LAST – Equity holders only get returns after all other claims (debts) have been paid.

LESSON 7 3. SENIORITY & MATURITY IN LBO’S (cont)

WHAT DOES MATURITY MEAN?

Simply, maturity means, when does the debt come due and needs to be paid back?

TERM LOANS have maturities of 4-8 years, but no pre-payment penalty.

JUNK BONDS are longer than term loans (5-10 years) but shorter than investment grade bonds, which can be of to 30 years.

EQUITY has no maturity. This is called a perpetual claim. Anytime, like stock, of course after everyone else has been paid. Has no maturity date.

LESSON 7 4. BUILDING A LBO MODELAGAIN, WHY DO AN LBO?

To build the investment so that equity holders earn large returns on their investments by using high levels of debt to leverage these returns. You might say, the equity holders are using “other peoples” money to increase their returns.

LESSON 7 4. BUILDING A LBO MODEL (cont)

IB build LBO models based on pro forma cash flow statements. Pro forma means “for the sake of form” – a best case scenario or result.

LESSON 7 4. BUILDING A LBO MODEL (cont)

IB build LBO models based on pro forma cash flow statements. Pro forma means “for the sake of form” – a best case scenario or result.The first step is to project the cash flows over the time frame of the LBO – usually 6-8 years. EBITDA (earnings before interest, taxes, depreciation and amortization) is the cash flow definition that is used in LBO’s

LESSON 7 4. BUILDING A LBO MODEL (cont)

From lesson 5 slide 23:

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 – Lenders plan on how much to lend as a multiple such as 4 or 6 times EBITDA.

The level of debt the market will support considers both the risk of the LBO and the current market conditions.

LESSON 7 4. BUILDING A LBO MODEL (cont)

RISK of an LBO – this refers to the change or volatility of the EBIDTA projections. The more sure an analyst is that there will not be surprises in EBITDA – the higher the multiples of EBITDA the LBO will support.

So, what might be some good businesses that make the best targets for LBO’s?

Not technology firms but more stable businesses like consumer products, food, etc.

LESSON 7 4. BUILDING A LBO MODEL (cont)

MARKET CONDITIONS – What might be a good market condition?

When credit is easier to get.

Or, when the market is strong! “Easy money” times

After the crisis, in 2009 the leverage of LBO’s was less than 4 times EBITDA. In 2012, LBO’s went up to 6 times EBITDA.

LESSON 7 5. DECIDING ON METHODS OF FINANCING

When building an LBO deal, analysts consider the market conditions to determine how much debt the market will support. They want to maximize debt and minimize equity capital yet ensure the long-term success of the firm.

So, let’s assume conditions are good and will support a total debt to EBITDA multiple of 6 times. The analysts have determined that the EBITDA level of the firm is $300 million annually. The total debt for this deal is likely to be what?

$1.8 billion. So, let’s build a model!

LESSON 7 5. DECIDING ON METHODS OF FINANCING (cont)

The deal will not just be debt. There will be equity. Let’s assume equity will be 1.5 times EBITDA – so $450 million.

We have $1.8 billion in total debt, $450 billion in equity for total capitalization of $2.25 billion, making the LBO 7.5 times EBIDTA.

Thus, the LBO structure might look like this:

Revolving credit (LIBOR + 2%) $100 million

5 year term loan at 8% $900 million

Mezzanine debt $800 million

Equity $450 million

Total $2.25 billion

LESSON 7 5. DECIDING ON METHODS OF FINANCING (cont)

So, what does $2.25 billion buy?

Income stream of $300 million annually in EBITDA

Let’s assume the term loan is paid in 5 years from cash flow. The 1st years of an LBO pay down debt

Let’s assume in 5 years the firm will still sell an EBITDA multiple of 7.5 times, although this could be higher as debt is paid down.

Firm is till valued at 2.25 billion. However, debt is paid down $900 million so equity increased in value by $900 million

LESSON 7 5. DECIDING ON METHODS OF FINANCING (cont)

In 5 years, the investment will be $1.35 billion

(the $450 invested and $900 loan paid back)

The internal rate of return (IRR) from chapter 5 is ____, not a bad rate of return!

How do we figure this? Since I am not a math wizard and I don’t have a financial calculator I will make an educated guesstimate (not actually a word) of 25%. Let’s see how close I am?

LESSON 7 5. DECIDING ON METHODS OF FINANCING (cont)

Using 450

Year 1 450 x 25% = 112.5 + 450 = 562.5

Year 2 562.5 x .25 = 140.63 + 562.5 = 703.13

Year 3 703.13 x .25 = 175.78 + 703.13 = 878.94

Year 4 878.94 x.25 = 219.74 + 878.94 =1098.68

Year 5 1098.68 x.25 = 274.67 1098.68 = 1,373.35

OR 1,373,350,000 billion. Pretty close to the 1.35 billion. A little over, but the correct answer is:

24.5%. The present value of 1.35 billion 5 years from now with a 24.5% IRR is the $450 m investment

LESSON 7 5. DECIDING ON METHODS OF FINANCING (cont)

PV = FV / (1+r)n

PV is Present Value

FV is Future Value

r is the interest rate (as a decimal, so 0.10, not 10%)

n is the number of years

450 = 1,350/ = the answer

r = - 1 r = -1 the formula for calculating the internal rate of return

LESSON 7 6. WHAT CAN GO RIGHT OR WORNG?

The example is simple but an LBO is always changing and there are things IB must consider:

THE GOOD,

A. EBITDA can improve and the firm can also grow.

B. Refinancing the debt at a lower rate can make the deal more attractive.

C. The multiple can grow beyond the 7.5 times EBITDA if the firm has less debt and market conditions are good.

LESSON 7 6. WHAT CAN GO RIGHT OR WORNG?

THE BAD, AND THE UGLY!

D. Returns end up being low as the cash flows fall short of projections and projected EBITDA multiples were too optimistic

E. The market condition changes and economic conditions make it difficult, or impossible

F. Investors decline the deal. In our example, if the EBITDA multiple is 5.5 times in 5 years instead of 7.5 the IRR would only be 10.8% instead of the projected 24.5%.