LBOs and LBIs

7/29/2019 LBOs and LBIs

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Leveraged buy outs andbuy ins

Dr Clive Vlieland-Boddy


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Terminology MBO = Management Buy-Out

The purchase of a business by its existing managementteam

MBI = Management Buy-In

Similar, but the Entrepreneurs leading the transactionwill 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, Depreciationand amortisation


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MBO / MBI s andEntrepreneurship

Entrepreneurship can involve the purchaseof 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.


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MBO Vs MBI

MBO

Recent research shows the importanceof innovative behaviour, and newproduct development, which may nototherwise have happened

Significantly better performance over 3-5 years than comparable non-buy-outs


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Why do MBO / MBIs Occur?

Typically, because of corporate restructuring activity,leading the parent company to want to divest asubsidiary.

BOs are the most common method of privatisation

Or, in the private arena, if an entrepreneur has nofamily to succeed him/her in the business

Significant levels of business exist in 1999 thisrepresented $50bn in value

An increasing proportion is in private companies inthe UK in 1998 half of all MBO/MBIs were in privateorganisations.


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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 anenterprise which is not realising its fullpotential


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WHY?

Opportunity to enhance performance(commonly for privatisations

Retaining the management team givesadditional stability

Wealth Creation studies prove that in theshort term after a buy-out there is substantialimprovements in profitability, cash flow and

productivity measures


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Leveraged Buyout GeneralCharacteristics

Leverage ranges from 6:1 to 12:1. Debt to EBITDAranges 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 thefirm 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


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European buyout value

European buyout value:72 billion in Q1-Q3 2008


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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 ofthis particular business) are often replaced by

the hybrid BIMBO (Buy In Management BuyOut)


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Leveraged Finance - Introduction

Leveraged Finance simply means funding a company orbusiness unit with more debt than would be considered normalfor that company or industry.

Higher-than-normal debt implies that the funding may beriskier, and therefore more costly, than normal borrowing --

higher credit spreads and fees. It is often also more complexwith covenants and waterfalls.

Hence leveraged finance is commonly employed to achieve aspecific, often temporary, objective: to make an acquisition, to

effect a buy-out, to repurchase shares or fund a one-timedividend, or to invest in a self sustaining, cash-generatingasset.


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Definition of an LBO

Transaction in which a group of private investorsuses debt financing to purchase a corporation ora corporate division. Equity securities of the

company are no longer publicly traded, thoughthe debt and preferred stock may be publiclytraded. Uses entire borrowing structure

Often involves an LBO sponsor who contributes

capital and expertise (KKR, Bass Brothers,Blackstone, etc.) and management team.


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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 fortransaction, re-sell the new company for a profit.

High amortization assures self-restraint on behalf of theborrower.

In a typical LBO, capital expenditures do not exceeddepreciation by much.

By changing the relative participation of debt and equityin the capital structure, an LBO redistributes returns andrisks among providers of capital.


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Typical LBO Structure

IncrementalDebt to EBITDAratio

This totals 7-8 xEBITDA

4-6


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Rewards

Because of the way deals are structured, themanagement team will often be given a larger

percentage of the equity than is warrantedjust by their investment

Equity ownership gives increased

entrepreneurial control and opportunity todevelop their own strategy


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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 managementoften have little idea what is involved (but have tolearn 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 ofpressure, and usually appoint their own FD, and non-exec Chairman.


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Distinct Features of an LBO

Significant increase in financial leverage

Average debt/total capital increases from 20% to70%

Management ownership interest increases

Non-mgmt equity investors join the board Before an LBO, non-management directors have

almost no ownership. After, non-managementdirectors may represent 40%-60% of equity

holders


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Characteristics of PotentialLBO 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 (hightech?)

Low-cost producers with modern capital

Take low risk business, layer on risky financing


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Typical LBO Structure Varies over time with market conditions

Debt Financing Total debt often 60-80% of entire deal (4-5 x LTMEBITDA, 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


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LBO Financing

LBO sponsors have equity funds raised from institutionslike pensions & insurance companies

Some have mezzanine funds as well that can be used forjunior subordinated debt and preferred

Occasionally, sponsors bring in other equity investors oranother sponsor to minimize their exposure

Balance from commercial banks (bridge loans, termloans, revolvers) & other mezzanine sources

Banks concentrate on collateral of the company, cashflows, level of equity financing from the sponsor,coverage ratios, ability to repay (5-7 yr)


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LBO Financing Senior Bank Debt

Senior bank debt which is secured with assets likereceivables, 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 forprotection


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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 ofthe business.


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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 thesame, but not necessarily a good assumption

rarely expect multiple expansion

Ask what the exit strategy is likely to be.


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Management Ownership

Management puts up 60% to 70% of wealth(excluding residence)

Management share of equity (sometimescalled management promote) usuallyincreases year by year as they meet targets

Managers are sometimes offered chance tobuy stock

Managers often already own shares in acompany that does an LBO and they do notnecessarily cash


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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 areasonable level, the entity issues a new round

of debt and pays a large dividend to equityholders (or repurchases shares). Some, but notall, equity holders may be taken out.


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Potential Motivations for an LBO

Increase in debt and concentrated ownershipincrease 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 inthe firm such as employees & bondholders


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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


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Simple ExampleAlbert Enterprises


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Simple Example Albert Enterprises

Albert Enterprises is a long establishedmanufacturing enterprise.

Run for over 40 years by the principal shareholder(100%) who is now approaching retirement.

The key management want to buy the business butdo not have any real capital.

The business is successful. EBITDA for last 10

years is5m before tax at 30%, and has not grown. The management want to grow the business but

the owners dislikes risks. They estimate that profitscould grow by 10% per annum


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The business has been valued at40m.

It has a freehold factory valued at15m.

It has cash in the bank of5m. It has no bank loans.

A private Equity firm has offered to finance

the MBO.


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Suggestions

..


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The company could borrow say 80-90% ofthe value of the freehold factory. Thiswould generate say12m at a low rate of

say 5% per annum interest. The management could request that the

owner takes out the cash in bank of5m.

That would leave a balance of23m.


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Private Equity has agreed to provide thefollowing:

7 year loan of20m at a rate of 8%.

2 year loan of3m at a rate of 10%

Equity kicker of 25% of the equity.



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Lets look at the figures

Before LBO Profits were 5.0m

Less Tax 30% 1.5m

Post Tax 3.5m

After LBO (Year 1) Profits were 5.0m

Add growth 0.5m

New Profits 5.5m

Less Interest 12m @ 5% 0.6m

20m @ 8% 1.6m

3m @ 10% 0.3m

Pre Tax Profit 3.0m

Less tax 30% 0.9m

Post Tax 2.1m


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Vendor Financing


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Reasons for Vendor Financing

Normally buyer cannot raise the capital.

Vendor keen to sell.


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Vendor Financing

The seller agrees that all or part of the agreedsale 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 knowingthat if there turns out to be undisclosed issuesthen they have some redress.

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LBOs and LBIs

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