Financing the Deal:Private Equity, Hedge Funds, and
Other Sources of Financing
No one spends other people’s money as carefully as they spend their own.
—Milton Friedman
Exhibit 1: Course Layout: Mergers, Acquisitions, and Other Restructuring Activities
Part IV: Deal Structuring and
Financing
Part II: M&A ProcessPart I: M&A Environment
Ch. 11: Payment and Legal Considerations
Ch. 7: Discounted Cash Flow Valuation
Ch. 9: Financial Modeling Techniques
Ch. 6: M&A Postclosing Integration
Ch. 4: Business and Acquisition Plans
Ch. 5: Search through Closing Activities
Part V: Alternative Business and Restructuring
Strategies
Ch. 12: Accounting & Tax Considerations
Ch. 15: Business Alliances
Ch. 16: Divestitures, Spin-Offs, Split-Offs,
and Equity Carve-Outs
Ch. 17: Bankruptcy and Liquidation
Ch. 2: Regulatory Considerations
Ch. 1: Motivations for M&A
Part III: M&A Valuation and
Modeling
Ch. 3: Takeover Tactics, Defenses, and Corporate Governance
Ch. 13: Financing the Deal
Ch. 8: Relative Valuation
Methodologies
Ch. 18: Cross-Border Transactions
Ch. 14: Valuing Highly Leveraged
Transactions
Ch. 10: Private Company Valuation
Learning Objectives
• Primary Learning Objective: To provide students with a knowledge of how M&A deals are financed and the role of private equity and hedge funds in this process.
• Secondary Learning Objectives: To provide students with a knowledge of – Advantages and disadvantages of LBO structures; – How LBOs create value;– Leveraged buyouts as financing strategies;– Factors critical to successful LBOs; and– Common LBO capital structures.
How are M&A Transactions Commonly Financed?
• Borrowing Options:– Asset based or secured
lending– Cash flow or unsecured
lenders (senior and junior debt)
– Long-term financing (junk bonds, leveraged bank loans, convertible debt)
– Bridge financing– Payment-in-kind
Financing M&As: Borrowing Options
Alternative Forms of Borrowing
Type of Security Backed By Lenders Loan Up to Lending Source
Secured Debt Short-Term (<1Yr.) Intermediate Term (1-10 Yrs.)
Liens generally on receivables and inventoryLiens on Land and Equipment
50-80% depending on quality
Up to 80% of appraised value of equipment; 50% of real estate
Banks, finance and life insurance companies; private equity investors; pension and hedge funds
Unsecured Debt (Subordinated incl. seller financing)Bridge FinancingPayment-in-Kind
Cash generating capabilities of the borrower
Life insurance companies, pension funds, private equity and hedge funds;target firms
Financing M&As: Equity Options
Alternative Forms of Equity
Equity Type Backed By Investor Types
Common Stock Cash generating capabilities of the firm
Life insurance companies, pension funds, hedge funds, private equity, and angel investors
Preferred Stock --Cash Dividends --Payment-in-Kind
Cash generating capabilities of the firm
Same as above
Financing M&As: Seller Financing
• Seller defers a portion of the purchase price• Advantages to seller:
– Buyer may be willing to pay seller’s asking price since deferral will reduce present value
– Makes sale possible when bank financing not available (e.g., 2008-2009)
• Advantages to buyer:– Shifts operational risk to seller if buyer defaults on
loan– Enables buyer to put in less cash at closing
Financing M&As: Cash on Hand and Selling
Redundant Assets
• “Cash on hand” represents cash in excess of normal operating requirements on the acquirer or target’s balance sheet.
• Target’s excess cash can be used to buy target firm’s outstanding shares.
• Redundant assets are those owned by the acquirer or target firm that are not considered germane to the acquirer’s business strategy.
Financial Buyers/Sponsors
In a leveraged buyout, all of the stock, or assets, of a public or private corporation are bought by a small group of investors (“financial buyers aka financial sponsors”), often including members of existing management and a “sponsor.” Financial buyers or sponsors:
• Focus on ROE rather than ROA.
• Use other people’s money.
• Succeed through improved operational performance, tax shelter, debt repayment, and properly timing exit.
• Focus on targets having stable cash flow to meet debt service requirements.
– Typical targets are in mature industries (e.g., retailing, textiles, food processing, apparel, and soft drinks)
Role of Private Equity and Hedge Funds in Deal Financing
• Financial Intermediaries– Serve as conduits between investors/lenders and borrowers– Pool resources and invest/lend to firms with attractive growth prospects
• Lenders and Investors of “Last Resort”– Buyers of about one-half of private placements– Source of funds for firms with limited access to credit markets
• Providers of Financial Engineering1 and Operational Expertise for Target Firms– Leverage drives need to improve operating performance to meet debt service– Improved operating performance enables firm to increase leverage– Private equity owned firms survive financial distress better than comparably leveraged
firms– Pre-buyout announcement date shareholder returns often exceed 40% due to investor
anticipation of operational improvement and tax benefits– Post-buyout returns to LBO shareholders exceed returns on S&P 500 due to improved
operating performance (better controls, active monitoring, willingness to make tough decisions)
1Financial engineering describes the creation of a viable capital structure that magnifies financial returns to equity investors.
Leveraged Buyouts (LBOs)
• Finance a substantial portion of the purchase price using debt.
• Frequently rely on financial sponsors for equity contributions
• Target firm management often equity investors in LBOs
• Management buyouts (MBOs) are LBOs initiated by management
LBOs As Financing Strategies
• LBOs are a commonly used financing strategy employed by private equity firms to acquire targets using mostly debt to pay for the cost of the acquisition
• Target firm assets used as collateral for loans
– Most liquid assets collateralize bank loans
– Fixed assets secure a portion of long-term financing
• Post-LBO debt-to-equity ratio substantially higher than pre-LBO ratio due to debt incurred to buy shares from pre-buyout private or public shareholders
– Debt-to-equity ratio also may increase even if pre-and post-LBO debt remains unchanged if the target’s excess cash and the proceeds from sale of target assets used to buy out target shareholders (Why? Assets decline relative to liabilities shrinking the target’s equity)
Impact of Leverage on Return to Shareholders
All-Cash Purchase ($Millions)
50% Cash/50% Debt ($Millions)
20% Cash/80% Debt ($Millions)
Purchase Price $100 $100 $100
Equity (Cash Investment by Financial Sponsor)
$100 $50 $20
Borrowings 0
$50 $80
Earnings Before Interest and Taxes (EBIT)
$20 $20 $20
Interest @ 10%1 0
$5 $8
Income Before Taxes $20 $15 $12
Less Income Taxes @ 40% $8
$6 $4.8
Net Income $12 $9
$7.2
After-Tax Return on Equity (ROE)2 12% 18% 36%
Impact of Leverage on Financial Returns
1Tax shelter in 50% and 20% debt scenarios is $2 million (I.e., $5 x .4) and $3.2 million (i.e., $8 x .4), respectively.2If EBIT = 0 under all three scenarios, income before taxes equals 0, ($5), and ($8) and ROE after tax in the 0%, 50% and 80% debt scenarios = $0 / $100, [($5) x (1 - .4)] / $50 and [($8) x (1 - .4)] / $20 = 0%, (6)% and (24)%, respectively. Note the value of the operating loss, which is equal to the interest expense, is reduced by the value of the loss carry forward or carry back.
LBO’s Impact of Target Firm Employment, Innovation, and Capital Spending
• Net reduction in employment at firms several years after undergoing LBOs is 1%– Employment at target firms declines about 3% in
existing operations compared to other firms in the same industry
– But employment at new ventures increases about 2%– Employment at private firms may increase
• LBOs often increase R&D and capital spending relative to peers
• Operating performance particularly for private firms undergoing LBOs improves significantly due to increased access to capital
Discussion Questions
1. Define the financial concept of leverage. Describe how leverage may work to the advantage of the LBO equity investor? How might it work against them?
2. What is the difference between a management buyout and a leveraged buyout?
3. What potential conflicts might arise between management and shareholders in a management buyout?
LBO Advantages and Disadvantages
• Advantages include the following:
– Management incentives,
– Better alignment between owner and manager objectives (reduces agency conflicts),
– Tax savings from interest expense and depreciation from asset write-up,
– More efficient decision processes under private ownership,
– A potential improvement in operating performance, and
– Serving as a takeover defense by eliminating public investors
• Disadvantages include the following:
– High fixed costs of debt raise the firm’s break-even point,
– Vulnerability to business cycle fluctuations and competitor actions,
– Not appropriate for firms with high growth prospects or high business risk, and
– Potential difficulties in raising capital.
How LBOs Create Value
Factors Contributing to LBO Value Creation
Buyouts of Private Firms
Buyouts of Public Firms
Key Factor: Alleviating Agency Problems
Key Factor: Provides Access to Capital
Factors Common to LBOs of Public and
Private Firms•Deferring Taxes•Debt Reduction•Operating Margin Improvement•Timing of the Sale of the Firm
LBOs Create Value by Reducing Debt and Increasing Margins Thereby Increasing Potential Exit Multiples
Firm Value
Debt Reduction Reinvest in Firm
Free Cash Flow
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Debt Reduction & Reinvestment Increases Free Cash Flow and In turn Builds Firm Value
Tax Shield Adds to Free Cash Flow
Debt Reduction
Adds to Free Cash Flow by
Reducing Interest & Principal
Repayments
Reinvestment Adds to Free Cash Flow by
Improving Operating Margins
Tax Shield1
1Tax shield = (interest expense + additional depreciation and amortization expenses from asset write-ups) x marginal tax rate.
LBO Value is Maximized by Reducing Debt, Improving Margins, and Properly Timing Exit
Case 1:
Debt Reduction
Case 2:
Debt Reduction + Margin Improvement
Case 3:
Debt Reduction + Margin Improvement + Properly
Timing Exit
LBO Formation Year:
Total Debt
Equity
Transaction/Enterprise Value
$400,000,000
100,000,000
$500,000,000
$400,000,000
100,000,000
$500,000,000
$400,000,000
100,000,000
$500,000,000
Exit Year (Year 7) Assumptions:
Cumulative Cash Available for
Debt Repayment1
Net Debt2
EBITDA
EBITDA Multiple
Enterprise Value3
Equity Value4
$150,000,000
$250,000,000
$100,000,000
7.0 x
$700,000,000
$450,000,000
$185,000,000
$215,000,000
$130,000,000
7.0 x
$910,000,000
$695,000,000
$185,000,000
$215,000,000
$130,000,000
8.0 x
$1,040,000,000
$825,000,000
Internal Rate of Return 24% 31.2% 35.2%
Cash on Cash Return5 4.5 x 6.95 x 8.25 x
1Cumulative cash available for debt repayment increases between Case 1 and Case 2 due to improving margins and lower interest and principal repayments reflecting the reduction in net debt.2Net Debt = Total Debt – Cumulative Cash Available for Debt Repayment = $400 million - $185 million = $215 million3Enterprise Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year4Equity Value = Enterprise Value in 7th Year – Net Debt5The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return, because it accounts for the time value of money.
Common LBO Deal Structures
• Direct merger: Target firm merged directly into the firm controlled by the financial sponsor
• Subsidiary merger: Target firm merged into a acquisition subsidiary wholly-owned by the parent firm which in turn is controlled by the financial sponsor
• A reverse stock split: Used when a firm is short of cash to reduce the number of shareholders below 300 which forces delisting of the firm from public exchanges. Majority shareholders retain their shares after the reverse split reduces the number of shares outstanding; minority shareholders receive a cash payment.
Direct Merger
Acquirer (Controlled by
Financial Sponsor)
Target Firm Shareholders
Target Firm
Lender
Target Merges with Acquirer
Target Stock
Acquirer Cash and Stock
Loan
Financial Sponsor (Limited Partnership
Fund)
Equity Contribution
Subsidiary Merger
Financial Sponsor Limited Partnership Fund
Parent (Controlled by Financial
Sponsor)
Lender
Target Firm
Target Firm ShareholdersMerger Sub
Equity Contribution
Merger Sub Cash & Shares
Target Firm Shares
Merger Sub Merges Into Target
Merger Sub SharesEquity
Contribution
Loan
Loan Guarantee
Typical LBO Capital Structure
Purchase Price
Equity (25%)
Debt (75%)
Common Equity (10%)
Preferred Equity (15%)
Revolving Credit (5%)
Senior Secured Debt
(40%)
Sub Debt/Junk
Bonds (30%)
Term Loan A
Term Loan B
Term Loan C
2nd Mortgage Debt
Mezzanine Debt & PIK
Case Study: Cox Enterprises Takes Cox Communications Private
In an effort to take the firm private, Cox Enterprises announced a proposal to buy the remaining 38% of Cox Communications’ shares not currently owned for $32 per share. Valued at $7.9 billion (including $3 billion in assumed debt), the deal represented a 16% premium to Cox Communication’s share price at that time. Cox Communications is the third largest provider of cable TV, telecommunications, and wireless services in the U.S, serving more than 6.2 million customers. Historically, the firm’s cash flow has been steady and substantial.
Cox Communications would become a wholly-owned subsidiary of Cox Enterprises and would continue to operate as an autonomous business. Cox Communications’ Board of Directors formed a special committee of independent directors to consider the proposal. Citigroup Global Markets and Lehman Brothers Inc. committed $10 billion to the deal. Cox Enterprises would use $7.9 billion for the tender offer, with the remaining $2.1 billion used for refinancing existing debt and to satisfy working capital requirements.
Cable service firms have faced intensified competitive pressures from satellite service providers DirecTV Group and EchoStar communications. Moreover, telephone companies continue to attack cable’s high-speed Internet service by cutting prices on high-speed Internet service over phone lines. Cable firms have responded by offering a broader range of advanced services like video-on-demand and phone service. Since 2000, the cable industry has invested more than $80 billion to upgrade their systems to provide such services, causing profitability to deteriorate and frustrating investors. In response, cable company stock prices have fallen. Cox Enterprises stated that the increasingly competitive cable industry environment makes investment in the cable industry best done through a private company structure.
Discussion Questions:
1. What is the equity value of the proposed deal?
•Why did the board feel that it was appropriate to set up special committee of independent board directors?
•Why does Cox Enterprises believe that the investment needed for growing its cable business is best done through a private company structure?
•Is Cox Communications a good candidate for an LBO? Explain your answer.
•How would the lenders have protected their interests in this type of transaction? Be specific.
Things to Remember…
• M&As commonly are financed through debt, equity, and available cash on balance sheet or some combination.
• LBOs make the most sense for firms having stable cash flows, significant amounts of unencumbered tangible assets, and strong management teams.
• Successful LBOs rely heavily on management incentives to improve operating performance and a streamlined decision-making process resulting from taking the firm private.
• Tax savings from interest and depreciation expense from writing up assets enable LBO investors to offer targets substantial premiums over current market value.
• Excessive leverage and the resultant higher level of fixed expenses makes LBOs vulnerable to business cycle fluctuations and aggressive competitor actions.