Leveraged Buyouts andManagement Buyouts

Using OPM to Buy a Firm

(Other People’s Money)

Leveraged Buyout

• Small group of investors borrows money to buy the stock of a public corporation.

• LBO transaction is expected to be reversed with a public offering within three to five years.

• Sometimes only a segment, a division or subdivision of the firm is bought.

Management

• Buyout:– An LBO where management plays a

significant role.

• Buyin:– An LBO where outside management plays a

significant role.

LBO and MBO Sponsors

• Leveraged buyout specialist (KKR)

• Venture capitalists

• Investment bankers

FORBES TOP 25 PRIVATE COMPANIESSource: www.forbes.com

Rank Name State Industry Revenues ($mil) Employees1 Cargill MN Crops 59,894 98,0002 Koch Industries KS Oil & Gas Operations 40,000 17,0003 Mars VA Food Processing 16,800 31,0004 Publix Super Markets FL Retail (Grocery) 16,027 123,0005 PricewaterhouseCoopers NY Business Services 15,900 125,0006 Ernst & Young NY Business Services 13,100 106,0007 Bechtel CA Construction Services 11,600 47,0008 C&S Wholesale Grocers VT Retail (Grocery) 11,300 9,0009 Meijer MI Retail (Grocery) 10,900 84,00010 HE Butt Grocery TX Retail (Grocery) 10,700 56,00011 TRW Automotive MI Auto & Truck Parts 10,630 63,00012 Huntsman UT Chemical Manufacturing 9,000 15,00013 Fidelity Investments MA Investment Services 8,937 29,14214 Swift & Co CO Food Processing 8,380 21,30015 JM Family Enterprises FL Auto & Truck Manufacturers 7,600 3,50016 Enterprise Rent-A-Car MO Business Services 6,900 53,50017 Science Applications Intl CA Aerospace & Defense 5,902 38,70018 Unisource GA Forestry & Wood Products 5,900 8,00019 Marmon Group IL Misc Fabricated Products 5,756 30,00020 Advance Publications NY Printing & Publishing 5,565 27,58521 Menard WI Retail (Home Improvement) 5,500 33,30022 SC Johnson & Son WI Personal & Household Prods 5,372 12,00023 MDFC Holding CA -- 5,105 60,50024 International Steel Group OH Iron & Steel 5,000 11,60025 Alticor MI Personal & Household Prods 4,900 11,50026 Giant Eagle PA Retail (Grocery) 4,739 26,00027 Cox Enterprises GA Broadcasting & Cable 4,444 53,17228 Southern Wine & Spirits FL Beverages (Alcoholic) 4,400 7,10029 MBM NC Retail (Grocery) 4,236 3,50030 Hy-Vee IA Retail (Grocery) 4,230 46,00031 Reyes Holdings IL Retail (Grocery) 4,180 3,99432 Levi Strauss & Co CA Apparel/Accessories 4,137 12,00033 Hallmark Cards MO Printing & Publishing 4,039 18,64534 Platinum Equity CA Computer Services 4,000 18,00035 Graybar Electric MO Electronic Instr & Controls 3,975 8,30036 Guardian Industries MI Constr - Supplies & Fixtures 3,940 19,00037 Gulf States Toyota TX Auto & Truck Manufacturers 3,750 3,00038 InterTech Group SC Chemical Manufacturing 3,700 16,00039 Peter Kiewit Sons' NE Construction Services 3,699 15,00040 Eby-Brown IL Retail (Grocery) 3,670 2,10041 Roundy's WI Retail (Grocery) 3,638 19,00042 Hearst NY Printing & Publishing 3,565 17,32043 Schwan Food MN Food Processing 3,500 24,00044 Milliken & Co SC Textiles - Non Apparel 3,419 14,00045 Flying J UT Oil & Gas Operations 3,417 12,00046 Raley's CA Retail (Grocery) 3,200 16,20047 JR Simplot ID Crops 3,100 12,00048 Wegmans Food Markets NY Retail (Grocery) 3,020 31,30049 Bloomberg NY Business Services 3,000 8,20050 Gordon Food Service MI Retail (Grocery) 3,000 5,750

DateAnnounced

Target Name Target Industry Sector TargetNation

Acquiror Name AcquirorNation

Value ofTransaction

($mil)29-Jul-02 Legrand SA Electronic and Electrical Equipment France Investor Group France 5,059.7211-Jun-03 Seat Pagine Gialle-Directories Printing, Publishing, and Allied Services Italy Silver SpA United Kingdom 4,367.534-Sep-03 Ondeo Nalco Co Chemicals and Allied Products United States Investor Group United States 4,350.0020-Aug-02 Qwest Commun Intl Inc-QwestDex Printing, Publishing, and Allied Services United States Investor Group United States 4,300.006-Oct-03 Scottish & Newcastle-Ret Bus Food and Kindred Products United Kingdom Spirit Amber Bidco Ltd United States 4,173.882-Oct-00 IBP Inc Food and Kindred Products United States DLJ Merchant Banking Partners United States 3,766.9817-Oct-03 Chelsfield PLC Investment & Commodity Firms,Dealers,Exchanges United Kingdom Duelguide PLC United Kingdom 3,413.4017-Jun-02 Jefferson Smurfit Group PLC Paper and Allied Products Ireland-Rep MDP Acquisitions Ireland-Rep 3,315.0126-May-01 Yell Group Printing, Publishing, and Allied Services United Kingdom Investor Group United Kingdom 3,043.0823-Jun-00 Johns Manville Corp Stone, Clay, Glass, and Concrete Products United States Investor Group United States 3,028.458-Mar-02 Southern Water(Scottish Power) Electric, Gas, and Water Distribution United Kingdom First Aqua Ltd United Kingdom 2,927.6112-Sep-03 Debenhams PLC Retail Trade-General Merchandise and Apparel United Kingdom Baroness Retail Ltd United Kingdom 2,912.7820-Mar-02 Unique Pub Co,Voyager Pub Co Retail Trade-Eating and Drinking Places United Kingdom Investor Group United Kingdom 2,865.9122-Feb-00 Deutsche Telekom AG-North Radio and Television Broadcasting Stations Germany Investor Group United States 2,784.6120-Aug-02 Qwest Comm Intl-QwestDex Printing, Publishing, and Allied Services United States Investor Group United States 2,750.0025-May-01 Le Meridien Hotels Hotels and Casinos United Kingdom Grand Hotels(M)Acquisition Co1 United Kingdom 2,675.9624-Nov-03 Warner Music Group Electronic and Electrical Equipment United States Investor Group United States 2,600.0029-Jun-01 Eircom PLC Telecommunications Ireland-Rep Valentia Group Ireland-Rep 2,560.7012-May-03 Debenhams PLC Retail Trade-General Merchandise and Apparel United Kingdom Laragrove Ltd United Kingdom 2,492.843-Jan-01 Messer Griesheim GmbH Chemicals and Allied Products Germany Investor Group Germany 2,467.967-Aug-00 VEBA Electronics Inc(VEBA AG) Wholesale Trade-Durable Goods United States Investor Group United States 2,350.0020-Mar-01 Fairbar Ltd Retail Trade-Eating and Drinking Places United Kingdom Shopgood Ltd(Morgan Grenfell) United Kingdom 2,327.9828-Jan-03 Deutsche Telekom-Cable TV Cos Radio and Television Broadcasting Stations Germany Investor Group United Kingdom 2,282.2912-Sep-01 Cognis BV(Henkel KGaA) Chemicals and Allied Products Netherlands Investor Group Germany 2,266.00

THE 25 LARGEST LBOs, Jan 2000 - Dec 2003

Source: Securities Data Corporation

THE 25 LARGEST LBOs, 1980-2003

Target Name Target Industry Sector TargetNation

Acquiror Name AcquirorNation

Value ofTransaction($mil)

RJR Nabisco Inc Tobacco Products United States Kohlberg Kravis Roberts & Co United States 30,598.78Beatrice Companies Inc Machinery United States BCI Holdings Corp United States 6,095.00Safeway Stores Inc Retail Trade-Food Stores United States SSI Holdings Corp United States 5,335.00Legrand SA Electronic and Electrical Equipment France Investor Group France 5,059.72Hospital Corp of America Health Services United States HCA-Hospital Corp of America United States 4,915.00Borden Inc Food and Kindred Products United States Kohlberg Kravis Roberts & Co United States 4,643.42Seat Pagine Gialle-Directories Printing, Publishing, and Allied Services Italy Silver SpA United Kingdom 4,367.53Ondeo Nalco Co Chemicals and Allied Products United States Investor Group United States 4,350.00Qwest Commun Intl Inc-QwestDex Printing, Publishing, and Allied Services United States Investor Group United States 4,300.00Borg-Warner Corp Electronic and Electrical Equipment United States Borg-Warner Holdings Corp United States 4,202.60Scottish & Newcastle-Ret Bus Food and Kindred Products United Kingdom Spirit Amber Bidco Ltd United States 4,173.88Southland Corp Retail Trade-Food Stores United States JT Acquisition Corp United States 4,055.00Montgomery Ward & Co Inc Retail Trade-General Merchandise and

ApparelUnited States BFB Acquisition Corp United States 3,800.00

Owens-Illinois Inc Stone, Clay, Glass, and Concrete Products United States Owens-Illinois Holdings Corp United States 3,640.00

NWA Inc Air Transportation and Shipping United States Wings Holdings Inc United States 3,580.00Fort Howard Corp Paper and Allied Products United States FH Acquisition Corp United States 3,579.40RH Macy & Co Inc Retail Trade-General Merchandise and

ApparelUnited States Macy Merger Corp United States 3,523.30

Elders IXL Ltd Food and Kindred Products Australia Harlin Holdings Pty Ltd Australia 3,434.34Jefferson Smurfit Group PLC Paper and Allied Products Ireland-Rep MDP Acquisitions Ireland-Rep 3,315.01American Medical International Health Services United States IMA Holdings Corp United States 3,307.85Gateway Corp PLC Retail Trade-Food Stores United Kingdom Isosceles PLC(Gateway Corp) United Kingdom 3,292.36Yell Group Printing, Publishing, and Allied Services United Kingdom Investor Group United Kingdom 3,043.08Southern Water(Scottish Power) Electric, Gas, and Water Distribution United Kingdom First Aqua Ltd United Kingdom 2,927.61Debenhams PLC Retail Trade-General Merchandise and

ApparelUnited Kingdom Baroness Retail Ltd United Kingdom 2,912.78

LBO Financing

• Secured Debt– Secured debt is also called asset-based lending, and it can be

either senior or intermediate term debt.

• Senior Debt– Comprises loan secured by liens on particular assets of the

company.– The collateral includes physical assets such as land, plant and

equipment, accounts receivable, and inventories.• Lenders will usually advance 85% of the value of the accounts

receivable and 50% of the value of the target inventories.

• The process of determining the collateral value of the LBO candidate's assets is sometimes called qualifying the assets.

Private companies outperform relative to the market.Source: McKinsey Quarterly, 2001, n. 2.

LBO companies remain private only for a few years.

Financial Acquirers (LBOs) negotiate better than Corporate Acquirors (Mergers & Tender Offers).

Intermediate Term Debt

• Is usually subordinate, and often backed up by fixed assets such as land and plant and equipment.

• The collateral value of theses assets is usually based on their liquidation value.

• Debt backed up by equipment typically has a term of six months to one year.

• Loans backed up by real estate tend to have a one- to two-year term.

Unsecured Debt Financing

• It is usually referred to as subordinated and junior subordinated debt.

• The term mezzanine layer financing is often applied to this financing because it has both debt and equity characteristics: it is equity like in that lenders typically receive warrants that may be converted into equity in the target.

• When the warrants are exercised, the share of ownership of the previous equity holders is diluted. It is important to be aware of the role of the warrants in computing the return to the providers of mezzanine layer financing.

Buyout Benefits

• Tax savings– Stepped up asset base.

• Approximately half of the companies involved in LBOs stepped up their asset base in 1980's (Kaplan, Journal of Financial Economics, 1989)

– Tax shields from interest payments.• One should realize, however, that these benefits should be

relatively low when all of the costs and benefits are factored in. Most likely the LBO companies do not have the optimal capital structure in the first few years after the LBO - why would they otherwise not keep those high debt levels?

The next two tables are from Kaplan, S. (1989), “Management Buyouts: Evidence on Taxes as a Source of Value”, Journal of Finance, 611-632.

Buyout Benefits Continued

• Managerial incentives and other agency issues.– Managers own a larger fraction of the equity.– Separation of ownership and control has been

reduced. As a result managers have larger incentives to worry about shareholders value.

• Often they also get a larger fraction of their compensation tied to company performance.

– Monitoring benefits.• Fewer and larger external shareholders (institutional

investors) have an incentive to monitor managerial behavior.– Debt-bonding effect.

• The debt payments reduce managerial discretion in the spending of free cash flows. “Debt provides discipline.”

Buyout Benefits Continued

• Expropriation of “old” bondholders– LBOs increase riskiness of old debt without

increasing their promised interest payments.– A bond with covenants to protect against this

are said to have “event risk protection.”• Bonds with event risk protection were common in

the early 1990’s.– Response to several large investment grade bond issues

that were reduced to high yield status overnight via leveraged buyouts.

• Few bonds now carry event risk protection.

Buyout Benefits Continued

• Expropriation of employees– Anecdotal evidence: easier layoffs and

reduction in over-funded pension plans.

Buyout Benefits Continued

• Exploiting undervaluation.– Management has more information about future cash-

flows than outside owners. Although selling shareholders are receiving high premiums, managers are possibly paying a too low price.

– Evidence:• Median annualized rate of return on equity to post-buyout

shareholders in a firm that goes public again was 286% in 1980-1987.

– This gain was positively related to managerial ownership.

• However, there also exists evidence that stock prices fall back to their pre-buyout levels in failed MBOs.

Buyout Benefits Continued

• Reducing costs of being a public company.– These costs include administrative costs

inside the company as well as regulatory costs to the stock exchange.

Buyout Costs

• Cost of financial distress.

• Managers become undiversified and may be less willing to take risks.

• Inappropriate investment policy (underinvestment) because of high leverage.

Good LBO Candidates

• High potential benefits:– Potentially high agency costs:

• Small managerial ownership currently• Large excess cash

– High marginal tax rate and stable earnings.• Makes debt financing attractive.

– Low current leverage.– No need for new equity financing.

Good LBO Candidates Continued

• Low potential costs:– Low investment needs - underinvestment and

non risk-taking behavior do not pose a threat.– Parts of the assets can be sold if necessary.