©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - -...

©2001 Prentice Hall Takeovers, Restructuring, and Corporate

Governance, 3/e Weston - 1

- - - - - - - - Chapter 16 - - - - - - - -

Going Private and Leveraged Buyouts



Introduction• Going private — transformation of a public

corporation into a privately held firm• Leverage buyout (LBO) — purchase of a

company by a small group of investors using a high percentage of debt financing– Investors are outside financial group or

managers or executives of company– Management buyout (MBO) — leveraged

buyout performed mainly by managers or executives of the company



– Results in significant increase of equity share ownership by managers

– Turnaround in performance is usually associated with formation of LBO

– Typical LBO operation• Financial buyer purchases company using high

level of debt financing• Financial buyer replaces top management• New management makes operating

improvements• Financial buyer makes public offering of improved

company at higher price than originally purchased



• Leverage buyout activity– Reached peak during 1986-1989– Largest LBO was RJR Nabisco in 1988 with

purchase price of $24.6 million– Total purchase price of 20 largest LBOs

formed during 1983-1995 was $76.5 billion

Characteristics of Leveraged Buyouts



• Buyout group may include incumbent management and may be associated with – Buyout specialists, e.g., Kohlberg Kravis

Roberts & Co.– Investment bankers– Commercial bankers



• Management buyouts (MBOs) – Investor group dominated by incumbent

management– Segment acquired from parent company

• LBO transaction may be reversed with future public offering – Aim is to increase profitability of company

and thereby increase market value of firm– Buyout group seeks to harvest gain within

three- to five-year period



Three Major Stages of Leveraged Buyouts

• The 1980s– Economic and financial environments

favorable to M&A activity and LBOs– For 1986-1989,

• LBO activity reached peak• LBOs accounted for 20.5% of total dollar value of

completed mergers• Premiums paid were at highest levels — mean of

33.9% and median of 26.5%• Price earning ratios paid — mean of 20.5



• Early 1990s– LBOs declined from peak total of $65.7

billion in 1989 to $6.8 billion in 1991– Decline due to

• Economic and legislative changes• Unsound LBO transactions of late 1980s

– For 1990-1992, • LBOs accounted for 6.8% of total dollar value of

completed mergers• Sharp decline in relative premiums paid — mean

of 27.6% and median of 19.9%• Sharp decline in price earning ratios paid —

mean of 14.6



• Post-1992– LBOs reached $62.0 billion in 1999– Revival of LBOs due to new developments in

nature of LBO transactions and market participants

– For 1993-1998,• LBOs accounted for 1.6% of total dollar value of

completed mergers• Relative premiums paid for LBOs slightly below

1986-1989 levels — mean of 33.5% and median of 24.2%

• Price earning ratios paid — mean of 23.8



LBOs in the 1980s• Characteristics

– Debt financing• Highly leveraged — up to 90% of purchase price• Debt secured by assets of acquired firm or based

on expected future cash flows• Paid off either from sale of assets or from future

cash flows generated by operations

– Acquired company became privately held– Firm expected to go public again after three

to five years



• General economic and financial factors– Same as factors stimulating mergers– Sometimes LBOs and MBOs were responses

to threat of unwanted takeovers– Sustained economic growth between 1982-

1990– Earlier inflation

• GNP implicit price deflator during 1968-1982 increased by no less than 5%

• Caused q-ratio to decline sharply — cheaper to buy capacity in financial markets than in real asset markets

• Provided opportunities to realize tax savings through recapitalization



– Financing innovations — high-yield bonds (junk bonds) made public financing available to companies below investment grade

– Legislative factors, especially taxes• Succession of laws that deregulated financial

institutions• Economic Recovery Tax Act (ERTA) of 1981• General Utilities doctrine • Legislative changes affecting ESOPs —

encouraged MBOs

– Change in antitrust climate - beginning in 1980



• Elements of a typical LBO operation– First stage — raise cash required for buyout

and devise management incentive systems• Financing

– About 10% of cash is put up by investor group headed by company's top managers and/or buyout specialist

– About 50-60% of required cash through secured bank loans

– Rest of cash by issuing senior and junior subordinated debt

• Private placement with pension funds, insurance companies, venture capital firms

• Public offerings of "high-yield" notes or bonds (junk bonds)



• Management incentives– Managers receive stock price-based incentive

compensation in form of stock options or warrants– Incentive compensation plans based on measures

such as operating performance

– Second stage — organizing sponsor group takes company private• Stock-purchase — buys all outstanding shares of

company• Asset-purchase — purchases all assets of

company and forms new privately held corporation

• New owners sell off parts of acquired firm to reduce debt



– Third stage — management strives to increase profits and cash flows• Cut operating costs • Cut spending in research and development• Cut new plants and equipment as long as

provisions for capital expenditures are adequate and satisfy lenders

• Increase revenues by changing marketing strategies



– Fourth stage — reverse LBOs• Investor group may take improved company

public again through public equity offering (secondary initial public offering - SIPO)

• Create liquidity for existing stockholders• Muscarella and Vetsuypens (1990)

– 72 reverse LBOs in 1976-1987– 86% of firms use offering proceeds to lower company's

leverage– Equity participants realized median annualized rate of

return of 268.4% on equity investment by time of SIPO– Median length of time between LBO and SIPO was 29

months



• Conditions and circumstances of going-private buyouts in the 1980s– Typical target industries

• Basic, nonregulated industries– Predictable and/or low financing requirements– Predictable/stable earnings

• High-tech industry less appropriate– Shorter history of profitability– Greater business risk– Fewer leveragable assets– Command high P/E multiples well above book value



• Lehn and Poulsen (1988) – Half of 108 LBOs during 1980-1984 were in five

industries:• Retailing• Textiles• Food processing• Apparel• Soft drinks

– Consumer nondurable goods• Low income elasticity of demand• Sales fluctuate less with GNP

– Mature industry with limited growth opportunities



– Other target characteristics• Track record of capable management• Strong market position within industry to enable

it to withstand economic fluctuations and competition

• Highly liquid balance sheet– Little debt, either short or long term– Large unencumbered asset base — for collateral– High proportion of tangible assets with fair market

value above net book value



– Leverage factors• Increase return on equity (ROE) and cash flows

to retire debt• Attractions for lenders

– Interest rates only 3-5 points above prime rate– Company and collateral characteristics

• Large amounts of cash/cash equivalents• Undervalued assets (hidden equity)• Could liquidate some subsidiaries to raise funds

– High prospective rates of return on equity especially for lenders such as venture capitalists and insurance companies with equity participation

– Confidence in management group spearheading LBO



– Management factors• Record of capability• Betting reputation and personal wealth on

success of LBO• Highly motivated by potential large personal

gains from stock ownership

– Sources of MBO targets• Divestitures of divisions by public companies• Private companies with low growth records• Public corporations selling at low P/E multiples

representing large discounts from book values



• Empirical results– DeAngelo, DeAngelo, and Rice (1984)

• 72 firms making 72 initial and 9 subsequent going-private proposals during 1973-1980

• Relatively small firms measured by median market value of total equity

– $6 million for 45 pure going-private sample– $15 million for 23 LBOs

• Pre-offer management ownership high– Mean of 45% and median of 51% for 72 going-private

sample– Mean of 32% and median of 33% for 23 LBOs



• Stockholder wealth effects– At announcement: +22%, significant– CAR for window [-40,0]: over +30%– Measured as average premium over market (two months

before proposal): Over +56% for 57 cash payment proposals

• Withdrawal of going-private announcements (18 firms)

– Negative return at announcement: -9%– Offset by positive 13% return (Days -40 through 0) for net

effect of +4%– Cumulative effect rises to +8% (Days 0 through +40)– Explanations for positive impact of withdrawal:

• Information effect — permanent upward revaluation of firm's prospects

• Probability that management might revive proposal• Possibility that another acquirer might step in to make offer



– Lowenstein (1985)• 28 MBOs during 1979-1984• Each valued at over $100 million at winning bid• Management ownership fraction very small

– Pre-offer: 3.8% (median); 6.5% (mean)– Post-offer: 10.4% (median); 24.3% (mean)

• Premium over market price 30 days before announcement:

– 58% (median); 56% (mean)– Premiums rose with number of bids — three or more

bids, premium = 76% (median), 69% (mean)– Premium over management bid in 11 successful third-

party bids relatively small — 8% (median), 14% (mean)



– Lehn and Poulsen (1988)• Sample of LBOs in 1980-1984• Substantial leverage increases in 58 firms

– Average pre-LBO debt/equity ratio of 46%– Average post-LBO debt/equity ratio of 552%

• Wealth effect for 92 LBOs (Days -20 through +20) = over +20%, significant

• Average premium (relative to stock price 20 days before announcement) = 41% for 72 all cash-offer LBOs



– Hite and Vetsuypens (1989)• 151 divisional MBOs• Small but significant wealth gain to parent

company shareholders – Mean abnormal return during two-day period

surrounding announcement = 0.55%– Abnormal return translates into 3.3% for full LBO (mean

sale price of division about 16.6% of market value of average seller)

– Gains lower than those found for LBOs

• Interpretation– Divisional MBOs reallocate ownership of corporate

assets to higher-valued uses – Parent company shareholders share in expected

benefits of change in ownership structure



– Muscarella and Vetsuypens (1990)• 45 divisional buyouts which subsequently went

public• Average period from buyout to public offering

was 34 months• Mean abnormal return of 1.98% to seller in two

days around announcement



• Sources of gains in LBOs during the 1980s– Tax benefits — can enhance already viable

transaction• Specific tax benefits

– Interest tax shelter from high leverage– Asset step-up provides higher asset value for

depreciation expenses; especially accelerated depreciation on assets involving little recapture — more difficult under Tax Reform Act of 1986

– Tax advantages of using ESOP as LBO vehicle

• Lowenstein (1985)– Most of premium paid is financed from tax savings– New companies may operate tax-free up to six years

(LBO often sold at this point anyway when debt/equity ratio declines from 10 times to 1 or under)



• Kaplan (1989a,b)– Value of tax benefits

• Assuming a 46% tax rate and permanent new debt, median value of tax benefit at 1.297 times premium

• 30% tax rate and new debt with maturity of eight years, median value of tax benefits at 0.262 times premium

• For firms that used step-up basis of their assets — median value of tax benefit at 0.304 times premium

– Large and predictable tax benefits result from buyout• Small portion attributed to unused debt capacity or

inefficient use of tax benefits prior to buyout• Implies that large portion of tax benefits attributable

to buyout – Prebuyout shareholders capture most of tax benefits– ESOP loans infrequently used due to nontax costs



– Management incentives and agency cost effects• Argument for: Increased ownership stake

provides increased incentives for improved performance

– Profitable investments that require disproportionate effort of managers may only be undertaken if managers are given disproportionate share of profits

– Concentrated ownership aligns managers and shareholders' interest, reducing agency costs

– Debt from LBO commits cash flows to debt payment, reducing agency costs of free cash flows

– Debt puts pressure on managers to improve firm performance to avoid bankruptcy



• Arguments against:– In DeAngelo et al. study, management already held

large stake before buyout– Internal and external controls are sufficient to align

managers' interests to shareholders

• Empirical evidence consistent with management incentive rationale

– Increased ownership share of management– Management incentive plans– Operating performance of LBO firms improved



– Wealth transfer effects• Payment of premiums in LBO transactions may

represent wealth transfer to shareholders from other stakeholders

• Wealth transfer from existing bondholders and preferred stockholders

– Reduction in value of firm's outstanding bonds and preferred stock due to

• Large increase in debt• Bond covenants may not protect existing

bondholders in event of control changes and debt issue

• In bankruptcy proceedings, "absolute priority rule" for senior security may not be strictly followed



– Lehn and Poulsen (1988) — no evidence that bondholders and preferred stockholders lose value at time of LBO announcement

– Travlos and Cornett (1993)• Significant bondholder losses at announcement

of going-private proposals• Losses small relative to gains to prebuyout

shareholders– Anecdotal evidence

• Lawsuit filed against RJR Nabisco by large bondholders

• Charged that $5 billion in highly rated bonds lost nearly 20% in market value



– Warga and Welch (1993)• Empirical results greatly influenced by source of

bond price data • Use trader-quoted data from major investment

bank as opposed to exchange-base data• Properly aggregated returns among correlated

bonds using S&P data source find no significant loss to bondholder wealth

• Using trader-quoted data, there is a risk-adjusted bondholder loss of 6%; but losses account for a very small percentage of shareholder gains



• Wealth transfer from current employees to new investors

– Management turnover in buyout firms lower than in average firm; sometimes new management team is brought in after LBO

– Number of employees grows more slowly in LBO firm than others in same industry and sometimes even decreases — may result from postbuyout divestitures and more efficient use of labor



• Tax benefits in LBO constitute subsidy from public and loss of revenue to government

– Premia paid in LBOs positively related to potential tax benefits

– Net effect of LBO on government tax revenues may be positive

• Shareholders pay capital gains taxes on sale of their stock in LBO tender offer

• LBO investor group pays capital gains taxes when firm goes public at a later date

• Improved profitability — firms pay more corporate taxes

– Many of tax benefits from increased leverage could be realized without LBOs



– Asymmetric information and underpricing• Managers or investor groups have more

information on value of firm than public shareholders

• Large premium in buyout proposal signals that future operating income will be larger than previously expected or firm is less risky than previously perceived

• Investor group believes new company worth more than purchase price — prebuyout shareholders receive less than adequately informed shareholders



• Kaplan (1991) — informed persons (managers and directors) do not participate in buyout even though they typically hold large stakes (median share of 10% compared to 4.67% held by management participants)

• Smith (1990)– MBO proposals that fail due to board/stockholder

rejection, withdrawal, or higher outside bid are not followed by increase in operating returns

– Indirect evidence that asymmetric information cannot explain improved performance of bought-out firms



– Other efficiency considerations• More efficient decision process as private firm

– No need to justify new programs with detailed studies and reports to board of directors, more speedy actions can be taken

– Public firms have to publish reports that can disclose valuable information to competitors

• Stockholders' servicing costs and other related expenses do not appear to be a major factor in going private

• Alternatively, perhaps LBOs performed well because of favorable stock market/economic conditions



• Evidence on postbuyout equity values– Muscarella and Vetsuypens (1990)

• Median change in firm value for 41 reverse LBOs was 89% for entire period between LBO and subsequent SIPO — mean rate was 169.7%

• Median annualized rate of return was 36.6%• Total shareholder wealth change positive and

significantly correlated with fraction of shares owned by officers and directors

• Correlation between size-adjusted measure of salary and shareholder wealth positive and significant

• Change in equity values were associated with improvement in accounting measures of performance



– Kaplan (1991)• For 21 buyouts, median excess return to

postbuyout investors (both debt and equity) is 26.1% above return on S&P 500

• Excess return close to premium earned by prebuyout shareholders

• Excess return to postbuyout investors significantly related to change in operating income, not to potential tax benefits

• Prebuyout shareholders capture most of tax benefits that become publicly known at time of LBO



– Degeorge and Zeckhauser (1993)• Reverse LBO experienced industry adjusted rise in

operating performance of 6.9% during year before SIPO

• Same firms experience industry-adjusted decline in operating performance of 2.59% in year following SIPO

• Reason: Information asymmetries and pure selection

– Managers take firm public only during exceptional years– Managers have incentive to improve current performance

at expense of future profitability– Purchasers look at strength of current performance and

future growth — only strong companies had ability to go public and experience normal mean reversion following SIPO



– Mian and Rosenfeld (1993)• 85 reverse LBOs during 1983-1989• Significant positive CAR measured for three-year

period beginning one day after SIPO• CARs using Comparable Firm Index for first three

years was 4.65%, 21.96%, and 21.05% • 39% of sample firms taken over within three years

after SIPO• Most takeovers during second year• Firms taken over outperformed comparable

investments over 100%• Sample not taken over, CAR nearly zero• 79% of acquired firms had gone public with an active

investor — reflects desire of main investor to liquidate ownership



– Holthausen and Larcker (1996)• 90 reverse LBOs during 1983-1988• Firms outperformed their industries for four years

following reverse LBO• Firm increased capital expenditure subsequent to

offering — firms were cash constrained while under LBO but reduced leverage after SIPO facilitated efficient investments

• Working capital increased after offering• Firm performance decreased with declines in

level of equity ownership by management and other insiders



• No evidence that performance after SIPO related to changes in leverage

• Firms still public three years after SIPO experienced median decline in ownership by management insiders of 15% and by nonmanagement insiders of 20%

• Board structure moved toward standard patterns of non-LBO firms after SIPO



Correction Period 1991-1992• Background

– LBO activity in 1991 dropped to $6.8 billion, l0.4% of $65.7 billion in 1989

– Opler (1992) — LBOs in 1985-1989 period had operating improvements comparable to those in earlier period

– Kaplan and Stein (1993) • LBOs formed in latter half of 1980s did not

perform as well • Many experienced financial distress



• Deteriorating quality of LBOs in second half of 1980s– Relatively high prices paid

• Dollar volume of funds available exceeded number of good prospects

• Multiples of price to expected cash flows rose sharply

• Extreme winner's curse — substantial difference between winning price and next highest bid

– Weakened financial structure• Deal promoters required more cash up front,

weakening structure and incentives of later LBOs



• Public high-yield debt substituted for both private subordinated debt and "strip" financing — raised costs of reorganizing

• Commercial banks took smaller positions; reduced commitments, shortened maturities, required accelerated principal repayments

• Coverage of debt service requirements declined — less than 1 in some cases

• Asset sales and immediate improvement of profitability margins were required to cover interest and other financial outlays in first year of the LBO



• High-yield bonds with either zero-coupons or interest payments consisting of more of same securities (payment-in-kind) were utilized

• Cash requirements for debt service were postponed for several years

– Legislative and regulatory changes — FIRREA • Required S&Ls to liquidate high-yield bonds

from portfolio holdings and prohibited further investment in high-yield bonds

• Prices of high-yield debt were impacted downward

– Economic downturn of 1990-1991



Role of Junk Bonds

• Junk bonds are high-yield bonds either rated below investment grade or unrated– S&P ratings: rated below BBB– Moody's ratings: rated below Baa3



• Characteristics– Size of market

• Between 1970 and 1977, junk bonds represented 3-4% of total public straight debt bonds

– Prior to 1977, high-yield bonds were "fallen angels,” investment grade bonds whose ratings had been subsequently lowered

– First issuer of bonds rated below investment grade was Lehman Brothers in 1977

• By 1985 share had risen to 14.4% of total public straight debt bonds

– Drexel Burnham Lambert became industry leader in junk bond issues

– Drexel had 45% of market in 1986 and 43.2% through November 1987



• Share of yearly new public bond issues had risen from 1.1% in 1977 to almost 20% by 1985

• FIRREA, enacted in 1989, caused temporary losses but by 1993 junk bond market achieved record high returns and size of market reached new highs

– Default rates 10 years after issuance as high as 20-30%

– Average recovery rate after default about 40% of original par value

– Promised yield spread over 10-year Treasury bonds about 4.5% during 1978-1994

– Realized return spread about 2%



• Use of high-yield bonds– Make financing available to high risk,

growth firms– Finance takeovers– Yago (1991)

• One-fourth of proceeds from issuing junk bonds in 1980-1986 used for acquisition financing

• Three-fourth of proceeds used to finance internal corporate growth



• Savings and loan industry– High-yield financing was not fundamental

cause of problems in S&L industry during the 1980s

– Total investment in junk bonds amounted to 1% or less of total assets in industry

– S&L basic problems due to• Changing nature of financial markets• S&L industry had negative net worth of over $100

billion by 1980, prior to era of high-yield financing• 90% of firms in S&L industry suffered losses in

1980 and 1981



• Role of Michael Milken– Saul (1993) set forth his views of illegal acts

by Milken• Securities parking

– Violation of Williams Act– Entails having associates hold securities in their

accounts to avoid triggering Rule 13(d) filing requirement

• Market stabilization– Milken guaranteed investment participants against

losses on their high-yield bond investment during time required for markets to absorb them

– He did not make public disclosure in high-yield offerings of securities taken as underwriting compensation

– He made side payoffs to portfolio managers for investing institutional funds in his issues



• Market monopolization — Milken became dominant player of high-yield bond market

– Financial competitors did not have Milken's network to be "highly confident" that it could successfully place a high-yield offering

– No other firm was prepared to commit so much capital to inventory high-yield bonds in secondary market trading

– Milken developed close relationships with client issuers, institutional customers, and employees



– Fischel (1995) presented a defense of Milken• Milken was guilty only of being a tough and

formidable competitor• Milken was not guilty of breaking any security

law violations• Action against Milken as result of

– Hysteria against "excesses of the 1980s"– Ability of government to invoke RICO

• After most thorough investigations, government came up with nothing



LBOs in the 1992-2000 Period

• Background– 1992-2000: Sustained economic growth —

resurgence of LBOs– Size of aggregate LBO transactions moved

to $62.0 billion in 1999 — almost as high as the peak of $65.7 billion in 1989



• Resurgence of LBOs– Favorable economic environment– Change in LBO financial structure

• Price to EBITDA ratios paid moved down to 5-6 times compared to 7-10 multiples of late 1980s

• Percentage of equity in initial capital structure moved up to 20-30% compared with equity ratios of 5-10% in late 1980s

• Interest coverage ratios moved up — ratio of EBITDA to interest and other financial requirements moved to standard of 2 times



– Restructuring of intermediaries• LBO activity no longer dominated by Milken-Drexel • Main players were other investment banking

houses, large commercial banks, and traditional LBO sponsors such as Kohlberg Kravis Roberts

– Innovative approaches developed by investment banking-sponsoring firms• Strategy of substituting sponsor equity for bank

debt• Less pressure for immediate performance

improvement or asset sales — deals structured so principal repayments sometimes not required until 10 years after deal



• Partnership structures with members who had considerable previous managerial experience

• Joint deals between financial buyers and corporate strategic buyers to purchase companies on leveraged basis

• Increased use of syndication among banks to sponsor highly leveraged transactions

• Development of highly liquid secondary loan trading market

• Continuing close client-focused relationship by commercial banks

• Capital structure strategies tailored to characteristics of transactions



• Leveraged buildups– Identify fragmented industry characterized by small

firms– Buyout firms purchase firm as platform for further

leveraged acquisitions in same industry– Buyout firms include partners with industry expertise

• LBOs applied beyond mature slow-growing industries to high-growth technology-driven industries

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - -...

Documents

Transcript of ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - -...