LBOs and LBIs
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Transcript of 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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Simple Example Albert Enterprises
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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Simple Example Albert Enterprises
Suggestions
..
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Simple Example Albert Enterprises
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.
Simple Example Albert Enterprises
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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.