KARIN CHONG (120018974)

ANH HO (120005724)

DOROTHY KIEW (120003293)

JOCELYN TAY (120039897)

WONG YUAN SING (120019673)

LEVERAGED BUYOUT

ACOVA RADIATEURS

Feasibility Review for

Baring Capital Investors

Pros and Cons of Acova Radiateurs LBO

(+) Strong Cash Flow Generation Ability

The radiators manufacturing market in France is a mature industry, with strong growth in a few types of radiators.

Acova’s financial statements post healthy results with a year-on-year increase in Net Income (Exhibit 1). Given

Acova’s positive financial history and the cash generating ability of the radiator industry as a whole, we agree

with the projected revenue forecast (Exhibit 2) and expect steady and increasing cash flow in the future with value

creation from 3 years after the date of acquisition. Cash generated would then help to support the capital structure

in the LBO deal.

(+) Leading and Defensible Market Position

Acova is a leader in the decorative radiator industry with a 75% share of the French decorative radiator market. It

is the generic name for products of this type, its towel-dryer radiators in particular. Success in the decorative

radiator market depends heavily on branding and the ability to customise products, and Acova enjoys significant

comparative advantage in both aspects. Also, under the guidance of Mr. Monnaye, Acova managed to strengthen

its market position by creating an exclusive wholesale distribution channel, effectively creating a barrier to entry

for competitors.

(+) Growth Opportunities

We believe that Acova has promising growth opportunities as a leader in the highly demanded towel-drying

radiator segment. The electric radiator business line is another area of potential growth for Acova. Although at

the time of valuation, it only made up 10% of Acova’s total sales and retains 8% market share in this segment,

there is room for Acova to innovate and grow as the market is still not saturated. Besides that, the hot-water

radiator segment which makes up half of Acova’s sales is expected to continue to thrive at a steady and consistent

growth rate.

(+) Expansion and Efficiency Improvement Opportunities

Given that other European markets for radiators are not as developed as the French market, this presents Acova

with the option for cross-border expansion. Acova has opportunities to reach out to other European countries and

developments in markets outside France are one of the company’s top priorities. The firm can reap the benefits

from economies of scale and increasing efficiency.

(+) Sound and Reliable Management

According to Mr. Hoppenot’s assessment, the management team at Acova is experienced and appear to be very

dedicated. This can help to reduce negative implications of the agency problem as objectives of the two parties

align. In addition, the then Acova’s CEO, Mr. Monnaye, had a strong sales and marketing background.

(-) Consequences of Corporate Restructuring

Corporate restructuring in the form of an LBO can adversely impact employees. Companies may have to downsize

their operations and reduce the number of paid staff. A sudden wave of unemployment after a leveraged

acquisition like this may cripple the economic prosperity and development of the local community and local

government may seek to prevent this with regulatory enforcement. Furthermore, in its usual protocol of

conducting a LBO, Baring Capital Investors takes hold of positions on the Board of Directors; this may bring

about a conflict with Acova’s managers and force a hostile takeover.

(-) Potential Optimization of Production Process Not Quantified

Acova’s longstanding reputation for producing high-quality products does not come without a cost. As mentioned

in the case, in ensuring the end product is of uniform high quality, the products often had to be reworked. If these

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operational improvements cannot be met, the expected returns of Baring Capital Investors will also be foregone.

Finally, no formal assessment was made at the time of valuation on the potential gains that could be derived.

Role Played by BCI in the Buyout

In the LBO, Baring Capital Investor (BCI) will act as an acquirer who seeks to buy an underperforming target

firm. Before making any decision, the acquirer has to assess and evaluate the value of the target company by

weighing its capabilities for further business prosperity and the bid price. BCI favours a target firm with consistent

cash flow, strong background, and experienced and responsive management. With the incentive to exploit the

mispricing by ‘buying low and selling high’, it will loan money from banks or attain other sources of financing to

acquire equity of underperforming companies in any industry and gain control over them.

Once the buy-out is settled, the acquirer will consider whether further acquisitions, asset sales or any other

restructuring would achieve growth/recovery of target firms. Rather than selling assets, BCI can remain in contact

with existing management to find a solution to generate cash flows. The solution can be either to cut cost, maintain

better control over inventories, or terminate any inefficient investments. Profits generated from the company is

then used to pay-off the initial loan borrowed, and the remaining is shared among the partners.

Risks Associated with the Bidding Competition

Assuming that the bidding process is a seal-bid auction, the requirement would be a tender offer made by each

bidder, thus presenting higher and lower offers to the table. First and foremost, BCI’s biggest risk will be losing

the bid itself if one of BCI’s competitors offers a higher price. Secondly, BCI’s risk may also arise from the under-

or over-valuation of Acova. Undervaluing Acova poses a risk that BCI loses the tender to a bidder with a better

offer. Overvaluing Acova puts BCI at risk of overpaying; this is generally caused by an overestimation of target

growth or market potential. Overbidding is often a result of management’s hubris and this heightened competition

gives the target higher bargaining power to negotiate a higher offer price from the bidders.

In addition, the company Zehnder poses a strong threat to BCI as it is the closest competitor to Acova in this

market and it also possesses the working knowledge to operate in the decorative radiator market. Moreover,

Zehnder having a big market share allows it to benefit from financial economies of scale which provides the firm

with greater access to more funding than BCI. BCI may need to place a higher bid when competing with Jones

and LBO France and higher initial investment translates to a lower premium for BCI. Lastly, the bid itself may be

an opportunity cost to BCI as BCI may lose the chance to invest in cheaper and possibly more profitable

alternatives.

BCI’s Valuation Method

BCI has to evaluate the value of the target firm through estimating its business value and suitable level of debt

and equity to ensure that there are sufficient funds to repay the initial loan issued to BCI. There are 5 main steps

that have been undertaken:

Step 1: Forecast the target firm’s FCF, EBITDA and Capital Cash Flow (CCF) because these figures indicate

profits and cash available for initial debt repayment. This is based on a number of assumptions (detailed in another

section below) including a constant tax rate of 37% and a constant discount rate.

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Step 2: Evaluate the current capital structure (debt and equity level) to arrive at a specific and realistic amount

needed to cover the company’s new leveraged position and determine the right time to exit the investment.

Step 3: Estimate the multiple for when the bidder decides to exit the investment – terminal value.

Step 4: Calculate the internal rate of return (IRR) to compare against the minimum required return by BCI for the

investment by measuring exit equity proceeds and initial equity invested.

Step 5: Solve for the maximum price BCI should pay for control over its target firm, Avoca Radiateurs.

Valuation and Assumptions Made

Post-LBO EV under CCF valuation is FFr 447.4 million. In order to arrive at this figure, we discounted total

capital cash flows over the period (1990-1994) and the terminal value of 6 times EBITDA at a rate of 16.06%,

and added the two together. Yearly CCF is calculated by adding FCF and tax shields.

The maximum bid price under the CCF method is FFr 348.9 million and FFr 275.5 million under the IRR method

assuming a rate of 30%. The discount rate used is 16.06% and is based on the assumption that the beta of assets

is 1, the equity risk premium is 6% and the yield on France long-term government of 10.06% is the risk-free rate.

When calculating CCF, the distribution of debt repayment is made on a cash-sweep basis – cashflow available is

prioritised to repay the amortised portion of Senior Debt A (assumed equal amounts for yearly repayments), WC

Loan and Mezzanine in that order. Although WC Loan is effectively not new debt, it is a form of debt financing

which we assume a similar treatment to other forms of debt, thereby including it in entry debt.

Senior Debt A holds the highest priority because of its explicit contractual agreements; we also assumed that

Acova would cover shortfalls in repayment for Senior Debt A as soon as FCF permits. WC Loan is given seniority

over Mezzanine debt because it is assumed to be secured against the current assets of Acova such as inventory. If

Acova failed to repay the WC Loan, inventory held as collateral may be seized and without inventory, Acova

would be driven straight into liquidity as it will fail to have going concern. We have also assumed that since

Mezzanine debt has attached warrants to purchase equity, any unpaid portion of debt can be sustained by debt-

holders as future capital gains from rise in equity price will offset losses.

Since given projections are only until 1994, we have assumed a 1.1% rate of growth for FCF and EBITDA because

the rate of growth for the 2 years before exit is 1.1% and as terminal value is based on 6 times 1994’s EBITDA,

it is safe to say that rate of change plateaus upon exit.

Differences Between CCF and IRR Valuation

CCF valuation ignores the impact of financial risk but takes into account financing benefits on the discount rate

as repayment takes place. It assumes that more debt will always increase firm value due to greater tax shields,

implying that tax shields have the same risk as FCF. Initial investment is deducted in the final step of valuation

under CCF but only BCI’s contribution to the initial investment is subtracted out under IRR because under the

IRR method only future cash flows to the levered equity-holders (LCF) are valued. Thus, LCFs are net of interest

payments while the initial investment under the IRR approach is correspondingly reduced by debt financing.

Finally, IRR assumes an average return to equity-holders to arrive at a multiple for maximum beginning equity

investment which is used to calculate entry enterprise value.

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Exhibit 1 Acova Financial Statements (millions of FFr)

1989 1988 1987 1986 1985

Sales 337.4 280.6 227.3 183.2 144.5

Other Products 3.5 4.4 1.5 2.0 0.0

340.9 285.0 228.8 185.2 144.5

Purchases/material cost 104.8 82.8 55.2 47.7 37.4

Other expenses 199.6 174.3 141.6 113.7 94.2

36.5 27.9 32.0 23.8 12.9

Net interest -3.7 -0.7 -1.4 -0.4 0.3

32.8 27.2 30.6 23.4 13.2

Taxes 12.9 10.3 14.5 11.7 6.2

Net income 19.9 16.9 16.1 11.7 7.0

Assets:

Cash 7.5 5.2 10.7

Account receivable 115.0 100.1 80.4

Inventory 33.9 33.7 18.8

156.4 139.0 109.9

PPE 72.5 55.6 36.5

Total Assets 228.9 194.6 146.4

Liabilities:

Accounts payable 88.1 79.9 71.7

Provisions 5.3 5.6 6.7

Bank debt 37.0 45.0 15.2

130.4 130.5 93.6

Net worth 98.5 64.1 52.8

Liabilities and net worth 228.9 194.6 146.4

Other information

Capital expenditures 29.0 27.5 19.0

Exhibit 2 Projected Yearly Earnings and FCF (millions of FFr)

1990 1991 1992 1993 1994 1995 1996 1997 1998

EBIT 43.1 56.0 71.0 77.2 85.1

Tax rate 37% 37% 37% 37% 37%

CAPX 20.0 25.0 25.0 25.0 25.0

Dep. 19.0 20.0 25.0 25.0 25.0

NWC 71.0 78.5 86.7 95.4 105.0

DNWC 8.0 7.5 8.2 8.7 9.6

FCF 18.2 22.8 36.5 39.9 44.0 48.4 53.3 58.6 64.4

EBITDA 62.1 76.0 96.0 102.2 110.1 121.1 133.2 146.5 161.2

Exhibit 3 Yearly Debt Schedule (millions of FFr)

1990 1991 1992 1993 1994 1995 1996 1997 1998

Senior Debt A

Year Beginning 190.0 182.9 181.7 166.6 147.0 121.8 90.4 51.7 22.0

Interest Payment 11.4 21.9 21.8 20.0 17.6 14.6 10.8 6.2 2.6

Tax Shield 4.2 8.1 8.1 7.4 6.5 5.4 4.0 2.3 1.0

Loan Repayment 7.1 1.2 15.1 19.6 25.2 31.5 38.7 29.7 22.0

Year End 182.9 181.7 166.6 147.0 121.8 90.4 51.7 22.0 0.0

WC Loan

Year Beginning 31.8 31.8 31.8 31.8 31.8 31.8 31.8 31.8 14.5

Interest Payment 1.7 3.5 3.5 3.5 3.5 3.5 3.5 3.5 1.6

Tax Shield 0.6 1.3 1.3 1.3 1.3 1.3 1.3 1.3 0.6

Loan Repayment 0.0 0.0 0.0 0.0 0.0 0.0 0.0 17.3 14.5

Year End 31.8 31.8 31.8 31.8 31.8 31.8 31.8 14.5 0.0

Mezzanine

Year Beginning 65.0 65.0 65.0 65.0 65.0 65.0 65.0 65.0 65.0

Interest Payment 4.4 8.8 8.8 8.8 8.8 8.8 8.8 8.8 8.8

Tax Shield 1.6 3.2 3.2 3.2 3.2 3.2 3.2 3.2 3.2

Loan Repayment 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 19.7

Year End 65.0 65.0 65.0 65.0 65.0 65.0 65.0 65.0 45.3

Year Beg Total Debt 286.8 279.7 278.5 263.4 243.8 218.6 187.2 148.5 101.5

ITS 6.5 12.7 12.6 11.9 11.1 10.0 8.6 6.8 4.8

Interest Expenses 17.5 34.2 34.1 32.3 29.9 26.9 23.1 18.5 13.0 Cash Available for Debt Repayment

7.1 1.2 15.1 19.6 25.2 31.5 38.7 46.9 56.2

Equity Cash Flow 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Year End Total Debt 279.7 278.5 263.4 243.8 218.6 187.2 148.5 101.5 45.3

D/EBITDA 4.5 3.7 2.7 2.4 2.0 1.5 1.1 0.7 0.3

Exhibit 4 CCF Valuation (millions of FFr)

1990 1991 1992 1993 1994

Capital Cash Flow 24.6 35.4 49.1 51.9 55.1

PV (CCF) @16.06% 133.7

Terminal Value 660.6

PV (TV) @16.06% 313.7

ENTERPRISE VALUE 447.4

Debt Pre-LBO 98.5

Equity Value (Maximum Price) 348.9

Exhibit 5 IRR Valuation (millions of FFr)

Entry Debt 286.8

Exit Debt 218.6

Exit EV 660.6

Exit Equity 442.0

Gross Return Consistent with 30% IRR 3.7

Max Equity Investment 119.0

Max EV at Entry 405.8

Debt Pre-LBO 98.5

Equity Value (Maximum Price) 307.3