Leveraged Buy Outs

LBO-Definition

• It involves the use of a large amount of debt to purchase a firm.

• LBOs are clear-cut example of a financial merger undertaken to create a high-debt private corporation with improved cash flows and value.

• Typically, in an LBO, 80% or more of the purchase price is financed with debt.

• A large part of the borrowing is secured by the acquired firm’s assets.

Features of an LBO Candidate

• An attractive candidate for acquisition via LBO should possess the following attributes:– It must have a good position in the industry with

sound profit history.– It should have a relatively low level of debt and high

level of “bankable” assets.– It must have stable and predictable cash flows that

are adequate to meet interest and principal payments on the debt and provide adequate working capital.

Leveraged Buy-Outs

Unique Features of LBOs

Large portion of buy-out financed by debt

Shares of the LBO no longer traded on the open market

Leveraged Buy-Outs

● Junk bond market● Leverage and taxes● Other stakeholders● Leverage and incentives● Leverage restructurings● LBOs and Leverage restructurings

Potential Sources of Value in LBOs

Leveraged Buy Outs

Acquirer Target Industry YearValue ($mil)

KKR RJR Nabisco Food, tobacco 1989 24,720 KKR Beatrice Food 1986 6,250 KKR Safeway Supermarkets 1986 4,240 Thompson Co. Southland (7-11) Convenience stores 1987 4,000 KKR Owens-Illinios Glass 1987 4,680 Wings Holdings NWA, Inc. Airlines 1989 3,690 TF Investments Hospitals 1989 3,600 Macy Acquisitions Corp. Department stores 1986 3,500 Carlyle Group & Welsh, Carson, Anderson and Stowe Quest Dex Yellow pages 2002 7,050

Blackstone GroupTRW Automotive Holdings Auto parts 2002 4,700

KKR PanAmSat Satellites 2004 4,380 Texas Pacific group, Bain Capital. & Goldman Sachs. Burger King Fast food 2002 2,260

Some Examples of LBO’s

Leveraged Buyouts

• The three main characteristics of LBOs

1. High debt

2. Incentives

3. Private ownership

Tata-Corus Deal

A Brief Analysis

Advantage Tata

• The acquisition helps Tata reach the fifth position from 56th in global steel production capacity.

• With the exception of Arcelor Mittal, which has a combined production capacity of 110 mtpa, Tata Corus, with a capacity of 23.5 mtpa, will be only 5-7 mtpa shy of the next three players-Nippon Steel, Posco, and JFE Steel.

• Globally top 5 players will now control only about 25% of global capacities.

• Tata Steel gets access to European market and significantly higher value-added presence.

Cost of the Acquisition

• Tata proposed to pay a price of 608 pence a share from 455 pence initially. CSN bid 603 pence.

• This translates to $12.1 billion in equity value and with a debt component of around $1.5 billion, the enterprise value of Corus is $13.6 billion. This is 34% higher than the initial offer (455 pence) the Tatas made.

Financing the Acquisition

• The acquisition would be funded through a debt-equity ratio of 53:47 (initially it was 78:22)

• The exposure of Tata Steel was initially thought to be in the region of $4.1 billion which will be a mix of debt and equity.

• The rest of the funding, through long term loans, will be done by the special investment vehicle created in UK for this purpose.

• Such loan will be serviced out of Corus’s cash flows.

Financing the Acquisition

• Tatas could raise the equity component in the form of preferential offer by Tata Steel to Tata Sons, or through GDR or rights offer to shareholders.

Expected Synergies

• In the third quarter ended September 2006, Corus had clocked an operating margin of 9.2% compared to 32% by Tata Steel for the third quarter ended December 2006.

• Synergies are expected in the procurement of materials, in the market place, in shared services, and operational efficiencies.

• Potential synergy value is $300-350 million a year

Valuation of LBOs: The APV Method

• The APV method captures values from investment and financing decisions separately

• i Two primary decisions in a corporation– T Investment & Financing

• I The APV method measures value from these two separately

• t Before studying APV, important to understand the effect of financing decisions on firm value

In the presence of taxes, Debt adds value sinceinterest payments reduce firm’s tax burden

• Different financial transactions are taxed differently:

• d Interest payments are tax exempt for the firm.• I Dividends and retained earnings are not.• Financial policy matters because it affects a

firm’s tax bill• Specifically, debt adds value since interest

payments reduce the tax burden for the firm

Illustration of Tax Shields from Debt

Intuition behind the APV method

• MM’s intuition still holds:– The pie is unaffected by capital structure!

• But the tax authority gets a slice too• Financial policy affects the size of that

slice.• Interest payments beingtax deductible, the tax slice is lower with debt than equity.

The APV Formula so far

• The contribution of debt to firm value is the PV of tax shields– V(levered firm) = V(all equity counterpart) + PV(tax shield)

• Each part is discounted based on its risk• The V(all equity) captures solely the risk of operations of the firm. It

is unaffected by financing risk. Hence use βA

• The tax shields can be discounted at either of two rates– If tax shields are as risky as the cash flows to the all-equity firm, use βA.

Appropriate for higher debt levels.– If tax shields are as risky as the debt, use cost of debt. Appropriate for

low and known debt levels.• If D is face value of debt, interest payment = rD * D• Tax shield = tC * Interest payment = tC * rD * D• Using perpetuity formula PVTS = (tC * rD * D) / rD = tC * D

The Dark Side of Debt is the ExpectedCost of Financial Distress

• If taxes were the only issue, (most) companies would be 100% debt financed.

• Debt would have only tax benefits but no costs– Common sense suggests otherwise– Debt must have costs as well

• If the debt burden is too high, the company will have trouble paying it.

• The result: financial distress.

Full APV formula

• F The value of a leveraged firm is:• V(with debt) = V(all equity) + PV[tax

shield] – PV[costs of distress]• PV(costs of distress) depends on:

– Probability of distress– Magnitude of costs encountered if distress

occurs

• This is the full APV formula

APV vs. WACCA Use WACC when the project’s debt to equityratio is knowni Use APV when the project’s level of debt is known

Appropriate for Leveraged Buy Out or High Leverage Transactions

T Also appropriate to see value separately from financing and operations.