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

Characteristics of Leveraged Buyouts

Leverage buyout activity - Derive few case studies

 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,
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,
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 19821990

 Financing innovations high-yield bonds (junk bonds) made public financing available to companies below investment grade Legislative factors,

 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

 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

LBO Deal Structure

Advantages include the following: Management incentives, Tax savings from interest expense and depreciation from asset write-up, More efficient decision processes under private ownership, A potential improvement in operating performance, and Serving as a takeover defense by eliminating public investors Disadvantages include the following: High fixed costs of debt, Vulnerability to business cycle fluctuations and competitor actions, Not appropriate for firms with high growth prospects or high business risk, and Potential difficulties in raising capital.

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