Leverage Financing

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readings for details. Removal of errors and omissions, if any, in this ppt
are your responsibility.

Agenda

Leverage Financing
LBO
Strip Financing
Empirical evidence
Numerical Valuation

Leverage Financing
Leveraged Finance is the provision of bank loans
and the issue of high yield bonds to fund
acquisitions of companies or parts of companies
In leverage financing the buyer invests a small
amount of money and borrows the rest (usually)
The buyer's own equity thus leverages a lot more
money from others
The buyer can achieve this due to the targeted
acquisition, if operated efficiently would be highly
profitable and have sufficient cash to repay the debt
and provide returns to equity holders
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Leverage Financing
Leverage Financing is used for three purposes
Taking a public company private (public-to-private)
Financing spin-offs
Carrying out ownership changes in small business
or some form of private property transfer (private
deals)

Leverage Financing
Some special cases of LBOs
Management Buy Out - existing internal
management team acquires a sizeable portion
of the shares of the company (could make it
private)
Management Buy In - external management
team acquires the shares of the target
Buy In Management Buy Out - combination of
internal existing managers and external
investors with some stake
Secondary or tertiary buyouts - third party
private equity firms
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LBO
In a leveraged buyout, all of the stock, or assets, of
a public corporation are bought by a small group of
investors (financial buyers), usually including
members of existing management
Focus is on ROE
The group that buys out uses other peoples money
Success is through improved oper. performance
LBO operators target firms having stable cash flow
to meet debt service requirements
Typical targets are in mature industries
The acquirer purchases the target with a loan
collateralized by the target's own assets
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LBO
Operating Characteristics: significant market
position, capable management team, strong brand
names, good relationships with key customers and
suppliers, mature industry, steady growth

Financial Characteristics: high debt capacity, steady

cash flow, operating improvement possibilities, low
operating leverage, possibility of substantial cost
reduction

LBO
Advantages include
Management incentives aligned
Reduction in agency costs debt provides a
monitoring role
Tax savings from interest expense and depreciation
from asset write-up and current loss acctg
Efficient decision processes under pvt. ownership
A potential improvement in operating performance
A form of takeover defense by eliminating public
investors

LBO
Disadvantages include
High fixed costs of debt
Vulnerability to business cycle fluctuations and
competitor actions due to high leverage
Complex capital structure often loss of
transparency
Not appropriate for firms with high business risk,
and potential difficulties in raising capital

LBO
Role of Junk bonds in LBO financing
Junk bonds are rated by credit agencies as
below investment grade or they are non-rated
debt with wide variation in bond quality
Interest rates in the 1980s was usually 3-5%
above the prime rate or government rate
Fallen Angels or Rising Stars
Started out as interim bridge loans but became
a permanent form of financing with high yields
Junk bond financing is highly cyclical, and
tapers off as the economy goes into recession
due to fears of increasing default rates
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LBO
Role of Junk bonds in LBO financing
Junk bond financing for LBOs dried up due to
series of defaults of over-leveraged firms in the
late 1980s
Another factor was insider trading and fraud at
such companies as Drexel Burnham, the
primary market maker for junk bonds

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LBO
Remember the example we discussed previously
Total Capital
EBITDA margin
Debt %
Interest rate
Tax rate
Firm Value

ABC
200
0.2
0
0.07
0.3
300

XYZ
200
0.2
0.5
0.07
0.3
300

The only difference is that company XYZ has 50% or $100m

of its $200m capital structure in debt

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LBO

EBITDA
Int
EAIBT
Tax
PAT

ABC
20
0
20
6
14

XYZ
20
7
13
3.9
9.1

The interest expense for

XYZ amounts to $7 leading
to a difference in the PAT for
both organizations
Lets us analyze the problem
a bit differently..

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LBO
Suppose you own both the debt and the equity of XYZ, then
what CF would you receive? In other words what is the FCFF?
$9.1 + $7 = $16.1 m
Suppose you owned all of ABC, the no-debt corp., you would
receive $14m (a difference of $2.1m)
This is the interest expense/tax arbitrage

In effect the government is subsidizing your capital structure

because interest expense is tax deductible
LBO's operate under this kind of interest subsidy where
wealth is in effect redistributed
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LBO
Even though tax is still owed note that the tax is paid by
the debt holder (individual) vs. the corporation
Individuals may more effectively manage their personal tax
and consequences than a large corporation; some
individuals may also be in a lower tax bracket than a
corporation
The after-tax cost of debt is much cheaper than the implied
cost of equity (based on risk etc.)

If XYZ is privately owned, the owner can take out $2.1m

more than in an equity financed business
Debt can be retired and soon the owner may have the
optimum level of debt and start earning equity profits
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LBO

Senior Debt

Subordinate Debt

Mezzanine
Financing

Strip
Financing

Convertible Debt

Preferred Stock
Common Stock
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LBO
LBOs are often financed with several layers of
non-equity financing such as senior debt,
subordinated debt, convertible debt, and
preferred stock
Mezzanine level financing refers to the
securities between senior debt and common
stock, e.g., subordinated and convertible debt
Strip financing is common in LBOs
This requires that a buyer purchasing, say,
12% of any mezzanine level security must also
purchase 12% of all mezzanine level securities
and some equity
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LBO
In an LBO
Senior Debt: Usually banks (30%-60% - usually 58 years)
Mezzanine: Third-party financiers, holding strips
and maybe equity as well (20%-30% - usually 7-10
years)
Equity: Venture capitalists and management;
venture capitalists usually get warrants attached to
bonds (approx. 25% - usually 7-12 years)
Expected returns is correlated to the risk
Senior Debt: 10% 15%
Mezzanine: 20% - 25%
Equity: over 28%

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Strip Financing
Consider two firms identical in every respect except
financing
Firm A is entirely financed with equity, and firm B
is highly leveraged with senior subordinated debt,
convertible debt and preferred as well as equity
Suppose firm B securities are sold only in strips,
that is, a buyer purchasing X percent of any
security must purchase X percent of all securities,
and the securities are "stapled" together so they
cannot be separated later

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Strip Financing
CF to the firms may be the same but,
organizationally the two firms are very different
If firm B managers withhold dividends to invest in
value reducing projects or if they are incompetent,
strip holders have recourse through covenants
not available to the equity holders of firm A
Each firm B security specifies the rights its holder
has in the event of default on its dividend or
coupon payment, for example, the right to take
the firm into bankruptcy or to have board
representation
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Strip Financing
It is easier and quicker to replace managers in
firm B
There are no conflicts among senior and junior
claimants over reorganization of the claims in the
event of default to the strip holder it is a matter of
moving funds from one pocket to another
Thus firm B never needs to go into bankruptcy,
the reorganization can be accomplished probably
voluntarily, quickly, and with less expense and
disruption than through bankruptcy proceedings

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Empirical Evidence
Empirical evidence on LBO performance
Very profitable for the new owners - Kohlberg,
Kravis, Roberts & Co. (KKR) earned an average
annualized return over 60% on its equity in highly
levered transactions
Potential conflict of interest
Managers are insiders and may make deals at
the expense of minority shareholders
Managers may also have better information
than the shareholders
Managers often have majority voting rights
Yet, no strong evidence that minority
shareholders are negatively affected
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Empirical Evidence
Alternatives to LBO voluntary restructuring
Cost-cutting associated with LBOs often gives
them a bad name
One option is a voluntary restructuring which
provides the same improved performance, if
implemented properly

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LBO - India
Indian companies can undertake a LBO of a foreign
target by obtaining financing from foreign banks
and is then subject to the legal issues of the targets
country

There is also a LBO possibility of an Indian target

by another Indian company or a foreign company
via FDI or FII each with its own regulatory issues
and restrictions

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LBO - India
Examples of foreign targets
Tetley Tata tea
Whyte & Mackay UB Group
Corus Tata Steel
Hansen Transmissions Suzlon Energy
American Axle potential bid by Tata Motors,
Lombardini buyout attempt by Zoom Auto
Ancillaries

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LBO - India
Examples of Indian targets
Flextronics Software Systems (renamed Aricent)
KKR (LBO)
GE Capital International Services General
Atlantic Partners (LBO)
Nitrex Chemicals Actis Capital (MBO)
Nirulas Navis Capital Partners (MBO)
ACE Refratories ICICI Venture (LBO)
Infomedia India ICICI Venture (LBO)

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LBO - India
Private Equity in India
In many firms the owners and managers are the
same making it difficult for a private equity
investor to gain control for instituting necessary
changes
Thus several private equity transactions that take
place are minority transactions based on personal
relationship
In the absence of control, it may be difficult to use
debt - no control on operations and performance
Minority private investors may not be able to sell
their stake thus limiting exit options
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LBO - India
MBOs in India
Indian model is different from the west given the
business environment
In the west, usually management creates the deal
and seeks investors
In India the promoters usually spin off or divest
and the private equity player partners with some
of the existing management
Management does not have the resource to
engineer a buyout, given the risk appetite and
market structure
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LBO - India
The corporate debt market is small and marginal
Private placements are common, limiting
transparency
The dominance of private placements has been
attributed to several factors - ease of issuance and
cost efficiency being the major ones
Highly rated debt is preferred by Indian investors
The junk bond market as in the west has no role or
equivalence in India since these bonds pay a high
return but have no covenants and protection against
default
Credit derivative market helps transfer risk such a
market is non-existent in India
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LBO - Return to Investors

Let the LBO purchase price be $210 million of which $60
million is secured debt, $100 million is subordinated debt
with a below market coupon interest of 6% plus 27% of the
equity, and $50 million is invested by the sponsor for 73% of
the equity. Assume the free cash flows generated during the
5 years go to pay interest and amortize the secured debt in
its entirety and that cash balances are negligible.
Furthermore, let the expected year-5 EBITDA equal $49.5
million and assume that the company is expected to be sold
for 8 times EBITDA or $396 million net of fees and
expenses, which, after paying the debt balance, leaves $296
of equity for distribution between the sponsor and
management. Discuss the CF to the subordinated debt and
the sponsor
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LBO - Return to Investors

Let us consider the CF to the subordinated debt
Year
Bond price
Coupon
Principal
Equity kicker
Total cash flow
Blended IRR

0
-100

-100
17.30%

6
100
80
186

In this case the equity kicker = 296 * 27%

What is this equity kicker?

Brings returns to the
acceptable levels to the
lender
Compensates for the
lower coupon interest of
the bond
Other than LBO - an
convertible bond has a
low coupon because of
the convertible feature
The sweetener could be
a warrant, combination
of stocks and warrants

Equity amount

Part of the contract

is 27% equity
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LBO - Return to Investors

Let us consider the CF to the sponsor
Year
Initial investment
Exit Proceeds
Return multiple(=216/50)
IRR

0
-50

5
216

4.3
34%

Exit proceeds = 296 * 73%

Equity amount

Part of the original

arrangement: 73%

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Numerical 1
Consider a firm undergoing LBO with the following details
Asset beta = 1, rf = 10%, risk premium = 8%
EBIT is growing at 15%, and in year 1 = $14,000
The firm has two categories of debt: senior debt of 50,000
at the annual rate of 12% and subordinate debt of
$40,000 at the annual rate of 15%
Debt declines over time as the available cash flow is used
to pay down the debt
Noncash adjustments year 1 year 6 are: $1000, $500,
-$100, -$100, -$100 and -$100
The after-tax asset sale amounts to $20,000 in year 1
The firm is in the 32% marginal tax bracket
Set up the cash flows for year 1- year 6 and compute the
enterprise value assuming 0%, 5% and 10% growth rates

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Numerical 2
FAT corporation stock is currently trading at $40 per share
There are 20m shares o/s and the firm has no debt
You are a partner in a firm that specializes in LBOs and
your analysis indicates that the operations of this target
could be improved considerably with some management
change
You estimate that with your capable management team in
place the value of the firm will increase by 50%
You decide to initiate an LBO and issue a tender offer for a
controlling interest of at least 50% of the o/s shares
What is the max amount of value you can extract and still
complete the deal?

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Numerical 3
Detailed LBO example - refer to the word doc for the problem
Firm C was a small specialty chemical company engaged in the manufacturing and
distribution of coatings, paints, and related products primarily in the USA. In the spring of
2005, its owner, a diversified chemical company, decided to sell Firm C. As it customary in
this type of transaction, Firm C was to be sold with no cash and no outstanding debt.
The debt capacity of the company, which depends on the lending terms available in the
market: (a) The fraction of the capital that could be borrowed via banks and the rate of
interest and the amortization period of secured loans: (b) the availability and terms of
subordinated debt, and (c) the minimum equity required by lenders. Assume that the firm
can initially borrow $569.9 m where lenders were willing to lend on a secured basis up to
60% of total debt and required 25% of the purchase price to be equity. They would charge
6.7% cash interest and require the term loan to be paid with all available pre-loan
amortization cash flow over 7 years. Subordinated lenders would provide 40% of the total
debt at 8% cash interest with principal due in 7 years. Both loans would be callable after
12/31/2010 without penalty. The sponsor needed to supply the remaining 25% capital and
required a 25% IRR. Fees and expenses associated with the transaction would be about
2% of the purchase price. The current cash interest rate is 5%.
2005 sales equals 578.0 m, Capex equals 34.0m and net increase in working capital
including cash equals 7.1m. Following are the assumptions that the analyst has used in the
evaluation.

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Numerical 3
Assumptions:
Net sales growth
EBITDA margin
Net fixed assets/sales
Net working capital
less cash/sales
Cash and marketable
securities/sales
Depreciation/sales
Deffered taxes/sales

Actual
2005
9.0%
16.1%
20.0%

Projection ------->
2006
2007
9.0%
8.5%
17.0%
17.5%
20.0%
20.0%

2008
8.5%
18.0%
20.0%

2009
8.0%
18.0%
20.0%

2010
7.5%
18.0%
20.0%

2011
7.0%
17.5%
20.0%

2012
7.0%
17.5%
20.0%

12.0%

11.5%

11.0%

11.0%

11.0%

11.0%

11.0%

11.0%

2.0%
2.8%
2.0%

2.0%
3.0%
2.0%

2.0%
3.0%
2.0%

2.0%
3.0%
2.0%

2.0%
3.0%
2.0%

2.0%
3.0%
2.0%

2.0%
3.0%
2.0%

2.0%
3.0%
2.0%

Examine the possibility of acquiring Firm C via an LBO led by an equity investor
and Firm Cs management.
Set up the relevant cash flows and amortization
Set up the sources and uses of funds what is the purchase price?
What multiple of EBITDA can the buyout finance?
Evaluate the exit equity return at the end of 2010?
If the median publicly traded comparable EBITDA multiple was 7.8 how
much more could the offer have been?
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Numerical 4
You work for a LBO firm and are evaluating a potential candidate XYZ Corp. Details of the firm as follows:
The current stock price of XYZ is $20 and it has 2m shares
outstanding
If your firm can buy XYZ and replace the management, you
believe that XYZs value will increase by 40%
You are planning an LBO and will offer $25 per share for
control of the company
Questions:
Assuming that you will get 50% control, what will happen to
the price of the untendered shares
Given the answer (price of the untendered shares) above,
will the shareholders tender their shares, not tender their
shares or be indifferent
What will your firm gain from the transaction
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Numerical 5
You are considering whether to invest $10m in the 5 year subordinated
notes of HTF, Inc. on October 1, 2007. The annual coupon of these notes
is 8%, and its principal is due at the end of fifth year. In order to obtain an
acceptable return you demand equity participation. HTFs current
revenue and EBITDA are $30m and $5m respectively. The EBITDA
margin is 20%, and the future EBITDA is expected to equal 0.20
revenue - 1000 with revenue growing 12% per year during the following 5
years. Fifth year net debt is projected at $15m.
a. What equity participation (percent ownership) would you demand if
you require 17% expected returns from the joint proceeds of the
subordinated note and the equity and you assume exit in year 5 at
an EBITDA multiple equal to 6. Under what conditions would your
return be more (less) than 17%?
HTF is not expected to make cash distributions during this period.
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Numerical 6
You have invested $1 million for a 25% equity stake in a new
venture. Current sales are $8.1 million and EBITDA is 10% of
sales. You expect to recover your investment plus return in 4
years via the sale of the company at an expected exit EBITDA
multiple of 8. No further equity shares are contemplated but
the company will have $6 million of net debt at exit time. Fees
and expenses will amount to 4% of sale price of the enterprise
(net debt plus equity).
a. What growth rate of sales is needed in order to provide you
with a 40% return?
b. What return will you attain if sales grow at half the required
rate and the exit EBITDA multiple is only 6?

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Numerical 7
ABC Corp. is a privately owned manufacturer of light trailers
that are sold to rental companies and individuals. Its sole
owner, Mr. Benjamin Webster is presently considering a
purchase offer from Prentice Works. The offer for the equity of
ABC Corp. is as follows:
1. A cash payment for $5 million due at closing
2. A 7.5% annual coupon 5-year subordinated note issued
by Prentice Works for $7 million with principle payable at
maturity and annual CF of $315,000 till maturity
3. An earnout agreement stipulating a payment to take
effect at the end of the 3rd year equal to 0.5 times 3rd
year EBITDA

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Numerical 7
Prentice Works will assume ABC Corp.s present net debt of $14.8 million.
Furthermore ABC Corp. would become a wholly owned subsidiary of
Prentice, and Mr. Webster would stay as its president with a 3-year contract
and competitive compensation, at the end of which he would retire.
The following additional information is available:
Prentice Works outstanding subordinated notes are considered risk free
and the riskless rate is 5%
Mr. Webster believed that he could make ABC Corp.s revenue grow at
10% per year during the following 3 years
Current revenue is $50 million
EBITDA = 0.15Revenue-1.5million such that current EBITDA is 6 million
Firms with characteristics similar to ABC have a WACC of about 14%
Prentice Works corporate tax rate is 40%
The 95% confidence range of ABC Corp.s revenue growth is [-20%,
+40%] implying an estimated volatility of 15%
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Numerical 7
a. Estimate the cost of the offer by Prentice Works?
b. What is the value of the earnout agreement?
c. How much is Prentice Works offering for the
enterprise (net debt plus equity) of ABC Corp.?
d. What is the initial enterprise value EBITDA multiple
offered by prentice?
e. Use option valuation methodology to price the
earnout using the volatility information given

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