6) Going Private and

Leveraged Buyouts (LBO)

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

 Buyout group may include

incumbent management and may
be associated with
Buyout specialists, e.g., Kohlberg
Kravis Roberts & Co. (KKR)
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

 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
Muscarella and Vetsuypens (1990)
72 reverse LBOs in 1976-1987
86% of firms use offering proceeds to lower
company's leverage
Equity participants realized median annualized
rate of return of 268.4% on equity investment by
time of SIPO
Median length of time between LBO and SIPO
was 29 months

 Conditions and circumstances of

going-private buyouts in the 1980s
Typical target industries
Basic, nonregulated industries
Predictable and/or low financing requirements
Predictable/stable earnings

High-tech industry less appropriate

Shorter history of profitability

Greater business risk
Fewer leveragable assets
Command high P/E multiples well above book
value

 Lehn and Poulsen (1988)

Half of 108 LBOs during 1980-1984 were in
five industries:
Retailing
Textiles
Food processing
Apparel
Soft drinks
Consumer nondurable goods
Low income elasticity of demand
Sales fluctuate less with GNP
Mature industry with limited growth
opportunities

 Other target characteristics

Track record of capable management
Strong market position within industry to
enable it to withstand economic
fluctuations and competition
Highly liquid balance sheet
Little debt, either short or long term
Large unencumbered asset base for
collateral
High proportion of tangible assets with fair
market value above net book value

 Leverage factors
Increase return on equity (ROE) and cash
flows to retire debt
Attractions for lenders
Interest rates only 3-5 points above prime rate
Company and collateral characteristics
Large amounts of cash/cash equivalents
Undervalued assets (hidden equity)
Could liquidate some subsidiaries to raise
funds
High prospective rates of return on equity
especially for lenders such as venture capitalists
and insurance companies with equity
participation
Confidence in management group spearheading
LBO

 Management factors
Record of capability
Betting reputation and personal wealth on
success of LBO
Highly motivated by potential large
personal gains from stock ownership

Sources of MBO targets

Divestitures of divisions by public
companies
Private companies with low growth
records
Public corporations selling at low P/E
multiples representing large discounts
from book values

 Sources of gains in LBOs

Tax benefits can enhance already
viable transaction
Specific tax benefits
Interest tax shelter from high leverage
Asset step-up provides higher asset value for
depreciation expenses; especially accelerated
depreciation on assets involving little recapture
more difficult under Tax Reform Act of 1986
Tax advantages of using ESOP as LBO vehicle

 Management incentives and agency

cost effects
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

 Wealth transfer effects

Payment of premiums in LBO transactions
may represent wealth transfer to
shareholders from other stakeholders
Wealth transfer from existing bondholders
and preferred stockholders
Reduction in value of firm's outstanding bonds
and preferred stock due to
Large increase in debt
Bond covenants may not protect existing
bondholders in event of control changes and
debt issue
In bankruptcy proceedings, "absolute priority
rule" for senior security may not be strictly
followed

 Wealth transfer from current employees to

new investors
Management turnover in buyout firms lower
than in average firm; sometimes new
management team is brought in after LBO
Number of employees grows more slowly in LBO
firm than others in same industry and
sometimes even decreases may result from
post buyout divestitures and more efficient use
of labor

 Tax benefits in LBO constitute subsidy from

public and loss of revenue to government
Premia paid in LBOs positively related to
potential tax benefits
Net effect of LBO on government tax revenues
may be positive
Shareholders pay capital gains taxes on sale
of their stock in LBO tender offer
LBO investor group pays capital gains taxes
when firm goes public at a later date
Improved profitability firms pay more
corporate taxes
Many of tax benefits from increased leverage
could be realized without LBOs

 Asymmetric information and

underpricing
Managers or investor groups have more
information on value of firm than public
shareholders
Large premium in buyout proposal signals
that future operating income will be larger
than previously expected or firm is less
risky than previously perceived
Investor group believes new company
worth more than purchase price
prebuyout shareholders receive less than
adequately informed shareholders

 Other efficiency considerations

More efficient decision process as private
firm
No need to justify new programs with detailed
studies and reports to board of directors, more
speedy actions can be taken
Public firms have to publish reports that can
disclose valuable information to competitors