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 firms 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
Potential Sources of Value in LBOs
Junk bond market Leverage and taxes Other stakeholders Leverage and incentives Leverage restructurings LBOs and Leverage restructurings

Leveraged Buy Outs

Some Examples of LBOs
Value ($mil) 24,720 6,250 4,240 4,000 4,680 3,690 3,600 3,500 7,050 4,700 4,380 2,260

Acquirer

KKR KKR KKR Thompson Co. KKR Wings Holdings TF Investments Macy Acquisitions Corp. Carlyle Group & Welsh, Carson, Anderson and Stowe Quest Dex TRW Automotive Blackstone Group Holdings KKR PanAmSat Texas Pacific group, Bain Capital. & Goldman Sachs. Burger King

Target RJR Nabisco Beatrice Safeway Southland (7-11) Owens-Illinios NWA, Inc.

Industry Food, tobacco Food Supermarkets Convenience stores Glass Airlines Hospitals Department stores Yellow pages Auto parts Satellites Fast food

Year 1989 1986 1986 1987 1987 1989 1989 1986 2002 2002 2004 2002

Leveraged Buyouts
The three main characteristics of LBOs

1. 2. 3.

High debt Incentives 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 debtequity 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 Coruss 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 Two primary decisions in a corporation
Investment & Financing

The APV method measures value from these two separately Before studying APV, important to understand the effect of financing decisions on firm value

In the presence of taxes, Debt adds value since interest payments reduce firms tax burden Different financial transactions are taxed differently: Interest payments are tax exempt for the firm. Dividends and retained earnings are not. Financial policy matters because it affects a firms 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

MMs 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 being tax 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 A 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 A. 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 Expected Cost 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

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. WACC

Use WACC when the projects debt to equity ratio is known Use APV when the projects level of debt is known

Appropriate for Leveraged Buy Out or High Leverage Transactions Also appropriate to see value separately from financing and operations.