Chapter 13
Financing Transactions
Private Equity, Hedge Funds, and Leveraged Buyout Structures and Valuation
A billion dollars isn't what it used to be.
—Nelson Bunker Hunt
Inside M&A: Kinder Morgan Buyout Raises Ethical Questions
In the largest management buyout in U.S. history at that time, Kinder Morgan Inc.'s management proposed to take the oil and gas pipeline firm private in 2006 in a transaction that valued the firm's outstanding equity at $13.5 billion. Under the proposal, chief executive Richard Kinder and other senior executives would contribute shares valued at $2.8 billion to the newly private company. An additional $4.5 billion would come from private equity investors, including Goldman Sachs Capital Partners, American International Group Inc., and the Carlyle Group. Including assumed debt, the transaction was valued at about $22 billion. The transaction also was notable for the governance and ethical issues it raised. Reflecting the struggles within the corporation, the deal did not close until mid-2007.
The top management of Kinder Morgan Inc. waited more than two months before informing the firm's board of its desire to take the company private. It is customary for boards governing firms whose managements are interested in buying out public shareholders to create a committee within the board consisting of independent board members to solicit other bids. While the Kinder Morgan board did eventually create such a committee, the board's lack of awareness of the pending management proposal gave management an important lead over potential bidders in structuring a proposal. By being involved early on in the process, a board has more time to negotiate terms more favorable to shareholders. The transaction also raised questions about the potential conflicts of interest in cases where investment bankers who were hired to advise management and the board on the “fairness” of the offer price also were potential investors in the buyout.
Kinder Morgan's management hired Goldman Sachs in February 2006 to explore “strategic” options for the firm to enhance shareholder value. The leveraged buyout option was proposed by Goldman Sachs on March 7, followed by their proposal to become the primary investor in the LBO on April 5. The management buyout group hired a number of law firms and other investment banks as advisors and discussed the proposed buyout with credit-rating firms to assess how much debt the firm could support without experiencing a downgrade in its credit rating.
On May 13, 2006, the full board was finally made aware of the proposal. The board immediately demanded that a standstill agreement that had been signed by Richard Kinder, CEO and leader of the buyout group, be terminated. The agreement did not permit the firm to talk to any alternative bidders for a period of 90 days. While investment banks and buyout groups often propose such an agreement to ensure that they can perform adequate due diligence, this extended period is not necessarily in the interests of the firm's shareholders because it puts alternative suitors coming in later at a distinct disadvantage. Later bidders simply lack sufficient time to make an adequate assessment of the true value of the target and structure their own proposals. In this way, the standstill agreement could discourage alternative bids for the business.
A special committee of the board was set up to negotiate with the management buyout group, and it was ultimately able to secure a $107.50 per share price for the firm, significantly higher than the initial offer. The discussions were rumored to have been very contentious due to the board's annoyance with the delay in informing them.1 Reflecting the strong financial performance of the firm and an improving equity market, Kinder Morgan raised $2.4 billion in early 2011 in the largest private equity–backed IPO in history. The majority of the IPO proceeds were paid out to the firm's private equity investors as a dividend.
Chapter Overview
This chapter discusses how transactions are financed, with an emphasis on the financing, structuring, and valuation of highly leveraged transactions. In a leveraged buyout (LBO), borrowed funds are used to pay for most of the purchase price, with the remainder provided by a financial sponsor, such as a private equity investor group or hedge fund. LBOs can be of an entire company or divisions of a company. LBO targets can be private or public firms. Typically, the tangible assets of the firm to be acquired are used as collateral for the loans. The most highly liquid assets often are used as collateral for obtaining bank financing. Such assets commonly include receivables and inventory.
The firm's fixed assets commonly are used to secure a portion of long-term senior financing. Subordinated debt, either unrated or low-rated debt, is used to raise the balance of the purchase price. This debt often is referred to as junk bond financing. When a public company is subject to an LBO, it is said to be going private in a public-to-private transaction because the equity of the firm has been purchased by a small group of investors and is no longer publicly traded. Buyers of the firm targeted to become a leveraged buyout often consist of managers from the firm that is being acquired. The LBO that is initiated by the target firm's incumbent management is called a management buyout (MBO).
This chapter begins with a discussion of the changing face of LBOs. Subsequent sections discuss how such transactions often are financed, alternative LBO structures, the risks associated with poorly constructed deals, how to take a company private, how to develop viable exit strategies, and how to estimate a firm's financing capacity. The terms buyout firm and financial sponsor are used interchangeably, as they are in the literature on the subject, throughout the chapter to include the variety of investor groups, such as private equity investors and hedge funds, that commonly engage in LBO transactions. Empirical studies of pre- and postbuyout returns to shareholders also are reviewed. The chapter concludes with a discussion of how to analyze and value highly leveraged transactions and to construct LBO models.
A detailed Microsoft Excel-Based Leveraged Buyout Valuation and Structuring Model is available on this book's companion site (www.elsevierdirect.com/companions/9780123854858). The site also contains a review of this chapter (including practice questions and answers) in the file folder entitled “Student Study Guide” and a Learning Interactions Library, which gives students the opportunity to test their knowledge of this chapter in a “real-time” environment.
Characterizing Leveraged Buyouts
An LBO investor is frequently called a financial buyer or financial sponsor. Such investors are inclined to use a large amount of debt to finance as much of the target's purchase price as possible. Leverage makes the potential returns to equity much more attractive than in unleveraged transactions (Table 13.1).
Table 13.1. Impact of Leverage on Return to Shareholdersa
a Unless otherwise noted, all numbers are in millions of dollars.
Historically, empirical studies of LBOs have been subject to small samples due to limited data availability, survival bias,2 and a focus on the conversion of public to private firms. Recent studies based on larger samples make some of the conclusions of earlier studies problematic.3 These more recent studies are discussed in the following sections.
The Changing Nature of LBOs since 1970
In an exhaustive study of 21,397 private equity transactions that could be identified between 1970 and 2007, Stromberg (2008) confirmed that private equity investments accelerated sharply in recent years from their longer-term trend, peaking in 2006 and 2007. In 2007, more than 14,000 LBOs operated globally as compared to about 5,000 in the year 2000 and only 2,000 in the mid-1990s. The major insights provided by this study are discussed next.
The Private Equity Market Is a Global Phenomenon
While private equity investors have been more active in the United States for a longer time period, the number of non-U.S. private equity transactions has grown to be larger than that of the United States. The ability to conduct public-to-private LBO transactions in different countries is influenced by the ability to squeeze out minority shareholders. The United States, United Kingdom, and Ireland tend to be at the less-restrictive end of the spectrum, while Italy, Denmark, Finland, and Spain tend to be far more restrictive.4 Although remaining relatively flat throughout the 1990s in both the United States and Western Europe following the recession early in the decade, LBO growth exploded between 2001 and 2007, particularly outside the United States.
Pure Management Buyouts Rare
Only one in five LBOs deals between 1970 and 2007 involved pure management buyouts, in which individual investors (typically the target firm's management) acquired the firm in a leveraged transaction. The majority were undertaken by a traditional private equity financial sponsor providing most of the equity financing.
LBO Transactions Widespread
While private equity transactions take place in a wide variety of industries, including chemicals, machinery, and retailing, buyout activity has shifted increasingly to the high-growth, “high-tech” market segments. The shift in the type of target may reflect a change in the composition of U.S. industry or simply a shortage of targets deemed appropriate by private equity investors in the more traditional industries.
Sales to Strategic Buyers Represent Primary Exit Strategy
LBO financial sponsors and management are able to realize their expected financial returns on exiting or “cashing out” of the business. Constituting about 13% of total transactions since the 1970s, initial public offerings (i.e., IPOs) declined in importance as an exit strategy. At 39% of all exits, the most common ways of exiting buyouts is through a sale to a strategic buyer; the second most common method, at 24%, is a sale to another buyout firm in so-called secondary buyouts.
Selling to a strategic buyer usually results in the best price because the buyer may be able to generate significant synergies by combining the firm with its existing business. If the original buyout firm's investment fund is coming to an end, the firm may be able to sell the LBO to another buyout firm that is looking for new investment opportunities. This option is best used when the LBO's management is still enthusiastic about growing the firm rather than cashing out. Consequently, the LBO may be attractive to another buyout firm.
An IPO is often less attractive due to the massive amount of public disclosure required, the substantial commitment of management time, the difficulty in timing the market, and the potential for incorrectly valuing the IPO. The original investors also can cash out while management remains in charge of the business through a leveraged recapitalization: borrowing additional funds to repurchase stock from other shareholders. This strategy may be employed once the firm has paid down its original debt level.
LBOs Not Prone to “Quick Flips”
“Quick flips,” those LBOs exited in less than two years after the initial investment, accounted for only 8% of the total deals and have declined in recent years. LBOs tend to remain in place for long periods, with almost 40% continuing to operate 10 years after the initial LBO announcement. Smaller firms tend to stay in the LBO ownership form longer than larger firms. The median firm remains under LBO ownership for nine years. These findings are in stark contrast to earlier studies of public-to-private transactions, which found the median LBO target remained private for 6.8 years.5
Most LBOs Involve Acquisitions of Private Firms
While receiving most of the research in prior studies, public-to-private transactions accounted for 6.7% of all transactions between 1970 and 2007, although they did make up about 28% of the dollar value of such transactions, since public companies tend to be larger than private firms. Acquisitions of private firms constituted 47% of all transactions between 1970 and 2007. During the same period, buyouts of divisions of companies accounted for 31% of the transactions and 31% of the total value of transactions.
The Effects of LBOs on Innovation
It has long been recognized that economic growth is influenced significantly by the rate of innovation, which is in turn affected by the level of R&D spending.6 Although early studies found a correlation between more debt and lower R&D spending,7 more recent studies demonstrate that increased leverage tends to reduce R&D only for the smallest firms.8 Studies show that LBOs increase R&D spending on an absolute basis and relative to their peers9 and that private equity-financed LBOs may tend to improve the rate of innovation.10
The Effects of LBOs on Employment Growth
In an international study of 5,000 LBOs between 1980 and 2005 (the largest such study to date), Davis and colleagues (2008) found that companies owned by buyout firms maintained employment levels on par with competitors in the first year after the buyout. However, their employment levels dropped relative to a control (i.e., comparison) sample consisting of non-LBO firms in the second and third years following the buyout. By the end of five years, cumulative job growth was in the aggregate about 2 percentage points less than firms in the control sample. In manufacturing, employment levels at firms subject to buyout were very similar to those at competitor firms; in retailing, services, and financial services, employment tended to be significantly lower. Job creation as a result of investment in new ventures (i.e., greenfield operations) tends to be higher at firms experiencing buyouts than at competitor firms.
The authors note that their findings are consistent with the notion that private equity groups act as catalysts to shrink the inefficient segments of underperforming firms. Furthermore, greenfield operations undertaken by firms having undergone buyouts accelerate the expansion of such firms in new, potentially more productive directions. The job creation rate in these new ventures tends to be substantially higher than those in current businesses, creating the potential for higher long-term employment gains than at firms not having undergone buyouts.
Hedge Funds as Investors of Last Resort
Since 1995, hedge funds have participated in more than one-half of the private placements of equity securities (i.e., equity issues outside of public markets) in the United States. Contributing more than one-fourth of the total capital raised, hedge funds have consistently been the largest single investor group in these types of transactions.11
Firms using private placements tend to be small, young, and poorly performing. Because it is often difficult to get reliable information, these firms have difficulty obtaining financing.12 These transactions often are referred to as private investments in public equity (PIPES).13 Because of difficulty in raising financing, firms issuing private placements of equities often have little leverage in negotiating with investors. Consequently, many of the private placements grant investors “repricing rights,” which protect investors from a decline in the price of their holdings by requiring firms to issue more shares whenever the price of the privately placed shares decreases.
Hedge funds are often willing to purchase PIPES because of the way in which they insulate their portfolios from price declines. Hedge funds can purchase PIPE securities that cannot be sold in public markets until they are registered with the SEC at discounts from the issuing firms and simultaneously sell short the securities of the issuing firms that are already trading on public markets. Although firms obtaining funding from hedge funds perform relatively poorly, hedge funds investing in PIPE securities perform relatively well, because they buy such securities at substantial discounts (affording some protection from price declines), protect their investment through repricing rights and short-selling, and sell their investments after a relatively short period. By being able to protect their investments in this manner, hedge funds are able to serve “as investors of last resort” for firms having difficulty borrowing.
Competition in the LBO Market
To finance the increased average size of targets taken private in 2006, buyout firms started to bid for target firms as groups of investors. The tendency of buyout firms to invest as a group is often referred to as clubbing. The HCA, SunGard, and Kinder Morgan transactions all involved at least four private equity investor funds. While mitigating risk, banding together to buy large LBO targets also made buyout firms vulnerable to accusations of colluding in an effort to limit the prices offered for target firms. The empirical evidence concerning whether club deals actually benefit target firm shareholders by enabling the payment of higher purchase prices is mixed.14
Factors in Successful LBOs
While many factors contribute to the success of LBOs, studies suggest that target selection, not overpaying, and improving operating performance are among the most important.
Target Selection
Traditionally, firms that represent good candidates for an LBO are those that have substantial unused borrowing capacity, tangible assets, predictable positive operating cash flow, and assets that are not critical to the continuing operation of the business.15 Competent and highly motivated management is always crucial to the eventual success of the LBO. Finally, firms in certain types of industries or that are part of larger firms often represent attractive opportunities.
Unused Borrowing Capacity and Redundant Assets
Factors enhancing borrowing capacity include cash balances on the books of the target company in excess of working capital requirements, a low debt–to–total capital ratio (as compared with the industry average), and a demonstrated ability to generate consistent earnings and cash-flow growth. Firms with undervalued assets may use such assets as collateral for loans from asset-based lenders. Undervalued assets also provide a significant tax shelter because they may be revalued and depreciated or amortized over their allowable tax lives. In addition, operating assets, such as subsidiaries that are not germane to the target's core business and that can be sold quickly for cash, can be divested to accelerate the payoff of either the highest cost debt or the debt with the most restrictive covenants.
Management Competence and Motivation
Even though management competence is a necessary condition for success, it does not ensure that the firm's performance will meet investor expectations. Management must be highly motivated by the prospect of abnormally large returns in a relatively short time. Consequently, management of the firm to be taken private is normally given an opportunity to own a significant portion of the equity of the firm.
Attractive Industries
Typical targets are in mature industries, such as manufacturing, retailing, textiles, food processing, apparel, and soft drinks. Such industries usually are characterized by large tangible book values, modest growth prospects, relatively stable cash flow, and limited research and development, new product, or technology requirements. Such industries are generally not dependent on technologies and production processes that are subject to rapid change. Empirical studies have shown that industries that have high free cash flows and limited growth opportunities are good candidates for LBOs.16
Large Company Operating Divisions
The best candidates for management buyouts often are underperforming divisions of larger companies, in which the division is no longer considered critical to the parent firm's overarching strategy. Frequently, such divisions are saddled with excessive administrative overhead, often required by the parent, and expenses are allocated to the division by the parent for services, such as legal, auditing, and treasury functions, that could be purchased less expensively from sources outside the parent firm.
Firms without Change of Control Covenants
Such covenants in bond indentures are clauses either limiting the amount of debt a firm can add or requiring the company to buy back outstanding debt, sometimes at a premium, whenever a change of control occurs. Firms with bonds lacking such covenants are twice as likely to be the target of an LBO.17
Not Overpaying
Overpaying for LBOs can be disastrous. Failure to meet debt service obligations in a timely fashion often requires that the LBO firm renegotiate the terms of the loan agreements with the lenders. If the parties to the transaction cannot reach a compromise, the firm may be forced to file for bankruptcy, often wiping out the initial investors. Highly leveraged firms also are subject to aggressive tactics from major competitors, who understand that taking on large amounts of debt raises the breakeven point for the firm. If the amount borrowed is made even more excessive as a result of having paid more than the economic value of the target firm, competitors may opt to gain market share by cutting product prices. The ability of the LBO firm to match such price cuts is limited because of the need to meet required interest and principal repayments.
Improving Operating Performance
Tactics employed to improve performance include negotiating employee wage and benefit concessions in exchange for a profit-sharing or stock ownership plan and outsourcing services once provided by the parent. Other options include moving the corporate headquarters to a less-expensive location, pruning unprofitable customer accounts, and eliminating such perks as corporate aircraft. As board members, buyout specialists, such as LBO funds, tend to take a much more active role in monitoring management performance.
How do LBOS create value?
LBOs create value by reducing debt, improving operating performance, and properly timing the sale of the business. LBOs often do not pay taxes for five to seven years or longer following the buyout due to the tax deductibility of interest and the additional depreciation resulting from the write-up of net acquired assets to fair market value. The firm's profits are likely to be shielded from taxes until a substantial portion of the outstanding debt is repaid and the assets depreciated. LBO investors (i.e., the sponsor group) utilize cumulative free cash flow to increase firm value by repaying debt and improving operating performance.
Debt Reduction
When debt is repaid, the equity value of the firm increases in direct proportion to the reduction in outstanding debt—equity increases by $1 for each $1 of debt repaid—assuming the financial sponsor can sell the firm for at least what it paid for the company. Debt reduction also contributes to cash flow by eliminating future interest and principal payments.
Operating Margin Improvement
By reinvesting cumulative free cash flow, the firm's operating margins can increase by improving efficiency, introducing new products, and making strategic acquisitions. The subsequent increase in margins will augment operating cash flow, which in turn raises the firm's equity value, if the level of risk is unchanged.
Timing the Sale of the Firm
The amount of the increase in firm value depends to a significant extent on the valuation that multiple investors place on each dollar of earnings, cash flow, or EBITDA when the firm is sold. LBO investors create value by timing the sale of the firm to coincide with the firm's leverage declining to the industry-average leverage and with favorable industry conditions.18 This typically occurs when the firm takes on the risk characteristics of the average firm in the industry and when the industry in which the business competes is most attractive to investors, a point at which valuation multiples are likely to be the highest.19
Table 13.2 provides a numerical example of how LBOs create value by “paying down” debt, by improving the firm's operating margins, and by increasing the market multiple applied to the firm's EBITDA in the year in which the firm is sold. Each case assumes that the sponsor group pays $500 million for the target firm and finances the transaction by borrowing $400 million and contributing $100 million in equity. The sponsor group is assumed to exit the LBO at the end of seven years. In Case 1, all cumulative free cash flow is used to reduce outstanding debt. Case 2 assumes the same exit multiple as Case 1 but that cumulative free cash flow is higher due to margin improvement and lower interest and principal repayments as a result of debt reduction. Case 3 assumes the same cumulative free cash flow available for debt repayment and EBITDA as in Case 2 but a higher exit multiple.
Table 13.2. LBOs Create Value by Reducing Debt, Improving Margins, and Increasing Exit Multiples
a Cumulative cash available for debt repayment and EBITDA increase between Case 1 and Case 2 due to improving margins and lower interest and principal repayments reflecting the reduction in net debt.
b Net Debt = Total Debt – Cumulative Cash Available for Debt Repayment = $400 million – $185 million = $215 million.
c Transaction value = EBITDA in the 7th Year × EBITDA multiple in the 7th Year.
d Equity Value = Transaction Value in the 7th Year – Net Debt.
e The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return because it accounts for the time value of money.
When Do Firms Go Private?
Firms are inclined to go private if the board and management believe that the firm's current share price is undervalued, the need for liquidity is low, the cost of governance is high, and the potential loss of control is high. While access to liquid public capital markets enables a firm to lower its cost of capital, participating in public markets creates the potential for significant disagreements between the board and management on one hand and shareholders on the other.20 The Sarbanes-Oxley Act of 2002 may also have contributed to the cost of governance, causing some firms (particularly smaller firms) to go private to avoid such costs.21
Financing Transactions
This section discusses how transactions are financed and addresses the complex capital structures of highly leveraged transactions, such as leveraged buyouts, and ways of selecting the appropriate capital structure. In addition to an acquirer using excess cash on hand, financing options range from borrowing to issuing equity to seller financing. These are discussed next.
Financing Options: Borrowing
An acquirer or financial sponsor may tap into an array of alternative sources of borrowing, including asset- and cash-flow–based lending, long-term financing, and leveraged bank loans.
Asset-Based or Secured Lending
Under asset-based lending, the borrower pledges certain assets as collateral. These loans are often short-term (i.e., less than one year in maturity) and secured by assets that can be liquidated easily, such as accounts receivable and inventory. Borrowers often seek revolving lines of credit that they draw upon on a daily basis to run their business. Under a revolving credit arrangement, the bank agrees to make loans up to a maximum for a specified period, usually a year or more. As the borrower repays a portion of the loan, an amount equal to the repayment can be borrowed again under the terms of the agreement. In addition to interest on the notes, the bank charges a fee for the commitment to hold the funds available. For a fee, the borrower may choose to convert the revolving credit line into a term loan. A term loan usually has a maturity of two to ten years and typically is secured by the asset that is being financed, such as new capital equipment.22
Loan documents define the rights and the obligations of the parties to the loan. The loan agreement stipulates the terms and conditions under which the lender will loan the firm funds; the security agreement specifies which of the borrower's assets will be pledged to secure the loan; and the promissory note commits the borrower to repay the loan, even if the assets, when liquidated, do not fully cover the unpaid balance.23 If the borrower defaults on the loan, the lender can seize and sell the collateral to recover the value of the loan.24 Loan agreements often have cross-default provisions that allow a lender to collect its loan immediately if the borrower is in default on a loan to another lender.
These documents contain certain security provisions and protective positive and negative covenants limiting what the borrower may do as long as the loan is outstanding. Typical security provisions include the assignment of payments due under a specific contract to the lender, an assignment of a portion of the receivables or inventories, and a pledge of marketable securities held by the borrower. An affirmative protective covenant in a loan agreement specifies the actions the borrower agrees to take during the term of the loan.
Typically, these include furnishing periodic financial statements to the lender, carrying sufficient insurance to cover insurable business risks, maintaining a minimum amount of net working capital, and retaining key management personnel acceptable to the lending institution. Negative covenants restrict the actions of the borrower. They include limiting the amount of dividends that can be paid; the level of salaries and bonuses that may be given to the borrower's employees; the total amount of indebtedness that can be assumed by the borrower; investments in plant and equipment and acquisitions; and the sale of certain assets.
Cash-Flow or Unsecured Lenders
Cash-flow lenders view the borrower's future cash-flow generation capability as the primary means of recovering a loan and the borrower's assets as a secondary source of funds in the event of default by the borrower. In the mid-1980s, LBOs' capital structures assumed increasing amounts of unsecured debt. To compensate for additional risk, the unsecured lenders would receive both a higher interest rate and warrants that were convertible into equity at some future date.
Unsecured debt that lies between senior debt and the equity layers is often referred to as mezzanine financing. It includes senior subordinated debt, subordinated debt, bridge financing, and LBO partnership financing. It frequently consists of high-yield junk bonds, which may also include zero coupon deferred interest debentures (i.e., bonds whose interest is not paid until maturity) used to increase the postacquisition cash flow of the acquired entity. Unsecured financing often consists of several layers of debt, each subordinate in liquidation to the next most senior issue. Those with the lowest level of security typically offer the highest yields to compensate for their higher level of risk in the event of default. Bridge financing consists of unsecured loans, often provided by investment banks or hedge funds, to supply short-term financing pending the placement of subordinated debt (i.e., long-term or “permanent” financing). The usual expectation is that bridge financing will be replaced six to nine months after the closing date of the LBO transaction.
On March 17, 2009, Pfizer Pharmaceuticals announced that it had successfully sold $13.5 billion in senior, unsecured long-term debt in maturities of 3, 6, 10, and 20 years to replace short-term bridge financing that had been issued to complete its acquisition of Wyeth Pharmaceuticals. Accounting for about one-third of the $68 billion purchase price, the bridge financing, consisting of $22.5 billion, had to be repaid by December 31, 2009. The five banks that originally had provided the bridge loans had syndicated (sold) portions of the loans to a total of 29 other banks such that no single bank financed more than $1.5 billion of the total $22.5 billion.
Types of Long-Term Financing
The attractiveness of long-term debt is its relatively low after-tax cost and the potential for leverage to improve earnings per share and returns on equity. However, too much debt can increase the risk of default on loan repayments and bankruptcy.
Long-term debt issues are classified by whether they are senior or junior in liquidation. Senior debt has a higher-priority claim to a firm's earnings and assets than junior debt. Unsecured debt also may be classified according to whether it is subordinated to other types of debt. In general, subordinated debentures are junior to other types of debt, including bank loans, and even may be junior to all of a firm's other debt. Debentures are unsecured, backed only by the overall creditworthiness of the borrower.
Convertible bonds are types of debt that are convertible, at some predetermined ratio (i.e., a specific number of shares per bond), into shares of stock of the issuing company. Such debt often is referred to as a hybrid security because it has both debt and equity characteristics. It normally has a relatively low coupon rate. The bond buyer is compensated primarily by the ability to convert the bond to common stock at a substantial discount from the stock's market value. Issuers of such debt benefit by having to make a lower cash interest payment. However, current shareholders will experience earnings or ownership dilution when the bondholders convert their bonds into new shares.
The extent to which a debt issue is junior to other debt depends on the restrictions placed on the company in an agreement called an indenture, which is a contract between the firm that issues the long-term debt securities and the lenders. The indenture details the nature of the issue, specifies the way in which the principal must be repaid, and specifies affirmative and negative covenants applicable to the long-term debt issue. Typical covenants include maintaining a minimum interest coverage ratio, minimum level of working capital, maximum amount of dividends that the firm can pay, and restrictions on equipment leasing and issuing additional debt.
Debt issues often are rated by various credit rating agencies according to their relative degree of risk.25 The agencies consider various factors, such as a firm's earnings stability, interest coverage ratios, the amount of debt in the firm's capital structure, the degree of subordination of the issue being rated, and the firm's past performance, in meeting its debt service requirements.26
Junk Bonds
Junk bonds are high-yield bonds that credit-rating agencies have deemed either to be below investment grade or to have no rating.27 When originally issued, junk bonds frequently yield more than 4 percentage points above the yields on U.S. Treasury debt of comparable maturity.
Junk bond financing exploded in the early 1980s but dried up by the end of the decade.28 Three-fourths of the proceeds of junk bonds issued between 1980 and 1986 were used to finance the capital requirements of high-growth corporations; the remainder was used to finance takeovers.29
Leveraged Bank Loans
Leveraged loans are defined as unrated or noninvestment-grade bank loans whose interest rates are equal to or greater than the London Interbank Rate (LIBOR) plus 150 basis points (1.5 percentage points). Leveraged loans include second mortgages, which typically have a floating rate and give lenders a lower level of security than first mortgages. Some analysts include other forms of debt instruments in this market, such as mezzanine or senior unsecured debt, discussed earlier in this chapter, and payment-in-kind notes, for which interest is paid in the form of more debt.
In the United States, the volume of such loans substantially exceeds the volume of junk bond issues. This represents a revival in bank loan financing as an alternative to financing transactions with junk bonds after junk bond issues dried up in the late 1980s; at the time, bank loans were more expensive. Leveraged loans are often less costly than junk bonds for borrowers because they have higher seniority in a firm's capital structure than high-yield bonds.
Globally, the syndicated loan market, including leveraged loans, senior unsecured debt, and payment-in-kind notes, is growing more rapidly than public markets for debt and equity. Syndicated loans are those typically issued through a consortium of institutions, including hedge funds, pension funds, and insurance companies to individual borrowers.
Financing Options: Common and Preferred Equity
There are many varieties of common stock, and some pay dividends and provide voting rights. Other common shares (often called super-voting shares) have multiple voting rights. In addition to voting rights, common shareholders sometimes receive rights offerings that allow them to maintain their proportional ownership in the company in the event that the company issues another stock offering. Common shareholders with rights may, but are not obligated to, acquire as many shares of the new stock as needed to maintain their proportional ownership in the company.
Although preferred stockholders receive dividends rather than interest payments, their shares often are considered a fixed income security. Dividends on preferred stock are generally constant over time, like interest payments on debt, but the firm is generally not obligated to pay them at a specific time.30 In liquidation, bondholders are paid first, then preferred stockholders, and common stockholders are paid last. To conserve cash, LBOs frequently issue paid in kind (PIK) preferred stock, where dividends are paid in the form of more preferred stock.
Seller Financing
Seller financing is a highly important source of financing and one way to “close the gap” between what a seller wants and a buyer is willing to pay on the purchase price. It involves the seller deferring the receipt of a portion of the purchase price until some future date—in effect, providing a loan to the buyer. A buyer may be willing to pay the seller's asking price if a portion is deferred because the buyer recognizes that the loan will reduce the purchase price in present value terms. The advantages to the buyer include a lower overall risk of the transaction because of the need to provide less capital at the time of closing and the shifting of operational risk to the seller if the buyer ultimately defaults on the loan to the seller.31 Table 13.3 summarizes the alternative forms of financing.
Table 13.3. Alternative Financing by Type of Security and Lending Source
Common Forms of Leveraged Buyout Deal Structures
Due to the epidemic of bankruptcies of cash-flow–based LBOs in the late 1980s, the most common form of LBO today is the asset-based LBO. This type of LBO can be accomplished in two ways: the sale of assets by the target to the acquiring company, with the seller using the cash received to pay off outstanding liabilities, or a merger of the target into the acquiring company (direct merger) or a wholly-owned subsidiary of the acquiring company (subsidiary merger). For small companies, a reverse stock split may be used to take the firm private. An important objective of “going private” transactions is to reduce the number of shareholders to below 300 to enable the public firm to delist from many public stock exchanges.
In a direct merger, the company to be taken private merges with a company controlled by the financial sponsor. If the LBO is structured as a direct merger, in which the seller receives cash for stock, the lender will make the loan to the buyer once the security agreements are in place and the target's stock has been pledged against the loan. The target then is merged into the acquiring company, which is the surviving corporation. Payment of the loan proceeds usually is made directly to the seller in accordance with a “letter of direction” drafted by the buyer.
In a subsidiary merger, the company controlled by the financial sponsor creates a new subsidiary that merges with the target. The subsidiary then makes a tender offer for the outstanding public shares. This may be done to avoid any negative impact that the new company might have on existing customer or creditor relationships. If some portion of the parent's assets are to be used as collateral to support the ability of its operating subsidiary to fund the transaction, both the parent and the subsidiary may be viewed as having a security interest (i.e., an implied guarantee) in the debt. As such, they may be held jointly and severally liable for the debt. To avoid this situation, the parent may make a capital contribution to the subsidiary rather than provide collateral or a loan guarantee.
A reverse stock split enables a corporation to reduce the number of shares outstanding. The total number of shares will have the same market value immediately after the reverse split as before, but each share will be worth more. Reverse splits may be used to take a firm private where a firm is short of cash. Therefore, the majority shareholders retain their stock after the split, while the minority shareholders receive a cash payment.
On January 9, 2008, MagStar Technologies, a Minnesota-based manufacturer of conveyor systems, announced a 1 for 2,000 reverse split of the firm's common stock, intending to take it private. Under the terms of the split, each 2,000 shares of the firm's common stock would be converted into 1 share of common stock, and holders of fewer than 2,000 shares of common stock on the record date would receive cash of $0.425 per presplit share. The anticipated split would reduce the number of shareholders to less than 300, the minimum required to list on many public exchanges. The company immediately stopped filing reports with the SEC. Under Minnesota law, the board of directors of a company may amend the firm's articles of incorporation to conduct the reverse split without shareholder approval.
Legal Pitfalls of Improperly Structured LBOs
Fraudulent conveyance laws are applicable whenever a company goes into bankruptcy following events such as a highly leveraged transaction. Under the law, the new company created by the LBO must be strong enough financially to meet its obligations to current and future creditors. If the new company is found by the court to have been inadequately capitalized, the lender could be stripped of its secured position in the company's assets, or its claims on the assets could be made subordinate to those of the general or unsecured creditors. Consequently, lenders, sellers, directors, or their agents, including auditors and investment bankers, may be required to compensate the general creditors. Fraudulent conveyance laws are intended to preclude shareholders, secured creditors, and others from benefiting at the expense of unsecured creditors. While fraudulent conveyance cases ordinarily do not get very far in court, the extreme leverage of many transactions during 2006 and 2007 has spawned increasing allegations of fraud.32
Leveraged Buyout Capital Structures
LBOs tend to have complicated capital structures consisting of bank debt, high-yield debt, mezzanine debt, and private equity provided primarily by the LBO sponsor (Figure 13.1). As secured debt, the bank debt generally is the most senior in the capital structure in the event of liquidation. Usually maturing within five to seven years, interest rates on such loans often vary at a fixed spread or difference over the London interbank offering rate. Bank loans usually must be paid off before other types of debt. Bank credit facilities consist of revolving credit and term loans.33 A revolving credit facility is used to satisfy daily liquidity requirements, secured by the firm's most liquid assets such as receivables and inventory. Term loans are usually secured by the firm's longer-lived assets and are granted in tranches or slices, denoted as A, B, C, and D, with A the most senior and D the lowest of all bank financing. While bank debt in the A tranche usually must be amortized or paid off before other forms of debt can be paid, the remaining tranches generally involve little or no amortization. While lenders in the A tranche often sell such loans to other commercial banks, loans in the B, C, and D tranches often are sold to hedge funds and mutual funds. In recent years, bank debt would make up about 40% of the total capital structure.
Figure 13.1 Typical LBO capital structure.
The next layer of LBO capital structure consists of unsecured subordinated debt, also referred to as junk bonds. Interest is fixed and represents a constant percentage or spread over the U.S. Treasury bond rate. The amount of the spread depends on the credit quality of the debt. Often callable at a premium, this debt usually has a seven- to ten-year maturity range, with the debt often paid off in a single payment. Such loans often are referred to as bullet loans.
As an alternative to high-yield publicly traded junk bonds, second mortgage or lien loans became popular between 2003 and mid-2007. Often called mezzanine debt, such loans are privately placed with hedge funds and collateralized loan obligation (CLO) investors. They are secured by the firm's assets but are subordinated to the bank debt in liquidation. By pooling large numbers of first and second mortgage loans (so-called noninvestment-grade or leveraged loans) and subdividing the pool into tranches, CLO investors sell the tranches to institutional investors such as pension funds and insurance companies. This type of debt is often issued with warrants to buy equity in the firm. The final layer of the capital structure consists of equity contributed by the financial sponsor (usually a single or a number of private equity or hedge funds) and management. The equity component consists of both preferred and common shares.
Prebuyout and Postbuyout Shareholder Returns
The following sections summarize the key factors affecting financial returns to shareholders before and after a leveraged buyout transaction.
Prebuyout Returns to Target Shareholders
The studies that are cited in Table 13.4 show that the premium paid by LBOs and MBOs to target company shareholders often exceeds 40% in nondivisional buyouts. These empirical studies also include so-called reverse LBOs (RLBOs)—public companies taken private and later taken public through an IPO. The latter IPO is called a secondary public offering.
Table 13.4. Empirical Studiesa of Returns to Shareholders (Prebuyout Returns)
| Nondivisional Buyouts | Premium Paid to Target Shareholders |
| DeAngelo, DeAngelo, and Rice (1984)
(Sample size = 72 U.S. MBOs) |
56% (1973–1983)b
76% (when there are 3 or more bids) |
| Lowenstein (1985)
(Sample size = 28 U.S. MBOs) |
48% (1979–1984) |
| Lehn and Poulsen (1988)
(Sample size = 92 U.S. LBOs) |
41% (1980–1984) |
| Kaplan (1989)
(Sample size = 76 U.S. LBOs) |
42% (1980–1986) |
| Renneboog, Simons, and Wright (2007)
(Sample size = 97 U.K. LBOs ) |
40% (1997–2003) |
| Divisional Buyouts | Return to Parent Corporation Shareholders |
| Hite and Vetsuypens (1989)
(Sample size = 151 MBOs) |
0.55% (1983–1987) |
| Muscarella and Vetsuypens (1990)
(Sample size = 45 MBOs) |
1.98% (1983–1988) |
a MBO, management buyout; LBO, leveraged buyout.
b The years in parentheses represent the time period in which the study took place.
Divisional buyouts represent opportunities for improved operating efficiency, since the division is removed from the bureaucracy of the parent. Although this may be a source of gain for the acquirer, it does not seem to be true for the shareholders of the parent firm divesting the division. The parent firm's shareholders receive only minuscule returns. The size of these returns may reflect the division's small share of the parent corporation's total market value. The fact that parent shareholders experience any gain at all may suggest that the parent's resources are redeployed to higher return investments.
Factors Determining Prebuyout Target Shareholder Returns
Table 13.5 summarizes a portion of the extensive empirical research that attempts to identify the factors that explain the sizable gains in share price accruing to prebuyout target shareholders. Although a number of factors are at work, the sizeable returns to these shareholders seem to reflect buyout firms' anticipated improvements in operating performance (i.e., cost reduction, productivity improvement, and revenue enhancement) due to management incentives, as well as large tax benefits. The anticipated improved operating performance is consistent with arguments that large abnormal returns to LBO target shareholders reflect investor undervaluation of the target prior to the announcement of an LBO.34
Table 13.5. Factors Contributing to Pre-LBO Buyout Returns to Target Shareholders
| Factor | Theory | Evidencea |
| MANAGEMENT INCENTIVES | ||
| Equity Ownership | ||
| Kaplan (1991) (sample size = 76 MBOs) | Management will improve performance when their ownership stake increases. | Management ownership increased for MBOs between 1980 and 1986 from 8.3% before the buyout to 29% after the buyout. |
| Incentive (Profit Sharing) Plans | ||
| Muscarella and Vetsuypens (1990) (sample size = 72 reverse LBOs) | Stock option and share appreciation plans motivate management to take cost-cutting actions that might otherwise have been unacceptable. | 96% of LBOs had at least one and 75% had two incentive plans in place during the 1983–1988 period. The change in shareholder gain is positively correlated with the fraction of shares owned by LBO's officers. |
| Improved Operating Performance | ||
| Holthausen and Larker (1996) (sample size = 90 reverse LBOs) | Equity ownership and incentive plans motivate management to initiate aggressive cost-reduction plans and to change marketing strategies. | For the 1983–1988 period, sales were up by 9.4% in real terms, and operating profits were up by 45.4% between the LBO announcement date and the secondary initial public offering. Firm performance also was highly correlated with the amount of ownership by officers and directors. |
| Kaplan (1989b) | Operating income in LBO firms increased more than in other firms in the same industry during 2 years following the LBO. | |
| TAX SHELTER BENEFITS | ||
| Kaplan (1989a) | An LBO can be tax-free for as long as 5–7 years. | Median value of tax shelter contributed 30% of the premium. |
| Lehn and Poulsen (1988) | Premium paid to pre-LBO shareholders positively correlated with pre-LBO tax liability/equity. | |
| UNDERVALUATION | ||
| Renneboog, Simons, and Wright (2007); Weir, Laing, and Wright (2005) | Investors undervalue the target firm prior to LBO. | Both studies report large abnormal returns in recent LBO wave consistent with those recorded in the 1980s. |
| WEALTH TRANSFER EFFECTS | ||
| Lehn and Poulsen (1988) | Premiums represent a transfer of wealth from bondholders to common stockholders. | Found no evidence that bondholders and preferred stockholders lose value when an LBO is announced. |
| Travlos and Cornett (1993) | Found small losses associated with the LBO announcement. | |
| Billet, King, and Mauer (2004) (sample size = 3073 LBOs) | Found no evidence of wealth transfer between bondholders and stockholders. | |
| INVESTOR GROUP HAS BETTER INFORMATION THAN PUBLIC SHAREHOLDERS ON MBO TARGET | ||
| Kaplan (1988) and Smith (1990) | Investor group believes target worth more than shareholders believe it is. | Found no evidence to support this theory. |
| IMPROVED EFFICIENCY IN DECISION MAKING | ||
| Travlos and Cornett (1993) | Private firms are less bureaucratic and do not incur reporting and servicing costs associated with public shareholders. | Shareholder-related expenses are not an important factor; difficult to substantiate more efficient decision making. |
a MBO, managed buyout; LBO, leveraged buyout.
Anticipated Improvement in Operating Performance and Tax Benefits
The most often cited sources of these returns are from tax benefits and expected post-LBO improvements in operating performance as a result of management incentives and the discipline imposed on management to repay debt. Because tax benefits are highly predictable, their value is largely reflected in premiums offered to shareholders of firms subject to LBOs.35
Wealth Transfer Effects
The evidence supporting wealth transfer effects is mixed. The exception may be for very large LBOs, such as RJR Nabisco, where largely anecdotal evidence suggests that a significant transfer of wealth may have taken place between the firm's pre-LBO debt holders and shareholders.
Superior Knowledge
There is little evidence to support the notion that LBO investors have knowledge of a business that is superior to the firm's public shareholders. Such knowledge, the theory suggests, would enable LBO investors to pay such high premiums because they understand better how to achieve cost savings and productivity improvements.
More Efficient Decision Making
There is also little empirical evidence to support the notion that decision making is more efficient. Nonetheless, the intuitive appeal of the simplified decision-making process of a private company is compelling when contrasted with a public company with multiple constituents directly or indirectly affecting decision making, including the board of directors with outside directors, public shareholders, public company regulatory agencies, and Wall Street analysts.
Postbuyout Returns to LBO Shareholders
Table 13.6 summarizes a cross-section of the studies of returns to shareholders following a leveraged buyout. A number of empirical studies suggest that investors in LBOs earned abnormal profits on their initial investments. Overall, studies suggest specifically that public to private LBOs (particularly MBOs) improve a firm's operating profits and cash flow, irrespective of methodology, benchmarks, and time period. However, there is evidence that more recent public to private LBOs may have a more modest impact on operating performance than those of the 1980s.36
Table 13.6. Postbuyout Returns to LBO Shareholdersa
| Empirical Study | Impact on Postbuyout Performance |
| Muscarella and Vetsuypens (1990) (Sample Size = 45 MBOs 1983–1987) | Of 41 firms going public, median annual return was 36.6% in 3 years following buyout. |
| Kaplan (1991) (Sample size = 21 MBOs 1979–1986) | Median annualized return was 26% higher than the gain on the S&P 500 during the 3-year postbuyout period. |
| Mian and Rosenfeld (1993) (Sample Size = 85 reverse LBOs 1983–1989) | Of the 33 LBOs that were acquired by another firm during the 3 years following the LBO, cumulative abnormal returns exceeded 21%. Of those not acquired, cumulative abnormal returns were zero. |
| Holthausen and Larker (1996) (Sample Size = 90 reverse LBOs 1983–1988) | Firms outperformed their industries over the 4 years following the secondary IPO. |
| Groh and Gottschaig (2006) (Sample size = 152 LBOs 1981–2004) | Risk-adjusted performance of U.S. LBOs significantly superior to S&P 500 stock index |
| Renneboog, Simons, and Wright (2006) (Sample size = 97 LBOs 1997–2004) | Share prices higher in aftermath of LBO |
| Guo et al. (2011) (Sample size = 192 LBOs 1990–2006) | Median postbuyout 3-year cumulative returns of 40.9%. Gains tend to be larger for firms that are more leveraged and when the CEO has been replaced at the time of the buyout. However, median operating performance is more modest than improvements recorded during 1980s. |
| Cao and Lerner (2009) (Sample Size = 496 reverse LBOs 1980–2002) | Reverse LBOs outperform other IPOs and the overall stock market, exhibiting a cumulative 3-year return of 43.8%. In contrast, “quick flips” (i.e., buyout firm sells its investment within a year of acquisition) underperformed the S&P 500 by a cumulative 5 percentage points during the following 3-year period. |
a MBO, managed buyout; LBO, leveraged buyout.
Factors Determining Postbuyout Returns
Postbuyout empirical studies imply that the effect of increased operating efficiency following a leveraged buyout is not fully reflected in the pre-LBO premium. These studies may be subject to selection or survivor bias in that only LBOs that are successful in significantly improving their operating performance are able to undertake a secondary public offering. In many instances, the abnormal returns earned by postbuyout shareholders were the result of the LBO being acquired by another firm within the three years immediately following the LBO announcement.37
In a larger sample and within a longer time period than in earlier studies, reverse LBOs showed a much larger three-year cumulative return (except for those “flipped” within one year of acquisition) than earlier studies.38 Researchers suggest that new owners choosing to retain their investment longer have more time to put the proper controls and reporting–monitoring systems in place for firms to survive the rigor of being a public company. In contrast, unless those systems are in place when acquired, firms resold within a year simply lack the time to adequately prepare for participating in public markets. Other factors contributing to postbuyout returns include professional management, tighter monitoring by owners, and often the reputations of the private equity firm investor groups.39
Using DCF Methods to Value Leveraged Buyouts
An LBO can be evaluated from the perspective of common equity investors only or all those who supply funds, including common and preferred investors and lenders. Conventional capital budgeting procedures may be used to evaluate the LBO. The transaction makes sense from the viewpoint of all investors if the present value (PV) of the cash flows to the firm (PVFCFF) or enterprise value, discounted at the weighted-average cost of capital, equals or exceeds the total investment consisting of debt, common equity, and preferred equity (I D + E + PFD) required to buy the outstanding shares of the target company:
(13.1)
Equation (13.1) implies that the target firm can earn its cost of capital and return sufficient cash flow to all investors and lenders, enabling them to meet or exceed their required returns.
However, it is possible for a leveraged buyout to make sense to common equity investors but not to other investors, such as pre-LBO debt holders and preferred stockholders. Once the LBO has been consummated, the firm's perceived ability to meet its obligations to current debt and preferred stockholders often deteriorates because the firm takes on a substantial amount of new debt. The firm's pre-LBO debt and preferred stock may be revalued in the open market by investors to reflect this higher perceived risk, resulting in a significant reduction in the market value of both debt and preferred equity owned by pre-LBO investors. Although there is little empirical evidence to show that this is typical of LBOs, this revaluation may characterize large LBOs, such as RJR Nabisco in 1989, HCA in 2006, and TXU Corp. in 2007.
What follows is a discussion of two methods for valuing leveraged buyouts. The cost of capital method attempts to adjust future cash flows for changes in the cost of capital as the firm reduces its outstanding debt. The second method, adjusted present value, sums the value of the firm without debt plus the value of future tax savings resulting from the tax deductibility of interest.
Valuing LBOs: The Cost of Capital Method
As long as the debt-to-equity ratio is expected to be constant, applying conventional capital budgeting techniques that discount future cash flows with a constant weighted-average cost of capital (CC) is appropriate. However, the extremely high leverage associated with leveraged buyouts significantly increases the riskiness of the cash flows available to equity investors as a result of the increase in fixed interest and principal repayments that must be made to lenders. Consequently, the cost of equity should be adjusted for the increased leverage of the firm. However, since the debt is to be paid off over time, the cost of equity decreases over time. Therefore, in valuing a leveraged buyout, the analyst must project free cash flows. Instead of discounting the cash flows at a constant discount rate, however, the discount rate must decline with the firm's declining debt-to-equity ratio. A five-step methodology for adjusting the discount rate to reflect a firm's declining leverage is discussed next.
Project Annual Cash Flows (Step 1)
Step 1 involves projecting free cash flow to equity (FCFE)—that is, the cash flow available for common equity investors, annually until the LBO has achieved its target debt-to-equity (D/E) ratio. The target D/E ratio often is the industry average ratio or a ratio that would appear to be acceptable to strategic buyers or investors in secondary IPOs.
Project Debt-to-Equity Ratios (Step 2)
The decline in debt-to-equity ratios depends on known debt repayment schedules and the projected growth in the market value of shareholders' equity. The market value of common equity can be assumed to grow in line with the projected growth in net income.
Calculate Terminal Value (Step 3)
Calculate the terminal value of equity (TVE) and of the firm in year t:
(13.2)
ke , and g represent the cost of equity and the cash-flow growth rate that can be sustained during the stable-growth or terminal period. TVE represents the present value of equity of the dollar proceeds available to the firm at time t, generated by selling equity to the public, to a strategic buyer, or to another LBO firm.
Adjust Discount Rate to Reflect Changing Risk (Step 4)
The high leverage associated with a leveraged buyout increases the risk of the cash flows available for equity investors. As the LBO's extremely high debt level is reduced, the cost of equity needs to be adjusted to reflect the decline in risk, as measured by the firm's levered beta (β FL). This adjustment may be estimated starting with the firm's levered beta in period 1 (β FL1) as follows:
(13.3)
βIUL1 is the industry unlevered β in period 1; (D/E) F 1 and tF are the firm's debt-to-equity ratio and marginal tax rate, respectively, and β IUL1 = β IL1/[1 + (D/E) I 1(1 – tI )], where β IL1, (D/E) I 1,and tI are the industry's levered β, debt-to-equity ratio, and tax rate, respectively. The firm's β in each successive period should be recalculated using the firm's projected debt-to-equity ratio for that period. The firm's cost of equity (k e) must be recalculated each period using that period's estimated β determined by Eq. (13.3).
Because the firm's cost of equity changes over time, the firm's cumulative cost of equity is used to discount projected cash flows.40 This reflects the fact that each period's cash flows generate a different rate of return. The cumulative cost of equity is represented as follows:
(13.4)
Determine If Deal Makes Sense (Step 5)
Making sense of the deal requires calculating the PV of FCFE discounted by the cumulative cost of equity generalized by Eq. (13.4) in Step 4, including the terminal value estimated by Eq. (13.2) in Step 3. Compare this result to the value of the equity invested in the firm, including transaction-related fees. The deal makes sense to common equity investors if the PV of FCFE exceeds the value of the equity investment in the deal. The deal makes sense to lenders and noncommon equity investors if the PV of FCFF exceeds the total cost of the deal (see Eq. (13.1)). Table 13.7 shows how to calculate the value of an LBO using the cost of capital method.
Table 13.7. Present Value of Equity Cash Flow Using the Cost of Capital Method
a Market value of common equity is assumed to grow by the rate of growth in income available to common stock (i.e., 2004: (0.77)%; 2005: 43.4%; 2006: 21.2%; 2007: 25%; 2008: 8%; 2009: 5.6%; and 2010: 5.3%. PIK preferred equity is assumed to equal its book value and to grow at its 12% dividend rate, and debt outstanding reflects its known principal repayment schedule.
b Comparable firm unlevered β u = β l/(1 + (D/E)(1 - t)).
c Firm's leveraged beta β l = β u(1 + (D/E)(1 − t)).
d Because of the changing D/E ratio, the discount factor is expressed in multiplicative form to reflect the differing cash-flow streams generated by investments made at each level of the D/E ratio.
e Adjusted equity cash flows come from Table 13.12.
f PV of adjusted equity cash flow equals the cumulative discount factor times the adjusted equity cash flow.
Valuing LBOs: Adjusted Present Value Method
Some analysts suggest that the problem of a variable discount rate can be avoided by separating the value of a firm's operations into two components: the firm's value as if it were debt-free and the value of interest tax savings. The total value of the firm is the present value of the firm's free cash flows to equity investors plus the present value of future tax savings discounted at the firm's unlevered cost of equity. The unlevered cost of equity is often viewed as the appropriate discount rate rather than the cost of debt or a risk-free rate because tax savings are subject to risk, since the firm may default on its debt or be unable to utilize the tax savings due to continuing operating losses.41
The justification for the adjusted present value (APV) method reflects the theoretical notion that firm value should not be affected by the way in which it is financed.42 However, recent studies suggest that for LBOs, the availability and cost of financing does indeed impact financing and investment decisions.43
In the presence of taxes, firms are often less leveraged than they should be, given the potentially large tax benefits associated with debt. Firms can increase market value by increasing leverage to the point at which the additional contribution of the tax shield to the firm's market value begins to decline.44 However, management's decision to increase leverage affects and is affected by the firm's credit rating. Consequently, the tax benefits of higher leverage may be partially or entirely offset by the higher probability of default associated with an increase in leverage.45
For the APV method to be applicable in highly leveraged transactions, the analyst needs to introduce the costs of financial distress (i.e., a firm's inability to pay interest and principal on its debt on a timely basis). The direct cost of financial distress includes the costs associated with reorganization in bankruptcy and ultimately liquidation (see Chapter 16). Such costs include legal and accounting fees. However, financial distress can have a material cost even on firms that are able to avoid bankruptcy or liquidation. These indirect costs include the loss of customers, employee turnover, less favorable terms from suppliers, higher borrowing costs, lost opportunities, management distraction costs, higher operating expenses, and reduced overall competitiveness.
Consequently, in applying the APV method, the present value of a highly leveraged transaction (PVHL) would reflect the present value of the firm without leverage (PVUL) plus the present value of tax savings (i.e., interest expense, i, times the firm's marginal tax rate, t, or tax shield PV ti resulting from leverage) less the present value of expected financial distress PVFD).
(13.5)
where PVFD = µFD.
FD is the expected cost of financial distress, and μ is the probability of financial distress. Unfortunately, FD and μ cannot be easily or reliably estimated and are often ignored by analysts using the APV method. Failure to include an estimate of the cost and probability of financial distress is likely to result in an overestimate of the value of the firm using the APV method. Despite these concerns, many analysts continue to apply the APV method because of its relative simplicity, as illustrated in the following five-step process.
Project Annual Cash Flows and Interest Tax Savings (Step 1)
For the period during which the debt–to–total capital ratio is changing, the analyst should project free cash flows to equity and the interest-related tax savings. During the firm's terminal period, the debt–to–total capital structure is assumed to be stable and the free cash flows are projected to grow at a constant rate.
Value Target Excluding Tax Savings (Step 2)
Estimate the unlevered cost of equity (COE) for discounting cash flows during the period in which the capital structure is changing and the weighted-average cost of capital (WACC) for discounting during the terminal period. The WACC is estimated using the COE and after-tax cost of debt and the proportions of debt and equity that make up the firm's capital structure in the final year of the period during which the capital structure is changing.
Estimate Present Value of Tax Savings (Step 3)
Project the annual tax savings resulting from the tax deductibility of interest. Discount projected tax savings at the firm's unlevered cost of equity, since it reflects a higher level of risk than either the WACC or after-tax cost of debt. Tax savings are subject to risk comparable to the firm's cash flows in that a highly leveraged firm may default and the tax savings go unused.
Calculate Total Value of Firm (Step 4)
To determine the total value of the firm, add the present value of the firm's cash flows to equity, interest tax savings, and terminal value discounted at the firm's unlevered cost of equity and subtract the present value of the expected cost of financial distress (see Eq. (13.5)). Note that the terminal value is calculated using WACC but that it is discounted to the present using the unlevered COE. This is done because it represents the present value of cash flows in the final year of the period in which the firm's capital structure is changing and beyond.
Determine Whether Deal Makes Sense (Step 5)
This requires that the present value of Eq. (13.5) less the value of equity invested in the transaction (i.e., NPV) be greater than or equal to 0. The magnitude of the cost of financial distress can range from 10 to 25% of a firm's predistressed market value.46 The probability of financial distress can be estimated by analyzing bond ratings47 and the cumulative probabilities of default for bonds in different ratings classes over five- and ten-year periods (see Table 13.8).48
Table 13.8. Bond Rating and Probability of Default
| Rating | Cumulative Probability of Distress (%) | |
| 5 Years | 10 Years | |
| AAA | 0.04 | 0.07 |
| AA | 0.44 | 0.51 |
| A+ | 0.47 | 0.57 |
| A | 0.20 | 0.66 |
| A− | 3.00 | 5.00 |
| BBB | 6.44 | 7.54 |
| BB | 11.90 | 19.63 |
| B+ | 19.20 | 28.25 |
| B | 27.50 | 36.80 |
| B- | 31.10 | 42.12 |
| CCC | 46.26 | 59.02 |
| CC | 54.15 | 66.60 |
| C+ | 65.15 | 75.16 |
| C | 72.15 | 81.03 |
| C− | 80.00 | 87.16 |
Source: Altman, 2007.
Table 13.9 illustrates the APV method. Assuming that the firm has a B credit rating, the present value of the expected cost of bankruptcy is $5.62 million and is calculated as the cumulative probability of default over ten years for a B-rated company (i.e., 0.3680 per Table 13.8) times the expected cost of bankruptcy (i.e., 0.25 × $61.07 million).49 Note that the estimate provided by the APV method is $61.07 million before the adjustment for financial distress. This is 6.8% (i.e., ($61.07/$57.2) – 1) more than the estimate provided using the CC method, shown in Table 13.7. After adjusting for financial distress, the estimate declines to $55.45 million versus $57.2 million, estimated using the cost of capital method, a difference of approximately 3%.
Table 13.9. Present Value of Equity Cash Flows Using the APV Method
a Cost of Equity (ke ) = 0.06 + 2.0(0.055).
b WACC = ke × W1 + Pref × W2 + i × (1 – 0.t) × W3, where ke = unlevered cost of equity; Pref = yield on preferred stock; i = interest rate on outstanding debt; W1 = common equity's share of total terminal year capital; W2 = preferred stock's share of total terminal year capital; W3 = debt's share of total terminal year capital; and t = marginal tax rate.
c Adjusted equity cash flows come from Table 13.12.
d Tax shield is the product of total interest expense times the marginal tax rate.
e The terminal value is calculated using the constant-growth method estimated based on total 2010 cash flow, terminal period WACC, and terminal period sustainable period cash flow growth rate.
f Equals 0.3680 (i.e., cumulative probability of default over ten years for a B-rated company) × (0.25 × $61.07) (i.e., expected cost of bankruptcy).
Comparing Cost of Capital and Adjusted Present Value Methods
Although the proposition that the value of the firm should be independent of the way in which it is financed may make sense for a firm whose debt-to-capital ratio is relatively stable and similar to the industry's, it is highly problematic when it is applied to highly leveraged transactions. Without adjusting for the cost of financial distress, the APV method implies that the value of the firm could be increased by continuously taking on more debt. Therefore, the primary drawback to the APV method is the implication that the firm should optimally use 100% debt financing to take maximum advantage of the tax shield created by the tax deductibility of interest.50
The primary advantage of the APV method is its relative computational simplicity. Although somewhat more complex, the cost of capital method attempts to adjust for the changing level of risk over time, as the LBO reduces its leverage over time. Thus, the CC method takes into account what is actually happening in practice.51 Table 13.10 summarizes the process steps as well as the strengths and weaknesses of the cost of capital and adjusted present value methods.
Table 13.10. Comparative LBO Valuation Methodologies
| Process Steps | Cost of Capital Method | Adjusted Present Value Method |
| Step 1 | Project annual cash flows, including all financing considerations and tax savings, until anticipate exiting the business | Project annual cash flows to equity investors and interest tax savings |
| Step 2 | Project annual debt-to-equity ratios | Value target, including terminal value but without tax savings |
| Step 3 | Calculate terminal value | Estimate PV of tax savings |
| Step 4 | Adjust discount rate to reflect declining cost of equity as debt is repaid | Add PV of firm without debt, including terminal period and PV of tax savings |
| Step 5 | Determine if NPV of projected cash flows ≥ 0 | Determine if NPV of projected cash flows ≥ 0 |
| Advantages | ||
| Disadvantages |
LBO Valuation and Structuring Model Basics
An LBO analysis is applied when there is the potential for a financial buyer or sponsor to acquire a business. Investment bankers frequently employ such analyses in addition to discounted cash flow and relative valuation methods in valuing businesses they are attempting to sell. The objective is to provide financial buyers with a leveraged buyout opportunity that offers a financial return in excess of their desired rate of return, while allowing the target firm to retain sufficient financial flexibility to meet potential future operating challenges.
The following sections discuss a simple approach to evaluating LBO opportunities and a useful template for building LBO models. The Excel-based spreadsheets underlying these sections, found on the companion site to this book, are entitled “Excel-Based LBO Valuation and Structuring Model” and “Excel-Based Model to Estimate Borrowing Capacity.” The reader is encouraged to examine the formulas that support these spreadsheets.
Evaluating LBO Opportunities
LBO analyses are similar to DCF valuations in that they require projected cash flows, terminal values, present values, and discount rates. However, the DCF analysis solves for the present value of the firm, while the LBO analysis solves for the discount rate or internal rate of return (IRR). The IRR is the discount rate that equates the projected cash flows and terminal value with the initial equity investment. Because the IRR is the discount rate at which the NPV is zero, the IRR can be derived from a DCF valuation.
The IRR is the critical decision variable in an analysis of a leveraged buyout opportunity because of the central role played by leverage. Without the lift to financial returns provided by leverage, financial buyers rarely can compete with strategic buyers, who can generally justify paying more for a target firm due to potential synergy.
The LBO analysis also requires the determination of whether there is sufficient future cash flow to operate the target firm while meeting interest and principal repayments and potentially paying dividends to the private equity investors. Financial buyers often will attempt to determine the highest amount of debt possible (i.e., the borrowing capacity of the target firm) to minimize their equity investment in order to maximize the IRR, although they may sometimes sacrifice some financial return to remain invested for a longer time period.52 Borrowing capacity is defined as the amount of debt a firm can borrow without materially increasing its cost of borrowing or violating loan covenants on existing debt, while maintaining the ability to engage in future borrowing to satisfy unexpected liquidity requirements.
While analysts differ on the measure of cash flow to use in evaluating LBO opportunities, EBITDA is commonly used despite its significant shortcomings.53 The following equations illustrate the linkages between the target firm's purchase price and the firm's borrowing capacity and the financial sponsor's equity contribution.
(13.6)
(13.7)
where
D TF = net debt (i.e., total debt less cash and marketable securities held by the target firm)
E TF = financial sponsor's equity contribution to the target firm's purchase price
PPTF = estimated purchase price of the target firm
EBITDATF = target firm earnings before interest, taxes, depreciation, and amortization
EV/EBITDA = appropriate recent LBO transaction enterprise value to EBITDA multiple
Equation (13.6) shows how the dollar value of the purchase price can be determined by multiplying an appropriate enterprise value multiple by the target firm's EBITDA. If the estimated purchase price for the target firm is six times EBITDA, the implied unlevered financial return for an all equity deal would be 16.7% annually (i.e., equity investors would be willing to pay $6 for each dollar of sustainable cash flow).54
Equation (13.7) equates the target firm's enterprise value (i.e., the sum of net debt and equity) to EBITDA multiple with the firm's purchase price to EBITDA multiple and illustrates how the purchase price may be financed from debt or equity contributed by the financial sponsor. For a given purchase price, level of net debt, and EBITDA, it is possible to estimate the financial sponsor's initial equity contribution by solving this equation for E TF.
What follows is a simple three-step process employed to assess the attractiveness of a firm as a potential LBO target. Step 1 involves estimating the maximum borrowing capacity of the firm. Step 2 entails determining the purchase price necessary to buy out the target firm's shareholders and estimating the initial equity contribution to be made by the financial sponsor. Step 3 entails calculating the IRR on the financial sponsor's initial equity investment. The deal would make sense to the financial sponsor if the resulting IRR were equal to or greater than their target IRR.
Step 1: Determine a Firm's Borrowing Capacity
An LBO analysis usually starts with the determination of cash available for financing a target firm's future debt obligations and the sources of such debt. This requires the projection of cash flow from operations. Any projected cash flow in excess of the need to meet the firm's normal operating requirements may be used to satisfy future principal and interest repayments. Once available future cash flow has been determined, the total debt that can be supported by the firm's projected cash flows may be estimated and confirmed in discussions with potential lenders. When the maximum amount of debt is determined, the financial sponsor can identify the sources of such debt, which include senior bank loans, subordinated debt, high-yield debt, and mezzanine financing.
Table 13.11 illustrates a simple model to estimate a firm's borrowing capacity. The estimate of borrowing capacity is expressed as a multiple of EBITDA. The model is divided into three panels: assumptions, estimating cash available for debt reduction, and estimating borrowing capacity. Year 0 represents the year immediately prior to the closing date (i.e., the beginning of year 1). The beginning debt figures are shown as of December 31 in year 0.
Table 13.11. Determining Borrowing Capacity
a Assumes 100% of cash available for debt reduction is used to pay off senior debt.
b Subordinated debt payable as a balloon note in year 10.
Assume that, based on similar transactions, the analyst believes that a buyout firm will be able to borrow about 5.5 times EBITDA of $200 million (i.e., about $1.1 billion), and the buyout firm has a target debt mix consisting of 75% senior and 25% subordinated debt. Further assume that investors in the buyout firm wish to exit the business within eight years once the senior debt has been repaid. To accomplish this objective, the investors intend to use 100% of cash available for debt reduction to pay off senior debt, and the subordinated debt is payable as a balloon note beyond year 8.
Using a trial-and-error method, insert a starting value for senior debt of $800 million in year 0. This $800 million starting number is in line with the firm's assumed target debt mix (i.e., 0.75 × total potential borrowing of $1.1 billion is approximately equal to $800 million). The amount of senior debt outstanding at the end of the eighth year is $75.7 million. If we now try $700 million in senior debt in year 0, the amount of senior debt outstanding at the end of the eighth year is $(63.3). Using the midpoint between $700 and $800 million, we insert $750 million for senior debt in year 0, resulting in $6.2 million in remaining debt at the end of the eighth year. Additional fine-tuning results in a zero balance at the end of year 8 if we use a starting value of $745.6 million for senior debt. Consequently, the firm's maximum total debt (i.e., borrowing capacity) based on the assumptions underlying Table 13.11 is estimated at $1,045.6 million.
Step 2: Estimate the Financial Sponsor's Initial Equity Contribution
Equation (13.6) provides an estimate of the target firm's purchase price. The preliminary valuation or purchase price estimate for the target firm is often based on an average multiple of enterprise value to EBITDA for recent comparable transactions times the target firm's EBITDA. A higher multiple might be used if potential bidders for the target firm include strategic buyers, who may justify a higher premium due to perceived synergy. The multiples are often based on a 12- to 24-month trailing average EBITDA and projections for 12 to 24 months into the future. In practice, valuations are usually based on the historical multiples, which may be adjusted up or down depending on their perceived riskiness to the target firm's future cash flows.
Assume the financial sponsor believes that the appropriate enterprise to EBITDA multiple to be applied to the target firm's EBITDA based on a review of recent comparable LBO transactions is 7. From Eq. (13.6), the purchase price for the target firm (PPTF) can be estimated as 7 × $210 (Year 1 EBITDA in Table 13.12 or $1,470 million.
Table 13.12. Leveraged Buyout Model Output Summary
a EBIT(1 – t) + Depreciation and Amortization – Gross Capital Spending – Change in Working Capital – Change in Investments Available for Sale.
b Net Income + Depreciation and Amortization – Gross Capital Spending – Change in Working Capital – Principal Repayments – Change in Investments Available for Sale (i.e., Increases in such investments are a negative cash-flow entry but represent cash in excess of normal operating needs).
Using this purchase price estimate and the target firm's maximum borrowing capacity of $1,045.6 million determined in Step 1 and multiplying both sides by EBITDATF, we can solve Eq. (13.7) to estimate the financial sponsor's initial equity contribution at $424.4 million (i.e., $1,470 – $1,045.6).
Step 3: Analyze Financial Returns
The most important calculation to the financial sponsor is the IRR. The calculation considers the initial investment in the firm and additional capital contributions as cash outflows and any dividend payments as cash inflows plus the exit or residual value of the business when sold. The financial multiple applied to the equity value on the exit date is usually the same as used by the financial sponsor when determining the target firm's preliminary valuation. The equity value of the firm is the sale value on the exit date less the value of debt repaid and any fees incurred in selling the business.
Due to their high sensitivity to the multiple applied to exit year cash flows and the number of years the investment is to be held, financial returns are usually displayed as a range reflecting different assumptions about exit multiples. If the calculated IRR is less than the target IRR, the financial sponsor can substitute lower purchase prices into Eq. (13.7), as described in Step 2, resulting in lower initial capital contributions, and recalculate the IRR until it exceeds the target IRR or walk away from considering the target firm as an LBO candidate.
Standard LBO Formats Used in Building LBO Models
Once the financial sponsor concludes that it is an attractive LBO candidate, the target firm's balance sheet is restated to reflect the new debt and equity structure of the business. The firm's financial statements are again projected to reflect the firm's new financial structure.
Table 13.12 summarizes the key elements of the analysis. The Sources and Uses of Funds section in the table shows how the transaction is to be financed. Representing total funds required, the Uses section shows where the cash will go and includes payments to the target firm's owners, including cash, any equity retained by the seller, any seller's notes, and any excess cash retained by the sellers. The Uses section also contains the refinancing of any existing debt on the balance sheet of the target firm and any transaction fees. The Sources section describes various sources of financing including new debt, any existing cash that is being used to finance the transaction, and the common and preferred equity being contributed by the financial sponsor. The equity contribution represents the difference between uses and all other sources of financing. The Pro Forma Capital Structure segment provides the percent distribution of the firm's capital structure among the various types of debt and equity. The Equity Ownership section illustrates the distribution of ownership between the financial sponsor and management. The Internal Rates of Return section provides the projected financial returns in both percentages and dollar amounts for three potential exit years (i.e., 2014, 2015, and 2016), as well as the multiple applied to the exit year's cash flow. The final segment, entitled Financial Projections and Analysis, provides summarized income, cash-flow, and balance sheet data. The table displays five years of historical data from 2001 to 2005 and five years of projected data from 2006 to 2010.
Supporting income, cash-flow, and balance sheet statements can be found on the companion site in a file folder entitled “LBO Structuring and Valuation Model.” The pro forma Excel-based balance sheet reflects changes to the existing balance sheet of the target firm altered to reflect the new capital structure of the firm. The new balance sheet also reflects the goodwill resulting from the excess of the purchase price over the fair market value of the net acquired assets and any interest expense that can be capitalized under current accounting rules.
The balance sheet projections are based on the pro forma balance sheet, with the debt outstanding and interest expense reflecting the repayment schedules associated with each type of debt. The model also reflects a projected sale value on the assumed exit date. The internal rates of return represent the average annual compounded rate at which the financial sponsor's equity investment grows, assuming that there are no dividend payments or additional equity contributions.
Some Things to Remember
A successful LBO is a result of knowing what to buy, not overpaying, and being able to substantially improve operating performance. Good candidates are those that have substantial tangible assets, unused borrowing capacity, predictable positive operating cash flow, and assets that are not critical to the continuing operation of the business. Successful LBOs rely heavily on management incentives to improve operating performance and the discipline imposed by the demands of satisfying interest and principal repayments.
Discussion Questions
13.1 What potential conflicts arise between management and shareholders in an MBO? How can these conflicts be minimized?
13.2 In what ways have private equity and hedge funds exhibited increasing similarities in recent years?
13.3 What are the primary ways in which an LBO is financed?
13.4 How do loan and security covenants affect the way in which an LBO is managed? Note the differences between positive and negative covenants.
13.5 What are the primary factors that explain the magnitude of the premium paid to pre-LBO shareholders?
13.6 What are the primary uses of junk bond financing?
13.7 Describe common strategies LBO firms use to exit their investment. Discuss the circumstances under which some methods of “cashing out” are preferred to others.
13.8 Describe some of the legal problems that can arise from an improperly structured LBO.
13.9 Is it possible for an LBO to make sense to equity investors but not to other investors in the deal? If so, why? If not, why not?
13.10 How does the risk of an LBO change over time? How can the impact of changing risk be incorporated into the valuation of the LBO?
13.11 In an effort to take the firm private, Cox Enterprises announced on August 3, 2004, a proposal to buy the remaining 38% of Cox Communications' shares that it did not already own. Cox Enterprises stated that the increasingly competitive cable industry environment makes investment in the cable industry best done through a private company structure. Why would the firm believe that increasing future levels of investment would be best done as a private company?
13.12 Following Cox Enterprises' announcement on August 3, 2004, of its intent to buy the remaining 38% of Cox Communications' shares that it did not already own, the Cox Communications board of directors formed a special committee of independent directors to consider the proposal. Why?
13.13 Qwest Communications agreed to sell its slow but steadily growing yellow pages business, QwestDex, to a consortium led by the Carlyle Group and Welsh, Carson, Anderson, and Stowe for $7.1 billion in late 2002. Why do you believe the private equity groups found the yellow pages business attractive? Explain the following statement: “A business with high growth potential may not be a good candidate for an LBO.”
13.14 Describe the potential benefits and costs of LBOs to stakeholders, including shareholders, employers, lenders, customers, and communities, in which the firm undergoing the buyout may have operations. Do you believe that on average LBOs provide a net benefit or a cost to society? Explain your answer.
13.15 Sony's long-term vision has been to create synergy between its consumer electronics products business and its music, movies, and games. On September 14, 2004, a consortium consisting of Sony Corporation of America, Providence Equity Partners, Texas Pacific Group, and DLJ Merchant Banking Partners agreed to acquire MGM for $4.8 billion. In what way do you believe that Sony's objectives might differ from those of the private equity investors making up the remainder of the consortium? How might such differences affect the management of MGM? Identify possible short-term and long-term effects.
Answers to these Chapter Discussion Questions are available in the Online Instructor's Manual for instructors using this book.
Practice Problems and Answers
13.16 Assume that, based on similar transactions, an analyst believes that a buyout firm will be able to borrow about 5.5 times first-year EBITDA of $200 million (i.e., about $1.1 billion) and that the buyout firm has a target senior to subordinated debt split of 75% to 25%. Further assume that investors in the buyout firm wish to exit the business within eight years after having repaid all of the senior debt. To accomplish this objective, the investors intend to use 100% of cash available for debt reduction to pay off senior debt; the subordinated debt will be is payable as a balloon note beyond year 8. Using the scenario in the template “Excel-Based Model to Estimate Firm Borrowing Capacity” on the companion site as the base case, answer the following questions:
a. Will the buyout firm be able to exit its investment by the eighth year if sales grow at 3% rather than the 5% assumed in the base case and still satisfy the assumptions in the base case scenario? After rerunning the model using the lower sales growth rate, what does this tell you about the model's sensitivity to relatively small changes in assumptions?
b. How does this slower sales growth scenario affect the amount the buyout firm could borrow initially if the investors still want to exit the business by the eighth year after paying off 100% of the senior debt and maintain the same senior to subordinated debt split?
13.17 By some estimates, as many as one-fourth of the LBOs between 1987 and 1990 (the first mega-LBO boom) went bankrupt. The data in Table 13.13 illustrate the extent of the leverage associated with the largest completed LBOs of 2006 and 2007 (the most recent mega-LBO boom). Equity Office Properties and Alltel have been sold. Use the data given in Table 13.13 to calculate the equity contribution made by the buyout firms as a percent of enterprise value and the dollar value of their equity contribution. What other factors would you want to know in evaluating the likelihood that these LBOs will end up in bankruptcy?
Table 13.13. Top Ten Completed Buyouts of 2006 and 2007 Ranked by Deal Enterprise Value
Source: The Economist, July 2008, p. 85.
a EBITDA less capital expenditures divided by estimated interest expense.
Answers to these problems are available in the Online Instructor's Manual for instructors using this book.
Chapter Business Cases
Case Study 13.1
TXU Goes Private in the Largest Private Equity Transaction in History—A Retrospective Look
Valued at $48 billion, the 2007 buyout of TXU, a Dallas-based energy giant, is the largest private equity deal in history. To complete the deal, an investor group moved aggressively to get approval from major stakeholders, including shareholders, consumers, legislators, regulators, environmentalists, and lenders. The buyout was a bet that the price of natural gas would continue to climb, benefiting the firm's natural gas revenues. However, the price of gas plummeted along with the U.S. economy, eroding TXU's cash flow. Since the transaction closed in October 2007, investors who bought $40 billion of TXU's bonds and loans have experienced large losses. Most of the bonds were trading between 70 and 80 cents on the dollar during most of 2010. The other $8 billion used to finance the deal came from private equity investors, banks, and large institutional investors. While the firm met its debt service obligations in 2010, it faces a $20 billion debt repayment coming due in 2014.
Wall Street banks were competing in 2007 to make loans to buyout firms on easier terms, with the banks also investing their own funds as a part of the deal. The allure to the banks was the prospect of dividing up as much as $1.1 billion in fees for originating the loans, repackaging such loans into pools called collateralized loan obligations, and reselling them to long-term investors such as pension funds and insurance companies. In doing so, the loans would be removed from the banks' balance sheets, eliminating potential losses that could arise if the deal soured at a later date. Furthermore, the deal appeared to be attractive as an investment opportunity as some banks put up $500 million of their own cash for a stake in TXU.
Under the terms of the February 2, 2007, merger agreement, ownership was transferred through a forward triangular cash merger–that is, a subsidiary merger. The financial sponsor group, which consisted of Kohlberg Kravis Roberts & Co., Texas Pacific Group, and Goldman Sachs, created a shell corporation referred to as Merger Sub Parent and its wholly-owned subsidiary Merger Sub. TXU was merged into Merger Sub, with Merger Sub surviving. Each outstanding share of TXU common stock was converted into the right to receive $69.25 in cash. Total cash required for the purchase was provided by the financial sponsor group and lenders (Creditor Group) to the Merger Sub (Figure 13.2). Regulatory authorities required that the debt associated with the transaction be held at the Merger Sub Parent holding company level so as not to further leverage the utility.
Figure 13.2 Forward triangular cash merger.
Subsequent to closing, the new company was reorganized into independently operated businesses under a new holding company, controlled by the Sponsor Group, called Texas Holdings (TH). Merger Sub (which owns TXU) was renamed Energy Future Holdings (EFH). TH's direct subsidiaries are EFH and Oncor (an energy distribution business formerly held by TXU). EFH's primary direct subsidiary is Texas Competitive Electric Holdings, which holds TXU's public utility operating assets and liabilities. All TXU non-Sponsor Group-related debt incurred to finance the transaction is held by EFH, while any debt incurred by the Sponsor Group is shown on the TH balance sheet (Figure 13.3).
Figure 13.3 Postmerger organization.
Loan covenants limit EFH's and its subsidiaries' ability to incur additional indebtedness or issue preferred stock; pay dividends on, repurchase, or make distributions of capital stock or make other restricted payments; make investments; sell or transfer assets; consolidate, merge, sell, or dispose of all or substantially all its assets; and repay, repurchase, or modify debt. A breach of any of these covenants could result in an event of default. Table 13.14 illustrates selected covenants in which certain ratios must be maintained either above or below stipulated thresholds. Note that EFH was in violation of certain covenants when actual December 31, 2009, ratios are compared with required threshold levels.
Table 13.14. EFH Holdings Debt Covenants
| December 31, 2009 | Threshold Level as of December 31, 2009 | |
| Maintenance Covenant | ||
| TCEH Secured Facilities: – Secured debt to adjusted EBITDA Ratio | 4.76 to 1.00 | Must not exceed 7.25 to 1.00 |
| Debt Incurrence Covenants | ||
| EFH Corp Senior Notes – EFH Corp fixed charge coverage ratio |
1.2 to 1.0 |
At least 2.0 to 1.0 |
| – TCEH fixed charge coverage ratio | 1.5 to 1.0 | At least 2.0 to 1.0 |
| EFH Corp 9.75% Notes – EFH Corp fixed charge coverage ratio |
1.2 to 1.0 | At least 2.0 to 1.0 |
| – TCEH fixed charge coverage ratio | 1.5 to 1.0 | At least 2.0 to 1.0 |
| TCEH Senior Notes | ||
| – TCEH fixed charge coverage ratio | 1.5 to 1.0 | At least 2.0 to 1.0 |
| TCEH Senior Secured Facilities | ||
| – TCEH fixed charge coverage ratio | 1.5 to 1.0 | At least 2.0 to 1.0 |
| Restricted Payments/Limitations on Investments Covenants | ||
| EFH Corp Senior Notes – General restrictions |
||
| – EFH Corp fixed charge coverage ratio | 1.4 to 1.0 | At least 2.0 to 1.0 |
| – General restrictions | ||
| – EFH fixed charge coverage ratio | 1.2 to 1.0 | At least 2.0 to 1.0 |
| – EFH Corp leverage ratio | 9.4 to 1.0 | ≤7.0 to 1.0 |
| EFH Corp 9.75% Notes – General restrictions |
||
| – EFH Corp fixed charge coverage ratio | 1.4 to 1.0 | At least 2.0 to 1.0 |
| – General restrictions | ||
| – EFH Corp fixed charge coverage ratio | 1.2 to 1.0 | At least 2.0 to 1.0 |
| – EFH Corp leverage ratio | 9.4 to 1.0 | ≤7.0 to 1.0 |
| TCEH Senior Notes – TCEH fixed charge coverage ratio |
1.5 to 1.0 | At least 2.0 to 1.0 |
Discussion Questions:
1. How does the postclosing holding company structure protect the interests of the financial sponsor group, creditors, and the utility's customers, employees, and other stakeholder groups?
2. What was the purpose of the preclosing covenants and closing conditions as described in the merger agreement?
3. Loan covenants exist to protect the lender. How might such covenants inhibit EFH from meeting its 2014 $20 billion obligations?
4. As CEO of EFH, what would you recommend to the board of directors as an appropriate strategy for paying the $20 billion in debt that is maturing in 2014?
5. In the fourth quarter of 2008 and first quarter of 2009, EFC Holdings recorded goodwill impairment charges of about $8 billion. The substantial write-down of the net acquired suggests that the purchase price paid for TXU was too high. How might this impact KKR, TPG, and Goldman's abilities to earn financial returns expected by their investors on the TXU acquisition? How might this write-down impact EFH's ability to meet the $20 billion debt maturing in 2014?
Answers to this case study is provided in the Online Instructors Manual for instructors using this book.
Case Study 13.2
“Grave Dancer” Takes Tribune Corporation Private in an Ill-Fated Transaction
At the closing in late December 2007, well-known real estate investor Sam Zell described the takeover of the Tribune Company as “the transaction from hell.” His comments were prescient in that what had appeared to be a cleverly crafted, albeit highly leveraged, deal from a tax standpoint was unable to withstand the credit malaise of 2008. The end came swiftly when the 161-year-old Tribune filed for bankruptcy on December 8, 2008.
On April 2, 2007, the Tribune Corporation announced that the firm's publicly traded shares would be acquired in a multistage transaction valued at $8.2 billion. Tribune owned at that time 9 newspapers, 23 television stations, a 25% stake in Comcast's SportsNet Chicago, and the Chicago Cubs baseball team. Publishing accounts for 75% of the firm's total $5.5 billion annual revenue, with the remainder coming from broadcasting and entertainment. Advertising and circulation revenue had fallen by 9% at the firm's three largest newspapers (Los Angeles Times, Chicago Tribune, and Newsday in New York) between 2004 and 2006. Despite aggressive efforts to cut costs, Tribune's stock had fallen more than 30% since 2005.
The transaction was implemented in two stages. Sam Zell acquired a controlling 51% interest in the first stage followed by a backend merger in the second stage in which the remaining outstanding Tribune shares were acquired. In the first stage, Tribune initiated a cash tender offer for 126 million shares (51% of total shares) for $34 per share, totaling $4.2 billion. The tender was financed using $250 million of the $315 million provided by Sam Zell in the form of subordinated debt, plus additional borrowing to cover the balance. Stage 2 was triggered when the deal received regulatory approval. During this stage, an employee stock ownership plan (ESOP) bought the rest of the shares at $34 a share (totaling about $4 billion), with Zell providing the remaining $65 million of his pledge. Most of the ESOP's 121 million shares purchased were financed by debt guaranteed by the firm on behalf of the ESOP. At that point, the ESOP held all of the remaining stock outstanding, valued at about $4 billion. In exchange for his commitment of funds, Mr. Zell received a 15-year warrant to acquire 40% of the common stock (newly issued) at a price set at $500 million.
Following closing in December 2007, all company contributions to employee pension plans were funneled into the ESOP in the form of Tribune stock. Over time, the ESOP would hold all the stock. Furthermore, Tribune was converted from a C corporation to a Subchapter S corporation, allowing the firm to avoid corporate income taxes. However, it would have to pay taxes on gains resulting from the sale of assets held less than ten years after the conversion from a C to an S corporation (Figure 13.4).
Figure 13.4 Tribune deal structure.
The purchase of Tribune's stock was financed almost entirely with debt, with Zell's equity contribution amounting to less than 4% of the purchase price. The transaction resulted in Tribune being burdened with $13 billion in debt (including the approximate $5 billion currently owed by Tribune). At this level, the firm's debt was ten times EBITDA, more than two and a half times that of the average media company. Annual interest and principal repayments reached $800 million (almost three times their preacquisition level), about 62% of the firm's previous EBITDA cash flow of $1.3 billion. Even though the ESOP owned the company, it was not be liable for the debt guaranteed by Tribune.
The conversion of Tribune into a Subchapter S corporation eliminated the firm's current annual tax liability of $348 million. Such entities pay no corporate income tax but must pay all profit directly to shareholders, who then pay taxes on these distributions. Since the ESOP was the sole shareholder, Tribune was expected to be largely tax exempt, since ESOPs are not taxed.
In an effort to reduce the firm's debt burden, the Tribune Company announced in early 2008 the formation of a partnership in which Cablevision Systems Corporation would own 97% of Newsday for $650 million, with Tribune owning the remaining 3%. However, Tribune was unable to sell the Chicago Cubs (which had been expected to fetch as much as $1 billion) and the minority interest in SportsNet Chicago to help reduce the debt amid the 2008 credit crisis. The worsening of the recession, accelerated by the decline in newspaper and TV advertising revenue, as well as newspaper circulation, thereby eroded the firm's ability to meet its debt obligations.
By filing for Chapter 11 bankruptcy protection, the Tribune Company sought a reprieve from its creditors while it attempted to restructure its business. Although the extent of the losses to employees, creditors, and other stakeholders is difficult to determine, some things are clear. Any pension funds set aside prior to the closing would remain with the employees, but it is likely that equity contributions made to the ESOP on behalf of the employees since the closing would be lost. The employees would become general creditors of Tribune. As a holder of subordinated debt, Mr. Zell had priority over the employees if the firm was liquidated and the proceeds distributed to the creditors.
Those benefiting from the deal included Tribune's public shareholders, including the Chandler family, which owned 12% of Tribune as a result of its prior sale of Times Mirror to Tribune, and Dennis FitzSimons, the firm's former CEO, who received $17.7 million in severance and $23.8 million for his holdings of Tribune shares. Citigroup and Merrill Lynch received $35.8 million and $37 million, respectively, in advisory fees. Morgan Stanley received $7.5 million for writing a fairness opinion letter. Finally, Valuation Research Corporation received $1 million for providing a solvency opinion indicating that Tribune could satisfy its loan covenants.
What appeared to be one of the most complex deals of 2007, which was designed to reap huge tax advantages, soon became a victim of the downward-spiraling economy, the credit crunch, and its own leverage. A lawsuit filed in late 2008 on behalf of Tribune employees contended that the transaction was flawed from the outset and intended to benefit Sam Zell and his advisors and Tribune's board. Even if the employees win, they will simply have to stand in line with other Tribune creditors awaiting the resolution of the bankruptcy court proceedings.
Discussion Questions
1. What are the acquisition vehicle, postclosing organization, form of payment, form of acquisition, and tax strategy described in this case study?
2. Describe the firm's strategy to finance the transaction.
3. Is this transaction best characterized as a merger, an acquisition, a leveraged buyout, or a spin-off? Explain your answer.
4. Is this transaction taxable or nontaxable to Tribune's public shareholders? To its post-transaction shareholders? Explain your answer.
5. Comment on the fairness of this transaction to the various stakeholders involved. How would you apportion the responsibility for the eventual bankruptcy of Tribune among Sam Zell and his advisors, Tribune's board, and the largely unforeseen collapse of the credit markets in late 2008?
Answers to these case study discussion questions are available in the Online Instructor's Manual for instructors using this book.
2 Failed firms were excluded from the performance studies because they no longer existed.
3 The data for the large sample studies come from Standard & Poor's Capital IQ and the U.S. Census Bureau databases. The studies compare a sample of LBO target firms with a “control sample.” Selected for comparative purposes, firms in control samples are known to be similar to the private equity transaction sample in all respects except for not having undergone an LBO.
4 Wright et al., 2008
7 Hall, 1992;Himmelberg and Petersen, 1994
9 Lichtenberg and Siegel, 1990
10 Lerner, Sorensen, and Stromberg (2011) examined the impact of private equity investment on the rate of innovation for a sample of 495 firms with at least one successful patent application filed from three years prior to five years following a private equity investment. The authors found that the rate of innovation, as measured by the quantity and generality of patents, does not change following private equity investments. However, such firms tend to concentrate their innovation efforts in areas in which the firm has historically focused. In fact, the patents of private equity–backed firms applied for in the years following the investment by the private equity firm are more frequently cited, suggesting some improvement in the rate of innovation.
13 See Chapter 10 for a more detailed discussion of PIPE transactions.
14 Meuleman and Wright (2007) and Guo et al. (2008) found some evidence that “clubbing” is associated with higher target transaction prices. However, Officer, Ozbas, and Sensoy (2008) argue that club deals are likely to be detrimental to public company shareholders by undermining the auction process that might result from having multiple suitors. In analyzing 325 public-to-private LBO transactions between 1998 and 2007, the U.S. General Accountability Office (2008) could find no correlation between club deals and prices paid for target firms.
16 Opler and Titman, 1993;Phan, 1995
17 Billett, Jiang, and Lie, 2010
18 Guo et al. (2011) find that operating performance, tax benefits, and market multiples applied when the investor group exits the business each contribute about one-fourth of the financial returns to buyout investors.
19 The annual ROE of the firm will decline, as the impact of leverage declines, to the industry average ROE, which usually occurs when the firm's debt–to–total capital ratio approximates the industry average ratio. At this point, the financial sponsor is unable to earn excess returns by continuing to operate the business. Table 13.1 illustrates this point. ROE is highest when leverage is highest and lowest when leverage is zero, subject to the caveat that ROE could decline due to escalating borrowing costs if debt were to be viewed by lenders as excessive.
20 Boot, Gopalan, and Thakor, 2008
21 There is evidence that the Sarbanes-Oxley Act of 2002 contributed to the cost of governance for firms as a result of the onerous reporting requirements of the bill. This has been a particular burden to smaller firms. Some studies estimate that the cost of being a public firm was more than $4 million in 2004, almost twice the cost incurred in the prior year (Engel, Hayes, and Xang, 2004;Hartman, 2005;Kamar, Karaca-Mandic, and Talley, 2006). Leuz, Triantis, and Wang (2008) document a spike in delistings of public firms attributable to the passage of the Sarbanes-Oxley Act of 2002.
22 Acquiring firms often prefer to borrow funds on an unsecured basis because the added administrative costs involved in pledging assets as security significantly raise the total cost of borrowing. Secured borrowing can be onerous because the security agreements can severely limit a company's future borrowing, ability to pay dividends, make investments, and manage working capital aggressively.
23 The security agreement is filed at a state regulatory office in the state where the collateral is located. Future lenders can check with this office to see which assets a firm has pledged and which are free to be used as future collateral. The filing of this security agreement legally establishes the lender's security interest in the collateral.
24 The process of determining which of a firm's assets are free from liens is made easier today by commercial credit reporting repositories such as Dun & Bradstreet, Experian, Equifax, and Transunion.
25 Prospectuses promoting bond sales have typically included ratings from the various agencies as a measure of risk provided by a third party. Prior to the Dodd-Frank Act of 2010 (see Chapter 2), institutional investors, including banks, insurers, and money market funds, were permitted to rely solely on credit ratings when making investment decisions. The Dodd-Frank Act now seeks to compel such investors to conduct an independent investigation into the factors influencing the risk associated with a security to diminish their reliance on credit rating agencies. The Act intends to achieve this objective by expunging from existing federal securities regulations the requirement that ratings from credit rating agencies be included in bond prospectuses. The Act also makes it easier to sue the rating agencies for credit ratings that turn out to be too optimistic, thereby discouraging the agencies from allowing the use of their ratings in bond prospectuses.
26 Rating agencies include Moody's Investors Services and Standard & Poor's Corporation. Each has its own scale for identifying the risk of an issue. For Moody's, the ratings are Aaa (the lowest risk category), Aa, A, Baa, Ba, B, Caa, Ca, and C (the highest risk). For S&P, AAA denotes the lowest risk category, and risk rises progressively through ratings AA, A, BBB, BB, B, CCC, CC, C, and D.
27 Moody's usually rates noninvestment-grade bonds Ba or lower; for S&P, it is BB or lower.
28 Rapid growth of the junk bond market coincided with a growing deterioration during the 1980s in their quality, as measured by interest coverage ratios (i.e., earnings before interest and taxes/interest expense), debt/net tangible book value, and cash flow as a percentage of debt (Wigmore, 1994). Cumulative default rates for junk bonds issued in the late 1970s reached as high as 34T by 1986 (Asquith, Mullins, and Wolff, 1989), but firms that emerged from bankruptcy managed to recover some portion of the face value of the junk bond. Altman and Kishore (1996) found that recovery rates for senior secured debt averaged about 58% of the original principal and that the actual realized spread between junk bonds and ten-year U.S. Treasury securities was actually about 4 percentage points between 1978 and 1994, rather than more than 4 percentage points when they were issued originally. This source of LBO financing dried up in the late 1980s after a series of defaults of overleveraged firms, coupled with alleged insider trading and fraud at companies such as Drexel Burnham, the primary market maker for junk bonds at that time.
30 Unpaid dividends may accumulate for eventual payment by the issuer if the preferred stock is a special cumulative issue.
31 Many businesses do not want to use seller financing, since it requires that they accept the risk that the note will not be repaid. Such financing is necessary, though, when bank financing is not an option. The drying up of bank lending in 2008 and 2009 due to the slumping economy and crisis of confidence in the credit markets resulted in increased reliance on seller financing to complete the sale of small- to intermediate-size businesses.
32 In late 2009, a group of junior creditors led by Centerbridge Partners charged that Chicago billionaire Sam Zell's $8.2 billion transaction to take the Tribune Company public in 2007 left the firm insolvent from the start. If provable, the court might invalidate more than $10 billon in claims held by senior lenders who financed the deal, forcing them to write off the entire amount.
33 Credit or loan facilities may represent a single loan or a collection of loans to a borrower. Such facilities vary in terms of what is being financed, the type of collateral, terms, and duration.
34 Renneboog et al., 2007;Weir, Laing, and Wright, 2005
35 Jensen (1986) argues that debt imposes a discipline that forces managers to stay focused on maximizing operating cash flows. Tax benefits are largely predictable and built into the premium offered for the public shares of the target firm as a result of the negotiation process (Kaplan, 1989b;Newbould, Chatfield, and Anderson, 1992). Successful MBOs are associated with improved operating performance, including increased efficiency and more aggressive marketing plans, while firms undertaking MBOs that were not completed showed no subsequent improvement in operating performance (Ofek, 1994).
36 Cumming et al. (2007) in a summary of much of the literature on post-LBO performance conclude that LBOs and especially MBOs enhance firm operating performance. However, Guo et al. (2011) find that the improvement in operating performance following public to private LBOs has been more modest during the 1990–2006 period than during the 1980s. Weir et al (2007) find similar results over roughly the same period.
38 Cao and Lerner, 2006
39 Katz (2008) reports that private equity–sponsored firms display superior long-term share price performance after they go public, reflecting professional ownership, tighter monitoring, and often the reputations of the private equity firm owners. Gurung and Lerner (2008) find that private equity groups have a greater capacity to squeeze more productivity out of companies they buy during times of financial stress than other types of acquirers. The authors attribute this success to the willingness of private equity sponsors to make the difficult choices of restructuring and shutting down poorly performing operations in times of economic downturns. The authors also find that private equity–owned firms are strong at adopting “lean manufacturing” practices.
40 Recall that the future value of $1 (FV$1) in two years invested at a 5% return in the first year and 8% in the second year is $1 × [(1 + 0.05)(1 + 0.08)] = $1.13; the present value of $1 received in two years earning the same rates of return (PV$1) is /[(1 + 0.05)(1 + 0.08)] = $0.88.
41 Brigham and Ehrhardt (2005), p. 597
42 Brealey and Myers, 1996. This concept assumes investors have access to perfect information, the firm is not growing and no new borrowing is required, and there are no taxes and transaction costs and implicitly that the firm is free of default risk. Under these assumptions, the decision to invest is affected by the earning power and risk associated with the firm's assets and not by the way the investment is financed.
43 Axelson et al. (2009) argue that the capital structure in buyouts requires a different explanation than in public firms, where investment decisions are believed to be made independently of the way in which they are financed. With respect to LBOs, the availability of financing appears to impact the decision to invest in LBOs, unlike public firms. This paper is consistent with the widely held view among buyout practitioners that the size and frequency of LBOs are driven by the availability and cost of financing.
45 Molina (2006) and Almeida and Philippon (2007) show that the risk-adjusted costs of distress can be so large as to totally offset the tax benefits derived from debt. This is particularly true during periods of economic downturns.
46 Andrade and Kaplan, 1998. Branch (2002) concludes that the impact of bankruptcy on a firm's predistressed value falls within a range of 12 to 20%. More recently, Korteweg (2010) estimates that the impact falls within a range of 15 to 30% of predistressed firm value.
47 While the failure of the credit rating agencies to anticipate the extreme financial distress in the credit markets experienced in 2008 and 2009 casts doubt on the use of credit ratings to assess financial distress, the lack of better alternatives supports their use for this purpose. Credit research departments of the major credit rating agencies use extensive models to assess the likelihood of default and bankruptcy. As discussed in Chapter 16, the probability of default is reflected in credit ratings and the maturity of the debt issue and is displayed in the credit spreads associated with the various bond issues. In general, higher-rated firms tend to issue debt with smaller credit spreads and default less than those with lower credit ratings. Furthermore, the size of credit spreads tends to increase with the maturity date of the bond, as does the frequency of default.
48 Altman and Kishore, 2001;Altman, 2007. Cumulative probability is the likelihood that a random variable will be less than or equal to each value that the random variable can assume. Intuitively, cumulative probability estimates reflect the likelihood of a particular outcome based on previous outcomes or events. Cumulative probabilities are used when reductions in cash flows due to financial distress in earlier years impact cash flows in subsequent years as the firm may be forced to underinvest in subsequent years. Assume that the probability of a firm experiencing financial distress in year 1 is 20%. If the firm ceases to exist at the end of the first year due to financial distress, there will not be any cash flows in year 2. If we assume that the likelihood of distress in year 2 is again 20%, the likelihood of the firm producing cash flows in the third year is now only 64% (i.e., (1 – 0.2)(1 – 0.2)).
49 Per Andrade and Kaplan, 1998.
51 For an excellent discussion of alternative valuation methods for highly leveraged firms, see Ruback (2002).
52 Financial sponsors may attempt to strike a balance between maximizing IRR and the total cash amount taken out of the investment on the exit date. For example, by holding an investment for five rather than three years, the sponsor may experience a lower IRR but may increase the multiple applied on the exit date by waiting for more favorable market conditions. The motivation for this behavior may reflect investor desire to remain invested longer to minimize the cost of redeploying the funds.
53 Some analysts use EBITDA as a proxy for cash flow. By not deducting interest, taxes, depreciation, and amortization, EBITDA supporters argue that it represents a convenient proxy for the cash available to meet the cost (i.e., interest, depreciation, and amortization) of long-term assets. In essence, EBITDA provides a simple way of determining how long the firm can continue to service its debt without additional financing. Furthermore, EBITDA is not affected by the method the firm employs in depreciating its assets. Critics of the use of EBITDA as a measure of cash flow argue that it can be dangerously misleading because it ignores changes in working capital. It implicitly assumes that capital expenditures needed to maintain the business are equal to depreciation. However, from the dotcom debacle in 2000, we know that a firm could have an attractive EBITDA–to–interest expense ratio but still have insufficient cash to finance interest expense, working capital, and needed capital outlays that exceed the long-term growth trend. Such critics argue that free cash flow to the firm (i.e., enterprise cash flow) is a better measure of how much cash a company is generating, since it includes changes in working capital and capital expenditures.
54 The implied unlevered return for an enterprise value multiple of 6 (which equals the purchase price paid to EBITDA for the target firm ratio) is calculated as the reciprocal of the purchase price paid for the target firm–to–EBITDA ratio—that is, EBITDATF / PPTF = 1/6 = 16.7%. Note that these returns are based on EBITDA. Actual unlevered after-tax returns to financial investors would be lower, reflecting the deduction of taxes, depreciation, and amortization expense. Leveraged returns would also be reduced by the deduction of interest expense.