This chapter will introduce the reader to leveraged buyouts (LBOs), which today often take place under the guise of private equity financing. It will explain how LBOs work and where the value created by LBOs comes from. As an example, we will use the 1979 leveraged buyout of Congoleum Corporation. This LBO, many times larger than any prior LBO, served as the template for many future LBOs and for today's private equity takeovers.1
Founded in 1886, Congoleum Narin was a flooring product firm that originally produced flooring from raw materials sourced in the Congo (hence the name Congo-leum). It later began producing linoleum, a flexible vinyl floor covering made from ground cork or wood, oxidized linseed oil with powdered pigments, and organic materials. Congoleum was an early producer of linoleum and owned several patents for improvements they made in the production process.2
In 1968, Bath Industries (a holding firm that owned Bath Iron Works, one of the oldest shipbuilding firms in the United States) acquired control of Congoleum Narin after purchasing 42% of its stock. Bath Industries renamed itself Congoleum Industries in 1975 because floor coverings represented 40% of the postacquisition conglomerate's sales and 95% of its profits.
Byron C. Radaker arrived at Congoleum in 1975, became COO in 1976, President and CEO in 1977, and then Chairman in 1980. Byron had previously resigned from Certain Teed Corporation (a building products firm) after allegations of insider self-dealing, which were never proven.
Eddy G. Nicholson had worked as the second in command with J. P. Fuqua (after whom the Duke University business school is named) building conglomerates. Mr. Nicholson joined Congoleum in 1975, became COO at the end of 1978, and then President in 1980.
James Harpel was a Harvard MBA who identified Congoleum as an LBO candidate. And what did Harpel do when he determined Congoleum was a good LBO target? Did he buy the company? Yes and no. He had Century Capital Associates (where he was a managing partner) buy 124,000 shares of Congoleum at just under $13 a share (or a total of about $1.6 million). He then took his idea of turning publicly traded Congoleum into a private firm through a leveraged buyout to the investment banking firm First Boston. Isn't that insider trading, which is illegal? No, not at all. Jim had an idea and thought it was a good one. He felt he had identified a potential LBO candidate before anyone else. He then bought shares. He was not an insider and was not using any inside, non-public information. Many years later, after becoming quite wealthy, Mr. Harpel endowed a chair at Harvard's Kennedy School of Government. Why not the business school that gave him the knowledge to become wealthy? Ah, we will discuss that a little later.
First Boston approached the Prudential Insurance Company and some other institutional investors to finance the LBO.3 Why would the firm conducting the LBO approach an insurance firm as a possible investor? Wait and we'll get there as well.
In early 1980, the various players (First Boston, Mr. Harpel's Century Capital Associates, various financial institutions including Prudential, and the Congoleum executives Byron C. Radaker and Eddy G. Nicholson) created Fibic Corp., a holding company. Fibic Corp. purchased all the outstanding shares of Congoleum for $445 million (or $38 per share, which represented a premium of more than 50% above the price at which Congoleum was trading at the time).
So let's ask: How does a firm look before an LBO? What was it that Jim Harpel saw that made him believe Congoleum was a takeover target? As we will discuss in more detail, Congoleum was an ideal LBO candidate because of its low debt level and stable cash flows.
Byron Radaker and Eddy Nicholson were hired in 1975 to revive Congoleum. As seen in Table 18.1, Congoleum had experienced disappointing sales and profits from 1973 to 1975. Congoleum's profits fell from $22.2 million in 1973 to a mere $500,000 in 1974. In 1975, sales fell by almost $111 million (or 30%), while profits rebounded to $9.6 million.
TABLE 18.1 Congoleum's Income Statements 1973 to 19787
| ($000s) | 1973 | 1974 | 1975 | 1976 | 1977 | 1978 |
| Net sales | 382,065 | 382,767 | 272,000 | 284,735 | 375,466 | 558,633 |
| Royalties | — | — | 6,983 | 10,080 | 13,163 | 17,197 |
| Total revenue | 382,065 | 382,767 | 278,983 | 294,815 | 388,629 | 575,830 |
| Cost of sales | 285,602 | 323,036 | 219,182 | 224,028 | 285,770 | 385,851 |
| Selling and general expenses | 49,703 | 53,116 | 34,441 | 37,805 | 55,023 | 108,648 |
| Operating profit | 46,760 | 6,615 | 25,360 | 32,982 | 47,836 | 81,331 |
| Other income (loss) | — | — | 5,171 | 3,821 | 3,538 | 4,281 |
| Interest expense | 4,153 | 6,412 | 5,192 | 2,064 | 1,734 | 1,266 |
| Profit before tax | 42,607 | 203 | 25,339 | 34,739 | 49,640 | 84,346 |
| Income tax | 19,752 | (1,705) | 11,985 | 17,400 | 24,900 | 42,600 |
| Loss on discontinued operations | (666) | (1,380) | (3,796) | (1,615) | — | — |
| Net profit | 22,189 | 528 | 9,558 | 15,724 | 24,740 | 41,746 |
| Earnings per share | 2.83 | 0.07 | 1.25 | 2.04 | 2.39 | 3.58 |
| Dividends per share | 0.30 | 0.40 | 0.40 | 0.50 | 0.60 | 0.80 |
| Stock price (high) | 36 7/8 | 22.25 | 13.75 | 19.38 | 21.88 | 26.25 |
| Stock price (low) | 12.75 | 3.83 | 4.50 | 12.00 | 13.25 | 16.25 |
How did Byron and Eddy do in their efforts to help sales and profits recover? Pretty well. In just four years (1975–1978), Congoleum's total revenues had grown to $575.8 million, which was 50.4% above their 1974 levels or an average annual increase of just under 11%. The net profit margin improved to 7.5% of sales, and EPS skyrocketed from $0.07/share in 1974 to $3.58 in 1978. Over the same period, Congoleum increased its dividend payout from $0.40/share to $0.80/share, and the firm's debt ratio fell from 41% ($78.5 million/$192.3 million) to 8% ($15.4 million/$202.9 million). This does not include excess cash, which the firm clearly had, as shown in Table 18.2, given its $77 million in cash and marketable securities at the end of 1978 (compared to debt of $15.4 million). Wall Street recognized the changes at Congoleum and the firm's stock price soared from a low of $3.83 in 1974 to a high of $26.25 in 1978.
TABLE 18.2 Congoleum's Balance Sheets 1973 to 1978
| ($000s) | 1973 | 1974 | 1975 | 1976 | 1977 | 1978 |
| Cash and marketable securities | 8,578 | 10,748 | 6,428 | 40,424 | 12,369 | 77,254 |
| Receivables | 48,212 | 43,518 | 28,533 | 37,478 | 73,989 | 64,482 |
| Inventory | 67,216 | 71,022 | 27,727 | 33,656 | 73,318 | 75,258 |
| Other current assets | 14,218 | 7,258 | 65,253 | 34,382 | 5,679 | 3,511 |
| Current assets | 138,224 | 132,546 | 127,941 | 145,940 | 165,355 | 220,505 |
| Net property, plant, and equipment | 70,004 | 79,324 | 53,113 | 51,102 | 71,149 | 70,777 |
| Goodwill and other | 24,616 | 24,964 | 48,798 | 31,320 | 29,876 | 31,770 |
| Total assets | 232,844 | 236,834 | 229,852 | 228,362 | 266,380 | 323,052 |
| Current portion long-term debt | 5,170 | 3,880 | 2,170 | 1,939 | 2,055 | 460 |
| Accounts payable | 25,663 | 20,534 | 15,212 | 18,662 | 38,391 | 41,578 |
| Other current liabilities | 19,240 | 15,419 | 29,419 | 48,542 | 46,913 | 68,359 |
| Current liabilities | 50,073 | 39,833 | 46,801 | 69,143 | 87,359 | 110,397 |
| Long-term debt | 59,330 | 74,627 | 52,246 | 16,596 | 16,067 | 14,949 |
| Other long-term liabilities | 7,139 | 8,564 | 10,489 | 10,075 | 9,886 | 10,221 |
| Total liabilities | 116,542 | 123,024 | 109,536 | 95,814 | 113,312 | 135,567 |
| Contributed capital | 14,967 | 15,015 | 15,032 | 15,390 | 15,812 | 16,256 |
| Retained earnings | 101,335 | 98,795 | 105,284 | 117,158 | 137,256 | 171,229 |
| Total equity | 116,302 | 113,810 | 120,316 | 132,548 | 153,068 | 187,485 |
| Total liabilities and equity | 232,844 | 236,834 | 229,852 | 228,362 | 266,380 | 323,052 |
So, was Congoleum still a “buy” after the stock price had gone up almost 585% in four years? Yes, Congoleum was still a “buy.” (Most of us can only say so with the benefit of hindsight, but Jim Harpel saw it at the time.) At the end of 1978, Congoleum's stock price was trading at 7.3 times its trailing earnings ($26.25/$3.58).4 At the time, the S&P was trading at about 10 times trailing earnings, with a long-run historical average of about 15.5 Congoleum's stock price therefore had room to grow.
What were Congoleum's principal businesses? Flooring (40% of sales and 65% of profits), shipbuilding (38% of sales and 21% of profits), and auto repair (22% of sales and 14% of profits).6 How secure and stable are the cash flows on these businesses and what is Congoleum's business risk? At the time, Congoleum's flooring business was well protected by the firm's patents. Also, Congoleum's shipbuilding operations (i.e., Bath Iron Works) had a huge backlog from U.S. government contracts. Finally, Congoleum's auto parts business had numerous patents of its own and produced mainly replacement parts, as opposed to supplying the original equipment market (OEM). The replacement parts business was much less cyclical than the OEM business, which depended on the manufacturing of new cars. Thus, all three of Congoleum's main businesses appeared to have strong, stable cash flows.
How about the two key executives, Bryon and Eddy—were they happy? They were paid base salaries of $370,000 and $295,000 a year, respectively, plus stock options. Is that a lot of money? Yes, both back then and to this day, but clearly not enough to be considered wealthy. Even with the huge increase in stock price (remember, they had stock options), the executives may have been looking for some way to increase their compensation.
So why did Wall Street value Congoleum at only 7.3 times trailing earnings, despite the fact it had strong, stable cash flows and the appearance of good management? One potential reason is that Congoleum's patents were set to expire soon.8 This meant that Congoleum was a cash cow at the time but would eventually have to figure out how to handle the expiration of its patents. However, this was not Congoleum's current problem in the late 1970s. The firm's problem at the time was figuring out what to do with all its cash from its improved operations.
What can firms do with their excess cash? As we have previously noted, there are only five things a firm can do with excess cash:
This was the Congoleum that Jim Harpel saw and believed was an LBO candidate. After he informed First Boston, they agreed with his analysis and took the idea to Prudential Insurance. Why did First Boston go to another firm? For financing. At the time of the case (1979), investment banks didn't finance their own deals, and private equity funds did not exist as they do today. First Boston did not want/have the ability to fund the entire transaction, so they contacted an insurance company. Insurance companies were and remain huge investors in the debt and equity markets, as are pension funds. Insurance companies and pension funds are considered institutional investors: they receive insurance premiums and retirement savings up front, which they must invest so they can pay out future claims.
As an interesting aside, Berkshire Hathaway's core business is insurance. Warren Buffett receives huge amounts of cash from premiums, which he must then invest. While he is known for his ability to invest well, a key part of his success has been obtaining the cash to invest, of which a major part has come from insurance premiums.
So how did the Congoleum LBO deal work?9 On July 16, 1979, Fibic Corp. offered $38 a share for all the outstanding shares (a 50% premium over the share price at the time, which was $25), or a total of $467.8 million (this included $10.1 million to buy out management's options, and $10 million in fees), as shown in Table 18.3.
TABLE 18.3 Total Purchase Price for Congoleum
| Payment to shareholders (11.783 million shares @ $38/share) | $447.7 million |
| Payment to buy out management options | $ 10.1 million |
| Fees | $ 10.0 million |
| Total | $467.8 million |
Remember, Fibic Corp. was the firm that was created to acquire Congoleum and jointly owned by Prudential, First Boston, Century Capital, Byron, and Eddy.
Prior to the offer, Fibic raised $379.6 million in debt and equity (from the various players), as shown in Table 18.4. Wait a second. Fibic paid $467.8 million but only raised $379.6 million. Is there a math problem here? How could Fibic have paid $88.2 million more than it raised? Where did the extra funds come from? The extra funds came from Congoleum itself. Fibic actually used some of Congoleum's own money—its pile of cash and marketable securities (i.e., “excess cash”)—to buy Congoleum. Let's step through this in detail:
TABLE 18.4 Financing the Deal
| Bank debt (14%) | $125.0 million | |
| Senior notes (11.25%, B+) | $113.6 million | |
| Junior notes (12.25%, B–) | $ 89.8 million | |
| Total debt | $328.4 million | |
| Preferred equity (13.5%, CCC) | $ 26.2 million | |
| Common equity | $ 25.0 million | |
| Total equity | $ 51.2 million | |
| Total financing | $379.6 million | |
| Or alternatively: | ||
| Bank debt | $ 125 million | |
| Strip financing: Senior notes | $113.6 million | |
| Junior notes | $ 89.8 million | |
| Preferred equity | $ 26.2 million | |
| Common equity | $ 16.5 million | $246.1 million |
| Investment bank and management equity | $ 8.5 million | |
| Total financing | $379.6 million |
If we break things down even more:
| Fibic | Congoleum | |
| Cash of $379.6 million | Cash of $130 million | |
| All other assets and liabilities | ||
| (Shipyard, auto parts, flooring, etc.) | ||
| ← | Cash of $130 million | |
| ← | All other assets and liabilities |
| Fibic | Congoleum |
| Cash $509.6 million | |
| Congoleum's assets and liabilities | |
| Payable Congoleum $447.7 million | Receivable Fibic $447.7 million |
| Payable for fees of $10 million | |
| Payable for options of $10.1 million | |
| Cash payment $447.7 million → |
| Fibic | Congoleum |
| Cash $41.8 million10 | Cash $447.7 million |
| All Congoleum's other assets and liabilities |
In fact, the transaction was much more complicated than that outlined above. A few details: First, Bath Iron Works was a wholly owned subsidiary of Congoleum. This meant Congoleum owned the shares of Bath Iron Works rather than the individual assets and liabilities. To avoid numerous tax issues, Bath Iron Works was sold to Fibic first in a separate transaction for $92.3 million, and later all of Congoleum's other assets and liabilities were purchased for $355.4 million ($92.3 million plus $355.4 million equals the total of $447.7 million). Second, a shell corporation (Fibic) was set up to facilitate the deal, and it was then liquidated once the deal was done. That is, Fibic became Congoleum (the name was part of the assets purchased). Thus, instead of having shareholders and being publicly traded, the new Congoleum was privately owned by First Boston, Prudential, Century Capital, Byron, and Eddy. Regardless of the accounting and legal details, the essence of the transaction is as described and illustrated above.
Consider this from another viewpoint: Essentially, 11.783 million shares of Congoleum were purchased for $379.6 million, which works out to $32.22 per share ($379.6/11.783). How do you pay only $32.22 a share when you bid $37.50 to the old shareholders? By using the old shareholders' (Congoleum's) money to help fund the purchase.
What was the actual funding for the deal (i.e., where did the $379.6 million come from)? Fibic borrowed $125 million in new bank debt. Prudential and other institutional investors purchased $246.1 million of securities through strip financing. First Boston and Century Capital purchased a combined $4.5 million of common stock in the new firm. Management (principally Radaker and Nicholson)11 also purchased a combined $4 million of common stock. The total financing for the deal was therefore $379.6 million from all parties combined.
Strip financing is a technique where the investor buys a “strip” of several different securities simultaneously. The strip is sold as a single security. In this case, the $246.1 million of strips consisted of four different pieces: $113.6 million of senior notes, $89.8 million of subordinated notes, $26.2 of preferred stock, and $16.5 million of common stock. Strips can either be separable or nonseparable. In a separable strip, the various securities can be separated and sold later as individual instruments. In a nonseparable strip, the different securities must remain combined in the same proportion. Congoleum's strips were nonseparable.
The Balance Sheet view of Fibic's new financing is shown in Table 18.4.
Where did the investment bankers (Century Capital and First Boston) get the $4.5 million they invested? Most of it came from the fees they collected for doing the deal. As noted, total fees were $10 million, which included the money to First Boston and Century Capital as well as a $3 million fee to Lazard Frères & Co. (another investment bank who provided a “fairness” opinion on the deal) and the fees to accountants and attorneys.12 Where did management get the $4 million they invested? They were paid $10.1 million for their stock options in the old firm and invested $4 million of that into the deal.
So when the smoke clears, what did the new Congoleum's Balance Sheet look like? Table 18.5 shows the restated 1978 debt and equity after the LBO. The new firm still retained old Congoleum's debt of $15.4 million (1978 year-end) plus the new debt of $328.4 million described above for total debt of $343.8 million. Comparing this with the preferred and common equity of $51.2 million, the firm increased its debt ratio (debt/(debt + equity)) from 7.6% ($15.4 million/($15.4 million + $187.5 million)) to 87.0% ($343.8 million/($343.8 million + $51.2 million)). This ignores for the moment the excess cash available on old Congoleum's Balance Sheet; we discuss all of this in more detail in Appendix 18A for those who want more information.
TABLE 18.5 Condensed Liabilities and Owner Equity in 1978
| Without LBO | Projected After LBO | ||
| Debt | $15.4 million | +$328.4 new debt | $343.8 million |
| Equity | $187.5 million | restated | $51.2 million |
| Debt/(debt + equity) | 7.6% | 87.0% |
Wow! This is a huge increase in leverage. Given our discussion on capital structure earlier in this book, it also should represent a huge increase in financial risk. But is this right? Was the new debt (and risk level) really this high? No. Why not? Look closely again at the debt and equity components in Table 18.4. Let's consider Congoleum's common stock. There was a total $25.0 million of common stock. It was split between the $16.5 million owned by Prudential, $4.5 million by First Boston and Century Capital, and $4 million by management (Byron and Eddy). In other words, Prudential owned 66% of the common stock, with First Boston and Century Capital owning 18% while Bryon, Eddy, and a few others owned 16%.
Next, let's consider Congoleum's bank debt. What happens if post-LBO Congoleum fails to pay its pre-LBO debt or any new bank debt incurred? The firm risks being forced into bankruptcy.
But what would happen if Congoleum fails to pay the senior or subordinated notes? Remember, Prudential's senior notes and subordinated notes were tied in with its preferred and common equity and sold as nonseparable strips. This is a critical detail. Would Prudential really have sued Congoleum and put the firm into bankruptcy? If Prudential had been willing to do this, who would it have hurt? The equity holders would have been hurt; however, Prudential was one of the equity holders and owned 66% of Congoleum's equity after the LBO! Essentially, the senior notes and the subordinated notes were not debt in the traditional sense because this debt was held by the equity holders and couldn't be separated from the equity. In a very important sense (that of the risk of being forced into bankruptcy), it is not debt. In effect, if Prudential forces bankruptcy, it is harming itself.
The bank debt and old debt were therefore the only “true” debt that added financial risk to Congoleum in the way we discussed in Chapter 6. This meant the new post-LBO firm's “true” debt was really only 35.5% of total financing (($15.4 million of old debt + $125 million of bank debt) / $395 million of debt plus equity). A 35.5% “true” debt level with cash flows as stable as Congoleum's was relatively safe with a low risk of bankruptcy.
Thus, the debt ratio may appear to have been 87% (total debt of $343.8 million/$395 million in total debt and equity), but in reality it was not. Prudential owned 59.2% of the debt and 66% of the common stock in strips. The “true” debt level was actually 35.5% as previously noted.
Let's consider this situation again using a simple example. Imagine you start your own firm in your garage and lend yourself money. You own all the stock. If you can't pay yourself back the money you lent yourself, are you going to take yourself to court and force yourself into bankruptcy? No. Similarly, as long as Congoleum paid the old debt and the bank debt, it was safe from bankruptcy. Congoleum did not face a substantial risk of bankruptcy if it failed to repay Prudential because the insurance company owned the senior debt, the subordinated debt, the preferred stock, and most of the common stock. So the strip was not really debt in the traditional sense that we talked about earlier in the book (i.e., in the sense of adding to the risk of being forced into bankruptcy in the event of being unable to repay debt).
So, how risky were the old debt and bank debt? The interest on the old debt was about $1.2 million, and the interest on the bank debt was about $17.5 million. This means Congoleum needed to earn $18.7 million to cover the interest on the old debt and bank debt. Table 18.1 showed that in 1978, Congoleum had EBIT of $85.6 million. This was a coverage ratio of 4.6 times. Note that Congoleum's $17.2 million of royalties alone in 1978 were enough to cover 92% of the interest charges. This shows that Congoleum could easily pay the interest on its old debt and bank debt, and that its risk was not high.
Now, let's explain the Congoleum LBO another way, using what we know about capital structure theory. Remember that in a pure M&M world with no taxes, capital structure doesn't matter. By contrast, in an M&M world with taxes and no costs of financial distress, the desired amount of debt is 100%. However, in the real world, as we add debt, we usually add costs of financial distress, so the optimal capital structure depends on the trade-off between the benefit of tax shields and the costs of financial distress. Thus, in determining target capital structure for an LBO, we need to understand the amount of financial distress the LBO has.
To restate our earlier question: Is there any financial distress associated with the strips used to finance the LBO of Congoleum? Not really. By using these nondetachable strips to finance the LBO, First Boston created an M&M world with taxes and very little costs of financial distress. So the optimal amount of debt in this case was much higher than if the firm had to consider the usual higher costs of financial distress.
We should have convinced you by now that the strips used in the Congoleum LBO were not really debt since they didn't increase the financial risk of the firm. However, let's add more evidence.
As can be seen from Table 18.4, where the strip is broken down into its various components, the interest rate on the senior notes was 11.25%. The interest rate on the subordinated notes was 12.25%. The preferred stock was paying a dividend of $11 per share, or about 13.5% ($11/$81.25 issue price per share). And the ratings on these three instruments were B+, B–, and CCC respectively.
What was the rate on the new bank debt at the time? About 14%. Let this sink in. What was the most senior debt in this firm? The bank debt was the most senior.13 Who had to get paid first? The holders of the most senior debt, which in this case were the banks. What was the rate on this senior debt? About 14%. Who came after the banks? The holders of the senior notes (otherwise known as senior debentures). What was the rate on the senior notes? 11.25%. And the subordinated notes only received 12.25%.
Note that the yield curve was flat for 1978 and slightly rising in 1979. (One-year government rates were 9.28% and 30-year rates were 10.65%.) This means the rate difference between Congoleum's senior debt and junior debt is not due to different lengths to maturity.
Does the interest rate on senior debt make sense? If the senior debt was getting 14%, what rate should the junior debt have gotten? Typically, higher than the senior debt, because it has more risk. So why did Prudential, which owned the junior debt, accept a lower interest rate than the bank, which owned the senior debt? Because the debt that Prudential owned was not really debt. Prudential was going to get the remainder of its return on the equity it owned. It was therefore willing to accept a lower rate on the senior and subordinated notes. Furthermore, Prudential kept the interest rates on the notes low enough so that Congoleum's cash flows could pay off the debt without technically defaulting. Thus, the fact that the senior debt (the bank debt) got 14% and the junior debt got at most 12.25% also tells us that the junior debt was not really debt in the traditional sense.
The strips more closely represented equity, since the majority equity holder (Prudential) also owned the strips. So why use strips, why not just use equity? Because if the firm called the strips equity and paid dividends, then the firm would have had to pay taxes before it paid the dividends. But if the firm called the strips debt and paid interest, the firm got to deduct the interest and reduce the amount it owed in taxes.
What was the key result of the LBO? Congoleum basically swapped out one stockholder for another: the firm swapped out the public stockholders for the private ones. To do this, it used a brilliant financing structure. By using strip financing, Congoleum was able to increase its nominal debt level and reduce taxes without a corresponding increase in financial distress.
This was the very first LBO with this structure (i.e., with strip financing). It was also five times larger than any LBO ever done before. The Congoleum LBO became the blueprint for future LBOs, and it started the LBO—and now, private equity—boom. We will discuss below how the equity return compensated Prudential and made up for the low rate it got on the debt it owned.
Let us now revisit: What was the basic business risk (BBR) of Congoleum? Since Congoleum had three distinct product lines, another way of asking this is: How much risk was there in each of the three businesses? Not very much. As previously noted, this was why the firm was such a good LBO candidate. Home furnishing had a very low basic business risk with Congoleum's patents and brand name (Congoleum flooring is still in the market today, 40 years later). Shipbuilding had a very low BBR because they were a government contractor with a multiyear backlog. The auto part business had low risk because it also had numerous patents, plus it sold in the maintenance market (less risky than the original equipment market). Furthermore, if cash flows turned out to be lower than forecasted, Congoleum could have easily divested one of these divisions for funds because none were critical to any other.
So let's ask: What are the expected cash flows? Later in this chapter, we will calculate pro formas for the LBO; we find there is very strong cash flows and very little risk to the debt holders.14 The coverage ratio (EBIT/interest) we project is strong and improves over time (from 1.38 to 5.74, as shown in Table 18.9), and the cash flows are stable. Importantly, the royalties to Congoleum from its patents remain equal to half the projected total interest payments. The combination of low BBR with stable cash flows, the ability to sell off a division, improving coverage ratios, and a “real” debt level of only 35.5% provided great comfort to the lenders.
What about the management of Congoleum? Was it good management? Would investors have been worried that management might leave? We know the management at the time was able to run the company because they had done a good job in the past. In addition, with the LBO, management would now own a substantial portion of the equity in Congoleum, providing them with added incentive and thus making them unlikely to leave.
So what was the risk from the bank's point of view? Low to moderate. This was a stable company with good cash flows, good collateral, good management, and a low-to-moderate “actual” debt level. The bank owned $125 million of debt, which was 32% of total capital and was all senior debt.
How about the risk from Prudential's point of view? Congoleum's total debt level with all debt included—regardless of its being “actual” or not—was 87% ($343 million/$395 million). Of this total debt, Prudential had 59% ($203.4 million/$343 million), all of which was junior. Without the equity component, this would have made Prudential's position quite risky, even given the stable cash flows and low business risk. However, Prudential also owned 66% of Congoleum's equity. This means its position should be viewed as that of an equity holder, not a debt holder. And while this equity position was riskier than the bank's position, Prudential (like any equity holder) also had a potential upside. Furthermore, unlike a typical equity holder in a firm with 87% debt, Prudential also owned much of the debt. As such, the risk of financial distress from the junior debt is not that high. Prudential, as the majority equity holder, would not have forced Congoleum (mostly owned by itself) into bankruptcy.
We stated earlier that the LBO structure used in Congoleum created value. How much value did the LBO create? Well, on July 15, 1979, Congoleum's share price was $25 a share. Since there were 11.783 million shares outstanding, this means Congoleum's market capitalization (market cap) was $299 million. This was the market value of the equity. On July 16, 1979, the consortium of Prudential, First Boston, Century Capital, and Congoleum's management made a tender offer to the current shareholders at $38 a share. This means the bid for all of the 11.783 million shares was for a total of $447.7 million. The market value of equity went up by $148.7 million ($447.7 million – $299.0 million) in one day, a 50% premium. How did the market value of equity go up by so much with the tender offer?
Through the miracle of modern finance!
| July 15, 1979 | July 16, 1979 | |
| Price per share | $25.375 | $38.00 |
| Shares outstanding | 11.783 million | 11.783 million |
| Market value of shares | $299.0 million | $447.7 million |
The operations of Congoleum did not change in any way as a result of the LBO, nor were they expected to.
| Was it the same company? | Yes. |
| Did the firm have the same management? | Yes. |
| Had the firm sold off or acquired any businesses? | No. |
| Were there any synergy stories to tell here? | No. |
| Were there increasing sales? | No. |
| New labor contracts? | No. |
Congoleum went from being a public firm worth $299 million to being a private firm worth $467.8 million (the price paid). Where did the additional value come? Let's take a look.
Let's put ourselves in July 1979 as the present and generate pro formas for Congoleum with and without the LBO. Since this chapter is not about pro formas (which we explained earlier in the book), the pro formas can be found in Appendix 18A. Note that there are two significant changes we want to focus on in the projections with the LBO as compared to the projections without the LBO: first, interest expense increases (from $1.2 million in 1978 to $41.6 million in 1980) due to the additional debt. Second, depreciation and amortization expenses increase due to the write-up of the assets to their purchase price by the LBO. Table 18.6 provides the projected Income Statements with and without the LBO, taken from Appendix 18A (Tables 18A.1 and 18A.4).
TABLE 18.6 Congoleum Pro Forma 1980 Income Statement without and with the LBO
| ($ millions) | Without LBO Projected 1980 | With LBO Projected 1980 | Difference |
| Total revenues | 709.5 | 709.5 | 0.0 |
| Cost of sales | 475.4 | 475.4 | 0.0 |
| SG&A | 134.8 | 176.8 | 42.0 |
| Operating profit | 99.3 | 57.3 | −42.0 |
| Interest expense | 0.0 | 41.6 | −41.6 |
| Miscellaneous | 0.0 | 0.0 | 0.0 |
| Income before tax | 99.3 | 15.7 | −83.6 |
| Income tax (48%) | 47.7 | 7.5 | −40.2 |
| Net income | 51.6 | 8.2 | −43.2 |
Table 18.6 shows that Congoleum's pro forma net income without an LBO is $51.6 million compared to a pro forma net income with an LBO of $8.2 million. Why such a huge difference? The reasons are that with the LBO:
Together these two changes cause the income tax to be reduced by $40.2 million. In finance, these tax savings are often referred to as depreciation tax shields and interest tax shields. Explaining these two tax shields one more time: the pro forma in Table 18.6 shows that the LBO has additional depreciation and amortization expenses of $42 million in 1980 (thus increasing SG&A). At a corporate tax rate of 48%, this translates to a tax savings of $20.2 million.
Similarly, the additional interest expense in 1980 is $41.6 million. At a corporate tax rate of 48%, this translates to a tax savings of $20.0 million.
Taken together, the additional tax shield on depreciation and amortization of $20.2 million and the tax shield on interest of $20.0 million combine to the $40.2 million shown in Table 18.7 for 1980.
TABLE 18.7 Congoleum's Change in Tax Expense with LBO versus without LBO
| ($millions) | 1980 | 1981 | 1982 | 1983 | 1984 |
| Tax expense without LBO | 47.7 | 52.9 | 58.7 | 65.2 | 72.4 |
| Tax expense with LBO | 7.5 | 14.4 | 22.9 | 32.5 | 43.1 |
| Projected tax savings from LBO | 40.2 | 38.5 | 35.8 | 32.7 | 29.3 |
Looking forward five years, the savings in taxes with the LBO is projected to be roughly $35.3 million per year (a high of $40.2 in 1980 to a low of $29.3 in 1984), as shown in Table 18.7.
Let us return to capital structure theory for a moment. If you recall, M&M (1958) showed us that the “pie” is fixed and that capital structure determines how we cut the slices and who gets them. M&M (1963) showed us that with taxes, the government also gets a slice of the pie and that therefore taxes reduce the size of the slices available to other stakeholders. By increasing debt, we reduce the size of the slice to the government. Keeping with this analogy, the LBO, by increasing interest and depreciation expense, reduces the size of slice going to the government and increases the slices to the other parties. In Congoleum, the government's share of the pie is reduced by $40.2 million in 1980, according to our pro formas.
However, and this is key, who gets the $40.2 million that used to go to the government in taxes? It now goes to the debt holders in the form of interest and principal repayment. And who are the debt holders? The banks (partially) and Prudential (principally). But remember, Prudential is also the largest equity holder (owning 66% of the equity). By leveraging up the firm to 87% debt, we have reduced the payments to the government and increased the payments to the debt holders. However, unlike our discussion of capital structure, where the cost of increasing the debt increased the risk,15 the strip financing means that debt holders and equity holders are the same parties, and thus the risk of distress has not increased with the increase in debt.
So, what has the firm accomplished by doing the LBO? For one thing, the firm has created a situation where it will pay roughly $40.2 million less in taxes in 1980. In essence, Congoleum borrowed money from Prudential to buy its stock and is now using the tax savings it gets from having debt to pay Prudential back.
To return to our tongue-in-cheek question above, why did Harpel (the Harvard MBA who started all this) give a chair to Harvard's Kennedy School of Government instead of Harvard's Business School, from which he graduated? Perhaps it was in honor of the government tax code, which allowed this modern miracle of finance. (This is pure unsupported speculation on your authors' part.)
Appendix 18A shows the Pro Forma Income Statements and Balance Sheets for 1980–1984 and how they were generated. (Again, we recommend that the reader take time out at this point to skim Appendix 18A.) From Table 18A.4, we are able to generate Congoleum's pro forma excess cash flows, as shown in Table 18.8.
TABLE 18.8 Congoleum's Pro Forma Excess Cash 1980–1984
| ($000s) | 1980 | 1981 | 1982 | 1983 | 1984 |
| Earnings before interest and tax | 57,346 | 68,272 | 80,400 | 93,862 | 108,805 |
| EBIT * (1 – tax rate of 48%) | 29,820 | 35,501 | 41,808 | 48,808 | 56,579 |
| Plus depreciation and amortization | 41,981 | 41,981 | 41,981 | 41,981 | 41,981 |
| Less CAPEX | 0 | 0 | 0 | 0 | 0 |
| Plus opening net working capital | 31,247 | 56,185 | 70,622 | 86,649 | 104,437 |
| Less ending net working capital | (56,185) | (70,622) | (86,649) | (104,437) | (124,183) |
| Free cash flows to the firm | 46,863 | 63,045 | 67,762 | 73,001 | 78,814 |
Note that we assume that Congoleum is depreciating the patents and other assets for tax purposes but does not require new CAPEX to maintain those patents and other assets. (As noted in Appendix 18A, CAPEX is assumed to equal the depreciation on the pre-LBO assets, so these don't change over time and the LBO write- ups decrease over time.) Prior to the LBO, additions to PP&E were $12.7 million in 1978 and $6.7 million in 1977.
Table 18.9, which is derived from Table 18A.5 in Appendix 18A, shows that over the first five years after the LBO, the amount of debt decreases substantially. This assumes the excess cash shown in Table 18.8 is used to pay down debt. In fact, even if the excess cash is held by the firm (i.e., not used to pay down debt), we know that the “actual” debt level is debt minus excess cash.
TABLE 18.9 Congoleum Pro Forma Capital Structure with the LBO
| ($000s) 1979 | 1980 | 1981 | 1982 | 1983 | 1984 |
| Debt 328,400 | 306,710 | 267,089 | 219,866 | 163,967 | 98,544 |
| Total equity 51,200 | 55,847 | 67,924 | 89,193 | 120,899 | 164,087 |
| Debt ratio 86.5% | 84.6% | 79.7% | 71.1% | 57.6% | 37.5% |
| Times interest n/a | 1.38 | 1.79 | 2.46 | 3.60 | 5.74 |
Thus, Congoleum is projected to go from being a firm with 86.5% of debt immediately after the LBO to being a firm with 37.5% debt just five years later. The bottom line is that tax payments that used to go to the government are now going to the capital providers of Congoleum, which are largely the debt holders (i.e., Prudential) but also include the equity holders. After the debt is paid down, the firm looks as though it has the same capital structure as before the LBO, but the ownership has changed to Prudential, the investment banks, and management.
In addition to the dramatic drop in debt, Congoleum's equity also increases substantially, as shown in Table 18.9. The preferred stock remains at $26.2 million. The common equity increases from the initial $25 million investment to $137.9 million (the cumulative net income minus the cumulative preferred dividends).
LBOs appear to be very complicated (different types of debt, preferred stock, etc.). The underlying reality is not that complicated, but it needs to look very complex. Why? So that it qualifies as debt for tax purposes even though the risk level is quite low. The reality of the financing is that the strips are technically debt, but are really more like equity. This is why the deal is structured with senior debt, subordinated debt, junior debt, preferred stock, and so on. Has the government figured this out and changed regulations to prevent companies from avoiding tax payments in this way? Yes and no. Some rules have been changed; others have not. However, this method was allowed in the Congoleum transaction and many others.
How much equity did First Boston, Century Capital, and Congoleum's management invest in Congoleum? They invested a total of $8.5 million in 1979. Prudential invested another $16.5 million of common equity. This is a total common equity investment of $25.0 million. What is this equity expected to be worth at the end of 1984? As seen in the pro forma in Appendix 18A, Table 18A.4, in 1984 the firm is projected to have $46.7 million of net income. In addition, the firm is expected to have paid off almost all its debt, as shown in Table 18A.5, with debt (short-term plus long-term) falling from $306.7 million at the end of 1980 to $98.5 million in 1984.
Assume the current equity holders of Congoleum now decide to go public. How much should they expect to receive for their equity? Let us first consider a P/E multiple. Selling the earnings at a multiple of 1.0 would mean the current common equity holders would almost double their money (going from the $25.0 million invested to $46.7 million). A multiple of 1.0 times earnings is clearly way too low. Using Congoleum's pre-LBO earnings multiple of 7.3, the firm's market capitalization (sale price) would be $340.91 million. This is a return of over 1,263%, or a compound annual return of 68.5% per year. Now you know why we call this the miracle of modern finance. If the current equity holders (Prudential, Century Capital, etc.) were able to sell Congoleum at the average market multiple of 15.0, the returns would be even more spectacular: a market capitalization of $700.5 million, meaning a total return of over 2,700% or a compound annual return of 94.7% per year.
How would Byron and Eddy do? Remember they initially put $4 million (of the $10.1 million they received for the stock options, pocketing the remaining $6 million for other uses) into the firm for a 16% equity share. At an earnings multiple of 7.3, management would receive $54.5 million ($340.9 * 16%) on their $4 million investment, plus the salary and perks they earn from running the firm. How does this compare to the salary of $370,000 Mr. Radaker was getting before the LBO? This is the difference between being rich and sincerely rich. Now we are talking sincerely. We can now also recognize the attraction that LBOs might have to management.
Prudential invested a total of $246.1 million in the strips, of which $16.5 million represented a 66% share of Congoleum's common equity. In our pro formas, five years later the debt and preferred stock of $229.6 million are repaid in full, and the equity is estimated to be worth $225.0 million ($340.9 * 66%) at a multiple of 7.3, or a total of $454.6 million ($229.6 + $225.0). Thus, Prudential earns 84.7%, or a compound annual return of 13.1% on its strip investment, in addition to the annual interest and preferred dividend payments.
A quick summary to this point: Congoleum was the first modern LBO. The key to understanding the value creation in this case is that modern LBOs represent an M&M world with little or no financial distress. In M&M's theoretical world, if there are taxes but no costs of financial distress, you should maximize the amount of debt. Typically, we don't want to maximize the amount of debt because of the costs of financial distress. In the Congoleum case, however, the participants figured out a way to finance the firm with equity while calling it debt. They then took the money they would have paid to the government and instead paid themselves (as the debt holders).
So now we have to ask: Was $38 a share (the LBO price) a fair price to pay? Remember, it was a 50% premium on the market price at the time. But at $38 a share, Congoleum's management, the investment bankers, Century Capital, and Prudential all made an enormous amount of money. Did they do this at the expense of the old stockholders? Should they have paid the old stockholders more? Well, the old stockholders got 50% more than the market price at the time.
If the management of a public company buys it from the stockholders, is this self-dealing? Furthermore, can management later be held liable? To prevent liability (or at least defend themselves from the charge of self-dealing), what must management do? They must hire an investment bank. Why? To obtain a fairness opinion.16 Management will be sued regardless (if the LBO works well), but a fairness opinion helps protect management from accusations of self-dealing. To the authors' knowledge, there has never been a successful lawsuit against management, a board of directors, or investment banks where a fairness opinion was obtained before an LBO.
So where did the Congoleum consortium get the fairness opinion? Lazard Frères, an independent investment bank (independent of First Boston, Prudential, Century Capital, and Congoleum's management). A summary of Lazard's fairness opinion is presented in Appendix 18B. What did Lazard use to justify its opinion that the price was fair? Lazard used a variety of multiples to value Congoleum's three separate divisions. Could you have valued Congoleum's three separate divisions? By this point in the book, your authors hope your answer is, “Absolutely!” Now, Lazard also had people sitting by the phone waiting to see if another bidder came in with a higher offer.
How much would you charge to provide a fairness opinion? What would your hourly rate be? We're guessing it is substantially below what Lazard charged, which was $3 million. (Your authors would like to point out at this time that they and other academics are perfectly capable of performing the same analysis as the investment banks, and for less money.)
Now, some people might think that Lazard is being compensated for the liability it assumes and for putting its reputation on the line when providing fairness opinions. However, when an investment bank gives a fairness opinion, it typically requires the firm that requested the opinion to indemnify the investment bank from any liability. This means that if there is a lawsuit against the investment bank and the investment bank loses, it does not have to pay. So much for any liability. What about the value of an investment bank's reputation? We will leave it to the reader to determine the value of an investment bank's reputation, but we do not believe that reputational risk is what determines their fees.
Furthermore, contingency fees are common for investment bankers in acquisitions. In this case, per page 12 of the proxy statement, Lazard gets a flat fee of $1 million regardless of whether the deal is consummated or not. Lazard also gets a contingency fee of $2 million if the deal goes through. So if Lazard finds that the deal is not fair, it gets the $1 million flat fee. If Lazard says the deal is fair and then the deal is successful, Lazard gets $3 million. Incentive effects are clearly possible.
An old joke is that if the world really wanted peace in the Middle East, then it should have Goldman Sachs represent one side and Morgan Stanley the other side, with the signing of a peace agreement on a contingency fee basis. The punch line is that the world would have peace by the end of the month.
So what actually happened to Congoleum? Congoleum did very well after the LBO. The company continued to operate effectively and took the forecast interest tax-shield and depreciation tax-shield. The firm was profitable, well above the forecast, and debt was paid down rapidly. After five years, the tax shields were greatly reduced because the assets were depreciated and the interest tax shield decreased as the debt was reduced. For many LBOs, this is often the time the firm goes public again. Why? The tax advantages of the LBO have been realized and are no longer as large. Furthermore, as we discussed earlier, even at modest earnings multiples, the returns to the LBO investors are significant.
Congoleum did not go public again. Rather, it did a second LBO in 1984. In the second case, the management team brought in new partners, and Byron and Eddy ended up owning 70% of the equity. Prudential, First Boston, and Century Capital all earned a healthy premium of three times earnings for their participation in the first LBO.
Then what happened? In 1986, the management team decided to sell Congoleum. According to the Wall Street Journal:17
Congoleum Corp. has completed the job of dismantling itself with the sale of Bath Iron Works, but the job now is to figure out what to do with the $850 million in cash. Pondering the problem last week was Eddy G. Nicholson, 48, and Byron C. Radaker, 52, formerly the chiefs of Congoleum. They say they owned or controlled 70% of Congoleum's common stock.
Basically, Byron and Eddy sold off the company to others in pieces18 and netted $595 million ($850 million * 70%) for themselves.
What happened to LBOs after Congoleum's LBO? A couple of things happened. Experience tells us that anytime someone gets a good idea, it will be copied. As a result, more money flows into funds to do these deals (i.e., “more money is chasing deals”). The best deals are picked off first. This means that over time the deals got riskier: the LBO candidates were not as good, their cash flows were not as stable, their management not as competent, and so forth.
In addition, the investment banks got greedy. They decided they wanted to keep more of the profits of the deals for themselves rather than selling the LBOs to institutional investors like Prudential and sharing the bulk of the profits. Independently, the junk bond market developed in the 1980s, providing another source of potential funding for LBOs. This allowed the investment banks to obtain funds in the junk bond market (discussed in Chapter 10) instead of going to insurance companies, and the investment bankers and management were able to retain 100% of the equity. The difference, however, is that they did not use strip financing. The junk bond investors didn't get part of the equity, and the different tiers of debt were not “stapled” together. It also meant that the cost of the debt rose, since the debt holders didn't share in the equity upside.
Perhaps most important, the debt and the LBO became far riskier with tiered financing than under the strip financing model. If the firm got into trouble, the debt holders were not the same as the equity holders and thus were more willing to force the firm into bankruptcy.
So what had the investment bankers done? They went from an M&M world with taxes and no financial distress back to one with financial distress. Before this change, sometime around late 1984, there had been almost 180 LBOs, only one of which went bankrupt. (There is an excellent article by Kaplan and Stein that studies and documents this change.19) After 1984, the number of LBOs going bankrupt rose, a clear response to the change in the financing structure.
In addition to the change made by investment bankers, Congress also changed the tax laws to make LBOs less attractive. In particular, as part of the Tax Reform Act of 1986 (enacted October 22, 1986), the General Utilities Act was abolished. This is relevant because the General Utilities Act had allowed firms to write up the assets they purchased to the price they paid for them and then to depreciate them from the new higher basis. The new law made it so that purchased assets could no longer be increased to the purchased value (written up) unless the seller paid taxes on the write-up of the assets.
For example, under the General Utilities Act, an investor could purchase a building (or a firm's assets) for $100 million, depreciate it down to zero, and then sell it to someone else for its market value. This second investor would then also be allowed to depreciate it from their purchase price to zero (thereby getting a tax advantage as well). This could occur repeatedly. This is no longer allowed. Once an asset has been depreciated, if it is sold, the seller will recapture (must pay tax) on the difference between the purchase price and the depreciated value. This one change took away close to half the tax shields in the Congoleum example and made LBOs less profitable in general.
The above analysis is not meant to imply that the only advantage to LBOs is the increase in tax shields. Importantly, when the managers are also the stockholders, there is evidence that they do a better job in managing the firm. An academic study by Steve Kaplan shows that performance measures (i.e., increases in operating income, decreases in capital expenditures, and increases in net cash flow) all substantially improve after an LBO.20
Thus LBOs, if properly structured, not only return us to an M&M world with no costs of financial distress, but they also return us to a world where the managers are the owners so there are no agency costs.
Although not required, it also helps if the firm's businesses are separable and can be sold off if things don't go as planned. In addition, excess cash is always nice. Thus, Congoleum was a perfect LBO candidate.
Second, LBO returns, even for good candidates, also went down because there were more bidders. For example: If Congoleum had not been the first LBO, what would have happened when First Boston made the $38 a share bid for the firm? Others would probably come in and bid. A bidding war causes the price to escalate, reducing the return to the winning bidders. In the Congoleum case, no one else bid because no one else understood what an LBO was. (In the proxy statement, Lazard states that they contacted fifteen other potential buyers but none were interested.) First Boston's new structure was difficult to understand at first. (People didn't see that it was M&M [1963] without financial distress.)
The next development in the LBO saga was the emergence of private equity firms. Private equity firms apply much of the original LBO model. These firms raise large pools of funds that they then use to acquire public companies and take them private. In this process, the private equity firms provide both the debt and equity financing for the acquisition (and a higher debt ratio than the public company had) and are thus able, like an LBO, to reduce risk while benefitting from large interest tax shields. In addition, private equity firms monitor acquired companies' management closely, thereby reducing agency costs. Later, the companies bought by private equity firms are spun off again as public firms, similar to the Congoleum LBO model.
Your authors expect the Tax Cuts and Jobs Act of 2018 to have a major effect on the private equity industry. While the new law decreased the corporate tax rate from 35% to 21%, it also put a cap on the amount of interest that is tax deductible. The cap is currently equal to 30% of the firm's EBITDA. This cap will eliminate much of the advantages of high leverage. The current portfolio held by private equity firms should not be affected much by the cap on interest-related tax deductions because the lower corporate tax rate will offset some or all of the loss of interest tax deductibility.
We expect the greatest effect of the cap on interest-related tax deductions will be felt with new LBOs or private equity acquisitions. This is due to a decrease in their profitability: consider what would have happened in the Congoleum case without much of its tax advantages.
Prior to the Tax Cuts and Jobs Act of 2018, private equity firms competed with public firms to purchase public companies. That is, Public Firm A could be acquired in a merger with Public Firm B, or Public Firm A could be taken private by a private equity firm. This will still be the case after the new tax law comes into effect, but private equity firms will not be able to pay as much as because the acquisition will be less profitable given the limitations now placed on interest deductibility. As such, we expect the private equity industry to grow slower and/or shrink.
Our next case involves the acquisition of Family Dollar by Dollar Tree. This case covers strategy, valuation, and execution, which we will do in four consecutive chapters.
The pro forma financial statements in this appendix are generated by your authors, taking historical ratios and projecting them forward. This is consistent with the discussion in Chapters 3 and 4 on generating pro formas. There are a number of pro formas generated as follows:
Tables 18A.1 and 18A.2 project Congoleum's Income Statements and Balance Sheets from 1978 to 1979 and 1980, assuming the LBO did not occur.
TABLE 18A.1 Congoleum Pro Forma Income Statement for 1979 and 1980 without the LBO
| ($000s) | 1978 | Adjustments | 1979 | 1980 |
| Total revenue | 575,830 | 11%/year | 639,171 | 709,480 |
| Cost of sales | 385,851 | 67% of sales | 428,245 | 475,352 |
| Selling and general expenses | 108,648 | 19% of sales | 121,443 | 134,801 |
| Operating profit | 81,331 | 89,483 | 99,327 | |
| Other income | 4,281 | removed | 0 | 0 |
| Interest expense | 1,266 | estimate | 1,000 | 0 |
| Profit before tax | 84,346 | sub-total | 88,483 | 99,327 |
| Income tax | 42,600 | 48% PBT | 42,472 | 47,677 |
| Net income | 41,746 | 46,011 | 51,650 | |
| Earnings per share | 3.58 | NI/11,783 | 3.90 | 4.38 |
| Dividends per share | 0.8 | 25% NI | 0.98 | 1.10 |
| Stock price year-end | 26.25 | 7.3 * EPS | 28.47 | 31.97 |
TABLE 18A.2 Congoleum Pro Forma Balance Sheet for 1979 and 1980 without the LBO
| ($000s) | 1978 | Adjustments | 1979 | 1980 |
| Cash | 77,254 | plug | 85,857 | 112,642 |
| Receivables | 64,482 | 11% sales | 70,309 | 78,043 |
| Inventory | 75,258 | 13% sales | 83,092 | 92,232 |
| Other current assets | 3,511 | flat | 3,511 | 3,511 |
| Current assets | 220,505 | 242,769 | 286,428 | |
| PP&E | 70,777 | flat | 70,777 | 70,777 |
| Goodwill and other | 31,770 | flat | 31,770 | 31,770 |
| Total assets | 323,052 | 345,316 | 388,975 | |
| Current portion long-term debt | 460 | paid off | — | — |
| Accounts payable | 41,578 | 7% sales | 44,742 | 49,664 |
| Other current liabilities | 68,359 | flat | 68,359 | 68,359 |
| Current liabilities | 110,397 | 113,101 | 118,023 | |
| Long-term debt | 14,949 | paid off | — | — |
| Other long-term liabilities | 10,221 | flat | 10,221 | 10,221 |
| Total liabilities | 135,567 | 123,322 | 128,244 | |
| Contributed capital | 16,256 | flat | 16,256 | 16,256 |
| Retained earnings | 171,229 | +NI – Divd | 205,738 | 244,475 |
| Total equity | 187,485 | 221,994 | 260,731 | |
| Total liabilities and equity | 323,052 | 345,316 | 388,975 |
Table 18A.3 projects Congoleum's Balance Sheet for 1979 and assumes the LBO occurs. In fact, the LBO occurred on January 29, 1980. For simplicity, the impact of the one extra month is ignored in the presentation. Note that the 1979 year-end Income Statement does not change since the LBO happened after the end of the year.
Tables 18A.4 and 18A.5 project Congoleum's Income Statements and Balance Sheets from 1980 to 1984, assuming the LBO occurs.
TABLE 18A.3 Congoleum Pro Forma Balance Sheet before and after the LBO
| ($000s) | Without LBO 12/31/1979 | With LBO 12/31/1979 | |
| Cash and marketable securities | 85,857 | plug | (2,343) |
| Receivables | 70,309 | no change | 70,309 |
| Inventory | 83,092 | no change | 83,092 |
| Other current assets | 3,511 | no change | 3,511 |
| Current assets | 242,769 | 154,569 | |
| Net property, plant, and equipment | 70,777 | + adjustment 71,806 | 142,583 |
| Intangibles and patents | 31,770 | + adjustment 174,000 | 205,770 |
| Total assets | 345,316 | 502,922 | |
| Bank debt | 0 | + bank debt 125,000 | 125,000 |
| Accounts payable | 44,742 | no change | 44,742 |
| Other current liabilities | 68,359 | no change | 68,359 |
| Current liabilities | 113,101 | 238,101 | |
| Long-term debt | 0 | + new notes 203,400 | 203,400 |
| Other long-term liabilities | 10,221 | no change | 10,221 |
| Total liabilities | 123,322 | 451,722 | |
| Contributed capital | 16,256 | reset to 51.2 | 51,200 |
| Retained earnings | 205,738 | reset to 0 | 0 |
| Total equity | 221,994 | 51,200 | |
| Total liabilities and equity | 345,316 | 502,922 |
TABLE 18A.4 Congoleum Pro Forma Income Statements after the LBO
| ($000s) | 1980 | 1981 | 1982 | 1983 | 1984 |
| Total revenue | 709,480 | 787,523 | 874,150 | 970,306 | 1,077,041 |
| Cost of sales | 475,352 | 527,640 | 585,681 | 650,105 | 721,617 |
| Selling and general expenses | 176,782 | 191,611 | 208,069 | 226,339 | 246,619 |
| Operating profit (EBIT) | 57,346 | 68,272 | 80,400 | 93,862 | 108,805 |
| Interest expense | 41,608 | 38,244 | 32,697 | 26,086 | 18,950 |
| Profit before tax | 15,738 | 30,028 | 47,703 | 67,776 | 89,855 |
| Income tax | 7,554 | 14,414 | 22,897 | 32,533 | 43,130 |
| Net income | 8,184 | 15,614 | 24,806 | 35,243 | 46,725 |
TABLE 18A.5 Congoleum Pro Forma Balance Sheets after the LBO
| ($000s) | 1980 | 1981 | 1982 | 1983 | 1984 |
| Cash | 10,642 | 11,813 | 13,112 | 14,554 | 16,156 |
| Receivables | 78,043 | 86,627 | 96,157 | 106,734 | 118,474 |
| Inventory | 92,232 | 102,378 | 113,639 | 126,140 | 140,015 |
| Other current assets | 3,511 | 3,511 | 3,511 | 3,511 | 3,511 |
| Current assets | 184,428 | 204,329 | 226,419 | 247,939 | 278,156 |
| Net property plant & equipment | 135,402 | 128,221 | 121,040 | 113,859 | 106,678 |
| Intangibles | 170,970 | 136,170 | 101,370 | 66,570 | 31,770 |
| Total assets | 490,800 | 468,720 | 448,829 | 431,368 | 416,604 |
| Bank debt | 103,310 | 63,689 | 16,466 | — | — |
| Accounts payable | 49,663 | 55,127 | 61,190 | 67,922 | 75,393 |
| Other current liabilities | 68,359 | 68,359 | 68,359 | 68,359 | 68,359 |
| Current liabilities | 221,332 | 187,175 | 146,015 | 136,281 | 143,752 |
| Long-term debt | 203,400 | 203,400 | 203,400 | 163,967 | 98,544 |
| Other long-term liabilities | 10,221 | 10,221 | 10,221 | 10,221 | 10,221 |
| Total liabilities | 434,953 | 400,796 | 359,636 | 310,469 | 252,517 |
| Preferred stock | 51,200 | 51,200 | 51,200 | 51,200 | 51,200 |
| Common equity (CS & R//E)25 | 4,647 | 16,724 | 37,993 | 69,999 | 112,887 |
| Total equity | 55,847 | 67,924 | 89,193 | 120,899 | 164,087 |
| Total liabilities and equity | 490,800 | 468,720 | 448,829 | 431,368 | 416,604 |
Table 18A.3 (which shows how Congoleum's Balance Sheet might have appeared in 1979 with the LBO) is generated using the pro forma 1979 Balance Sheet in Table 18A.2 (which shows how Congoleum might have appeared in 1979 without the LBO). Table 18A.3 is then adjusted for the changes due to the LBO (e.g., with changes in value due to the LBO). Note that there is no change in the 1979 Income Statement as the LBO occurs after year-end and thereby has no effect on income until 1980. The key changes are:
| To restate the preceding paragraph: | (millions) | |
| Cash paid for Congoleum (Table 18.3) | $467.8 | |
| Pro forma total assets 12/31/1979 | $345.3 | |
| Pro forma total liabilities 12/31/1979 | $123.3 | |
| Net book value 12/31/1979 | $222.0 | |
| Purchase price discrepancy | $245.8 | |
| Allocated to patents (appraisal) | $174.0 | |
| Allocated to PP&E | $ 71.8 | $245.8 |
We are now able to generate Congoleum's pro forma Income Statements and Balance Sheets with the LBO. We will use many of the assumptions in Tables 18A.1 and 18A.2 as well as the changes noted in Table 18A.3.
The pro forma Income Statements (Table 18A.4) are generated using the following assumptions:
| Yearly additionally depreciation on PP&E | $ 71.8/10 | $ 7.18 |
| Yearly additional amortization on patents | $174.0/5 | $34.80 |
| Total increase in depreciation and amortization | $41.98 |
The pro forma Balance Sheets (Table 18A.5) are generated using the following assumptions:
Thus, Tables through help generate Tables 18A.4 and 18A.5. These in turn generate Table 18.8 in the chapter.
January 8, 1980
Dear Sirs,
In connection with the proposed acquisition of Congoleum Corporation (“Congoleum”) by a group of private investors organized by The First Boston Corporation (“First Boston”), you have requested our opinion on the fairness of the $38 cash per share proposal to be paid to the stockholders of Congoleum. The acquisition will be effected by the sale of substantially all the assets of Congoleum (with the exception of cash and equivalents to be retained by Congoleum as described in the Proxy Statement, as defined below), subject to substantially all the liabilities of Congoleum, to a privately held company formed to acquire Congoleum. The stockholders of Congoleum will be paid a liquidating distribution of $38 per share from the proceeds of the sale and the cash items retained by Congoleum, and Congoleum will be dissolved (all of the foregoing transactions being referred to herein as the “Transactions”).
In arriving at our opinion we have, among other things:
We have assumed, without independent verification, the accuracy and completeness of the information in the Proxy Statement, other publicly available information and information provided to us by Congoleum and Fibic.
Based upon our analysis of the foregoing and upon such other factors as we deem relevant including our assessment of general economic, market and monetary conditions…we are of the opinion that the $38 cash per share to be paid as a liquidating distribution is fair to the stockholders of Congoleum from a financial point of view.
Yours very truly,
Lazard Frères & Co.
In addition to the letter above, the proxy statement notes (in a memorandum Lazard gave to the Board) that Lazard: “explored with fifteen companies that it regarded as prospective buyers the possible purchase of Congoleum and/or any of its major divisions and found that none of them was interested in any such purchase … that only one outside source had contacted it expressing possible interest in acquiring Congoleum, but that source did not actively pursue the matter… . made a valuation of Congoleum's three business units as if they were “free standing companies.” Based upon this method of valuation, the range of values of Congoleum as a whole included a low of approximately $430,000,000 ($35 per share) and a high of approximately $479,000,000 ($39 per share), with a mid-point of the derived range being approximately $455,000,000 ($37 per share). These values were before any expenses… .”