1. THEORY
1.1. O VERVIEW OF LEVERAGED BUYOUTS
As the subject of my thesis is much more oriented on the business then academics and scholars I would like to introduce its reader in this part of the thesis to basic terms and history of Leveraged buyouts (“LBO”). Terminology explained will be further used in following parts, especially in analysis and no much of it will be explained so thoroughly as in here.
In a typical leveraged buyout transaction (shortly “buyout”) “borrowed funds are used to pay for all or most of the purchase price”2. Percentage of this debt financing depends on; (i) industry of the firm which is being taken over, (ii) availability of the fund of the acquirer including both his funds and his ability to borrow funds and (iii) state of the financial market and economy. Risk aversion of the financial markets, i.e. funds providers, can change significantly over period of time. For example in early years of LBOs transaction with 90 or more percent external financing were not sporadic. State of the economy significantly affects ability to raise funds on capital markets as well.
During the years / periods of booming economies risk premium decreases and thus the mergers and acquisition markets (“M&A”) thrive. Perfect example confirming such statement is 2006 which was the biggest year for M&A and surpassed the tech boom years of 1999 and 20003. Trends concerning development of the M&A market will be provided in the second part of the thesis.
Financial investors
Buyers side of the transactions are usually represented by various types of financial investors with aim to resale the acquired company in due time for higher-than-purchase-price price. Due time means either after expiration of tax brakes and leverage effects or developing company business model and adding value via improvement of market share, effectiveness etc. This can happen in range of several months to several years, therefore short- to medium-term period. Example confirming that several month ownership could be sufficient for financial investor is investment of Pamplona Capital Partners into Pegas, a.s. and its initial public offering (“IPO”) on Prague Stock
2 DePamphilis (2003)
3 Saigol and Politi (21 December 2006)
Exchange in December 2006. We should not forget that IPO was not for entire share capital and Pamplona still holds certain share.
Financial investors should be distinguished from strategic investors as these have significantly different objectives and expectations regarding the transaction. Strategic investors mostly do not use such a high leverage and their aims are for long-term. In transactions they usually seek entry to new market, improvement of their market position (e.g. purchase of Karneval by UPC from MidEuropa Partners) and synergy effects from horizontal or vertical supply chains incorporation. Instead of developing company and “adding value” to it, strategic investors look for mature targets which can be swiftly included into their organization.
Financial investor can be represented either by private equity firm as seen in the above mentioned example and more thoroughly described in second subchapter of the thesis, management of the company, which is the case of so called management buyout (“MBO”). In this case management and / or executives of a company will acquire, usually with the backing (means financing or co-investing) of private equity firms, controlling interest in a company from existing shareholders, because they believe in the company’s future profit generating potential. Other examples of financial investors are wealthy individuals or investment banks. Into the former group belong individuals who invest their personal wealth into the company with great potential to grow when financing for such company in any other form is either not possible or too expensive.
Venture capitalists use either direct investment into the share capital or financing via loan (mostly subordinated). They are called “angel investors” and usually invest into small start up companies.
Later group of investment banks taking interest in companies is fairly recent development as usually such institutions fulfill role of buy- or sell-side advisors. In order to increase their returns investment banks in recent years switched from strictly advising and capital raising role towards equity. In Central Europe this trend is represented by KBC Private Equity, a KBC Group member who provides deal financing and also invests into targets it finds suitable. Globally, Goldman Sachs sets trends and pace not only in advisory services but also in switch to ownership instead of advisory-only firm.
Structure of the transactions
Targets, i.e. companies subject to LBO transaction are of various kinds, industries and sizes. Here in Central and Eastern European market which will be of our prime concern, deals can be really small and start at EUR 3m purchase price but can reach up to billions of euros. There are several ways how to approach LBO transaction.
Besides straight acquisition by financial investor from former owner there can be various ways of purchase of company’s equity. For example divestments are used by conglomerates in order to get rid of themselves of their non-core or unprofitable businesses. Especially companies fighting back to profitability strip themselves of their subsidiaries offering and facilitating sales of their core products. A situation experienced by US car manufacturers when they sold their leasing companies.
Another way to enter target company is so called management buy-in (“MBI”). In this situation “outside manager or management team purchases an ownership stake in the first company and replaces the existing management team.”4 Such way is used when company is apparently undervalued or has poor management team and new management feels confident to turn things around.
Not very often used acquisition method is carve out, as certain assets or part of selling company is excluded from the balance sheet and subsequently sold to buyer. Strategic investors prefer this method using it to expand their current businesses as they are interested in long-term effects. Financial investors looking for immediate cash generation in order to service their debt are not interested. Carve outs were more popular in 1970’s and 1980’s as sales of assets were deemed tax free5.
Last but certainly not least used way of acquisition of target is “taking private”. Mature capital markets offer plenty of opportunities for private equity firms to add to their portfolios publicly traded companies and delist them in order to increase their value.
Trend of publicly traded companies going private was prominent in 2006 when markets experienced some of the biggest deals in its history. Here in Central and Eastern Europe going private transactions are caused by undervaluation of listed companies as underdeveloped capital markets value stocks improperly (at least in eyes of financial investors).
4 Investopedia (www.investopedia.com)
5 DePamphilis (2003), chapter 11
Main timeline of buyout transactions is shown in Appendix of the thesis. Please bear in mind that this is only rough outline and buyouts can vary significantly. After feasibility assessment of each buyout, business plan has to be outlined in order to set goals and prepare for challenges. Tax structuring together with financial structuring are of utmost importance in LBO transactions as it is in this phase decided what amount of own funds will be used and what amount of outside financing will have to be raised in next stage.
Vendor negotiations are long and slow process as private equity investors need great detail of information in order to perform successful buyout with satisfying exit value.
These negotiations are conduct under exclusivity basis in difference to most of the M&A transactions which are run in auction processes today (see below). They do not want to find any skeletons in the closet. Last three stages are basically winding up stages when main terms are agreed and legal documents need to be drawn and project should be operated until deals closing.
Financing of the transactions
Financial investors have plenty of options of financing the deals they intend to conduct. Between the most common belong6:
i. Financing of the deal via cash held by the target in excess of normal level of working capital required7. Method liked by risk adverse buyers.
ii. Venture capital loan and financing, but as stated above venture capitalist might also require becoming an investor and thus buyers might end up with significantly lower interest in the company.
iii. Swap for the buyer’s stocks, which is only possible if buyer is publicly traded company which is very uncommon in LBOs as the buyers are mostly private equity funds, privately held companies or the deal is an MBO. Mechanism is rather used in mergers or acquisitions of companies which is intended to last longer than few years.
iv. Public long-term debt issue, but this puts significant restriction on the company and the way it’s being operated (disclosure requirements by regulatory body or capital market). Such form of financing is used only in the large deals as public debt issue is the most expensive way in terms of administrative, marketing, regulatory reporting costs. As most of such debt is rated as junk bonds instead
6 see DePamphilis (2003), chapter 11
7 please refer to second subchapter for more details on working capital topic.
and below investment grade bonds we should not be surprised to see investors looking at alternative ways of financing.
v. Loan financing is the most common way of financing the transaction (by number of transactions financed) and as this includes various types of loans we will discuss them on following pages.
Loan financing can be differentiated on asset based lending and unsecured lending as two main categories. Asset based lending is based on borrower’s pledge certain assets as collaterals, upon which will lenders look as their primary protection against borrower’s default. Pledged assets are those of the target as the debt is as well provided for the target. Only in small transaction pledged asset can be those of the buyer.
Collateral can be not only fixed assets (both tangible and intangible) but also receivables and inventory as the assets which are liquidated easily8. Most liquid assets such as cash and cash equivalents are considered not suitable for collateral as they are needed for working capital purposes. Banks providing finance at emerging markets usually ask for blank promissory note as another way of securing repayment of provided loans. It is due to much easier forcibility of promissory notes at bankruptcy courts.
In order to protect repayment of the loans, finance providers also usually ask for covenants and provisions. Security provisions are put in place in such way that cash payment to borrower from special contracts are transferred or assigned to the lender if certain conditions apply. Most common are insurance payments assignment, mortgage on property, plant and equipment in possession of borrower and pledges of portions of receivables, inventories or securities held for sale. Default provisions and cross default provisions “are permitting the lender to collect the loan immediately under certain conditions”9 and if the borrower is in default on a loan to other lender (respectively).
Certain conditions in this case represent not meeting repayment schedule and / or misrepresentation of required information and / or breach of covenants.
8 Funds are not provided up to 100 % of balance sheet value of receivables and inventory. Only within due date receivables are considered as easily collectible and therefore available as collateral. As there are certain amounts that will not be collected even though they are within due date, discounts of 10-20 % on receivables book value can be applied. Regarding inventories, only raw materials and finished goods are considered as liquid and therefore work-in-progress is not used for collateral purposes as well. See DePamphilis (2003), chapter 11
9 DePamphilis (2003)
Covenants are in fact “an agreement by a borrower which is legally binding upon borrower over the life of an issue or loan to perform certain acts or to refrain from certain acts”10. Affirmative covenants (maintenance based) are specifying actions of the borrower during the term of the loan. This can mean providing information to the lender, putting in place “proper” insurance, maintaining certain ratios above or below certain levels (interest cover, working capital, EBITDA margin etc.). Negative covenants (incurrence based) limit the actions of the borrower. Restrictions are usually put on dividend payments, bonuses and remuneration of the executives and management, use of provided funds only for stated purposes, restriction of borrower’s gearing etc. Lenders might also require their approval for drawing of funds.
Secured bonds are issued in form of mortgage bonds or equipment trust certificates.11 But this is not common form of deal financing and therefore it would not be further discussed.
Unsecured lending or mezzanine financing is much more common in transactions which require great amounts of capital and asset based lending would be administratively too demanding and costly but public debt issue is not viable option (either due to capital market conditions or size of transaction). To compensate no security such debt bears higher interest rates and usually offer warrant or option that is convertible into equity at certain date. Position of mezzanine financing is shown on Graph 1. It is placed somewhere between debt financing and equity of the target.
Besides distinguishing between unsecured and secured debt we should take into account seniority of loans in liquidation. Certain loans can be junior to others which basically mean that they are repayable upon settling of other loans (senior to them) from assets and earnings of the company in case of company’s default. Loans repayable only upon repayment of certain loans are subordinated to such loans.
Mezzanine financing is provided by specialized financial investors or private equity firms and fulfills gap between commercial banks and equity holders as mean of financing acquisition. Especially options and warrants are interesting for the private equity firms which can gain through them significant portion of company’s share capital.
10 Bloomberg definition
11 DePamphilis (2003)
Graph 1: Providers of financing
Expected return
Risk Debt
Mezzanine financing
Equity
Senior debt
(Subordinated) loan
(Subordinated) loan with variable (Subordinated) loan with equity-link
Automatic convertible loan
Common shares Preferred shares
Commercial banks
Private equity
Securred loans
Between other sources of finance for LBO we can include promissory notes held by seller and equity types of financing. Promissory notes are held by sellers in amount of certain portion of purchase price in cases when buyer is unable to raise sufficient capital and / or is unwilling to increase equity of target. Even though, this is rare option for both sides to take. Preferred shares issue is more understandable as this not dilute voting rights but preferred shares are shown in the equity of the target and thus do not affect gearing. Please note that preferred stocks are due to their characteristics considered as fixed income security. Dividends paid are usually constant and in case of liquidation preferred stocks claims are senior to common stocks but junior to bondholders’ claims.
Pros vs Cons
From the above stated we can now draw main conclusions about advantages and dangers of LBOs. Main advantages of LBO transactions are seen in12:
i. Low capital and cash requirement for the acquiring entity.
ii. Synergy gains by expanding operations into new industries and business.
Especially in case of private equity led LBO.
12 As mentioned at ValueBasedManagement.net
iii. Efficiency gains by divesting its non-core businesses and thus getting rid of value-destroying effects.
iv. Improvement of management as LBO replaces threats introduced by principal-agent theory, either by replacement of management team or disciplining them.
Large debt service requirements as well as repayments of principal force managers to increase efficiency of operations and overall performance. It creates further pressure by stressing importance of outstanding performance of the target.
v. Leverage effect enables private equity firms to purchase companies by putting up 20-40 percent of total purchase price. Bottom line of this is possibility of ever bigger transactions and acquisitions of world recognized brands by private equity firms (Pizza Hut??, Toys R Us, etc.).
vi. Revaluation of companies is in place when stock market does not evaluate properly shares of the target and financial investor feels confident that taking it private would enable him to gain significant returns upon exit. This is the case of immature markets as well as the case of depressed capital markets.
vii. Liquidity of capital markets is increased by IPO which is favorite exit techniques by private equity investors. Most obvious effect is seen in Central and Eastern Europe where only dozens of stocks are traded regularly. Any new IPO has then serious impact on traded values which can double from day to day13.
After explaining some of the main advantages we should also point out dangers LBO transactions can cause. These are14:
i. Main concern of the critics is the fact that LBO buyers are squeezing cash flows from operations of the target by expropriating the wealth from third parties.
Wealth is taken from governments (by paying lower taxes as interest payments are tax deductible while dividends are not).
ii. Risk of financial distress associated with LBO is much higher than in transactions financed via cash. Not meeting covenants, sudden recession, changes in regulatory environment and others can disrupt ability of the company
13 Prague Stock Exchange monthly statistics (2006)
14 DePamphilis (2003)
to stick with its repayment schedule and thus ultimately force her into liquidation.
iii. Return driven private equity firms are merciless cost cutters as they do not hesitate to shed long established brands and close factories. All in order to increase profit margins and effectiveness of the companies.
iv. In order to extract as much money as it is possible from companies, private equity firms are charging exorbitant management fees for their services provided to the company or use remuneration schemes greatly exceeding industry averages in order to pay top management of its portfolio companies in order to motivate them.
v. We should not omit the fact that some of financial investors stop operations of the company they think is beyond help or its assets sold separately would bring higher return on investment then continuing of its operations. Due to this fact, financial investors in 1970’s and 1980’s have become known as “corporate raiders” and later after dotcom bubble burst as “vulture capitalists”.
History of LBOs
History of LBOs dates back into 1970s when first highly leveraged transactions appeared. As conglomerates assembled during boom years of 1960s begin to divest their portfolio companies struggling in sloppy economy, investors in order to be able to pay for such divestments used debt financing. Most of such transactions went through as asset based. Soon after, assets were not sufficient as collateral as service companies become on sale and financial investors were able to attract funding in sufficient amount to pay high premiums to companies shareholders. Thus classic unsecured debt financing had to be introduced.
Together with this development emerged financial investor on scene. He did not focus solely on one company but amazed portfolio of companies from different industries and was not interested in their long-term development but in its sale in short to medium
Together with this development emerged financial investor on scene. He did not focus solely on one company but amazed portfolio of companies from different industries and was not interested in their long-term development but in its sale in short to medium