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University of Economics in Prague Faculty of Finance and Accounting

Major: Finance

L EVERAGED B UYOUTS IN C ENTRAL E UROPE AND B EYOND

diploma thesis

Author: Vladimír Halás

Diploma counselor: Doc. Ing. Petr Dvo ř ák, Ph.D.

Year: 2007

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I hereby declare that I wrote this diploma thesis independently and cited all literature I have used.

Vladimír Halás

In Prague, 14 January 2007

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Acknowledgement

I would like to thank Doc. Ing. Petr Dvorak PhD. for his patience he showed during my attempts to finish this thesis. Without his kind approach I would not be able to succeed.

My gratitude also belongs to my Deloitte colleagues, especially to Mila Lukes and Martin Iltis as they were not only willing to help but also provided me with plenty of information which I incorporated into the thesis.

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To mama and oco.

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Abstract

Paper concentrates on issues regarding Leveraged Buyout transactions. It briefly depicts most common structure of transactions and means of financing.

Substantial space is dedicated to two main participants on leveraged buyouts;

investment banks and private equity funds. Instead on focusing on thoroughly described financing of the acquisition via secured bank loans we dedicate space in the thesis to mezzanine finance and high yield bonds. Second part of the thesis analysis latest development in the two main and most active regions regarding mergers and acquisition activity (Europe and USA) and compares Central Europe with it. Although capital markets developed substantially over past decades they are still lagging significantly former.

JEL Classification: G240; G340; G150

Abstrakt

Tato práce se zaměřuje na problémy spojeny s dluhovým financováním transakcí. Zevrubně popisuje nejběžnější strukturu transakce a jejího financování. Podstatná část práce je věnovaná dvěma nejdůležitějším aktérům procesu dluhových transakcí a to; investičním bankám a fondům soukromého kapitálu. Místo zaměření se na již podrobně popsané financování transakce zajištěnýma bankovními půjčkami, vyhrazujeme místo pro „mezaninové“

financováni a vysoce úročené dluhopisy. Druhá část této práce bude věnovaná analýze trendů ve dvou nejaktivnějších regionech co se týče fúzí a akvizic (Evropa a USA) a jejich srovnání s regionem střední Evropy. I když se kapitálové trhy podstatně změnily stále ještě nedosahují úrovně těch dříve jmenovaných.

JEL Klasifikace: G240; G340; G150

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Content

INTRODUCTION... 6

1. THEORY... 9

1.1. OVERVIEW OF LEVERAGED BUYOUTS... 9

Financial investors ... 9

Structure of the transactions ... 11

Financing of the transactions... 12

Pros vs Cons ... 15

History of LBOs... 17

1.2. INVESTMENT BANKS AND ADVISORS... 19

Transaction process ... 20

High Yield ... 23

Moral hazard and adverse selection problem ... 28

1.3. PRIVATE EQUITY... 30

Mezzanine financing... 32

Adding value ... 34

2. ANALYSIS ... 38

2.1. GLOBAL LBO TRENDS... 38

Deals and targets... 38

European deal financing trends ... 44

Other trends... 53

2.2. CENTRAL EUROPEAN MARKET... 55

CONCLUSION... 63

REFERENCES ... 66

APPENDIX ... 69

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Abbreviations

bn billion

CAPEX Capital Expenditure

CDO Collateralized Debt Obligation

EUR Euro

Fitch Fitch Ratings; Fitch IBCA etc.

FT Financial Times

HY High Yield

IPO Initial Public Offering ING ING Barrings; ING Bank etc.

IRR Internal Rate of Return LBO Leveraged Buyouts

m Million

M&A Mergers and Acquisitions MBO Management Buyout MBI Management Buy-in USD US dollars

NPV Net Present Value

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Introduction

Leveraged buyouts are important part of today’s financial market. In year 2006 they accounted for almost 20 percent of all mergers and acquisition activities globally and therefore we should not neglect them in our considerations. Their increasing presence should be noted and we should get ready for their rise in our Central European region.

Leveraged buyout transactions are characterized by high usage of debt (up to 90 percent of purchase price) to finance takeover of the target company. They are used mostly by private equity firms which are able to purchase multibillion dollar companies with considerably low capital of their own.

Although relatively young financial instrument, in short time since their introduction in 1970s they gained on importance and size. During the years leveraged buyouts experienced turbulent development (similar to transactions) and become more sophisticated as well as demanding in every aspect. Their development is similar that of mergers and acquisition which is correlated with economic cycles.

Rise of leverage buyouts and buyout funds can be explained by several reasons such as insufficiency of asset based financing and its inappropriateness in service based deals, boom of high yield bonds and ability of financial investors to pay higher premiums on shares and further by prosperous economy of 1990s.

In the thesis I would like to compare development and situation on both major mergers and acquisitions markets (being USA and Europe). Further more I would like to discuss trends on those markets and establish their pattern for next two years if possible. Europe will be considered as direct competitor to USA because of size of the market. Comparison of smaller units would not be appropriate as trends seen in those units are based on local characteristics. In my analysis I would not comment extensively on Asia and its development as it is market significantly smaller than those above mentioned and information regarding this market are not available in sufficient amount for thorough analyses.

Main question I would like to ask in my thesis is whether Central Europe after more than 17 years of free market development is relevant market for leveraged buyout transaction. I would like to analyze trends and developments it went through and find answer to question what can be expected further on. Main focus will be on comparison

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of trends in mature markets of USA and Europe with trends at Central European market. Each trend will be analyzed and at least one example will be described extensively according to information available.

Structure of the thesis will be similar to those of transaction. During reading of it reader should gain understanding of leveraged buyout process from inception of the transaction till its end. Exit strategies of the leveraged buyout transactions are discussed very briefly as leveraged buyouts are usually refinanced and recapitalized during its lifetime or effects of leverage are diminished (as debt is repaid) by the time exit strategy is chosen.

First chapter is divided into three sections, first of which is introductory section. This is done so in order to get reader accustomed with terminology and language used in following parts of the thesis as well as get him familiar with structure of sources of capital of the company. Throughout the first chapter we will try to describe history of LBOs and particular areas of it, meaning history from the beginning up to year 2000.

Developments of M&A markets in new century will be described in second chapter.

Purchase price in typical leveraged buyout transactions is financed through bank debt (approximately 50 percent), high yield bonds issue (approximately 10 percent), mezzanine financing from subordinated debt (10 percent usually) and equity covering the rest of the purchase price (up to 30 percent)1. In smaller deals several other means of finance can be used. Mezzanine financing and subordinated debts are described in the following subchapters.

These subchapters are dedicated to two main participants of the leveraged buyout.

Investment banks, which represent source of finance (high yield bonds) and advisory, play major role during leveraged buyout. Subchapter dedicated to private equity is besides mezzanine financing describing ways private equity houses are using in order to develop their portfolio companies and thus concentrates on post acquisition period.

Second chapter of the thesis will be also divided into subchapters. First global look at the mergers and acquisitions market as well as leveraged buyout portion of it will be provided. Subsequent analysis of trends in Central European leveraged buyout market will follow.

1 Blaydon and Wainwright (29 September 2006)

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Information used in this thesis is based mostly on internal documents of companies involved in the leveraged buyout transactions. Literature regarding leveraged buyouts is hard to find and almost not present in Czech Republic. Therefore we had to rely mainly on few papers written on the topic and on statistics from internet sources and newspapers.

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1. Theory

1.1. Overview 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)

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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.

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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

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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.

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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)

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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)

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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

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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)

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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 term. To illustrate its position and intentions we would draw your attention to example of car industry. Car manufacturers purchase car parts from suppliers who produce them from raw materials (add value to them in form of their work). Car manufacturers would then use these parts and assemble car of it on assembly line. Strategic investors would represent car manufacturer as they purchase companies and include them into

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their organization. Financial investors would add value to raw materials (e.g. venture capitalists) or semi finished goods and then sale it to strategic investors or other financial investor in “secondary buyout”.

In 1980s were obvious two notable circumstances. First junk bond market experienced huge boom and in the second half of the decade new ways to finance the transactions emerged (e.g. LBO funds and mezzanine financing).

Bonds rated below investment grade (Ba and lower by Moody’s and BB or lower by S&P) or not graded at all, emerged as very popular way to finance at least portion of purchase price. These bonds are called either High Yield (“HY”) or junk bonds, depending on investor’s aversion to risk. During first half of the decade junk bonds share on issue of all publicly traded corporate bonds rose from 3-4 percent up to 14 percent15. Downward turn came in the second half of the decade as several overleveraged companies defaulted and scandals hitting investors, traders and market makers and downturn of the economy at the beginning of 1990s. This corresponds with peaks in junk bonds default rates around 10 percent and their subsequent stabilization at 2 percent level during 1990s.

Emergence of mezzanine financing and LBO funds filled gap after crash of junk bonds market at the end of 1980s. LBO funds are established by financial investor into which institutional investors insert their funds. Institutional investors represent insurance companies, pension funds, today also universities etc. Theirs funds are then used for provision of secured or unsecured debt but as this was already discussed we will not elaborate more on the topic.

1990s saw more conservative approach to LBO transactions as market sobered up after heavy partying on junk bonds. With ever-growing stock markets financial investors found new ways to repay loans taken and to earn some money. IPO became very popular exit strategy. Initial public offer was firstly used to repay debt and after several months or year secondary stock offerings were used to dilute financial investors share on equity. Different approach was to ride the globalization wave and consolidate several companies in different countries into one and than sale it via IPO or to the strategic investor.

15 DePamphilis (2003)

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As we summarized briefly history of LBO transactions we turn our attention to present and future of this part of M&A market. In second section of diploma thesis we will examine trends and developments of LBO transactions from approximately 2000. But first on the following pages we will describe role of two main participants on LBO transactions; private equity firms and advisors.

1.2. Investment banks and advisors

Second part of this chapter of the thesis will be dedicated to description of investment banks and their role in transactions. In order to do so we will focus on transaction process as such and role of other advisors in it. We will elaborate also on theory of moral hazard and adverse selection theory as they are main reason for usage of advisory services by buyers. Investment banks in their strictest definition are institutions raising funds for their clients both in debt and equity. In accordance with this definition we will dedicate part of this subchapter to High Yield bonds – an investment banks specialty.

On the other hand today due to their expansion into other areas of finance, investment banks are providing also services of M&A advisory, corporate finance, trading of fixed income, commodity, foreign exchange and equity securities. With repeal of barriers imposed by Glass-Steagall Act and subsequent Banking Act in 1932 and 1933 (respectively) by Gramm-Leach-Bliley Act from 1999 we can see them entering other areas of banking and introduction of new service lines (e.g. private banking offered by Morgan Stanley etc.). With their role in securities trading diversified they become known as “sell side” to the contrary of “buy side” represented today by institutional investors (insurance companies, pension funds, mutual funds etc.).

Advisory roles are more important for non-private equity M&As. In such transactions investment banks can stand on either of sides (buyer as well as seller) and are responsible for facilitation of transaction process, coordination of advisory teams, evaluation and sales and purchase agreement negotiation. Very often, especially in Central and Eastern Europe region, investment banks are used as privatization advisors of governments. This is done mostly due to their experience with transactions, emerging countries governments’ (eventually national property funds’) desire to increase credibility of the privatization process and to woe investors who would not consider their participation otherwise.

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Transaction process

In order to show investment bankers involvement and role we will now describe stages of transaction of typical two round transaction process. Length and number of stages of transactions depend on its size, structure, sophistication, number of participants etc.

Besides our example transaction can be conducted as a one round process, direct acquisition, takeover (hostile or friendly), merger, carve out of assets etc. Roles and activities of advisors depend on structure of transaction process. For purpose of our thesis we will focus solely on buy side advisory activities as sell side is not imminently involved in LBO transactions as we look at it.

Graph 2: Two round transaction process and roles of advisors

- appointment by the buyer

- negotiation with seller

- submitting indicative offer on behalf of buyer

- appointment of other advisors - appointment by the lead advisor

- facilitation of information flow - performance of due diligence

- preparation of valuation model

- information for valuation model - valuation of the target

- presentation of findings to lead advisor and buyer - submitting binding bid on behalf of buyer

- negotiation with seller and its advisors

- preparation of sales and purchase agreement

- optimal tax set up for the transaction - closing of the transaction

Investment bank - lead advisor Transaction Other advisors

Final bidder Binding bids Selected bidders Non-binding bids Initial bidders Information memorandum

After appointment by the buyer as official transaction lead advisor (appointed, in most of the cases, based on selection process with main criteria the proposed fees), he is responsible for early negotiation with seller and submission of initial bids. At this stage prime goal is to stay competitive and to be selected for second round.

Upon commencement of second round lead advisor after consultations with buyer appoints other advisors who will be responsible for information gathering and due diligence reviews. Due diligence is a process of finding and providing information for

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investment decision16. The number of advisors performing respective due diligence reviews depends on capacity of lead advisor and needs of buyer. In some cases only simple financial due diligence would suffice. In other transactions all possible reviews will be necessary.

In order to perform due diligence properly advisors need access to information. These are made available in the “data-room” which can be defined as a place at which information regarding target are stored. Information can be stored in hard copies in particular room (either at premises of target company or at third party premises or at premises of sellers advisor) or in electronic form (e.g. dvd, server etc.) or simply given away buy sellers to the buyers. Most common form of the data-room is combination of the above stated possibilities. In bilateral transactions so called full access is given to the buyer, which enables him to meet target’s management, auditors and so on. The most difficult access to information is in case of hostile take over attempt. There is no willing seller and therefore company has to use extraordinary measures in order to get access to information.

At this point lead advisor (investment bank) is responsible for coordination of advisory teams, proper distribution of information provided and management of data flow between both transaction sides. It is usually him who communicates with opposing side during the access to the data room and takes care that all questions and request are properly answered.

There are significantly different due diligence reviews which can be conduct by advisors of the buyer or by buyer himself (only if he has capacities to do so) such as:

i. Financial due diligence, which is performed in order to find all potential and present threats to operations of the company from financial point of view. In particular it looks on trends in margins, sales, working capital trends, commitment of future CAPEX, and sources of funds for the company etc.

ii. Tax due diligence aims to eliminate issues affecting investment decision on tax side (e.g. unpaid taxes, transfer pricing etc.)

iii. Commercial due diligence has goal to map past and present state of market for company’s products and services as well as company’s share on it. If possible and information make it available it also should dedicate some time to analysis

16 Deloitte (2006a)

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of trends and future developments of market. Main concern of this review process is not on the company but on the market on which company operates.

An analysis focuses on competitors, key products and distribution channels, main customers (their concentration) and quality of the management (via benchmarking).

iv. Environmental due diligence looks at operations of the company and their compliance with safety and environmental regulations. It aims to eliminate any possible contingencies arising due to environmental contamination and focuses on investments needed to comply with present as well as eventually future legislation.

v. Technical due diligence concentrates on machinery and equipment capacity as well as their usage and remaining capacity / useful life and future need of CAPEX.

vi. IT due diligence pays attention to the development and operations of company’s information technology and software. Theirs reliability, simplicity of operation, cost (both cost of maintenance and upgrading) and last but not least quality of outputs.

vii. Legal due diligence which are together with financial due diligence the most important parts of due diligence process. It focuses on legal status of contracts, company’s incorporation etc.

Main conclusion and finding of due diligence have impact on; (i) valuation and deal model (if purchase price is based on multiples of EBITDA or EBIT any decrease or change in normal level of EBITDA alters price substantially), (ii) actions of the potential buyers (discovering a “deal breaker”), (iii) sales and purchase agreement preparation and negotiation (buyer can ask for indemnities), (iv) deal financing (previous loan agreements can exclude certain financing options)17.

Principally due diligence process is conducted in order to provide investors with as much information as possible for their investment decision. Information gathered and analyzed by due diligence advisory teams, are incorporated into valuation model upon which is based valuation of the target by bidder. Responsible for its preparation is lead

17 Deloitte (2006b)

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advisor who in post due diligence phase assumes biggest responsibility for successful conclusion of the transaction.

After submitting biding bid lead advisor prepares contract and negotiates its terms as well as purchase price mechanism with seller and his advisors. In order to increase his motivation advisory contracts put so called success fee options for lead advisors. They are triggered by successful negotiation and lowering of purchase price (on seller side is the situation exactly opposite). If the negotiations are successfully concluded, lead advisor usually assumes the role of provider of finance for buyer and attempts to negotiate best terms at the market. Of course we are now referring to normal two round bidding process but in most of the LBO cases buyer is gathering finances even prior to the acquisitions, as soon as he is granted exclusivity in negotiations. In hostile takeover situations no exclusivity is granted and therefore funds needs to be ready prior to any actions of buyer. Funds assembled are mostly via issue of high yield debt which is placed by investment banks acting on behalf of issuer.

Last stage of transaction process is deal tax structuring in order to obtain the most advantageous tax position.

High Yield

Although presence of High Yield bonds was very well established throughout US, Europe got to know them well only towards the end of twentieth century. Slow acceptance was due to different institutional composition of the financial markets as banks have dominant position over the capital market, opposite to US. As will be later showed, European HY developed into significantly diverse product from US HY. Main differences will be brought to lime light throughout the thesis.

As we already mentioned HY bonds are defined today as bonds rated bellow investment grade (BB+ or Ba1 and lower). Ratings are assigned usually by at least two rating agencies with dominant position of Moody’s and S&P. In order to achieve position as liquid as possible they are issued in US dollars or Euros as both currencies have the strongest positions in investors’ portfolios. To narrow the definition we can consider HI only those bonds rated BB or B grade (all sub-grades included) as bonds rated below those levels are one step from default (CCC rated bonds). Comparison of

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selected characteristics / rating criteria of bonds of companies rated in certain categories are shown in the table below.

Table 1: Rating criteria comparison Rating criteria

BBB BB B

Interest cover (EBITDA/interest cover) 6.3 3.9 2.3

Total debt / EBITDA 2.1 3.2 4.5

Total debt / Market capitalisation 27.9% 43.5% 55.0%

Sales (US m) 2082 731 276

Book equity (US m) 794 228 64

Assets (US m) 2230 824 374

High Yield

Source: ING (October 2001)

As we can observe requirements significantly loosen between BBB and BB rating categories. Besides those ratios and numbers, there are plenty other qualitative criteria taken into account while assigning rating (e.g. management and its quality, operating trends, shareholders etc.).

Volumes of issues are today only approximately above EUR 100m as below this level placement of bonds will be difficult and investors would not be interested (although in markets flooded by liquidity we can experience issues of lower amounts). Below EUR 100m are very rare in Europe but can be seen in US fairly often. This is due to unwillingness of companies to undergo bank financing as capital markets are much more effective sources of capital and have incomparably higher appetite. It should be also mentioned that low volume issues are difficult and illiquid for trading on secondary markets and thus not interesting for general investors.

Tenor is from seven years up, on average about 10 years. Of course longer issues of up to 16 years are also fairly common. To protect investors they have incorporated call protections which attributes to their dislike by private equity funds which desire to refinance loans of their portfolio firms as soon as possible after the deal in so called recapitalization or shortly recap. Further to this bonds can be called only at premium as compensation for shortening of investments18.

Fixed rate (defined as spread over benchmark) coupons still completely dominate today’s market and floating rate HY are especially in Europe very rare occasion with only around 2-3 percent of the global total volume outstanding and about 10 percent of

18 Usually half of the coupon. In Monaghan (November 2005)

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new issuance. HY floaters can be seen as attempt to blur the lines between HY and loans in order to cut of the loans slice of LBO market.

Main investors into HY are various mutual funds, pension funds, asset management funds, insurance companies and other financial institutions. As these are found mostly in US, issuers accommodate it with identical issues at US capital markets. Issuance under Security and Exchange Commission rules requires much more administrative work and incorporation of other issues (disclosure of risk factors in prospect or opinions from council and translation into US GAAP).

Approximate timeline of HY bond issue is in the Gantt chart below. As can be seen whole process is effective today with average length of 10-12 weeks. Investment bank acts as mandate representative on behalf of issuer with leading due diligence process, preparing presentation and running road show, ultimately printing prospectus and leading the issue.

Graph 3: Timeline of HY issue process

Mandate Weeks

Due diligence Offering circular Rating agencies Printing Roadshow

4 5 6 7

0 1 2 3 12

Pricing and closing 8 9 10 11

Source: ING (October 2001)

Due diligence is the same process as the one described earlier except that now it is concerned mainly with business, legal and accounting issues, therefore it consists only from financial, tax and legal due diligence usually. Throughout whole process abbreviated prospectus (offering circular) is distributed in order to rise awareness among potential investors about issue. Meetings with rating agencies are very important due to the fact that rating determines interest rates / coupons HY bond will bear. Investment bank advising on bonds issue fulfills usually role of rating advisor as

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well. As such she takes proactive approach to position the credit as near as possible o investment grade. Roadshow is basically when the bond is being sold. Issuer with his advisor (investment bank) is meeting with potential investors and is trying to “sell”

them HY. Printing means issue of “Red Herring” (preliminary prospectus filed with exchange commission regarding bonds offering) and later final prospectus for regulator and investors.

Depending of issued volume lead bank is also lead underwriter and thus it leads whole transaction. If there are other members of underwriting group they can participate on particular phase of the process as they see fit. On the other hand lead underwriter runs the book and controls allocation of the bonds according to book building exercise.

Investors can enter the process until the offering circular is printed.

There are two main characteristics followed with HY bonds. These are default and recovery rates of issuers and issues. Rates can significantly differ depending on industry issuer’s enterprise operates and are followed for these industries. In the thesis we will focus only on general rates as this is not in scope of the paper.

Default as defined by Moody’s includes three types of default event19:

i. missed or delayed disbursement of interest and / or principal, including delayed payments made within a grace period;

ii. an issuer filed for bankruptcy (e.g. Chapter 11 protection in US) or legal receivership occurs; or

iii. a distressed exchange occurs where; (i) the issuer offers bondholders a new security or package of securities that amount to a diminished financial obligation, or (ii) the exchange had the apparent purpose of helping the borrower avoid default.

Default as per definition is viewed of any action or circumstance putting lender into disadvantageous position and causing loss to him. Points (i) and (ii) are clear but point (iii) is based on subjective measures. It is in order to capture not only obvious but also defaults being hidden or masked by other actions but still causing substantial harm / loss to the lender.

Default and default rates are by rule of thumb cyclical events as they correlate with macroeconomic activity. Correlation is caused by increases and decreases of operating

19 Moody’s (February 2001)

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margins and cash flows during expansions and contractions (respectively). In 1960s change in lag-lead environment happened as default rate increases became leaders to downturns in economic activity20. Lead of default rates should not be viewed as cause of downturn but more as an indicator of it. It is much more likely that problems within economy are affecting the most levered companies first and only later they transform into GDP and industrial production statistics. Taking into account above mentioned and looking at this business cycle and ever increasing multiples (see later chapters) and leverage of companies, we should expect rise of default rate anytime soon (from 2007 onwards). Indicator of this can be downgrading trend by rating agencies.

Recovery rates of defaults are statistics measuring either; price of defaulted instrument upon attempt of investor to get out of it on secondary market or ability of investor to recover owed amount in bankruptcy proceedings. As second case depends more on administrative process and legal framework it is hard to measure (it takes too long).

Basically if we return to Graph 1: Providers of financing, we should envision downward sloping line of recovery rates from the highest point at secured debt portfolio to its lowest point at preferred stock. As usually collaterals are demanded in excess of loan / financing we should expect high recovery rate even though discounts are applied upon sale of pledged assets.

In order to ensure cash flow from bonds acquired, preserve the quality of the credit, ensure management actions and bondholders’ interests are in line, investors / lenders ask for covenant protection. Further more such protection is taken into account also by rating agencies (although it can not affect final rating). Covenants aim to protect and eliminate “potentially material deterioration in credit quality during the tenure of the bond”21. Their ability to do so strongly depends not only on regulatory issues (such as insolvency legislation, bankruptcy protection etc.) but also on extent of any contractual and / or structural subordination. There is no point in having strong covenant package while the debt is against holding company which does not have any recourse to operating assets or debt is of the most junior kind. Therefore it is wise to insert additional guarantees on such senior unsecured debt by operating companies of holding issuer.

Covenants used in HY bond issues are incurrence covenants which restrict actions of the management. Banks on the other hand require maintenance covenants to protect

20 Moody’s (February 2001)

21 Fitch (October 1999)

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their loans. These affirmative covenants would not be of greater use for HY issuers as they tend to be loss making (HY is issued in order to provide financing for restructuring besides LBO financing). From historical point of view we should underline that European HY market and thus covenants is an off-spring of US HY. As such it followed similar trend in loosening of covenants over past years. To the contrary although it adopted certain standardized package of covenants as in US covenants are still more tailored and differ from deal to deal.

Most commonly used covenants are22; (i) limitations of indebtedness (based upon debt to EBITDA ratio), (ii) limitations of indebtedness of subsidiaries, (iii) limitations on restricted payments (to prevent recapitalizations and payments to the benefits of junior bondholders), (iv) limitations on dividend and other payment restriction (in order to prevent negative effects of dividend pay outs on ability of company to repay its outstanding debt), (v) limits on sales of assets (protection of quality and quantity of assets), (vi) limits on sale and leaseback (to avoid sale of assets falling out of definition of previous one), (vii) limitation on creation of liens, (viii) change of control, (ix) provisions regarding M&A and transfers of assets (protecting bondholders positions pre and after merger and restructuring), (x) limitation of layering (preventing subordinated obligations from becoming senior to HY issue), (xi) limitations of transactions with affiliates (in order to avoid transfers of value within a group or related parties at the expense of bondholder), (xii) cross default and (xiii) information provision covenants were already mentioned earlier.

Moral hazard and adverse selection problem

Moral hazard was and still is insurance term and refers “to the generally well known empirical phenomenon that a group of persons which is insured against a certain risk tends to become victimized by the risk more often or more severely than a comparable group not insured”23. Discussion and development of this theory involved attempts of how to eliminate or diminish its effects and introduction of long-term contracts as in Lambert (1983). Stretching moral hazard into economic perspective, theory relates to willingness to riskier behavior of insured individuals or institutions as they are aware that they will be bailed out and do not have to bear losses resulting from their behavior.

Fit example is Czech banking industry in 1990s as banks lent money recklessly and

22 Fitch (October 1999)

23 Grubel (1971)

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eventually went into bankruptcy or nonperforming loans had to be transferred out of their portfolios at significant loss to the state. As this is extensively discussed in literature we will not elaborate more on it.

Theory of moral hazard introduced in Arrow (1963) can be observed in many aspects of transactions. Main concern of LBO and finance as general is not about riskier projects undertaken by the agent on behalf of principal24 but about lack of his action. As agents – management of the company – have different goals to those of owners (principals) discrepancies arise. Management as all employees tends to keep their position and increase their influence. In order to do so they tend to be ineffective in their decision making as they tend to hire more people in order to increase number of their subordinates and thus increase their influence. Also they are unwilling to undertake projects with higher Net Present Value (“NPV”) as they tend to be riskier. In case of failure of such projects management will be replaced.

LBO transactions eliminate this problem by creating pressure on increase of profitability (in order to repay debt interest and principal). Also it forces management to undertake projects with positive NPV. In order to eliminate effects and attempts of moral hazard behavior private equity funds use stock options as part of remuneration package to management of their portfolio companies. To ensure loyalty of management after LBO or to lure experience managers to work in their portfolio companies, private equity houses do not hesitate to offer ownership shares to them.

This technique is today used also by non LBO companies in order to keep top managers within the house (see exorbitant remuneration packages consisting of stock options in e.g. investment banking industry – GoldmanSachs paid its CEO USD 26.1m in stock options as part of USD 54m annual bonus for 2006 financial performance).

Another aspect of principal – agent relationship can be found between debtholders (principals) and shareholders (agents). In this case this behavior is underlining morality part of the phrase. As debtholders have disadvantage in regards of information about company performance shareholders can use their knowledge and deliberately extract money from the company and thus lead company into default. By replacing assets with more risky assets shareholders can further diminish value of debtholders receivables.

This process of replacement of assets or even their sale for much less was seen in

24 for more on principal – agent problem please refer to Alchian and Demsetz (1972), Sobel (1993)

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Czech Republic during the 1990s and was later named “tunneling”. Fortunately, it’s usage was eliminated by introduction of proper legislation, institutions and stricter screening of potential debtors.

Adverse selection problem was generalized in Akerlof (1970) and it describes situation of the market when “bad” decisions are made due to information asymmetries. These bad decisions are purchases of lemons or bad cars as mentioned in the article and eventually bad cars will drive out the good ones out from the market. Bad cars succeed in doing so due to the fact that good cars are kept by their owners who are unwilling to sell for approximately the same price as bad cars are being sold.

According to this in asymmetric information market can drive out good firms unless there is substantial difference in price paid (for two same size companies from same industry). In order to determine price and eliminate any price premiums on sellers side, buyers often use already described due diligence reviews. During such review information asymmetries are at least partially if not completely eliminated. On the other hand, premiums paid by buyers over market price of shares indicates greater expectations in future proceeds from the transactions by the buyer and thus price premium on buyer’s side.

1.3. Private equity

In this part of the thesis we will focus on period after the transaction and main player in it – private equity firms. Private equity firms assume two roles in LBOs; which are the one of the buyer and / or the one of the provider of finance. Below we will attempt to describe both roles as thoroughly as possible given our experience and access to information.

Private equity firms operate through funds which are their investment vehicles. These funds are basically pools of capital compiled from entries of private equity firm and various institutional investors. They are organized as limited partnerships although other legal structures are used as well25. Private equity firm fulfills role of general partner and controls operations of the fund.

Limited partners committing their capital to funds are mostly institutional investors but also individuals of substantial wealth. They become passive partners as funds provided

25 Kaplan and Schoar (2003)

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by them are managed by general partner (private equity firm). Institutional investors are represented by insurance companies, pension funds, financial institutions, universities’ trusts etc. Limitations on investments into private equity funds make it virtually impossible for commoner to invest into such funds. Initial investments are almost always in excess of USD 100ths and further investments (“drawdown”) are required26. Other drawbacks include illiquidity of the investments and high risk of losing all money if invested into failing companies.

Illiquidity is caused by the legal form of funds which is limited partnership and nature of the business. Limited partner shares is considered as equity of the company and therefore it is last to be settled in case of liquidation. Also to the contrary of stocks and bonds, limited partner share has no market to be traded on and thus it is very rare to sell the investors share. Distribution are made only upon cashing the investments from the portfolio of the fund when there are sold which is done after several years. General partners have several years (e.g. 5) to invest fund’s capital and another period (e.g. 7 years) to improve performance of portfolio companies and resale them. Overall fund life cycle can last up to 12 years. If the fund was successful and investors are pleased with their returns, follow up fund can be created.

Not every fund is successful and investors can easily lose lot of money as investments are chosen not wisely. Risk is lower then risk venture capital investors are facing as investments are made into established and running companies. Venture capital invests into start-up companies in which bright future venture capitalists believe. On the other hand risk of private equity funds investors is higher then the one facing investors into mezzanine funds. These funds offer mezzanine financing to the companies and as this is debt financing (although subordinated) it is less risky than any of equity investment.

General partners make all decision regarding investments and their subsequent management. For these activities he charges annual management fee which is 1.5-2.5 percent of committed capital and approximately 20 percent of carried interest or share of the profit27. 20 percent charge kicks in only if hurdle rate is achieved (meaning target rate of return of the fund). Repeatedly successful funds are able to charge fees even in excess of those stated above. Considering use of leverage funds are able to

26 www.wikipedia.org

27 Kaplan and Schoar (2003)

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