Leveraged Buyouts Characteristics Evidence on LBOs An LBO

Leveraged Buyouts Characteristics Evidence on LBOs An LBO (Private Equity) Model Reverse LBOs Wharton School 1 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Definition of an LBO • No precise definition -- different forms • Transaction in which a group of private investors uses debt financing to purchase a corporation or a corporate division. Equity securities of the company are no longer publicly traded, though the debt and preferred stock may be publicly traded. Uses entire borrowing structure • Often involves a financial sponsor who contributes capital and expertise (KKR, Bass Brothers, Blackstone, etc. ) and management team. Wharton School 2 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Distinct Features of an LBO • Significant increase in financial leverage – Average debt/total capital increases substantially • Management ownership interest increases – Median ownership of a Fortune 500 U. S. Corporation is 0. 5%, for Value Line 1000 is 5% – After an LBO the ownership is 10% - 35% • Non-mgmt equity investors join the board – Before an LBO, non-management directors have almost no ownership. After, non-management directors may represent 40%-60% of equityholders – Typical board of 5 individuals, 2 -3 from the LBO sponsor Wharton School 3 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Historical Characteristics of Potential LBO Candidates • • History of profitability Predictable cash flows to service financing Low current debt and high excess cash Readily separable assets or businesses Strong management team - risk tolerant Known products, strong market position Little danger of technological change (high tech? ) • Low-cost producers with modern capital • Take low risk business, layer on risky Corporate Valuation -- Chapter 18 4 Wharton School financing Copyright, Robert Holthausen, 2010

Typical LBO Structure • Varies tremendously over time with market conditions • Debt Financing – Total debt sometimes 60 -80% of entire deal (4 -5 x LTM EBITDA, but depends on industry, cash flow, and time period etc. – 40% - 60% senior bank debt (repayment in 5 -7 years) – 0 -15% senior subordinated (repayment in 8 -12 years) – 0 -20% junior subordinated (repayment in 8 -12 years) – 0 - 15% preferred stock – 10% - 50% common equity • Equity Ownership – 10% - 35% management/employee owned – 40% - 60% investors with board representation – 20% - 25% owned by investors not on board Wharton School 5 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

LBO Financing • Financial sponsors have equity funds raised from institutions like pensions & insurance companies • Some have mezzanine funds as well that can be used for junior subordinated debt and preferred • Occasionally, sponsors bring in other equity investors or another sponsor to minimize their exposure • Balance from commercial banks (bridge loans, term loans, revolvers) & other mezzanine sources • Banks concentrate on collateral of the company, cash flows, level of equity financing from the sponsor, coverage ratios, ability to repay (5 -7 yr) Wharton School 6 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

• • LBO Financing – Senior Bank Debt Senior bank debt which is secured with assets like receivables, inventory, PP&E is often priced at T-Bills, LIBOR or prime + 400 to 700 basis points (three years ago spreads were much lower). Often in tranches where first tranche is repaid quickly and other tranches are not due until maturity (7 -8 year maturity with average life of 4 -5 years) 2. 5 – 3. 5 x LTM EBITDA (varies by industry and rating and with credit market conditions) Lend up to X % (40%-65%) of receivables less than Y (90) days, over certain $ amount, at T-Bill, LIBOR or Prime, plus a risk premium Inventory usually 20% to 60% Securities 10% to 90% (US Govt Bonds @ 90%) PP&E (Cars (60%), Computers (25%), Building (60% to 70%, unique factories (10% to 30%) Bankers historically like to see 25% to 35% equity for protection (now much more) Wharton School 7 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

LBO Financing – Unsecured Debt • Unsecured debt (senior and junior) • Potentially many different pieces (cash pays are senior and senior subordinated while junior subordinated may be zero coupon issued by holding company) • Longer maturity than bank debt • Covenants not to pay dividends, increase debt or sell assets • Supported by cash flows and operations of the business. • High-yield a favorite (senior subordinated), but hard to sell high yield for less than $150 million and high-yield market not always viable. • High-yield is typically non-callable for about five years and then have call penalties for 3 -5 years. Wharton School 8 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Junior Subordinated and Preferred • Below the high-yield bonds (or below the bank debt if the deal isn’t big enough to support high-yield bonds) but above the common would be junior subordinated and preferred stock. • Junior subordinated may be PIK (zeros) for some time period. May be issued by a holding company of the operating company and may be issued with warrants. Holding company notes almost always PIK because there is no cash flow into the holding company for some time. – In transactions of this type, the PIK interest may not be deductible until it is paid in cash or the bond matures and is paid off (so called AHYDO rules) • Preferred can be PIK as well, so dividends accrue but are not paid and at sale of the company the preferred holders get their investment plus accrued dividends (often called the liquidation preference) -- often sold with warrants. Alternatively, can issue convertible preferred instead of including warrants. Wharton School 9 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Common Equity • Typically 20% - 45% of capital structure historically, but varies over time (at high end or more right now). • Typically seeking a 20%-40% IRR but depends on how levered the capital structure • Often assume exit and entry multiples are the same, but not necessarily a good assumption – rarely expect multiple expansion • Ask what the exit strategy is likely to be. Wharton School 10 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Management Ownership • Management puts up 60% to 70% of wealth (excluding residence) • Management share of equity (sometimes called management promote) usually increases year by year as they meet targets (e. g. , revenue and EBITDA and non-financial targets) through performance vesting options. Strike price usually at equity buy-in price at time of deal. • Managers are sometimes offered chance to buy stock with a mixture of recourse and non-recourse notes. • Managers often already own shares in a company that does an LBO and they do not necessarily cash out those shares – that equity goes into the new entity – called rollover equity. Wharton School 11 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Financial Sponsors • Typically won’t put more than certain percentage of a fund in one company and another percentage of a fund in one industry. Increases in % of financing that is equity has caused deal sharing. • Razor edge margins because of the high risk profiles. Shooting for 20% - 30% on every deal, some earn 100%, some 4%, some -80%, etc. • Sponsor takes funds from pension funds only when required, a draw down notice (LBO sponsors do not want to be generic portfolio managers). • Typically assume will take 3 -5 years to invest a fund and then another 3 -5 years to cash out (monetize) the investments. • Expertise in layering risk, financial structure Wharton School 12 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Financial Sponsors • Normally get a management fee that is 1% to 1. 5% of fund size. • In addition, they split returns between investors and themselves and often get a percentage in the capital gain of the fund (so called carried interest). • In addition, they invest their own money in the fund. Wharton School 13 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Financial Sponsor M&A Activity 1998 – 2010 Global Sponsor M&A Activity $ in billions % of Total Value (1) ______________ Source: Thomson Financial based on rank date excluding equity carveouts, exchange offers and open market repurchases. As of 12/31/10. (1) Total Global M&A Volume includes government interventions, defined as deals in which a government entity is the acquiror, excluding SWF transactions. 18 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Financial Sponsor M&A Activity 2007 -2010 Sponsor Volume has reemerged, steadily gaining more share of Global M&A Volume u u 2009 Sponsor volume was off 47% from 2008 year-over-year average; Strategic volume was down 30% 2010 Sponsor volume was up 107% from 2009 volume; Strategic volume was up 14% Global Sponsor Quarterly M&A Activity ______________ (1) Source: Thomson Financial based on rank date excluding equity carveouts, exchange offers and open market repurchases. As of 12/31/10. (1) Total Global M&A Volume includes government interventions, defined as deals in which a government entity is the acquiror, excluding SWF transactions. 20 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Strategics are Driving the M&A Market Risk right-sizing in credit markets will continue to allow Strategics to be more competitive buyers of assets, but Sponsor volume has reemerged Strategics Financial Sponsors u Harder time getting to DCF range, cheap credit subsidy gone u Leveraged finance market recovered, although still below pre-2008 levels u Reemerged due to opening of credit markets - 2010 tax-driven transactions - Portfolio backlog waiting to be monetized - High acquisition appetite u Search for assets where they have a comparative advantage as buyer u Deal size sweet spot for Financial Sponsors moves to the midcap market u Reemergence of large LBOs, $5+ billion 21 u MBO a less viable path for CEOs u No longer getting out-bid – ability to push the strategic agenda u Synergies > financing subsidy u Resurgence of cash as an acquisition currency u Historically high cash levels on balance sheets that needs to “go to work” u Investment grade corporates “rule” with maximum financial flexibility Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Risk Profile Questions • Is cash flow consistent (no cyclical industries)? • Is a turnaround required to meet projections? • Any outside threats to long-term performance? • Are there larger, better capitalized competitors? • Does the firm have high quality management? • Are there other successful LBOs in that industry? • Can the company grow with the leverage increase? • What is the exit strategy? Corporate Valuation -- Chapter 18 Wharton School 17 Copyright, Robert Holthausen, 2010

U. S. LBO Acquisition Financing Market Trends Sample Capital Structure Terms for Leveraged Deals Average Debt Multiples (1) Average Equity Contribution to LBO (2) ________ Source: S&P Leveraged Commentary & Data. As of 12/31/10. 1) Excludes media loans. Too few deals in 1991 to form a meaningful sample. 2) Rollover equity prior to 1996 is not available. Too few deals in 1991 to form a meaningful sample. 41 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Current State of the Market • • Driven by the recovery of the leveraged finance market, as well as the return of the corporate buyer, the M&A market has recovered to a “new normal”. There have been several $1 B+ LBOs including Del Monte at $5. 3 billion. The size of LBOs that can get done is a function of size, industry, quality of asset, quality of sponsor, quality of management team. As equity valuations have rebounded and stabilized, sellers are more comfortable with valuations and believe they are not selling at impaired values and are no longer constrained by 2009 “trough” financial results. The robust and recovering leveraged finance market is causing valuations and structures to change monthly. Right now, Sponsors can easily do deals up to about $3 -5 Billion, perhaps larger for just the right target characteristics. Deals greater than $5 billion still require a number of attributes including stable earnings, world-class management and a top-tier Sponsor. These larger deals will test depth of the market and will be constrained by the size of the accompanying equity check (majority of deals are 30%-50% equity). Recent large deals include Del Monte, Burger King, Syniverse, Corporate Valuation -- Chapter 18 19 Wharton School Gymboree and other $1+ billion LBOs. Copyright, Robert Holthausen, 2010

Current State of the Market • • • Access to high yield market is strong, however underwriters’ capacity is a constraint (multi-billion full commitment is now a couple of banks, not one. Leverage loan market (5 to 7 year term loans) with some amortization (from banks and senior loan funds), has rebounded. Deal action seen mainly in industries with stable cash flows and less cyclicality. Some industries that have had highly levered deals in the past (e. g. , media) are lagging because the leverage terms do not yet fully support valuations that are considered attractive. A typical capital structure now is 30%-50% equity, senior secured or first lien debt of about 40%-50 and subordinated debt/mezzanine at 20%-30%. Senior debt yielding less than 6% with High Yields yielding anywhere from around 6% to 9% now and the mezzanine debt in the low-double digits (coupon rates) but depends on credit risk. Sponsor firms hope to earn low- to mid-20 s IRR on equity. However, in the interest of putting money to work and against the backdrop of lower benchmark returns, sponsors will invest at a lower calculated rate (high upper teens) on a “base case” with the hope of getting to the target Corporate Valuation -- Chapter 18 20 Wharton School IRRs through the “upside case”, acquisitions or other improvements in Copyright, Robert Holthausen, 2010 cash flows.

Exit Strategies • Exit strategies include: – – IPO Buyout by a strategic buyer Buyout by another financial buyer Leveraged recapitalization --- not really an exit, but essentially after the debt is paid down to a reasonable level, the entity issues a new round of debt and pays a large dividend to equityholders (or repurchases shares). Some, but not all, equityholders may be taken out. Wharton School 21 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Potential Motivations for an LBO • Increase in debt and concentrated ownership increase incentives to maximize value. • Non-management on board with significant equity stakes increases board effectiveness • Advantage to being private (filings, etc. ) • Beneficial tax consequences (debt, step -up) • Wharton Transfer wealth from other stakeholders Corporate Valuation -- Chapter 18 22 School Copyright, Robert Holthausen, 2010 in the firm such as employees &

Performance of LBOs • Evidence indicates that the median premium paid to existing shareholders is 42%. • What are the potential sources of value? – Improved operating performance – wealth transfers from employees – reduction of taxes – wealth transfers from pre-buyout debtholders – overpayment by post-buyout investors Wharton School 23 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Changes in Median Performance • In three year period after the buyout relative to the year before the buyout – – – – – EBIT increases by 42% EBIT/assets increases by 15% EBIT/sales increases by 19% EBIT-CAPEX increases by 96% EBIT-CAPEX/assets increases by 79% EBIT-CAPEX/sales increases by 43% working capital management improves no decline in advertising, maintenance or R&D CAPEX falls by 33% relative to industry Wharton School 24 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Transfers from Employees • No evidence that investor wealth gains can be attributed to wage reductions or layoffs – median change in number of employees is 0. 9% among all LBOs and is 4. 9% among LBOs that did not engage in divestitures – significant increase in average annual compensation for non-management employees – there is evidence that LBOs are not adding to their payrolls at the same rate as the industry (12% declines for all, 6. 2% decline Corporate Valuation -- Chapter 18 25 Wharton School Copyright, Robert Holthausen, 2010 for those with no divestitures)

Tax Effect of LBOs • Firms’ interest deductions increase substantially after an LBO. Depending on how you value them & how long you think the highly levered structure will be in place, 21% to 70% of the premium is attributable to the interest • Additional depreciation (pre-1986 Tax Reform Act accounted for at least 30% of the premium • Ratio of federal taxes/EBIT falls from 20% pre -buyout to 1% for 2 yrs. after buyout. Wharton School 26 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Transfers from Bondholders • If leverage increases dramatically, prebuyout debtholders with no protection could experience wealth losses – on average, pre-buyout debtholders lost 2. 1% – represents 3% of the premium paid – wealth losses accrue only to those bondholders not safeguarded by protective covenants (limitations on debt issuance, etc. ) Wharton School 27 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Overpayment by Post-Buyout Investors • Evidence indicates over three years subsequent to the buyout, post-buyout equity investors earned a mean excess return of 45%. • Evidence for debtholders is less clear as it is difficult to track bonds that default. Default rates on low grade bonds were roughly 2. 5% per year, but returns are less easily quantified Wharton School 28 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

John Harland -- An LBO? • Typical LBO Model • Model cash flows -- see how it supports the debt financing structure • Treat exit year as a choice variable to determine sensitivity of IRR to exit date. • Determine the IRR for the mezzanine and equity providers and see if it hits target • Models don’t typically assess value Corporate Valuation -- Chapter 18 except as exit multiple (can do DCF of 29 Wharton School Copyright, Robert Holthausen, 2010

LBO Models as an Alternative Valuation • LBO models can serve as an alternative valuation. • Take the cash flow forecasts, determine the amount of financing available in the market place currently and the IRR that LBO sponsors would target for this company. Based on all that, determine the maximum amount that could be paid as an LBO transaction that satisfies the required IRR. • Triangulate with DCF and Market Multiple Valuations Wharton School 30 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

LBO Model Logic • Create a sources (debt, equity contribution) and uses (purchase price, fees, debt payoff) statement for inception of LBO • Debt schedules • Proforma balance sheet, income statement and statement of cash flows based on operating assumptions • Cash flows pay down the debt (senior first and then mezzanine) • Perform valuations at alternative exit dates and determine IRR to equity holders Wharton School 31 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Reverse Leveraged Buyouts • Reverse LBO occurs when an LBO goes public • Constituted roughly 10% of IPO market in 1980 s • Leverage and ownership changes at time of reverse LBO that moves them back toward pre-LBO structure • Leverage falls from 83% to 56% (debt/capital) • Inside ownership falls from 75% to 49% (management and board -- includes sponsor). • Board size increases from 5 to 7, roughly 1/3 each of operating management, non Corporate Valuation -- Chapter 18 32 Wharton School Copyright, Robert Holthausen, 2010 management capital providers and external

Financial Performance OCF Before Interest and Taxes • Year Firm Industry-Adjusted – – – -1 19. 3% 9. 2% 0 14. 6% 4. 7% +1 11. 9% 1. 5% +2 14. 3% 4. 1% +3 13. 5% 2. 4% Avg +1 to +3 13. 9% 2. 9% • Doing much better than their industry, but evidence of deterioration relative to prior performance Wharton School 33 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Discretionary Expenditures • Discretionary expenditures defined as capital expenditures, advertising and R&D. – Spending as much as their industry prior to the reverse LBO and increases subsequently (discretionary expend. /sales) 2% greater than industry – CAPEX low before reverse LBO and normal after – Advertising above industry before and after – R&D tracks industry before and after • Employees/sales same as industry both before and after the reverse LBO Wharton School 34 Corporate Valuation -- Chapter 18 Copyright, Robert Holthausen, 2010

Effect of ownership and leverage • No evidence that changes in leverage affect performance • Significant correlation between decline in performance and decline in ownership. – 10% additional decline in percentage equity owned by managers results in an additional 3. 6% fall in OCF/assets over three subsequent years – 10% additional decline in percentage equity owned by non-management insiders results in an additional 4. 1% fall in OCF/assets over three subsequent years • Suggests important role for ownership Corporate Valuation -- Chapter 18 35 Wharton School incentive Copyright, Robert Holthausen, 2010

Stock Market Performance • Evidence of a large increase in stock prices of the reverse LBO firms over the next four years. • Large increase in stock prices exactly tracks the stock market. As such, there is no evidence of positive or negative excess returns • Very different from IPOs in general. Strong evidence of negative excess returns Corporate Valuation -- Chapter 18 Wharton School 36 Copyright, Robert Holthausen, 2010