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Leveraged Buy-out (LBO) analysis

1.1.

Introduction

Leveraged buy-outs (LBOs) are a very common way of acquiring companies. The practice was pioneered by houses such as Kohlberg, Kravis & Roberts (KKR) in the 1970s and over the last two to three decades LBOs have assumed an ever-greater importance. LBOs are characterised by the significant debt levels relative to total capital employed. The attractive returns that financial buyers have been able to generate by using LBO structures has led, in recent years, to a proliferation in the number of financial buyers and a significant increase in the size of funds they have available to invest in acquisition opportunities. As a result, competition for suitable acquisitions is intense. This factor, combined with the significant reduction in European and US interest rates during the 1990s, has meant that financial buyers are prepared to pay full prices, often even outbidding trade buyers who can extract significant synergies from a target or who are prepared to pay a strategic premium for the business. 1.2. Rationale

A highly leveraged entity has a number of advantages for an equity investor, including the following:
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Interest on debt is tax deductible and the cost of debt is generally lower that the cost of equity. As a result, increasing a companys gearing should reduce its cost of capital. In other words, given the effect of taxes, debt is cheaper than equity In a highly leveraged company, a relatively small increase in the companys enterprise value can lead to a substantial increase in the value of its equity. In a bull market, the attractiveness of an LBO will therefore increase. Of course, the gearing effect also means that high gearing increases an equity investors risk, since a relatively small decline in enterprise value could severely impact the value of the equity investment. Moreover, high interest charges increase the risk of default by the company High gearing tends to be a discipline on management, since a companys cash flow is usually quite tight due to the necessary pay-down of interest and debt. Management is therefore likely to focus on driving down costs and controlling capital expenditure Many LBOs are structured so that managers have substantial incentives to increase the value of the business. In these acquisitions, management will subscribe for a small proportion of the equity. A ratchet will often be put into place which will give management an increased share of the companys equity in circumstances where the returns accruing to shareholders are greater than a pre-determined level. Whilst the ratchet allows management to benefit disproportionately compared with other equity investors, other investors usually recognise the additional value for them

However, given the risks associated with high gearing, financial buyers demand high projected returns on any investment they make. The key consideration is the expected internal rate of return (or IRR) of the investment. This is the discount rate which is required to make the net present value of all future cash flows of the business equal to zero and effectively represents the opportunity cost of capital to the buyer. In order to maximise returns a financial buyer will seek the highest IRR possible and, in considering any potential transaction, will usually require an IRR of at least 25%.

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1.3.

Suitable LBO candidates

Not all companies are suitable targets for an LBO. A financial buyer will only look at companies which exhibit many of the following characteristics:
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Strong and stable (free) cash flows . Since the LBO will be highly geared, significant interest and capital repayments will need to be made out of its cash flows. The targets cash flows need to be stable enough to support these payments. This is often regarded as the key criteria Leading market position/brand or clearly defined niche market. This established strength in a particular market would act as comport for a financial buyer as there is greater certainty (or cash flows), relatively less capex is required to generate growth, and it provides a platform on which to leverage its position (often with an established management team in place) Low capital expenditure requirements. Reduced capex will increase the cash flows available and increase the debt levels, which the company can bear. As a result, an LBO is often not suitable for high growth companies Low working capital requirements Good historical track record Scope for margin improvement/cost reduction potential. This is true even if historically the business has not been well run since a financial buyer may be interested if margins can be improved to the levels of its major competitors Strong/successful/proven management. However, it is not uncommon for new management to take over the running of the business (though the new management are likely to have proven track records) Acquisition oppor tunities. A financial buyer may be prepared to use the target as a platform for growth, or as part of industry consolidation Exit. A financial buyer will need to be convinced that a suitable exit can be found. This will normally occur by way of trade sale or IPO. A buyer will typically have a time horizon of between three and five years, although a number of financial buyers target longer or shorter periods

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As a result, issues to beware of would include:

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Limited and/or volatile free cash flow generation (key issue) Weak market position Emerging markets risks Questionable management team new/inexperienced/indicted Small size The business is in a turnaround situation Types of financing

1.4.

In a leveraged transaction, the majority of a companys capitalisation is debt financed, which enables financial sponsors to achieve their IRR targets and corporates to acquire larger companies. The equity is provided by the buyer and is frequently 30% 40% of the total capitalisations. There are a number of types of financing which can be used in an LBO. These include, for example, the following (in order of risk):
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Senior debt . This is debt which ranks ahead of all other debt and equity capital in the business. Bank loans are typically structured in up to three tranches : A, B and C. The debt is usually secured on specific assets of the company, which means the lender can automatically acquire these
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assets if the company breaches its obligations under the relevant loan agreement; therefore it has the lowest cost of debt. These obligations are usually quite stringent though senior debt is often not subject to reporting requirements as they are usually unrated. The bank loans are usually held by a syndicate of banks and specialised funds. Typically, the terms of senior debt in an LBO will require repayment of the debt in equal annual instalments over a period of approximately 7 years. Senior debt is prepayable and has a floating rate of interest. From the lenders perspective, this is the most secure form of financing
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A financial buyer will usually want the LBO to be financed by as much senior debt as possible as it provides the platform for the debt financing, since it is the lowest cost form of financing. However, the providers of senior debt will be reluctant to accept very high levels of senior debt (which may affect their security) or may impose conditions which are unacceptable to the equity investor. As a result senior debt will often only form about 50% of the total financing

Typical terms in Europe Arranging fee

A B C 2.25% upfront 2.25% upfront 2.25% upfront

Interest
LIBOR + 2.25% LIBOR + 2.75% LIBOR + 3.25%

Final maturity
7 years 8 years 9 years

Average life
4 5 years 8 years 9 years

Repayment
In semi-annual instalments In the last year In the last year

Size
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Senior debt multiples are usually 3.0x 4.0x times historic EBITDA of target Deutsche Banks target transaction size begins with senior debt of E200 million and will typically include high yield or mezzanine in the capital structure

Pros and cons for the issuer? Pros

Usually offers the lowest cost of funding Prepayable at no or little cost Deep established market in Europe which can accommodate large transactions Private market and therefore less exposed to volatile market conditions No equity dilution
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Cons
Requires periodic amortisation out of free cash flows. Therefore this instrument may not be suitable for companies consuming cash for some years Strict maintenance covenants are tightly monitored, usually on a quarterly basis (eg total leverage, interest cover, fixed charge cover ratio, etc) Full security required in most cases

Subordinated debt. This debt ranks behind senior debt in order of priority on any liquidation. The terms of the subordinated debt are usually less stringent than senior debt. Repayment is usually required in one bullet payment at the end of the term. Since subordinated debt gives the lender less security than senior debt, lending costs are typically higher. An increasingly important form of subordinated debt is the high yield bond, often listed on US markets. High yield bonds can either be senior or subordinated securities (though they tend to be the latter in Europe and typically rank structurally and contractually below senior secured debt) that are publicly placed with institutional investors and are rated by Moodys and S&P. They are fixed rate, publicly traded, long-term securities with a looser covenant package than senior debt though they are subject to stringent reporting requirements. High yield bonds are not prepayable for the first five years and after that, they are prepayable at a premium

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Typical terms Underwriting fee

2.5 3.0% payable upfront

Interest
8 13% per year (fixed rate)

Final maturity
7 10 years

Repayment
A single payment at maturity

Size
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Minimum size typically E100 million High yield bridges can be used as temporary funding for an acquisition until a high yield bond is issued. It is not usually possible to issue high yield bonds at closing because of the time required to prepare offer documents, organise roadshows, etc. The size of high yield bridges are estimated to be the amount achievable from the high yield bond that will replace it. However, such bridges are expensive and the cost explodes if not replaced with a high yield bond in the expected timeframe (usually twelve months) because they are risky instruments for the underwriter Mezzanine finance. This is usually high risk subordinated debt (prepayable at a pre mium), and is regarded as a type of intermediate financing between debt and equity and an alternative to high yield bonds. An enhanced return is made available to lenders by the grant of an equity kicker (eg warrants, options and shares), which crystallises upon an exit. A form of this is called a PIK, which reflects interest paid in kind, or rolled up into the principal, and generally includes an attached equity warrant (for larger financings)

Typical terms Arranging fee

3.0% payable upfront

Interest
LIBOR +4.0% (normal cash interest) +4.5% (PIK) Warrants are usually added on top of this Total target IRR by holders of 17.0% - 18.0%

Final maturity
Up to 10 years

Repayment
Single payment at maturity

Size
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Around 1.0x historic EBITDA (on top of bank debt) Very low minimum size (EUR10 million) Loan stock. This can be a form of equity financing if it is convertible into equity capital. The question of whether loan stock is tax deductible should be investigated thoroughly with the companys advisers Preference shares. This forms part of a companys share capital and usually gives preference shareholders a fixed dividend and fixed share of the companys equity (subject to there being sufficient available profits) Ordinary shares. This is the riskiest part of an LBOs capital structure. However, ordinary shareholders will enjoy the majority of the upside if the company is successful

Only some of these forms of financing will be used in a transaction, unless the transaction is extremely complex. Furthermore, this list is a very general summary and many of these categories comprise a number of different products . There are also certain types of financing which do not fall within these categories.

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1.5.

Building an LBO model

A basic LBO model is similar in many respects to a stand alone DCF model in that exactly the same methodology is used to derive the companys financial statements. The major difference is that an LBO analysis, unlike a DCF, takes account of interest charges and debt repayments. As a result, the financial statements need to be adjusted to include these payments. The key steps in completing an LBO model are as follows: 1.5.1. Forecast cash flows

Projected cash flows should be modelled in exactly the same manner as for a DCF valuation. The forecast period should end no earlier than the latest date on which an exit is expected or the latest date on which the debt is expected to be repaid in full (whichever is later). While a DCF valuation requires the unlevered free cash flows to be discounted to provide enterprise value, an LBO uses free cash flows to derive IRRs . 1.5.2. Estimate debt capacity

The next step is to estimate the amount of debt that the company can take on. The financial statements should make provisions for interest and debt costs. The company can only bear debt to the extent that it has available cash flows. Note that all existing debt will need to be refinanced. When modelling, consult your team about the financing assumptions to be used. These will vary according to market conditions, industry characteristic and company specific issues . Consultation with the leveraged finance team or the financial sponsors group is advisable, since they have more day-to-day exp erience about the current parameters in the marketplace. Set out below are some parameters that will influence financing considerations for the model:
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Minimum interest cover (times) Total debt/EBITDA (times) Senior debt repayment (in years) Mezzanine debt repayment (in years) Senior debt interest rate Subordinated interest rate Mezzanine finance exit IRR

It may also be appropriate to model the potential sale of non-core assets in order to ensure maximum leverage. Note that, when modelling interest charges, a circular reference is likely to be encountered resulting from calculating interest payable as the average of the debt at the start and end of the relevant period. This is to be expected and iterations can be used to resolve the circular reference. The best way to avoid this is to copy the formula to another cell and delete the cells generating the circular reference before making any amendments to the model. When all changes have been made, you can copy the formula back into the relevant cells.

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1.5.3.

Estimate equity required

The equity required is, in simplistic terms, the cost of acquiring the company (including existing debt) less its debt capacity. The total cost of the company comprises both the purchase price and transaction expenses. The level of transaction costs should not be underestimated these can often amount to approximately 3% of the purchase price, particularly for smaller transactions. 1.5.4. Estimate the exit price

A financial buyer will typically wish to exit within 3 5 years. The exp ected value of the company at that time is critically important to the buyer. Therefore, an estimate of the value of the business should be made, usually as a multiple of EBIT or EBITDA, at the end of that period. As a base case, the multiple should normally be no more than the multiple paid for the business by the financial buyer. Furthermore, a discount of 10 15% should be included if an IPO is the most likely exit route. 1.5.5. Calculate the IRR

There is an Excel function which can be used to estimate the IRR. It is advisable to run sensitivities for the IRR in different years and for different exit multiples. 1.6. Management investment

In order to provide an incentive to management, managers are often asked to invest in the business. They will usually be asked to invest an amount which, although immaterial in the context of the transaction, is significant to the manager in a personal context . The returns to the managers if the LBO proves successful are usually far greater than the returns made by institutional shareholders. Furthermore, if the IRR is exceptional and exceeds a certain level (agreed at the time of the LBO), a ratchet will usually kick in, which will multiply the returns achieved by management according to a set formula.

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