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Department of Finance
RSM Erasmus University
Module 4
Leveraged Buyouts (LBO)
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Today’s Program
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Leveraged Buyouts (LBOs)
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Value of Worldwide LBOs
1980-2011
$ Millions
The Value of Worldwide LBO, 1980 - 2011
900,000
800,000
700,000
600,000
500,000
400,000
300,000
200,000
100,000
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
2,500
2,000
1,500
1,000
500
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
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Deal Size of Worldwide LBOs
2003-2011
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Basic Structure of LBOs
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The private equity cycle
closing of fund
year 0
first capital call
4-5 years
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Largest Worldwide LBOs in History
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Buyouts in the Netherlands
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Look Back at the 1980s’ Merger Wave
LBOs
The 1980s’ merger wave was the period that
made LBOs famous
However, those deals, while considered mega-
deals then, are generally smaller compared to
the mega-deals of the 2000s (except the deal of
RJR Nabisco)
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Top Ten LBO Deals of the 1980s
Purchase Average Premium
Year Company
Price ($ mil) P/E Offered (%)
1988 RJR Nabisco 24,561 19.5 92.1
1985 Beatrice 5,361 10.7 14.9
1986 Safeway Stores 4,198 18.4 43.8
1987 Borg-Warner 3,798 20.4 30.6
1987 Southland 3,732 13.8 14.1
1986 Owens-Illinois 3,632 19.6 36.0
Hospital Corp. of
1988 3,602 N/A 44.7
America
1988 Fort Howard Paper 3,574 22.6 35.3
1989 NWA, Inc. 3,525 18.5 12.6
1985 R.H. Macy 3,485 18.4 54.4
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LBO Fundamentals
Key Participants
Financial Sponsors
Traditional private equity firms, merchant banking divisions
of IBs, hedge funds, venture capital funds, and special
purpose acquisition companies
Investment Banks – plays a key role in LBOs
As a provider of financing & as a strategic M&A advisor
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Characteristics of LBOs
• Acquisitions financed primarily with debt
• Debt is secured with assets of the enterprise being acquired
- This is why the financing is called asset-based lending
• Originally many LBOs were in Capital Intensive industries as
opposed to high-tech and service industries
- Capital Intensive industries have assets which can be used as collateral
for debt
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Characteristics of a Strong LBO
Candidate
Strong cash flow generation
Leading and defensible market positions
Growth opportunities
Efficiency enhancement opportunity
Low Capex requirement
Strong asset base
Proven management team
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Economics of LBO
Return Analysis – Internal Rate of Return (IRR)
Primary metric by which sponsors gauge the attractiveness of a
potential LBO; meeting acceptable IRR thresholds is critical
(historically, a 20%+ threshold)
IRR measures the total return on a sponsor’s equity investment,
including any additional equity contribution made, or dividend
received, during the investment horizon
r: NPV=0
Primary IRR drivers: target’s projected financial performance,
purchase price, financing structure, exit multiple and year
Example: A sponsor contributes $250 mil of equity at the end
of year 0 and receives equity proceeds upon sale of $750 mil at
the end of year 5. What is IRR (assuming no interim div.)? 19
Economics of LBO (cont’d)
Return Analysis – Cash Return
Sponsors also examine returns on the basis of a
multiple of their cash investment
Unlike IRR, the cash return approach does not factor
in the time value of money
Example: A sponsor contributes $250 mil of equity at
the end of year 0 and receives equity proceeds upon
sale of $750 mil at the end of year 5 (assuming no
additional investments or dividends during the
period)
The cash return is 3x 20
Primary Exit Strategies
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Successful Reverse LBO Case:
Hertz Rent-A-Car
Acquired by the Carlyle Group, Clayton Dubilier &
Rise and Merrill Lynch Global Private Equity in 2005
from cash-strapped Ford Motor Co. for $5.6 billion
(PE firms contributed $2.3 billion in equity – each firm
$765 million; deal size $15 billion incl. debt)
Extracted a $1 billion special dividend
They took the company public again (29%) after 6
months for $1.32 billion
Buyout firm still owns 70% of the company
As of early 2007 Carlyle estimates it earned 54% on
its $765 million investment
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LBO Value Creation
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Realized Returns of LBO Funds
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Realized Returns of LBOs of Recent
Wave 1996-2006
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Reverse LBOs Research
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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
• Why capital structure may cause greater efficiencies:
Management equity typically higher than (10%) greater
incentive to generate gains
Buyout firms hold 90% equity in Bank America database
Both have greater incentives to monitor more closely
versus a widely distributed equity base
More focus on the cash flow no longer need to focus on
EPS for securities market reporting to outside shareholders
Reason: Cash flow is what is needed to service debt as
opposed to earnings per share to pay dividends
- Firms even try to minimize taxable income
which increases after-tax cash flows 29
Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
• Baker and Wruck (JFE 1989): A case study which describes the
organizational changes at O.M. Scott after its LBO in 1986
The board had five members, of which one was a manager
and three represented the buyout sponsor. All board
members owned stock
The board met quarterly, and an executive committee
monthly
One of the private equity partners served as a liaison
between the LBO sponsor and the firm’s managers
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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
• Baker and Wruck (JFE 1989): ct’d.
The operating partner, which functioned as an advisor and
a consultant, spent several weeks at O.M. Scott after the
buyout closed and was thereafter in telephone contact with
the CEO daily
The close monitoring by the LBO sponsor, combined
with the restrictions imposed by the high leverage and
significant managerial shareholdings and bonus plans,
led to a substantial improvement in O.M. Scott’s
operating performance and investment efficiencies
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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
• Cornelli and Karakas (2008, WP)
investigate the evolution of board
size and composition surrounding
88 UK private equity backed going
private deals from 1998-2003
• Boards are drastically restructured:
reduction in outside directors and
increase in directors from private
equity house
• Private equity investors prefer to
use their own employees rather than
outside experts
• They are likely to step in and fire
CEOs in case of poor peformance
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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
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Better monitoring: less private benefits
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Reported Success of LBOs and
Irrelevance of Capital Structure (cont.)
• Jensen (1989):
Active governance by buyout sponsors and high-powered
managerial incentives, combined with the pressure from
high leverage, provides an incentive structure that is
superior to that of public firms with dispersed ownership
and weak governance
The LBO organizational form may ”eclipse” the traditional
corporate form to become the dominant organizational
form (at least for firms in low-growth industries)
There will be long-lived LBO companies
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LBO Exits
• Stromberg (2007): Studies exits for 21,000 buyout transactions
in 1970–2007. Of these buyouts 17,000 (80%) were backed by a
financial sponsor. The value of firms acquired in LBOs between
1970 and 2007 as a total of $3.6 trillion, three-quarters of which
represent LBOs undertaken after 2000
Only 40% of the firms in his sample have exited
39% of the exits are in the form of a sale to a strategic
buyer. One quarter of the exits are a secondary buyout, i.e.,
a sale to another LBO fund (which has increased in
importance over the last decade)
IPOs account for 13% of the exits
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Exit Strategies of Worldwide LBOs
2007-2011
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LBO Exits
• Stromberg (2007):
Despite the significant leverage used in buyouts, only 6% of
exiting firms file for bankruptcy or initiates a financial
restructuring
The median firm stays in LBO ownership for nine years,
and only 8% of the firms are sold within two years of the
buyout
Overall, the evidence suggests that leveraged buyouts are
a long-term organizational form for many firms
(potentially supporting Jensen’s (1989) prediction)
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LBO Financing: Structure
In a traditional LBO, debt has typically comprised
60% - 70% of the financing structure, with the
remainder of the purchase price funded by equity
contribution from a sponsor (or group of
sponsors) and rolled/contributed equity from
management
General Ranking of Financing Sources in an LBO
capital structure
Debt Financing Equity Financing
Equity
Bank Debt High Yield Bonds Mezzanine Debt Contribution
Higher Ranking <------------------------> Lower Ranking
Lower Flexibility <------------------------> Higher Flexibility
Lower cost of capital <------------------------> Higher cost of capital
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LBO Debt Financing: Key Terms
Debt Financing
Bank Debt High Yield Bonds Mezzanine Debt
Secured <--------- Security ------------> Unsecured
Senior <--------- Seniority ------------> Junior
Shorter <--------- Maturity ------------> Longer
Lower <--------- Coupon ------------> Higher
More Prepayability <--------- Call Protection ------------> Negotiated
More Restrictive <--------- Covenants ------------> Less Restrictive
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LBOs of the 1990s versus the 1980s
• Senior Debt: shorter term
Bank of America averages: 3-4 years (1990s) vs. 6-7 years (1980s)
• Debt/Cash Flow Ratios: lower
Bank of America averages: senior debt 2.5 times EBITDA (1990s)
versus 3-4 times EBITDA (1980s)
• More Equity:
Bank of America averages: sponsor controlled equity capital of 35%
of the capital structure in the 1990s versus 20 to 25% in the 1980s
• Buyout Prices Lower
5-6 times EBITDA (1990s) versus 7-10 times EBITDA (1980s)
Conclusion: 1990s deals had:
Reduced debt; Shorter maturities; Greater cash flow requirements;
More equity; Buyout prices lower
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Comparison of Two Largest LBO’s:
RJR versus HCA
RJR Nabisco HCA Inc.*
Date April 1989 (closed) Nov. 2006 (closed)
Deal Value ($ bill.) $31.3 $33.0
including assumption of debt
Equity invested ($ bill.) $2.0** $5.8
EV/EBITDA $10.9 $7.7
Debt/ EV 94% 84%
Blended average interest rate 13.8% 7.9%
EBITDA/interest 1.1 1.9
Advisory fees to sponsors ($ mill.) $75 $150
* Debt terms and fees are estimates
Source: The Deal ** Included $500M of junior debentures
October 2 – October 8, 2006 43
• Thank you for your attention!
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