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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Editions
- Sprache: Englisch
A comprehensive look at the world of leveraged buyouts The private equity industry has grown dramatically over the past twenty years. Such investing requires a strong technical know-how in order to turn private investments into successful enterprises. That is why Paul Pignataro has created Leveraged Buyouts + Website: A Practical Guide to Investment Banking and Private Equity. Engaging and informative, this book skillfully shows how to identify a private company, takes you through the analysis behind bringing such an investment to profitability--and further create high returns for the private equity funds. It includes an informative leveraged buyout overview, touching on everything from LBO modeling, accounting, and value creation theory to leveraged buyout concepts and mechanics. * Provides an in-depth analysis of how to identify a private company, bring such an investment to profitability, and create high returns for the private equity funds * Includes an informative LBO model and case study as well as private company valuation * Written by Paul Pignataro, founder and CEO of the New York School of Finance If you're looking for the best way to hone your skills in this field, look no further than this book.
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Veröffentlichungsjahr: 2013
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Contents
Cover
Series
Title Page
Copyright Page
Dedication
Preface
THE HEINZ CASE STUDY
HOW THIS BOOK IS STRUCTURED
Part One: Leveraged Buyout Overview
Chapter 1: Leveraged Buyout Theory
CASH AVAILABILITY, INTEREST, AND DEBT PAY-DOWN
OPERATION IMPROVEMENTS
MULTIPLE EXPANSION
WHAT MAKES GOOD LEVERAGED BUYOUT?
EXIT OPPORTUNITIES
IS HEINZ A LEVERAGED BUYOUT?
Chapter 2: What Is Value?
BOOK VALUE
MARKET VALUE
ENTERPRISE VALUE
MULTIPLES
THREE CORE METHODS OF VALUATION
Chapter 3: Leveraged Buyout Analysis
PURCHASE PRICE
SOURCES AND USES OF FUNDS
IRR ANALYSIS
Part Two: Leveraged Buyout Full-Scale Model
Chapter 4: Assumptions
PURCHASE PRICE
SOURCES OF FUNDS
USES OF FUNDS
Chapter 5: The Income Statement
REVENUE
COST OF GOODS SOLD
OPERATING EXPENSES
OTHER INCOME
DEPRECIATION AND AMORTIZATION
INTEREST
TAXES
NONRECURRING AND EXTRAORDINARY ITEMS
DISTRIBUTIONS
SHARES
HEINZ INCOME STATEMENT
LAST TWELVE MONTHS (LTM)
INCOME STATEMENT—PROJECTIONS
Chapter 6: The Cash Flow Statement
CASH FLOW FROM OPERATING ACTIVITIES
CASH FLOW FROM INVESTING ACTIVITIES
CASH FLOW FROM FINANCING ACTIVITIES
FINANCIAL STATEMENT FLOWS EXAMPLE
HEINZ CASH FLOW STATEMENT
HEINZ LAST TWELVE MONTHS (LTM) CASH FLOW
CASH FLOW STATEMENT PROJECTIONS
Chapter 7: The Balance Sheet
ASSETS
LIABILITIES
HEINZ BALANCE SHEET
Chapter 8: Balance Sheet Adjustments
THE BUYER IS PAYING FOR
THE BUYER IS RECEIVING
GOODWILL
HEINZ BALANCE SHEET ADJUSTMENTS
Chapter 9: Depreciation Schedule
STRAIGHT-LINE DEPRECIATION
ACCELERATED DEPRECIATION
DEFERRED TAXES
PROJECTING DEPRECIATION
PROJECTING AMORTIZATION
PROJECTING DEFERRED TAXES
Chapter 10: Working Capital
ASSET
LIABILITY
OPERATING WORKING CAPITAL
HEINZ’S OPERATING WORKING CAPITAL
PROJECTING OPERATING WORKING CAPITAL
OPERATING WORKING CAPITAL AND THE CASH FLOW STATEMENT
Chapter 11: Balance Sheet Projections
CASH FLOW DRIVES BALANCE SHEET VERSUS BALANCE SHEET DRIVES CASH FLOW
BALANCING AN UNBALANCED BALANCE SHEET
Chapter 12: Debt Schedule and Circular References
DEBT SCHEDULE STRUCTURE
MODELING THE DEBT SCHEDULE
CIRCULAR REFERENCES
AUTOMATIC DEBT PAY-DOWNS
BASIC SWITCHES
FINALIZING THE MODEL
Chapter 13: Leveraged Buyout Returns
EXIT VALUE
RETURNS TO 3G CAPITAL
MULTIPLE EXPANSION
DEBT PAY-DOWN
CONCLUSION
Part Three: Advanced Leveraged Buyout Overview
Chapter 14: Accelerated Depreciation
MACRS
ACCELERATED VERSUS STRAIGHT-LINE DEPRECIATION
Chapter 15: Preferred Securities, Dividends, and Returns to Berkshire Hathaway
PREFERRED SECURITIES
PREFERRED DIVIDENDS
RETURNS TO BERKSHIRE HATHAWAY
Chapter 16: Debt Covenant Ratios, and Debt Fee Amortization
COVERAGE RATIOS
LEVERAGE RATIOS
DEBT FEE CAPITALIZATION AND AMORTIZATION
Chapter 17: Paid-in-Kind Securities
Appendixes
Appendix A: Model Quick Steps
Appendix B: Financial Statement Flows
INCOME STATEMENT TO CASH FLOW
CASH FLOW TO BALANCE SHEET
Appendix C: Excel Hot Keys
About the Companion Website
About the Author
Index
Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.
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Copyright © 2014 by Paul Pignataro. All rights reserved.
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Library of Congress Cataloging-in-Publication Data:
Pignataro, Paul. Leveraged buyouts: a practical guide to investment banking and private equity / Paul Pignataro. pages cm. — (Wiley finance series) Includes index. ISBN 978-1-118-67454-3 (cloth)—ISBN 978-1-118-67458-1 (ePDF)—ISBN 978-1-118-67445-1 (ePub) 1. Leveraged buyouts. 2. Consolidation and merger of corporations. 3. Investment banking. 4. Private equity. I. Title. HD2746.5.P54 2013 658.1'62—dc23
2013023885
This book is dedicated to every investor in the pursuit of enhancing wealth. Those who have gained, and those who have lost—this continuous struggle has confounded the minds of many. This book should be one small tool to help further said endeavor; and if successful, the seed planted will contribute to a future of more informed investors and smarter markets.
Preface
In the 1970s and 1980s, the corporate takeover market began to surge. As a means to continue to enhance corporate wealth and leadership, growth through mergers or acquisitions flooded the corporate environment. Although such mergers and acquisitions had existed for decades, the mid-1970s led the multibillion-dollar hostile takeover race. This was followed by a surge in the 1980s of the leveraged buyout, a derivative of the takeover, culminating with the most noted leveraged buyout of its time, the $25 billion buyout of RJR Nabisco by Kohlberg Kravis Roberts in 1989.
A leveraged buyout, most broadly, is the acquisition of a company using a significant amount of debt to meet the acquisition cost. Arguably, the increase in leveraged buyouts in the 1980s was partly due to greater access to the high-yield debt markets (so-called junk bonds), pioneered by Michael Milken. Access to such aggressive types of lending allowed buyers to borrow more money to fund such large acquisitions. The more debt borrowed, the less equity needed out-of-pocket, leading to potentially higher returns. This concept of higher returns for less equity sparked interest among many funds and even individual investors, and extended worldwide. From buyouts of small $10 million businesses to the recent $25 billion potential buyout of Dell, small investors, funds, and enthusiasts alike have been fascinated by the mechanics, aggressiveness, and high-return potential of leveraged buyouts.
This book seeks to give any investor the fundamental tools to help analyze a leveraged buyout and determine if the potential returns are worth the investment. These fundamental tools are used by investment banks and private equity funds worldwide. We will evaluate the potential leveraged buyout of the H.J. Heinz Company, determining its current financial standing, projecting its future performance, and estimating the potential return on investment using the exact same methods used by the bulge bracket investment banks and top private equity firms. We will have you step into the role of an analyst on Wall Street to give you a firsthand perspective and understanding of how the modeling process works, and to give you the tools to create your own analyses. Whether you are an investor looking to make your own acquisitions or a fund, these analyses are invaluable in the process. This book is ideal for both those wanting to create their own analyses and those wanting to enter the investment banking or private equity field. This is also a guide designed for investment banking or private equity professionals themselves if they need a thorough review or simply a leveraged buyout modeling refresher.
THE HEINZ CASE STUDY
PITTSBURGH & OMAHA, Neb. & NEW YORK–(BUSINESS WIRE)—H.J. Heinz Company (NYSE: HNZ) (“Heinz”) today announced that it has entered into a definitive merger agreement to be acquired by an investment consortium comprised of Berkshire Hathaway and 3G Capital.
Under the terms of the agreement, which has been unanimously approved by Heinz’s Board of Directors, Heinz shareholders will receive $72.50 in cash for each share of common stock they own, in a transaction valued at $28 billion, including the assumption of Heinz’s outstanding debt. The per share price represents a 20% premium to Heinz’s closing share price of $60.48 on February 13, 2013, a 19% premium to Heinz’s all-time high share price, a 23% premium to the 90-day average Heinz share price and a 30% premium to the one-year average share price.
(Heinz Press Release, February 14, 2013)
In this press release dated February 14, 2013, Heinz announces the possibility of being acquired by both Berkshire Hathaway and 3G Capital. We will analyze this potential buyout of Heinz throughout this book. Heinz manufactures thousands of food products on six continents, and markets these products in more than 200 countries worldwide. The company claims to have the number-one or number-two brand in 50 countries. Each year Heinz produces 650 million bottles of ketchup and approximately two single-serve packets of ketchup for every man, woman, and child on the planet. The company employs 32, 000 people worldwide.
What is the viability of such a buyout? How are Berkshire Hathaway and 3G Capital finding value in such an investment? What are their potential returns? There is a technical analysis used by Wall Street analysts to help answer such questions. We will walk you through the complete buyout analysis as a Wall Street analyst would conduct that analysis.
It is important to note that the modeling methodology presented in this book is just one view. The analysis of Heinz and the results of that analysis do not directly reflect my belief, but rather, a possible conclusion for instructional purposes only based on limiting the most extreme of variables. There are other possibilities and paths that I have chosen not to include in this book. Many ideas presented here are debatable, and I welcome the debate. The point is to understand the methods and, further, the concepts behind the methods to equip you properly with the tools to drive your own analyses.
HOW THIS BOOK IS STRUCTURED
This book is divided into three parts:
In Part One, we explain the concepts and mechanics of a leveraged buyout. Before building a complete model, it is important to step through, from a high level, the purposes of a leveraged buyout and the theory of how a leveraged buyout works. A high-level analysis helps us to understand the importance of key variables and is crucial to understanding how various assumption drivers affect potential returns.
In Part Two, we build a complete leveraged buyout model of Heinz. We analyze the company’s historical performance and step through techniques to make accurate projections of the business’s future performance. The goal of this part is not only to understand how to build a model of Heinz, but to extract the modeling techniques used by analysts and to apply those techniques to any investment.
Part Three also adds more modeling complexity, ideal for those who already have basic experience modeling leveraged buyouts. Adjusting scenarios, advanced securities such as paid-in-kind (PIK) securities and preferred dividends, and the capitalization and amortization of debt fees add more complexity and will further your understanding of using leveraged buyouts in practice.
The book is designed to have you build your own leveraged buyout model on Heinz step-by-step. The model template can be found on the companion website associated with this book and is titled “NYSF_Leveraged_Buyout_Model_Template.xls” To access the site, see the About the Companion Website section at the back of this book.
PART One
Leveraged Buyout Overview
Aleveraged buyout (LBO) is a fundamental, yet complex acquisition commonly used in the investment banking and private equity industries. We will take a look at the basic concepts, benefits, and drawbacks of a leveraged buyout. We will understand how to effectively analyze an LBO. We will further analyze the fundamental impact of such a transaction and calculate the expected return to an investor. Last, we will spend time interpreting the variables and financing structures to understand how to maximize investor rate of return (IRR).
The three goals of this part are:
CHAPTER 1
Leveraged Buyout Theory
Aleveraged buyout is an acquisition of a company using a significant amount of debt to meet the cost of the acquisition. This allows for the acquisition of a business with less equity (out-of-pocket) capital. Think of a mortgage on a house. If you take out a mortgage to fund the purchase of a house, you can buy a larger house with less out-of-pocket cash (your down payment). Over time, your income will be used to make the required principal (and interest) mortgage payments; as you pay down those principal payments, and as the debt balance reduces, your equity in the house increases. Effectively, the debt is being converted to equity. And maybe you can sell the house for a profit and receive a return. This concept, on the surface, is similar to a leverage buyout. Although we use a significant amount of borrowed money to buy a business in an LBO, the cash flows produced by the business will hopefully, over time, pay down the debt. Debt will convert to equity, and we can hope to sell the business for a profit.
There are three core components that contribute to the success of a leveraged buyout:
CASH AVAILABILITY, INTEREST, AND DEBT PAY-DOWN
This is the concept illustrated in the chapter’s first paragraph. The cash being produced by the business will be used to pay down debt and interest. It is the reduction of debt that will be converted into the equity value of the business.
It is for this reason that a company with high and consistent cash flows makes for a good leveraged buyout investment.
OPERATION IMPROVEMENTS
Once we own the business, we plan on making some sort of improvements to increase the operating performance of that business. Increasing the operating performance of the business will ultimately increase cash flows, which will pay down debt faster. But, more important, operating improvements will increase the overall value of the business, which means we can then (we hope) sell it at a higher price. Taking the previous mortgage example, we had hoped to make a profit by selling the house after several years. If we make some renovations and improvements to the house, we can hope to sell it for a higher price. For this reason, investors and funds would look for businesses they can improve as good leveraged buyout investments. Often the particular investor or fund team has particular expertise in the industry. Maybe they have connections to larger sources of revenue or larger access to distribution channels based on their experience where they feel they can grow the business faster. Or, maybe the investor or fund team sees major problems with management they know they can fix. Any of these operation improvements could increase the overall value of the business.
MULTIPLE EXPANSION
Multiple expansion is the expectation that the market value of the business will increase. This would result in an increase in the expected multiple one can sell the business for. We will later see, in a business entity, we will most likely base a purchase and sale off of multiples. We will also conservatively assume the exit multiple used to sell the business will be equal to the purchase multiple (the multiple calculated based on the purchase price of the business). This would certainly enhance the business returns.
WHAT MAKES GOOD LEVERAGED BUYOUT?
In summary, a good leveraged buyout has strong and consistent cash flows that can be expected to pay down a portion of the debt raised and related interest. Further, the investor or fund sees ways to improve the operating performance of the business. It is hoped that the combination of debt converting into equity and the increase in operating performance would significantly increase the value of the business. This results in an increase in returns to the investor or fund. The next pages of this book step through such an analysis in its entirety and are intended to give you the core understanding of how such an analysis can provide not only benefits to a company, but high returns to an investor. This will also indicate pitfalls many investors face and reasons why many LBOs may not work out as planned.
EXIT OPPORTUNITIES
The financial returns from a leveraged buyout are not truly realized until the business is exited, or sold. There are several common ways to exit a business leveraged buyout:
IS HEINZ A LEVERAGED BUYOUT?
There is a debate on whether the Heinz situation is technically a leveraged buyout. I believe we can all agree this is in fact a buyout; Heinz is being acquired by 3G Capital and Berkshire Hathaway. But is the buyout leveraged? Those believing that the Heinz deal is not a leveraged buyout argue that the debt raised to meet the acquisition cost is not significant enough to constitute a leveraged buyout. I agree that what justifies the amount of debt raised to be significant is not formally defined in the leveraged buyout world. However, we will see in Chapter 4 that the amount of debt raised is approximately 40 percent to 45 percent of total funds used to acquire Heinz; I believe this is a significant amount of debt. The second important thing to consider is how the debt is being raised. In a leveraged buyout, typically the debt raised is backed by the assets of the company being purchased. As this will most likely be the case for Heinz, I would certainly consider this a leveraged buyout.
Others also argue this is not technically a leveraged buyout based on intent. In other words, the Heinz buyers are stating that their intent is not to exit the investment after a fixed time horizon, as is often the case for large buyout funds. Although this may be true, I am not sure “intent” is an appropriate determinant of what constitutes a leveraged buyout. It is still a buyout; it is still leveraged. Whether you believe the transaction is a leveraged buyout still stands as a relatively subjective debate. For purposes of instruction, we will model the case as if it were a full-fledged leveraged buyout. What’s interesting is that the modeling does not change either way.
CHAPTER 3
Leveraged Buyout Analysis
There are three major steps to conducting a leveraged buyout (LBO) analysis:
PURCHASE PRICE
In order to conduct a leveraged buyout analysis, we first need to obtain a potential purchase price of the entity. Conducting a valuation analysis on the entity will help us arrive at an approximate current value of the entity. The book Financial Modeling and Valuation steps through how to model and value a company. Although a valuation analysis is helpful in providing an indication of what the appropriate value of the entity is today, one will most likely have to consider a control premium. A control premium is the percentage above current market value one would consider paying to convince the business owner or shareholders to hand over the business or shares. Let’s take another look at the Heinz press release presented in the Preface.
Heinz Leveraged Buyout Press Release
PITTSBURGH & OMAHA, Neb. & NEW YORK–(BUSINESS WIRE)—H.J. Heinz Company (NYSE: HNZ) (“Heinz”) today announced that it has entered into a definitive merger agreement to be acquired by an investment consortium comprised of Berkshire Hathaway and 3G Capital.
Under the terms of the agreement, which has been unanimously approved by Heinz’s Board of Directors, Heinz shareholders will receive $72.50 in cash for each share of common stock they own, in a transaction valued at $28 billion, including the assumption of Heinz’s outstanding debt. The per share price represents a 20% premium to Heinz’s closing share price of $60.48 on February 13, 2013, a 19% premium to Heinz’s all-time high share price, a 23% premium to the 90-day average Heinz share price and a 30% premium to the one-year average share price.”
(Heinz Press Release,February 14, 2013)
This states that the company will be purchased for $72.50 per share. Heinz, however, at the time this article was written, was trading at $60.48 per share. So the buyers are paying a price per share ($72.50) that is approximately 20 percent higher than the current trading price per share—a control premium.
Public versus Private Company Purchase
It is important to note that for a public company the purchase price is most likely based on a percentage above the current market trading value per share as exemplified in the preceding press release. However, private companies are popular leveraged buyout candidates as well. If we are evaluating a private company, we do not have a current market trading value from which to value the business. So, we need to use multiples to establish an estimated purchase price. Multiples of a private company can be based on public company comparables or historical transactions. In other words, to find an appropriate value of a private company, you can look for companies that are similar in product and size to that company: comparable companies. The multiples ranges of these comparable companies can determine the value of the private company. Also, looking at the price paid for historical transactions similar in product and size to the private company as a multiple can help establish an appropriate purchase price.
Types of Acquisitions
A business acquisition can be considered an asset acquisition or a stock acquisition. There are several differences between the two.
Asset acquisition
In an asset acquisition, the buyer purchases selected assets in the business and may take on the liabilities directly associated with the assets selected. Here, the net value of the assets purchased are “stepped-up, ” or written up, on the acquirer’s tax balance sheet. In other words if a buyer pays a higher value for an asset than what is stated on the seller’s balance sheet, and that purchase price represents the fair market value of the asset, then that incremental value paid can be amortized over 15 years (under U.S. tax law) for tax purposes. This amortization is tax deductible. The value of the asset can also be “stepped-down” or written down if the purchase price is less than what is stated on the seller’s balance sheet.
Stock acquisition
In a stock acquisition, the buyer purchases the target’s stock from the selling shareholders. This would result in an acquisition of the entire business entity—all of the assets and liabilities of the seller (some exceptions will be later noted). In a stock acquisition, if the purchase price paid is higher than the value of the entity as per its balance sheet, the difference needs to be further scrutinized. Unlike in an acquisition of assets, where the difference can be amortized and tax deductible, here the difference cannot all be attributed to an asset “stepped-up” and may be attributed to other items such as intangibles assets or Goodwill. While intangible assets can still be amortized, Goodwill cannot under us G.A.A.P rules. Because Goodwill cannot be amortized, it will not receive the same tax benefits as amortizable assets. We will detail this further in Chapter 8.
338(h)(10) Elections
To a buyer, an acquisition of assets is generally preferred for several reasons: First the buyer will not be subject to additional liabilities beyond those directly associated with the assets, and second the buyer can receive the tax benefits of an asset “step-up.”
However, to a seller an acquisition of equity is generally preferred as the entire business, including most liabilities, are sold. This also avoids the double-taxation issue sellers face related to an asset purchase. See Table 3.1.
TABLE 3.1 Types of Acquisitions
Source: Breaking into Wall Street (BIWS): http://samples.breakingintowallstreet.com.s3.amazonaws.com/22-BIWS-Acquisition-Types.pdf.
The 338(h)(10) election is a “best of both worlds” scenario allowing the buyer to record a stock purchase as an asset acquisition in that the buyer can still record the asset “step up.” The section 338(h)(10) election historically has been available to buyers of subsidiaries only, but are now permitted in acquisitions of S corporations even though, by definition, S corporations do not fulfill the statute’s requirement that the target be a subsidiary. Thus, an S corporation acquisition can be set up as a stock purchase, but it can be treated as an asset purchase followed by a liquidation of the S corporation for-tax purposes.
Since Heinz is a public company, the buyers will consider the acquisition a stock acquisition.
See Table 3.1 from the popular website Breaking Into Wall Street for a nice summary of all the major differences between an Asset Acquisition, a Stock Acquisition, and the 338(h)(10) Election.
SOURCES AND USES OF FUNDS
Once a purchase price has been established, we need to determine the amount of funds we actually need raised to complete the acquisition (uses), and we need to know how we will obtain those funds (sources).
Uses of Funds
The uses of funds represent how much funding we need to complete the acquisition. These uses generally fall into three major categories:
Purchase Price
As discussed previously in the purchase price section of this chapter, the purchase price is based either on the current market trading value of the business or on some multiple.
Net Debt
Quite often, in addition to the purchase price, a buyer is responsible for raising additional funds to pay off the target company’s outstanding debt obligations. This can also include other liabilities such as capital lease obligations. The need to pay down such obligations is dependent on several factors including whether the company is public or private.
Public Company
If the company is public, which means the buyer is buying all existing shares from the shareholders, the buyer must assume responsibility for obligations on the target company’s balance sheet. Certainly the shareholders cannot be responsible for the corporate debt. So the buyer has to determine whether it can or should assume the debt that will carry over after purchase, or if it must raise additional funds to pay down those obligations. The buyer must conduct some due diligence on the company’s debts. Most likely, when lenders lend to companies, those debts come with covenants and bylaws that state if there are any major company events, such as a change in control (an acquisition), so those lenders would require to be paid back. If that is the case, then the buyer has no choice but to refinance or raise additional funds to pay those obligations. If there are no such requirements, then the buyer must make the decision whether it would prefer to pay back the obligations or take them on and just keep them outstanding on the balance sheet. That decision will most likely be based on the interest rates or other terms of the outstanding loans. If the buyer can get a loan with a better rate, the buyer will most likely prefer to pay back the old debt and raise new debt.
Private Company
If the company is private, the buyer has most likely negotiated a purchase price based on some multiple. Remember that there are market value multiples and enterprise value multiples (see Chapter 2). The multiple becomes an important factor here because this multiple determines whether the purchase price is effectively a market value or an enterprise value. In other words, if the purchase price was derived based on a market value multiple, then of course the purchase price is an effective market value, whereas if the purchase price was derived based on an enterprise value multiple, then the purchase price is an effective enterprise value. This is important to consider because if the purchase price negotiated is effectively an enterprise value, then that purchase price includes the value of debt. And that means we should not have to raise additional funds to pay down the target company’s debt obligations. We are basically saying that the seller should be responsible for such obligations. Let’s say, for example, that we negotiated to buy a company for 5x EBITDA. If the company’s EBITDA is $100, 000, then we will pay $500, 000 for the company. However, since $500, 000 is based on an enterprise value, which is the value of the business including obligations, then the $500, 000 effectively includes the value of debt and obligations and the seller should assume responsibility for paying them down.
On the other hand, let’s say we negotiated a purchase price based on a market value multiple of 10x net income. If the net income is $25, 000, then the purchase price is $250, 000. However, that purchase price is a market value (because it is based on net income—after debt and obligations), which means the value of debt is not included. Inherently, the buyer is now responsible for the obligations on the business. This should make sense because this is a lower purchase price than that obtained when we used the EBITDA multiple.
Let’s say the total value of obligations is $250, 000. If we have negotiated a purchase price based on EBITDA, then we pay $500, 000 and are not responsible for the debt (the seller holds responsibility). However, if the negotiated purchase price is based on net income and the purchase price is $250, 000, then we are responsible for raising additional funds to pay the obligations of $250, 000, which totals $500, 000.
Public CompanyPrivate CompanyValuation Methods UsedPercent premium above market price, multiplesMultiplesNet Debt ResponsibilityGoes to the buyer; is either rolled over, refinanced, or paid down upon acquisition.Can go to the buyer or seller; depends on valuation method, negotiations, and debt contractsSo, depending on how the buyer has arrived at a purchase price, net debt may or may not need to be included in uses of funds. Note that we mention net debt as opposed to total debt, as net debt is the total debt less cash and cash equivalents. In other words, we assume if there is any outstanding cash on the target company balance sheet at acquisition, it will be used to pay target obligations. Note that for a private company, it is likely that a seller will pocket all outstanding cash before sale. In that situation, the cash will be $0 on the balance sheet.
Transaction Fees
Transaction fees are expenses related to the pursuit and close of the transaction. Lawyers and investment bankers need to get paid for their services in helping the deal come together, for example. The buyer needs to allocate additional funds to pay such fees. The fees can run from a small retainer to a percentage of the transaction size. The amount depends on negotiations and firmwide policy. Some of these fees can be capitalized. (See Table 3.2.) Examples of a few of the more common transaction fee categories follow.
TABLE 3.2 Transaction Fee Table Example
Transaction FeesRateAmountEquity Investor2.00%$ 600, 000Senior Lender0.50%37, 500Mezzanine Lender2.00%120, 000Legal150, 000Accounting75, 000Environmental10, 000Due Diligence15, 000Human Resources25, 000Miscellaneous25, 000Total$1, 057, 500Investment Banking Fees
Investment banks will often be hired to help pursue the purchase or sale of a business on behalf of a client. The investment banking fees are often based on a percentage of the transaction value (1 percent to 3 percent, for example, or even less than 1 percent for some multibillion-dollar businesses). Investment banks also receive fees for conducting business valuations, seeking out other investing parties such as lenders, and conducting due diligence.
Legal Fees
Attorneys are needed for contract negotiation, regulatory review and approval, legal due diligence, preparation of documents for approval, and closing documents. There will also be attorney fees for negotiating, reviewing, and preparing the documents necessary for funding the transaction, which can include private placement memoranda for debt and / or equity. Investment banks also aid in authoring memoranda hand-in-hand with legal council.
Due Diligence Costs
Due diligence refers to examining and auditing a potential acquisition target. This process includes reviewing all financial records, appraising assets, and valuing the entity and anything deemed material to the sale.
Environmental Assessment
If land or property is involved in the acquisition, an environmental assessment may be required to assess the positive or negative impacts the asset may have on the environment.
Human Resources
Quite often if the strategy of a leveraged buyout is to improve the operational performance of the business, there will be a need to search for better talent. New management such as a CEO with a proven track record may be key to achieving such desired operational results. A human resources search may then need to be conducted.
Debt Fees
Lenders often charge a fee, either a flat rate or a certain percentage of the debt lent out. This percentage can be less than 1 percent for standard term loans or 1 percent to 3 percent for more aggressive types of debt. It can also vary significantly based on the size of debt lent. Sometimes fees charged associated with term loans can be capitalized and amortized on the balance sheet. We discuss in detail the capitalization and amortization of debt fees in Chapter 16.
Equity Fees
The equity investor may also charge a fee upon transaction closing. Such fees are again dependent on the size of equity invested and are one of several ways a private equity fund can generate operating profit. Table 3.2 is an example of a transaction fee structure for a recent $30 million leveraged buyout transaction.
In the example, the equity investor is the private equity firm purchasing the business. He has charged a 2 percent fee on the $30 million purchase price. The senior lender has raised $7, 500, 000 and receives a 0.5 percent fee. The mezzanine lender has raised $6, 000, 000 and receives a 2 percent fee. There are also several other fees that are flat fees. This is based on a real example, so it gives you an indication of fee amounts for a $30 million acquisition. In total, these fees amounted to 3.33 percent of the overall transaction size.
In summary, the purchase price, net debt, and transaction fees all represent the uses of cash. This is the amount of money a buyer needs to raise to meet the total cost of acquisition.
Sources of Funds
Now that we know how much we need to raise in total to fund the acquisition, we need to source such funds. Funds are sourced either by raising equity or debt or by using cash on hand. Table 3.3 gives an example of the types of sources one would see in a leveraged buyout. The percentage ranges in the left column represent on average the percentage of total sources raised by each security. The expected returns can vary depending on the market environment. Also note that the expected equity returns of > 25% stated in Table 3.3 is the percentage many funds hope to achieve; different from what has actually been achieved on average given the recent market environment.
TABLE 3.3 Example of Leveraged Buyout Capital Structure
Bank Debt (30% to 50%)Has initial rights on the assetsLowest-risk securityExpected returns (interest): 5% to 12%High Yield Debt(0% to 10%)Junk bondsHigher-risk securityHigh interestNot used as often (mezzanine is more common today)Expected returns: 12% to 15%Mezzanine Lending (20% to 30%)Combination of debt and equity; downside protection (debt) and upside potential (equity)Also can be considered convertible debt or preferred equityHelpful in increasing equity returnsExpected returns: 13% to 25%Equity (20% to 30%)Financial sponsorsNo downside protectionExpected returns: > 25%Debt
A company can raise various types of debts in order to obtain funding for an acquisition. Common debts raised exist in several categories.
Bank Debt
Bank debt or a term loan is the most fundamental type of debt. It usually carries 5 percent to 12 percent interest and can be backed by the core assets of the business. Such debt is also typically amortized over the transaction horizon, five to seven years for example. Bank debts can come from commercial or investment banks, private funds, or investors. It is also possible, but more difficult, to receive multiple loans from different lenders. However, there is almost always a hierarchy where one is subordinate to another. Subordinated debt would be riskier and warrant a higher interest rate.
Note that the purpose of this book is not to educate on all the various debt instruments. The selection is vast and there are other great books out there that focus solely on debt instruments. This is meant to be a brief overview to better illustrate how various debts are applied to a leveraged buyout analysis.
