Download INVESTMENT BANKING

INVESTMENT BANKING
LESSON 7 STRUCTURING A LEVERAGED
BUYOUT
Investment Banking (2nd edition) Beijing Language and Culture University
Press, 2013
Investment Banking for Dummies, Matthew Krantz, Robert R.
Johnson,Wiley & Sons, 2014
WHAT’S IN THE NEWS OR
WHAT’S THERE TO LEARN?
 THE
ACQUISITION THAT GOT AWAY!
LESSON 6 REVIEW
1. WHAT IS EDGAR AND HOW IS IT HELPFUL TO IB?
2. HOW CAN SOCIAL MEDIA, LIKE FACEBOOK,
TWITTER, WE CHAT, etc HELP OR HURT IB
ACTIVITIES?
REVIEW CHAPTER 5
1. DESCRIBE WHAT AN LBO IS IN 3-4 SENTENCES.
2. WHAT IS THE GOAL OF AN LBO?
3. WHO ARE THE 4 KEY PLAYERS IN AN LBO AND
WHAT DO THEY DO?
4. NAME 5 TARGETS RIGHT AND READY FOR AN
IPO AND WHY?
5. WHY IS CASH FLOW IMPORTANT IN AN LBO AND
WHAT CALCULATION(S) IS IMPORTANT TO THE
SPONSORS AND INVESTORS?
6. WHAT ARE THE OPTIONS FOR EXITING AN LBO
1. INTRODUCTION
2. THE 4 MAIN TYPES OF FINANCING
3. SENIORITY AND MATURITY IN
LBO’S
4. BUILDING A LBO MODEL
5. DECIDING ON METHODS OF FINANCING
6. WHAT CAN GO RIGHT AND WHAT CAN GO
WRONG?
In one sentence what is an LBO?
An LBO is a deal in which a buyer borrows
money (usually a lot!) and uses that money
to buy a target.
An LBO is a favorite tool of an IB because the
returns can huge! The income made relative
to the amount of cash you put at risk can be
very large.
In this lesson we will see how different
types of debt can be used to make
LBO’s successful. And we will see how
IB put LBO’s together.
The primary reason for using debt is
that, in America, the interest payments
on debt are tax deductible and reduce
a company’s tax bill.
If the debt is used wisely, equity
holders (investors who put money
in) and the private equity sponsor
(the co. that gets money from
investors to buy out the firms) can
get a very good return in its
invested capital.
There are four kinds:
A. BANK DEBT
1. REVOLVING CREDIT
2. TERM LOANS
B. JUNK BONDS
C. MEZZANINE DEBT
D. EQUITY
Let’s look at each of these!
A. BANK DEBT – There are 2 types
1. Revolving Credit – Just like a credit card
this is not used for large items like physical
plant and equipment. More as a source of funds
for working capital – to purchase inventory or
raw materials. This debt is then paid off when
cash is available.
The rate is based on the prime rate (rates
banks give to their best customers) or Libor
(the London Interbank offered rate) plus a %
added to both of them.
A. BANK DEBT
2. Term loans – Just like a car loan or
mortgage a term loan is paid back over the
term (time – 6 months 1, 3,5 years) in equal
payments. The payment represents interest
+ repayment of principal. This is called
amortization.
Some term loans can be interest only
payments with a bullet or balloon payment
at the end of the loan.
SAMPLE AMORTIZATION SCHEDULE
Loan Information
Loan amount-$200,000 Annual interest rate-5% No. of months-240
Monthly principal and interest payment $1,319.91










Year Beginning Balance Principal
InterestPayment
Ending Balance
1
$200,000
$5,975
$9,864 $15,839
$194,025
2
194,025
6,280
9,559 15,839
187,745
3
187,745
6,602
9,237 15,839
181,143
4
181,143
6,939
8,900 15,839
174,204
5
174,204
7,294
8,545 15,839
166,910
6-17………………………………………………………………………………………………..
18 44,040
13,954
1,885 15,839
30,086
19 30,086
14,668
1,171 15,839
15,418
20 15,418
15,418
421
15,839
0
B. JUNK BONDS – Bonds of lower quality
than investment-grade bonds. Bond ratings
range from AAA to C & D, which refer to
bonds already in default.
The purpose of bond ratings is to provide
investors with an idea of creditworthiness.
Will an investor receive his promised
interest and principal payments?
Mostly used by large capitalized LBO’s.
B. JUNK BONDS - Some individual investors
will invest in junk bonds but the market is
dominated by large investors such as mutual
funds and foundations.
Why invest in junk bonds?
They pay a much higher interest rate and
are considered high-yield bonds. Junk
bonds become more attractive as the
market rate for better bonds is low. As the
crisis of 2008 gets farther away, junk bonds
Become an option funding LBO’s.
C. MEZZANINE DEBT – A form of financing
between debt and equity. Mostly used by
mid-size capitalized LBO’s (below $1billion)
and goes for 3-5 years.
It’s like a bond but with a warrant which
allows an investor to buy stock in a company
during the 3 to 5 year period at a price of
$10/share.
C. MEZZANINE DEBT – The current price of a
stock may be $7/share. If the company is
successful the stock could rise say from $7
to even $21/share which makes the
purchase of the warrant at a beginning
higher price of $10 a bargain.
This kind of debt allows an investor to
become an owner should the company be
successful. The warrants can also be sold
and the holder can retain the bond (debt).
C. MEZZANINE DEBT – An advantage of this
debt, with warrants is that it can be issued
at a lower interest rate. This type or
financing helps with the cash flow limiting
the amount of interest and principal to be
paid.
Most common investors are insurance
companies, commercial banks and other
private equity firms.
D. EQUITY – After the mound of debt are
the equity holders (stockholders). These are
the people that own the company and are
entitled to the returns after the debt has
been paid back. This is mainly the private
equity partnership – the firm that
sponsored the LBO and put the deal
together. Some of the equity will be held by
the management so there is an incentive to
help make the deal work.
WHAT DOES SENIORITY MEAN?
Simply, seniority means, who gets paid
back first?
FIRST - Revolving bank debt is the least
risky form of financing with also the lowest
expected return.
LAST – Equity holders only get returns after
all other claims (debts) have been paid.
WHAT DOES MATURITY MEAN?
Simply, maturity means, when does the debt
come due and needs to be paid back?
TERM LOANS have maturities of 4-8 years, but
no pre-payment penalty.
JUNK BONDS are longer than term loans (5-10
years) but shorter than investment grade
bonds, which can be of to 30 years.
EQUITY has no maturity. This is called a
perpetual claim. Anytime, like stock, of course
after everyone else has been paid. Has no
maturity date.
AGAIN, WHY DO AN LBO?
To build the investment so that
equity holders earn large returns on
their investments by using high
levels of debt to leverage these
returns. You might say, the equity
holders are using “other peoples”
money to increase their returns.
IB build LBO models based on pro
forma cash flow statements. Pro
forma means “for the sake of
form” – a best case scenario or
result.
IB build LBO models based on pro forma
cash flow statements. Pro forma means
“for the sake of form” – a best case
scenario or result.
The first step is to project the cash
flows over the time frame of the LBO –
usually 6-8 years. EBITDA (earnings
before interest, taxes, depreciation and
amortization) is the cash flow definition
that is used in LBO’s
From lesson 5 slide 23:
Lenders use
of a measure of cash
flow to determine how much debt they are
willing to provide in LBO deal. The most
common measure is EBITDA – Lenders plan
on how much to lend as a
such as 4
or 6 times EBITDA.
RISK of an LBO – this refers to the change or
volatility of the EBIDTA projections. The more
sure an analyst is that there will not be
surprises in EBITDA – the higher the multiples of
EBITDA the LBO will support.
So, what might be some good businesses that
make the best targets for LBO’s?
Not technology firms but more stable businesses
like consumer products, food, etc.
MARKET CONDITIONS – What might be a
good market condition?
When credit is easier to get.
Or, when the market is strong! “Easy
money” times
After the crisis, in 2009 the leverage of
LBO’s was less than 4 times EBITDA. In 2012,
LBO’s went up to 6 times EBITDA.
When building an LBO deal, analysts consider the
market conditions to determine how much debt
the market will support. They want to maximize
debt and minimize equity capital yet ensure the
long-term success of the firm.
So, let’s assume conditions are good and will
support a total debt to EBITDA multiple of 6
times. The analysts have determined that the
EBITDA level of the firm is $300 million annually.
The total debt for this deal is likely to be what?
$1.8 billion. So, let’s build a model!
The deal will not just be debt. There will be equity. Let’s
assume equity will be 1.5 times EBITDA – so $450 million.
We have $1.8 billion in total debt, $450 billion in equity
for total capitalization of $2.25 billion, making the LBO
7.5 times EBIDTA.
Thus, the LBO structure might look like this:
Revolving credit (LIBOR + 2%)
$100 million
5 year term loan at 8%
$900 million
Mezzanine debt
$800 million
Equity
$450 million
Total
$2.25 billion
So, what does $2.25 billion buy?
Income stream of $300 million annually in EBITDA
Let’s assume the term loan is paid in 5 years from
cash flow. The 1st years of an LBO pay down debt
Let’s assume in 5 years the firm will still sell an
EBITDA multiple of 7.5 times, although this
could be higher as debt is paid down.
Firm is till valued at 2.25 billion. However, debt is
paid down $900 million so equity increased in
value by $900 million
In 5 years, the investment will be $1.35 billion
(the $450 invested and $900 loan paid back)
The internal rate of return (IRR) from chapter 5
is ____, not a bad rate of return!
How do we figure this? Since I am not a math
wizard and I don’t have a financial calculator I will
make an educated guesstimate (not actually a
word) of 25%. Let’s see how close I am?
Using 450
Year 1 450 x 25% = 112.5 + 450 = 562.5
Year 2 562.5 x .25 = 140.63 + 562.5 = 703.13
Year 3 703.13 x .25 = 175.78 + 703.13 = 878.94
Year 4 878.94 x.25 = 219.74 + 878.94 =1098.68
Year 5 1098.68 x.25 = 274.67 1098.68 = 1,373.35
OR 1,373,350,000 billion. Pretty close to the 1.35
billion. A little over, but the correct answer is:
24.5%. The present value of 1.35 billion 5 years
from now with a 24.5% IRR is the $450 m
investment
PV = FV / (1+r)n
PV is Present Value
FV is Future Value
r is the interest rate (as a decimal, so 0.10, not
10%)
n is the number of years
450 = 1,350/ (𝟏+. 𝟐𝟒𝟓)𝟓 = the answer
𝒏
𝟓
r = 𝑭/𝑷 - 1 r = 𝟏𝟑𝟓𝟎/𝟒𝟓𝟎 -1 the formula for
calculating the internal rate of return
The example is simple but an LBO is always
changing and there are things IB must consider:
THE GOOD,
A. EBITDA can improve and the firm can also grow.
B. Refinancing the debt at a lower rate can make
the deal more attractive.
C. The multiple can grow beyond the 7.5 times
EBITDA if the firm has less debt and market
conditions are good.
THE BAD, AND THE UGLY!
D. Returns end up being low as the cash flows fall
short of projections and projected EBITDA
multiples were too optimistic
E. The market condition changes and economic
conditions make it difficult, or impossible
F. Investors decline the deal. In our example, if the
EBITDA multiple is 5.5 times in 5 years instead of
7.5 the IRR would only be 10.8% instead of the
projected 24.5%.