This Christmas Buy a Gift of Learning and Add Value to 2014 and Beyond!
This Christmas Buy a Gift of Learning and Add Value to 2014 and Beyond!
This blog is an extension of our blog on Dell’s Leveraged Buyout.
In the previous article, we discussed the importance of LBO with a hypothetical example on how a financial institution benefited in two different scenarios from a purchasing out a company. But to find these kinds of benefits from an LBO, there are some perquisites which make a good LBO. The list is endless but there are some important factors which are mentioned here:
1. Clean Balance Sheet with little/no debt: A company with a small amount of debt can become an LBO candidate since the acquiring company gets room to raise debt or leverage it without taking the burden of the candidate’s debt.
2. Steady and predictable cash flow: The acquirer needs to forecast the future cash flows as he raises a huge amount of debt to buy the target company and plans to pay a substantial amount of this debt using the cash flows of the target company before making an exit.
3. Divestible Assets: The acquirer looks for non-core or non-operating assets that can be divested to pay off the debt.
4. Viable exit opportunity: An institution always looks at any transaction from the perspective of generating returns on it; this applies to an LBO model too. The investor will look for a hassle free exit opportunity.
These are some of the many important factors that an investor considers to find a good candidate for an LBO. You can more learn about this through our video on what makes a good LBO by downloading it from here!
Finding the perfect LBO candidate is a tough task from the universe of equities and requires a great amount of data to be collected and analyzed to fit the perfect match. To give a brief idea on how to search for a company from such a huge universe can be understood by taking an exercise. We extract the data of nearly 700 well known companies in the US & Europe in the form of Market Cap, Enterprise value and the Free Cash flow to the firm.
Data of well known companies in the US & Europe
With the above data we analyze some important ratios to carry on our search for the right LBO candidate. Ratios such as Equity/Enterprise are used to understand the depth of leverage a company is currently positioned at. The higher the ratio, the lower the company is leveraged on its balance sheet. Similarly important valuation matrix such as EV/EBIDTA and EV/Free cash flow are calculated and help in judging the right company for taking over.
Once we have the figures for the multiples calculated we sort out the companies which have a positive EV/Free cash flow but less than a multiple of 4. Also as discussed previously in the first paragraph above the factors to be considered to get a good LBO candidate can be implemented in a better way in this small exercise.
Out of the given data, we search for companies which have positive EV/Free cash flow, an Equity/Enterprise value of more than 100% and a high enterprise value, which can be seen in the above figure highlighted. In this case we extracted the information based on the criteria and was able to find healthy companies to fit for the LBO and thus selected the Dell model since it matches all criteria.
You can learn about analyzing the information from the data and also on selecting the best LBO candidate with the help of the video (why Dell) by downloading it from here.
There will be more blogs on the same topic. So stay tuned for more!
Acquisitions or takeovers are a transaction or process wherein one company (commonly called as acquirer) or an investor acquires another company (known as target). Acquisition can be done in a number of ways that can range from one firm merging with another firm to create a new firm or managers of a firm acquiring the firm from its stockholders and creating a private firm.
Briefly the transactions can be classified as follows:
If a firm is acquired by another firm, the various distinctions are:
Merger: Target firm becomes part of acquiring firm; stockholder approval is needed from both firms
Consolidation: Target firm and acquiring firm become new firm; stockholder approval needed from both firms
Tender offer: Target firm continues to exist, as long as there are dissident stockholders holding out. Successful tender offers ultimately become mergers. No shareholder approval is needed
Acquisition of assets: Target firm remains as a shell company, but its assets are transferred to the acquiring firm. Ultimately, target firm is liquidated.
If the company is acquired by its own manager or/and outside investors
Buyout: Target firm continues to exist, but as a private business. It is usually accomplished with a tender offer.
Here, we will discuss Buyout only with particular reference to the Leveraged Buyout case of DELL which is in the news nowadays.
Any type of acquisition aims at creating synergy by acquisitions or takeover of another company. Some companies use these transactions to create strategic synergies wherein the acquirer target the companies in same sector and thus profit by increasing economies of scale and capturing market share and expertise of target company. This type of buyer is a strategic buyer and finances the purchase through company cash, company stock as well as some percentage of debt.
On the other hand LBO is the purchase or the acquisition of the company using significant amount of debt and some amount of sponsor’s equity. Ratio of Debt to Equity is generally 70 to 30.
LBO is often undertaken by financial buyers or investors who seek to generate high returns on the equity and increase their potential returns by using financial leverage (debt) and implementation of cost cutting strategies in operations of the company.
Acquisition of HCA Inc. in 2006 by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch is the largest LBO transaction in recent times. The three companies paid around $33 billion for the acquisition.
While looking for a company for a leveraged buyout, an acquirer looks for company which:
Has very little or no debt on its balance sheet
Is a non-cyclical and mature company with a well established brand, products, and industry position
Has a strong management team
Has non-core assets which can be liquidated to generate cash flows
Has an operating cash flow which is predictable and strong enough to service the debt raised for LBO
Has limited Working capital requirements
Has a viable exit strategy.
It is essential for an acquirer to perform a detailed analysis while determining the Purchase value to be paid for buying out a company.
Most important parameters in the valuation of a company are EBITDA and Free Cash Flow (FCF). Projections for these two have to be drawn out for the investment horizon (typically 3 to 7 years)
Exit Multiple: Valuation Multiples such as EV/EBIDTA and EV/FCF are used to determine the value of the company at time of acquisition. An acquirer aims at multiples which are similar or higher at the time of exit then at the time of acquisition
Key Leverage levels and Capital structure (senior and subordinated debt, mezzanine financing, etc.) which has to be managed for the achievement of required results
Determining equity returns (IRRs) to the financial sponsor and performing sensitivity analysis of the results across range of leverage and exit multiples, as well as investment horizons
Reaching a value which can be paid to acquire the company.
For a successful LBO generating positive returns, three factors are most essential:
De-levering (paying down debt): Company is generating cash flow sufficient to pay off the debt raised to buy it
Operational improvement (e.g. margin expansion, revenue growth): Cost cutting measures and sale of non-core assets result in lean structure thereby generating higher profits
Multiple expansions (buying low and selling high): EV/EBIDTA increasing or remaining similar.
Along with operating risk, there is risk associated with financial leverage. High Interest costs which are also “fixed costs” are a huge burden on company. It is a risk for both debt as well as equity holders. Small changes in the enterprise value (EV) of a company can have a significant effect on the equity value since the company is highly levered and the value of the debt remains constant.
Financial buyers can use many exit strategies to realize the profits made on their investments. A financial buyer typically expects to realize a return on its LBO investment within 3 to 7 years via one of these strategies.
Outright sale of the company to a strategic buyer or another financial sponsor
IPO: Initial Public offering , that is, issuing new equity to the public
Recapitalization: By paying off the debt over the time thereby converting debt into Equity and optimizing capital structure of the company.
Let us have a look at the LBO of computer manufacturer DELL Inc. (DELL.O) which was completed in October 2013.
On September 12, 2013, the buyout by founder and CEO Michael DELL and private equity firm Silver Lake Partners of DELL for $25 billion had been approved by DELL stockholders. The merger transaction closed on October 29, 2013, and the delisting from NASDAQ Stock Market commenced. DELL shareholders received $13.75 in cash, in addition to a special dividend of $0.13 per common share.
LBO of DELL faced stiff opposition from minority stake controllers Southeastern Asset Management, second largest shareholder after Mr. DELL and T. Rowe Price, third largest holder. As per an analysis by Southeastern Asset Management, share price of DELL was determined at $23.72 per share.
It allows DELL to solicit alternative takeover proposals for 45 days. It is an exercise to promote level playing field. Blackstone and Carl Icahn emerged as the two interested parties offering $14.25 per share and $15 per share.
Offer was withdrawn due to DELL’s deteriorating business.
A debt of $7.5 billion has been issued which is the second-largest institutional LBO loan this year, behind Heinz’s $9.5 billion institutional issuance for Heinz’s $28 billion buyout by Berkshire Hathaway and 3G Capital.
DELL has proposed to raise the first-lien secured debt totaling $7.5 billion and the company has proposed $1.25 billion second-lien notes due in 2021.
Once the deal closes, DELL will have a debt load of about $18 billion, including a $2 billion loan provided by Microsoft Corp. (MSFT), up from $6.8 billion in debt before the LBO, according to data compiled by Bloomberg.
It will take DELL at least three years to repay its debt if it continues to generate cash flow of $2 billi4on to $3 billion a year. Also, reduction of workforce by a number 108,800 is also in the pipeline in order to make DELL more efficient.
The business of laptops and workstations is decreasing and thus there is an immediate requirement for DELL to grow by acquisitions in upcoming technologies such as Tablets and Pads.
The company has a strong brand name, broad customer base and good market position.
The deal is expected to close before the end of the second quarter of DELL’s fiscal 2014 year.
Leveraged Buyout has emerged as most preferred way to acquire in recent times. DELL’s CEO and co-founder Michael DELL believes that as a private entity DELL has conquered horizons and will continue to do so. He quotes that:
“DELL has made solid progress executing this strategy over the past four years, but we recognize that it will still take more time, investment and patience, and I believe our efforts will be better supported by partnering with Silver Lake in our shared vision. I am committed to this journey and I have put a substantial amount of my own capital at risk together with Silver Lake, a world-class investor with an outstanding reputation. We are committed to delivering an unmatched customer experience and excited to pursue the path ahead”
If you have any comments, questions or queries, post them below!
Leveraged Buyout in simple terms means purchasing a company or an asset with the combination of Equity and Debt capital, with a significant portion of Debt in the total capital. The debt capital ranges between 70%-80% of the total capital. Because of this, it is known as Leveraged Buyout since the company leverages itself by way of borrowed funds.
The purpose of a buyout can be different as it depends on the purpose of purchasing a company. If the company wants to expand its current operations or increase its scale of business then it is a strategic buyout and is done by way of Mergers & Acquisition. On the other hand if a company or an Institution is just targeting to buy a company only for the sole purpose of generating returns then it is called a Financial Buyout. This is known as Leveraged Buyout
One question which can come to anybody’s mind is why a Financial Institution will be interested in buying a company. This can be portrayed through a simple example referred below.
This company has an EBIDTA of $100 million. The EV/EBIDTA multiple in this case is 6.0 times. So that creates a value of the company to be $600 million.
The Financial Institution funds this transaction in the following way:-
Now the Institution can generate the value on this Investment/Transaction:
1. Improvement in acquired company’s performance through improving the EBIDTA
2. Improvement in Industry outlook and hence increase in the multiple
3. Selling assets of the acquired company.
An explanation on how an Institution can generate returns can be understood by referring the video on “Why LBO?”
There can also be a case when the Institution cannot generate returns from the any of the three mentioned in the above cases. Does that mean that the Institution should not invest in the company? Not really.
Consider a Hypothetical Scenario where the Institution exits after 5 years.
We see that the Enterprise value remains same after 5 years and all the values remains the same. The only figure changed in the 5 years is the Capital Structure.
We see that at exit, the Equity value has increased from $200 million to $500 million and the debt has reduced drastically from $400 million to $100 million.
How did this happen?
The company used its positive free cash flows gained over the five years to pay off the debt the Institution raised at the time of Buyout.
This provides a fundamental reason for Institutions to invest in a company through a Leveraged Buyout.