November 13, 2013
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”
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