Leveraged Buyouts and

Management Buyouts

Using OPM to Buy a Firm

(Other Peoples Money)
 Leveraged Buyout
Small group of investors borrows money to
buy the stock of a public corporation.
LBO transaction is expected to be
reversed with a public offering within three
to five years.
Sometimes only a segment, a division or
subdivision of the firm is bought.
 Management
Buyout:
An LBO where management plays a
significant role.
Buyin:
An LBO where outside management plays a
significant role.
 LBO and MBO Sponsors
Leveraged buyout specialist (KKR)
Venture capitalists
Investment bankers
 FORBES TOP 25 PRIVATE COMPANIES
Source: www.forbes.com

Rank Name State Industry Revenues ($mil)

Employees
1 Cargill MN Crops 59,894 98,000
2 Koch Industries KS Oil & Gas Operations 40,000 17,000
3 Mars VA Food Processing 16,800 31,000
4 Publix Super Markets FL Retail (Grocery) 16,027 123,000
5 PricewaterhouseCoopers NY Business Services 15,900 125,000
6 Ernst & Young NY Business Services 13,100 106,000
7 Bechtel CA Construction Services 11,600 47,000
8 C&S Wholesale Grocers VT Retail (Grocery) 11,300 9,000
9 Meijer MI Retail (Grocery) 10,900 84,000
10 HE Butt Grocery TX Retail (Grocery) 10,700 56,000
11 TRW Automotive MI Auto & Truck Parts 10,630 63,000
12 Huntsman UT Chemical Manufacturing 9,000 15,000
13 Fidelity Investments MA Investment Services 8,937 29,142
14 Swift & Co CO Food Processing 8,380 21,300
15 JM Family Enterprises FL Auto & Truck Manufacturers 7,600 3,500
16 Enterprise Rent-A-Car MO Business Services 6,900 53,500
17 Science Applications Intl CA Aerospace & Defense 5,902 38,700
18 Unisource GA Forestry & Wood Products 5,900 8,000
19 Marmon Group IL Misc Fabricated Products 5,756 30,000
20 Advance Publications NY Printing & Publishing 5,565 27,585
21 Menard WI Retail (Home Improvement) 5,500 33,300
22 SC Johnson & Son WI Personal & Household Prods 5,372 12,000
23 MDFC Holding CA -- 5,105 60,500
24 International Steel Group OH Iron & Steel 5,000 11,600
25 Alticor MI Personal & Household Prods 4,900 11,500
 THE 25 LARGEST LBOs, Jan 2000 - Dec 2003
Source: Securities Data Corporation

Date Target Name Target Industry Sector Target Acquiror Name Acquiror Value of
Announced Nation Nation Transaction
($mil)
29-Jul-02 Legrand SA Electronic and Electrical Equipment France Investor Group France 5,059.72
11-Jun-03 Seat Pagine Gialle-Directories Printing, Publishing, and Allied Services Italy Silver SpA United Kingdom 4,367.53
4-Sep-03 Ondeo Nalco Co Chemicals and Allied Products United States Investor Group United States 4,350.00
20-Aug-02 Qwest Commun Intl Inc-QwestDex Printing, Publishing, and Allied Services United States Investor Group United States 4,300.00
6-Oct-03 Scottish & Newcastle-Ret Bus Food and Kindred Products United Kingdom Spirit Amber Bidco Ltd United States 4,173.88
2-Oct-00 IBP Inc Food and Kindred Products United States DLJ Merchant Banking Partners United States 3,766.98
17-Oct-03 Chelsfield PLC Investment & Commodity Firms,Dealers,Exchanges United Kingdom Duelguide PLC United Kingdom 3,413.40
17-Jun-02 Jefferson Smurfit Group PLC Paper and Allied Products Ireland-Rep MDP Acquisitions Ireland-Rep 3,315.01
26-May-01 Yell Group Printing, Publishing, and Allied Services United Kingdom Investor Group United Kingdom 3,043.08
23-Jun-00 Johns Manville Corp Stone, Clay, Glass, and Concrete Products United States Investor Group United States 3,028.45
8-Mar-02 Southern Water(Scottish Power) Electric, Gas, and Water Distribution United Kingdom First Aqua Ltd United Kingdom 2,927.61
12-Sep-03 Debenhams PLC Retail Trade-General Merchandise and Apparel United Kingdom Baroness Retail Ltd United Kingdom 2,912.78
20-Mar-02 Unique Pub Co,Voyager Pub Co Retail Trade-Eating and Drinking Places United Kingdom Investor Group United Kingdom 2,865.91
22-Feb-00 Deutsche Telekom AG-North Radio and Television Broadcasting Stations Germany Investor Group United States 2,784.61
20-Aug-02 Qwest Comm Intl-QwestDex Printing, Publishing, and Allied Services United States Investor Group United States 2,750.00
25-May-01 Le Meridien Hotels Hotels and Casinos United Kingdom Grand Hotels(M)Acquisition Co1 United Kingdom 2,675.96
24-Nov-03 Warner Music Group Electronic and Electrical Equipment United States Investor Group United States 2,600.00
29-Jun-01 Eircom PLC Telecommunications Ireland-Rep Valentia Group Ireland-Rep 2,560.70
12-May-03 Debenhams PLC Retail Trade-General Merchandise and Apparel United Kingdom Laragrove Ltd United Kingdom 2,492.84
3-Jan-01 Messer Griesheim GmbH Chemicals and Allied Products Germany Investor Group Germany 2,467.96
7-Aug-00 VEBA Electronics Inc(VEBA AG) Wholesale Trade-Durable Goods United States Investor Group United States 2,350.00
20-Mar-01 Fairbar Ltd Retail Trade-Eating and Drinking Places United Kingdom Shopgood Ltd(Morgan Grenfell) United Kingdom 2,327.98
28-Jan-03 Deutsche Telekom-Cable TV Cos Radio and Television Broadcasting Stations Germany Investor Group United Kingdom 2,282.29
12-Sep-01 Cognis BV(Henkel KGaA) Chemicals and Allied Products Netherlands Investor Group Germany 2,266.00
 THE 25 LARGEST LBOs, 1980-2003

Target Name Target Industry Sector Target Acquiror Name Acquiror Value of
Nation Nation Transaction
($mil)
RJR Nabisco Inc Tobacco Products United States Kohlberg Kravis Roberts & Co United States 30,598.78
Beatrice Companies Inc Machinery United States BCI Holdings Corp United States 6,095.00
Safeway Stores Inc Retail Trade-Food Stores United States SSI Holdings Corp United States 5,335.00
Legrand SA Electronic and Electrical Equipment France Investor Group France 5,059.72
Hospital Corp of America Health Services United States HCA-Hospital Corp of America United States 4,915.00
Borden Inc Food and Kindred Products United States Kohlberg Kravis Roberts & Co United States 4,643.42
Seat Pagine Gialle-Directories Printing, Publishing, and Allied Services Italy Silver SpA United Kingdom 4,367.53
Ondeo Nalco Co Chemicals and Allied Products United States Investor Group United States 4,350.00
Qwest Commun Intl Inc-QwestDex Printing, Publishing, and Allied Services United States Investor Group United States 4,300.00
Borg-Warner Corp Electronic and Electrical Equipment United States Borg-Warner Holdings Corp United States 4,202.60
Scottish & Newcastle-Ret Bus Food and Kindred Products United Kingdom Spirit Amber Bidco Ltd United States 4,173.88
Southland Corp Retail Trade-Food Stores United States JT Acquisition Corp United States 4,055.00
Montgomery Ward & Co Inc Retail Trade-General Merchandise and United States BFB Acquisition Corp United States 3,800.00
Apparel
Owens-Illinois Inc Stone, Clay, Glass, and Concrete Products United States Owens-Illinois Holdings Corp United States 3,640.00

NWA Inc Air Transportation and Shipping United States Wings Holdings Inc United States 3,580.00
Fort Howard Corp Paper and Allied Products United States FH Acquisition Corp United States 3,579.40
RH Macy & Co Inc Retail Trade-General Merchandise and United States Macy Merger Corp United States 3,523.30
Apparel
Elders IXL Ltd Food and Kindred Products Australia Harlin Holdings Pty Ltd Australia 3,434.34
Jefferson Smurfit Group PLC Paper and Allied Products Ireland-Rep MDP Acquisitions Ireland-Rep 3,315.01
American Medical International Health Services United States IMA Holdings Corp United States 3,307.85
Gateway Corp PLC Retail Trade-Food Stores United Kingdom Isosceles PLC(Gateway Corp) United Kingdom 3,292.36
Yell Group Printing, Publishing, and Allied Services United Kingdom Investor Group United Kingdom 3,043.08
Southern Water(Scottish Power) Electric, Gas, and Water Distribution United Kingdom First Aqua Ltd United Kingdom 2,927.61
Debenhams PLC Retail Trade-General Merchandise and United Kingdom Baroness Retail Ltd United Kingdom 2,912.78
Apparel
 LBO Financing
Secured Debt
Secured debt is also called asset-based lending, and it can be
either senior or intermediate term debt.
Senior Debt
Comprises loan secured by liens on particular assets of the
company.
The collateral includes physical assets such as land, plant and
equipment, accounts receivable, and inventories.
Lenders will usually advance 85% of the value of the accounts
receivable and 50% of the value of the target inventories.
The process of determining the collateral value of the
LBO candidate's assets is sometimes called qualifying
the assets.
Private companies outperform relative to the market.
Source: McKinsey Quarterly, 2001, n. 2.
LBO companies
remain private only
for a few years.
Financial Acquirers
(LBOs) negotiate
better than
Corporate Acquirors
(Mergers & Tender
Offers).
 Intermediate Term Debt
Is usually subordinate, and often backed
up by fixed assets such as land and plant
and equipment.
The collateral value of theses assets is
usually based on their liquidation value.
Debt backed up by equipment typically
has a term of six months to one year.
Loans backed up by real estate tend to
have a one- to two-year term.
 Unsecured Debt Financing
It is usually referred to as subordinated and
junior subordinated debt.
The term mezzanine layer financing is often
applied to this financing because it has both
debt and equity characteristics: it is equity like in
that lenders typically receive warrants that may
be converted into equity in the target.
When the warrants are exercised, the share of
ownership of the previous equity holders is
diluted. It is important to be aware of the role of
the warrants in computing the return to the
providers of mezzanine layer financing.
 Buyout Benefits
Tax savings
Stepped up asset base.
Approximately half of the companies involved in LBOs
stepped up their asset base in 1980's (Kaplan, Journal of
Financial Economics, 1989)
Tax shields from interest payments.
One should realize, however, that these benefits should be
relatively low when all of the costs and benefits are factored
in. Most likely the LBO companies do not have the optimal
capital structure in the first few years after the LBO - why
would they otherwise not keep those high debt levels?
The next two tables are from Kaplan, S. (1989), Management Buyouts:
Evidence on Taxes as a Source of Value, Journal of Finance, 611-632.
 Buyout Benefits Continued
Managerial incentives and other agency issues.
Managers own a larger fraction of the equity.
Separation of ownership and control has been
reduced. As a result managers have larger incentives
to worry about shareholders value.
Often they also get a larger fraction of their compensation
tied to company performance.
Monitoring benefits.
Fewer and larger external shareholders (institutional
investors) have an incentive to monitor managerial behavior.
Debt-bonding effect.
The debt payments reduce managerial discretion in the
spending of free cash flows. Debt provides discipline.
 Buyout Benefits Continued
Expropriation of old bondholders
LBOs increase riskiness of old debt without
increasing their promised interest payments.
A bond with covenants to protect against this
are said to have event risk protection.
Bonds with event risk protection were common in
the early 1990s.
Response to several large investment grade bond issues
that were reduced to high yield status overnight via
leveraged buyouts.
Few bonds now carry event risk protection.
 Buyout Benefits Continued
Expropriation of employees
Anecdotal evidence: easier layoffs and
reduction in over-funded pension plans.
 Buyout Benefits Continued
Exploiting undervaluation.
Management has more information about future cash-
flows than outside owners. Although selling
shareholders are receiving high premiums, managers
are possibly paying a too low price.
Evidence:
Median annualized rate of return on equity to post-buyout
shareholders in a firm that goes public again was 286% in
1980-1987.
This gain was positively related to managerial ownership.
However, there also exists evidence that stock prices fall
back to their pre-buyout levels in failed MBOs.
 Buyout Benefits Continued
Reducing costs of being a public company.
These costs include administrative costs
inside the company as well as regulatory
costs to the stock exchange.
 Buyout Costs
Cost of financial distress.
Managers become undiversified and may
be less willing to take risks.
Inappropriate investment policy
(underinvestment) because of high
leverage.
 Good LBO Candidates
High potential benefits:
Potentially high agency costs:
Small managerial ownership currently
Large excess cash
High marginal tax rate and stable earnings.
Makes debt financing attractive.
Low current leverage.
No need for new equity financing.
 Good LBO Candidates Continued
Low potential costs:
Low investment needs - underinvestment and
non risk-taking behavior do not pose a threat.
Parts of the assets can be sold if necessary.