The balance between debt and added value

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The leveraged buyout (LBO) model has evolved into a powerful mechanism for corporate transformation. Multibillion-dollar buyout funds are busy purchasing private companies and taking public companies private. Nine of the top ten largest buyouts in history have been completed in the past 18 months by private equity houses, and with these record amounts of capital, both in terms of debt and equity, available, megadeals are almost commonplace.

This article will survey the basics of buyout transactions, discuss how value is created and describe current industry issues. Recent developments include club deals, technology buyouts, the high levels of credit currently available and the institutionalisation of the industry.

What is an LBO?

An LBO is the purchase of a company or division of a company using significant debt, whereby the target company’s cash flows are used to support the loan payments. Integral to the alignment of incentives is management participation in the equity of the new company, usually a combination of personal cash investment and stock option compensation. Debt can be in the form of traditional bank financing, bond offerings, seller financing and loans from specialised funds.

According to data collected by Thomson Financial and the National Venture Capital Association, in the US, the buyout industry is expected to raise over $100bn in 2006 and top quartile buyout funds have generated net annual returns in excess of 40 per cent returns in the past 20 years. The average net annual returns of the industry have been 13.3 per cent, according to Thomson, and the S&P 500 index has returned just 12.1 per cent per year.

In strategic terms, there are three ways that a buyout transaction can build value:

■ buying low and selling high (value arbitrage or multiple expansion);

■ structuring an improved combination of equity and debt (restructuring the balance sheet or recapitalising to add value);

■ improving operations to increase cash flow (restructuring the income statement).

Of course, there are many combinations of these three strategic objectives and the timing and application of any of them is part of the challenge for management and buyout investors. These objectives correspond to the historic evolution of the modern buyout industry. At the start of this era, in the early 1980s, it was the age of the hostile takeover, acquisition and breaking up of inefficient conglomerates. At that time, buyouts were examples of value arbitrage and/or balance sheet engineering. In the early 1990s, buyout value creation focused on improving operating margins and bottom line cash flows. In the mid-1990s, the “growth LBO” emerged with an emphasis on expanding sales and increasing scale. By contrast, today, most buyouts are relatively friendly among buyers and sellers and buyout houses use all four methods to add value.

A common misperception

Some people mistakenly believe that the key to capturing value in a LBO is to use an aggressive amount of debt to buy a company and then pay down that debt over time with the company’s cash flows. According to this logic, paying off debt allows the company to use cash flow to build the value of the equity. In reality, reducing acquisition debt has often been a requirement of senior lenders. They see the aggressive amount of debt used in the acquisition as unsustainable or too risky in the long term. Thus, they often require a rapid pay down of the debt. In contrast, the company’s management and investors make every effort to eliminate or at least minimise loan principal payments in the early years of ownership.

A few quarters of good post-deal financial performance will present management with the opportunity to approach lenders to renegotiate terms and perhaps even increase the level of debt in a “leveraged recapitalisation”. In today’s generous debt markets, senior acquisition debt has had much less stringent repayment requirements than has historically been the case. This is important – clearly, the company would be better off reinvesting any excess cash, after paying loan interest, back into the core business. The rate of return on internal projects or growth through acquisitions is often higher than the cost of capital. If this is not the case, a company’s investors will prefer to have excess cash returned to them in the form of a dividend.

Value arbitrage

The new reality of public markets is that many good companies are ignored by the relatively slimmed down analyst groups of major financial institutions. Even before a series of recent corporate scandals spawned a wave of new corporate regulation that affected investment banks, there were many publicly traded companies that were poor at marketing themselves to investors.

By contrast, buyout funds are experts at knowing when and how to communicate with various constituencies of a business, from employees and shareholders to potential lenders and buyers. This is not just window dressing – often, adjustments need to be made to the management team or new markets found for a product. What is surprising is how often the changes are minimal but the resulting increase in valuation, whether through an IPO after taking a company private or through a sale to a strategic buyer, is substantial. In addition, sectors suffer from the cyclical nature of supply commodity prices or other macroeconomic trends as well as investor fads. Good companies can be caught in these downdrafts of investor sentiment, which create opportunities for buyout funds to help management make adjustments to the company in private and then relaunch with an IPO when the sector is in better favour.

Major corporations periodically expand their range of products and operating divisions then slim down and sell off non-core assets. Buyout groups stand ready to sell their fund’s portfolio companies when major corporations are buying. Conversely, when corporations are selling divisions, the buyout funds are willing to take the risk of helping the divisions develop their own internal operating structures and external market positioning.

Today, sophisticated sellers and their advisers are aware of the value increase that private equity acquirers are anticipating. Therefore, sales are frequently achieved through auctions or multiple bilateral negotiations, and relatively few are unilateral proprietary acquisitions. The result is that the seller anticipates and generally receives a premium over any current market valuation and, thus, participates in the anticipated value increase.

Recapitalising to add value

The earliest LBOs were based on the idea that some companies with hard assets and/or steady cash flows could be financed in a manner similar to real estate. Real estate transactions have long been financed with substantial amounts of debt because lenders rely on the physical assets and relatively steady rents.

The first LBO practitioners realised that many companies could be leveraged but had historically carried little debt. The companies were valued based on an expectation that they would continue to use low amounts of debt, so buyout houses could pay a premium for two reasons: they were only using relatively small amounts of cash to make equity investments (the rest of the purchase price was paid via debt); and the interest payments on the debt were tax deductible.

In fact, the latter point enables the creation of tax shields that add value to the enterprise. This is well known to financial economists who understand that the value of a company can be expressed as the value of the company financed with equity only plus the value of any future interest tax shields created by adding debt to the capital structure. Of course, there is a limit to this value adder because the introduction of financial risk due to significantly higher debt can result in increased debt and equity costs that offset the value of the tax shields.

Today, sophisticated restructuring of the balance sheet is commonly practised by large private equity houses and investment banking advisers. Some claim that such restructuring capability has become a commodity available to all qualified companies that seek it and balance sheet restructuring is no longer an approach that is available exclusively to private equity groups. However, there is no doubt that the private equity investors have extensive deal structure experience that can result in favourable arrangements that add value to an enterprise. But this value alone is no longer of a sufficient magnitude to achieve the returns required by buyout investors.

Capital structure

The capital structure of a typical LBO consists largely of four types of capital: bank debt, which usually accounts for about 50 per cent; high-yield debt at about 10 per cent; mezzanine debt at about 10 per cent; and private equity, which represents the remaining 30 per cent. Other forms of debt may also be utilised, such as asset-based loans and securitisations, second-lien loans, equipment leases and seller financing, but these are less common.

■ Bank debt consists of a revolving credit facility that can be paid back and drawn down as needed by the company, as well as several tranches or categories of term loans differing in seniority, maturity and cost.

■ High-yield debt is used to increase leverage beyond levels that banks are willing to provide. Companies will make offerings to either the public bond market or the private institutional market (for example, insurance companies and pension plans) of debt with a relatively high interest rate (or large discount to par) reflecting the risks involved in being in a subordinate position to bank debt.

■ Mezzanine debt is in an even lower position, so buyout funds, hedge funds and other lenders will provide this capital with a high interest rate and require warrants (options to purchase stock) as additional compensation.

■ Private equity is the riskiest form of capital. If a company goes bankrupt, debt holders control the bankruptcy process and, in the case of liquidation, have priority in receiving the proceeds from the sale of any assets such as real estate and equipment. Equity investors, being last in line, lose control of the company and usually lose their entire investment.

Increasing cash flow

There are three ways to improve the cash flow of a company: reduce the costs of making products or providing services; reduce the costs of operating the company; and increase sale profitably.

In the early 1990s, private equity investors realised that they could no longer rely on finding acquisitions at attractive prices and aggressively adding debt to achieve their investment objectives. They were going to have to actively encourage or even intervene to achieve improved operating performance of their acquired companies. Thus, the era of re-engineering of operations was born. In addition to working with management and often bringing in consultants, other techniques were used to enhance financial statements and increase cash flow.

In the abstract, improving operations, cutting costs and increasing efficiency can sound benign. But many of the specific actions undertaken to improve profitability are the reasons that LBOs are sometimes criticised and perceived negatively. These can include reducing R&D and capital expenditures, extending accounts payable, lowering accounts receivable, selling real estate and other assets, modifying compensation to reduce base salaries and increase performance bonuses, and restructuring health and retirement benefits.

Some communities in the US, and some European and Asian governments have reacted critically to buyout funds that purchase companies, reduce work forces and then sell the companies for large profits. These reactions have raised concerns among the international private equity funds that governments might act to restrict investor access, alter tax or regulatory practices or place constraints on capital movement.

The growth LBO

After the emphasis in the 1980s on acquiring undervalued and undercapitalised stable companies and, in the early 1990s, on operations improvements, private equity investors began to look for acquisitions that had the potential for significant expansion in the market. This was the beginning of the era of the growth LBO.

After purchasing a company with strong products and services, some buyout funds will invest the company’s cash into expanding regionally, nationally or internationally as well as developing derivative products and services. If the core business model is proven to produce decent financial results, growing sales will often give the company the necessary clout to secure volume discounts from suppliers, negotiate advantageous alliances and buy smaller competitors. Scale can be a powerful tool.

For buyout funds, however, the risks are significant. They have to depend on company management to execute expansion or acquisition strategies without letting the company lose momentum or cost control. Many acquisitions do not work, often due to cultural differences or a lack of synergies at the operations or marketing levels. If management does not perform as it promised it would to its board, buyout funds will not hesitate to replace the CEO and/or the senior leadership team.

The new world of LBOs

The last two years have seen a dramatic transformation in the world of LBO transactions. These changes have included an unprecedented influx of funding resulting in the first $10bn-plus LBO funds, the first equity syndications, called “club deals”, the first buyouts of large technology companies, a greatly expanded reliance on leveraged recapitalisations or sales to other financial buyers for investment exits and a dramatic increase in the reliance on debt and a corresponding relaxation in the stringency of debt covenants. In addition, new institutional structures are evolving, including multiproduct companies accessing public markets and, for the first time, the formation of an industry association.

Club deals

An important characteristic of the venture capital industry is the ability of multiple companies to operate effectively as board members of startup and growth companies. The challenge of these risky investments and the amount of co-ordination or negotiation among venture capital companies is substantial.

In contrast, buyout groups have been accustomed to operating as “lone rangers”. They find companies in which to invest, provide most of the risk equity themselves and form relatively small boards of portfolio companies to work with management to resolve issues.

In the past two years, buyout funds have begun to invest together as syndicates of three to seven players. This equity syndication enables them to diversify risk, buy bigger companies and reduce the level of competition in an acquisition auction.

So far, this new type of arrangement has not been fully tested. A single buyout investor can act quickly and unilaterally to fix problems and seize opportunities, and this has often been viewed as the advantage of the private equity governance model over public company governance. So, it remains to be seen if a multibusiness private equity governance structure will be as effective as the lone ranger model that has served the industry so well.

Technology buyouts

As many technologies have become mainstream, banks and other lenders have become more comfortable with helping buyout groups who target established technology companies. Until recently, such a buyout was viewed as a contradiction in terms: buyout funds assumed they could not take a technology risk and convince lenders to provide capital in highly volatile industries.

But a few technology investors realised that a number of technology companies had developed stable recurring revenue streams that were also diversified. Buyout funds have targeted healthcare data providers, electronic commerce systems, software companies, disc drive manufacturers and chip manufacturers. Furthermore, it is entirely possible that larger technology companies, whose performance has been sideways at best, will be candidates for buyout transactions.

The credit bubble

Buyout veterans are not shy about admitting that the amount of leverage and the number of lenders in the marketplace is at levels not seen since the 1980s. Banks and other lenders are aggressively competing with each other for deals to generate fees and interest income in the midst of a relatively low interest rate environment. The result has been a steady expansion of the amount of debt available for leveraged acquisitions and a relaxation of lenders’ terms and conditions.

This expansion of debt availability has permitted investors to quickly recapitalise their acquired companies and make large dividend payments to themselves and other equity owners. This debt expansion has also encouraged the sale of companies from one buyout fund to another. These early and significant returns on investment have led to a strong performance by the LBO sector in the past couple of years. Endowments, pension plans, insurance companies and other institutional investors in buyout funds have committed greater amounts of capital to the sector.

It is not anticipated that the debt markets will continue to expand as they have in the past few years. This means that the emphasis on creating value in the future will have to focus on operations improvement and profitable growth.

Moreover, if the debt markets tighten, the hurdle to achieving successful exits will be raised even higher. Still more challenging would be an economic slowdown. In that event, companies with significant debt on their balance sheets could have difficulty meeting their debt obligations. This could lead to a cycle of distress where opportunities for buyout funds could lie in restructuring companies with over-leveraged balance sheets. A few buyout houses have actually developed funds specifically for such distressed investing.

New institutional arrangements

As the buyout sector of the international economy reaches unprecedented levels, several new institutional structures are emerging. First, a small number of private equity groups, such as Carlyle and Blackstone, have become large multiproduct enterprises spanning buyout, venture capital, hedge funds, specialty lending, energy and real estate. Second, other houses, such as Apollo and Kohlberg Kravis Roberts, are turning to public capital markets for funds that will provide a base of permanent capital to supplement the traditional ten-year term fund structure upon which they previously relied. Finally, concerns about possible adverse reactions to expanded and visible buyout investment activity worldwide has led to the formation of a buyout industry association.

Conclusion

The leveraged buyout model of incentives, financing and governance has been shown to generate significant value. It has evolved over the past 25 years and holds promise as a new standard for corporate transformation worldwide.

Today, there does not appear to be a limit on the size of these buyout transactions. The amount of capital available and the willingness among buyout funds to collaborate with each other gives them significant power in global capital markets. However, the continuation of this trend will rely on the health of the debt markets, global economic growth and lack of a political backlash worldwide.

Colin Blaydon is the William and Josephine Buchanan Professor of Management at the Tuck School of Business, Dartmouth College.

Fred Wainwright is adjunct associate professor of business administration at the Tuck School of Business, Dartmouth College.

The authors are principals at the Center for Private Equity and Entrepreneurship at Tuck. For more information go to www.tuck.dartmouth.edu/pecenter

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