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Chapter 16


									-----   Chapter 16      -----
 Going Private and Leveraged
• Going private — transformation of a public
  corporation into a privately held firm
• Leverage buyout (LBO) — purchase of a
  company by a small group of investors
  using a high percentage of debt financing
  – Investors are outside financial group or
    managers or executives of company
  – Management buyout (MBO) — leveraged
    buyout performed mainly by managers or
    executives of the company
– Results in significant increase of equity share
  ownership by managers
– Turnaround in performance is usually
  associated with formation of LBO
– Typical LBO operation
   • Financial buyer purchases company using high
     level of debt financing
   • Financial buyer replaces top management
   • New management makes operating
   • Financial buyer makes public offering of improved
     company at higher price than originally purchased
  Characteristics of Leveraged

• Leverage buyout activity
  – Reached peak during 1986-1989
  – Largest LBO was RJR Nabisco in 1988 with
    purchase price of $24.6 million
  – Total purchase price of 20 largest LBOs
    formed during 1983-1995 was $76.5 billion
• Buyout group may include incumbent
  management and may be associated
  – Buyout specialists, e.g., Kohlberg Kravis
    Roberts & Co.
  – Investment bankers
  – Commercial bankers
• Management buyouts (MBOs)
  – Investor group dominated by incumbent
  – Segment acquired from parent company
• LBO transaction may be reversed with
  future public offering
  – Aim is to increase profitability of company
    and thereby increase market value of firm
  – Buyout group seeks to harvest gain within
    three- to five-year period
     Three Major Stages of
      Leveraged Buyouts
• The 1980s
  – Economic and financial environments
    favorable to M&A activity and LBOs
  – For 1986-1989,
    • LBO activity reached peak
    • LBOs accounted for 20.5% of total dollar value of
      completed mergers
    • Premiums paid were at highest levels — mean of
      33.9% and median of 26.5%
    • Price earning ratios paid — mean of 20.5
• Early 1990s
  – LBOs declined from peak total of $65.7
    billion in 1989 to $6.8 billion in 1991
  – Decline due to
    • Economic and legislative changes
    • Unsound LBO transactions of late 1980s
  – For 1990-1992,
    • LBOs accounted for 6.8% of total dollar value of
      completed mergers
    • Sharp decline in relative premiums paid — mean
      of 27.6% and median of 19.9%
    • Sharp decline in price earning ratios paid —
      mean of 14.6
• Post-1992
  – LBOs reached $62.0 billion in 1999
  – Revival of LBOs due to new developments in
    nature of LBO transactions and market
  – For 1993-1998,
    • LBOs accounted for 1.6% of total dollar value of
      completed mergers
    • Relative premiums paid for LBOs slightly below
      1986-1989 levels — mean of 33.5% and median
      of 24.2%
    • Price earning ratios paid — mean of 23.8
         LBOs in the 1980s
• Characteristics
  – Debt financing
     • Highly leveraged — up to 90% of purchase price
     • Debt secured by assets of acquired firm or based
       on expected future cash flows
     • Paid off either from sale of assets or from future
       cash flows generated by operations
  – Acquired company became privately held
  – Firm expected to go public again after three
    to five years
• General economic and financial factors
  – Same as factors stimulating mergers
  – Sometimes LBOs and MBOs were responses
    to threat of unwanted takeovers
  – Sustained economic growth between 1982-
  – Earlier inflation
    • GNP implicit price deflator during 1968-1982 increased
      by no less than 5%
    • Caused q-ratio to decline sharply — cheaper to buy
      capacity in financial markets than in real asset markets
    • Provided opportunities to realize tax savings through
– Financing innovations — high-yield bonds
  (junk bonds) made public financing available
  to companies below investment grade
– Legislative factors, especially taxes
  • Succession of laws that deregulated financial
  • Economic Recovery Tax Act (ERTA) of 1981
  • General Utilities doctrine
  • Legislative changes affecting ESOPs —
    encouraged MBOs
– Change in antitrust climate - beginning in
• Elements of a typical LBO operation
  – First stage — raise cash required for buyout
    and devise management incentive systems
    • Financing
       – About 10% of cash is put up by investor group headed
         by company's top managers and/or buyout specialist
       – About 50-60% of required cash through secured bank
       – Rest of cash by issuing senior and junior subordinated
           » Private placement with pension funds, insurance
             companies, venture capital firms
           » Public offerings of "high-yield" notes or bonds (junk
  • Management incentives
     – Managers receive stock price-based incentive
       compensation in form of stock options or warrants
     – Incentive compensation plans based on measures
       such as operating performance
– Second stage — organizing sponsor group
  takes company private
  • Stock-purchase — buys all outstanding shares of
  • Asset-purchase — purchases all assets of
    company and forms new privately held
  • New owners sell off parts of acquired firm to
    reduce debt
– Third stage — management strives to
  increase profits and cash flows
  • Cut operating costs
  • Cut spending in research and development
  • Cut new plants and equipment as long as
    provisions for capital expenditures are adequate
    and satisfy lenders
  • Increase revenues by changing marketing
– Fourth stage — reverse LBOs
  • Investor group may take improved company
    public again through public equity offering
    (secondary initial public offering - SIPO)
  • Create liquidity for existing stockholders
  • Muscarella and Vetsuypens (1990)
     – 72 reverse LBOs in 1976-1987
     – 86% of firms use offering proceeds to lower company's
     – Equity participants realized median annualized rate of
       return of 268.4% on equity investment by time of SIPO
     – Median length of time between LBO and SIPO was 29
• Conditions and circumstances of going-
  private buyouts in the 1980s
  – Typical target industries
     • Basic, nonregulated industries
        – Predictable and/or low financing requirements
        – Predictable/stable earnings
     • High-tech industry less appropriate
        –   Shorter history of profitability
        –   Greater business risk
        –   Fewer leveragable assets
        –   Command high P/E multiples well above book value
• Lehn and Poulsen (1988)
   – Half of 108 LBOs during 1980-1984 were in five
       » Retailing
       » Textiles
       » Food processing
       » Apparel
       » Soft drinks
   – Consumer nondurable goods
       » Low income elasticity of demand
       » Sales fluctuate less with GNP
   – Mature industry with limited growth opportunities
– Other target characteristics
   • Track record of capable management
   • Strong market position within industry to enable
     it to withstand economic fluctuations and
   • Highly liquid balance sheet
      – Little debt, either short or long term
      – Large unencumbered asset base — for collateral
      – High proportion of tangible assets with fair market
        value above net book value
– Leverage factors
  • Increase return on equity (ROE) and cash flows
    to retire debt
  • Attractions for lenders
     – Interest rates only 3-5 points above prime rate
     – Company and collateral characteristics
         » Large amounts of cash/cash equivalents
         » Undervalued assets (hidden equity)
         » Could liquidate some subsidiaries to raise funds
     – High prospective rates of return on equity especially for
       lenders such as venture capitalists and insurance
       companies with equity participation
     – Confidence in management group spearheading LBO
– Management factors
  • Record of capability
  • Betting reputation and personal wealth on
    success of LBO
  • Highly motivated by potential large personal
    gains from stock ownership
– Sources of MBO targets
  • Divestitures of divisions by public companies
  • Private companies with low growth records
  • Public corporations selling at low P/E multiples
    representing large discounts from book values
• Empirical results
  – DeAngelo, DeAngelo, and Rice (1984)
     • 72 firms making 72 initial and 9 subsequent
       going-private proposals during 1973-1980
     • Relatively small firms measured by median
       market value of total equity
        – $6 million for 45 pure going-private sample
        – $15 million for 23 LBOs
     • Pre-offer management ownership high
        – Mean of 45% and median of 51% for 72 going-private
        – Mean of 32% and median of 33% for 23 LBOs
• Stockholder wealth effects
   – At announcement: +22%, significant
   – CAR for window [-40,0]: over +30%
   – Measured as average premium over market (two months
     before proposal): Over +56% for 57 cash payment
• Withdrawal of going-private announcements (18
   – Negative return at announcement: -9%
   – Offset by positive 13% return (Days -40 through 0) for net
     effect of +4%
   – Cumulative effect rises to +8% (Days 0 through +40)
   – Explanations for positive impact of withdrawal:
       » Information effect — permanent upward revaluation of firm's
       » Probability that management might revive proposal
       » Possibility that another acquirer might step in to make offer
– Lowenstein (1985)
  • 28 MBOs during 1979-1984
  • Each valued at over $100 million at winning bid
  • Management ownership fraction very small
     – Pre-offer: 3.8% (median); 6.5% (mean)
     – Post-offer: 10.4% (median); 24.3% (mean)
  • Premium over market price 30 days before
     – 58% (median); 56% (mean)
     – Premiums rose with number of bids — three or more
       bids, premium = 76% (median), 69% (mean)
     – Premium over management bid in 11 successful third-
       party bids relatively small — 8% (median), 14%
– Lehn and Poulsen (1988)
  • Sample of LBOs in 1980-1984
  • Substantial leverage increases in 58 firms
     – Average pre-LBO debt/equity ratio of 46%
     – Average post-LBO debt/equity ratio of 552%
  • Wealth effect for 92 LBOs (Days -20 through
    +20) = over +20%, significant
  • Average premium (relative to stock price 20
    days before announcement) = 41% for 72 all
    cash-offer LBOs
– Hite and Vetsuypens (1989)
  • 151 divisional MBOs
  • Small but significant wealth gain to parent
    company shareholders
     – Mean abnormal return during two-day period
       surrounding announcement = 0.55%
     – Abnormal return translates into 3.3% for full LBO (mean
       sale price of division about 16.6% of market value of
       average seller)
     – Gains lower than those found for LBOs
  • Interpretation
     – Divisional MBOs reallocate ownership of corporate
       assets to higher-valued uses
     – Parent company shareholders share in expected
       benefits of change in ownership structure
– Muscarella and Vetsuypens (1990)
  • 45 divisional buyouts which subsequently went
  • Average period from buyout to public offering
    was 34 months
  • Mean abnormal return of 1.98% to seller in two
    days around announcement
• Sources of gains in LBOs during the 1980s
  – Tax benefits — can enhance already viable
    • Specific tax benefits
       – Interest tax shelter from high leverage
       – Asset step-up provides higher asset value for
         depreciation expenses; especially accelerated
         depreciation on assets involving little recapture — more
         difficult under Tax Reform Act of 1986
       – Tax advantages of using ESOP as LBO vehicle
    • Lowenstein (1985)
       – Most of premium paid is financed from tax savings
       – New companies may operate tax-free up to six years
         (LBO often sold at this point anyway when debt/equity
         ratio declines from 10 times to 1 or under)
• Kaplan (1989a,b)
   – Value of tax benefits
       » At a 46% tax rate and permanent new debt, median
         value of tax benefit at 1.297 times premium
       » 30% tax rate and new debt with maturity of eight
         years, median value of tax benefits at 0.262 times
       » For firms that used step-up basis of their assets —
         median value of tax benefit at 0.304 times premium
   – Large and predictable tax benefits
       » Small portion attributed to unused debt capacity or
         inefficient use of tax benefits prior to buyout
       » Implies that large portion of tax benefits attributable
         to buyout
   – Prebuyout S/H capture most of tax benefits
   – ESOP loans infrequently used due to nontax costs
– Management incentives and agency cost
  • Argument for: Increased ownership stake
    provides increased incentives for improved
     – Profitable investments that require disproportionate
       effort of managers may only be undertaken if
       managers are given disproportionate share of profits
     – Concentrated ownership aligns managers and
       shareholders' interest, reducing agency costs
     – Debt from LBO commits cash flows to debt payment,
       reducing agency costs of free cash flows
     – Debt puts pressure on managers to improve firm
       performance to avoid bankruptcy
• Arguments against:
   – In DeAngelo et al. study, management already held
     large stake before buyout
   – Internal and external controls are sufficient to align
     managers' interests to shareholders
• Empirical evidence consistent with
  management incentive rationale
   – Increased ownership share of management
   – Management incentive plans
   – Operating performance of LBO firms improved
– Wealth transfer effects
  • Payment of premiums in LBO transactions may
    represent wealth transfer to shareholders from
    other stakeholders
  • Wealth transfer from existing bondholders and
    preferred stockholders
     – Reduction in value of firm's outstanding bonds and
       preferred stock due to
         » Large increase in debt
         » Bond covenants may not protect existing
           bondholders in event of control changes and debt
         » In bankruptcy proceedings, "absolute priority rule"
           for senior security may not be strictly followed
– Lehn and Poulsen (1988) — no evidence that
  bondholders and preferred stockholders lose value at
  time of LBO announcement
– Travlos and Cornett (1993)
    » Significant bondholder losses at announcement
      of going-private proposals
    » Losses small relative to gains to prebuyout
– Anecdotal evidence
    » Lawsuit filed against RJR Nabisco by large
    » Charged that $5 billion in highly rated bonds lost
      nearly 20% in market value
– Warga and Welch (1993)
   » Empirical results greatly influenced by source of
     bond price data
   » Use trader-quoted data from major investment
     bank as opposed to exchange-base data
   » Properly aggregated returns among correlated
     bonds using S&P data source find no significant
     loss to bondholder wealth
   » Using trader-quoted data, there is a risk-adjusted
     bondholder loss of 6%; but losses account for a
     very small percentage of shareholder gains
• Wealth transfer from current employees to new
   – Management turnover in buyout firms lower than in
     average firm; sometimes new management team is
     brought in after LBO
   – Number of employees grows more slowly in LBO firm
     than others in same industry and sometimes even
     decreases — may result from postbuyout divestitures
     and more efficient use of labor
• Tax benefits in LBO constitute subsidy from
  public and loss of revenue to government
   – Premia paid in LBOs positively related to potential tax
   – Net effect of LBO on government tax revenues may be
       » Shareholders pay capital gains taxes on sale of
          their stock in LBO tender offer
       » LBO investor group pays capital gains taxes when
          firm goes public at a later date
       » Improved profitability — firms pay more corporate
   – Many of tax benefits from increased leverage could be
     realized without LBOs
– Asymmetric information and underpricing
  • Managers or investor groups have more
    information on value of firm than public
  • Large premium in buyout proposal signals that
    future operating income will be larger than
    previously expected or firm is less risky than
    previously perceived
  • Investor group believes new company worth more
    than purchase price — prebuyout shareholders
    receive less than adequately informed
• Kaplan (1991) — informed persons (managers
  and directors) do not participate in buyout even
  though they typically hold large stakes (median
  share of 10% compared to 4.67% held by
  management participants)
• Smith (1990)
   – MBO proposals that fail due to board/stockholder
     rejection, withdrawal, or higher outside bid are not
     followed by increase in operating returns
   – Indirect evidence that asymmetric information cannot
     explain improved performance of bought-out firms
– Other efficiency considerations
  • More efficient decision process as private firm
     – No need to justify new programs with detailed studies
       and reports to board of directors, more speedy actions
       can be taken
     – Public firms have to publish reports that can disclose
       valuable information to competitors
  • Stockholders' servicing costs and other related
    expenses do not appear to be a major factor in
    going private
  • Alternatively, perhaps LBOs performed well
    because of favorable stock market/economic
• Evidence on postbuyout equity values
  – Muscarella and Vetsuypens (1990)
    • Median change in firm value for 41 reverse LBOs was
      89% for entire period between LBO and subsequent
      SIPO — mean rate was 169.7%
    • Median annualized rate of return was 36.6%
    • Total shareholder wealth change positive and
      significantly correlated with fraction of shares owned
      by officers and directors
    • Correlation between size-adjusted measure of salary
      and shareholder wealth positive and significant
    • Change in equity values were associated with
      improvement in accounting measures of performance
– Kaplan (1991)
  • For 21 buyouts, median excess return to
    postbuyout investors (both debt and equity) is
    26.1% above return on S&P 500
  • Excess return close to premium earned by
    prebuyout shareholders
  • Excess return to postbuyout investors
    significantly related to change in operating
    income, not to potential tax benefits
  • Prebuyout shareholders capture most of tax
    benefits that become publicly known at time of
– Degeorge and Zeckhauser (1993)
  • Reverse LBO experienced industry adjusted rise in
    operating performance of 6.9% during year before
  • Same firms experience industry-adjusted decline in
    operating performance of 2.59% in year following
  • Reason: Information asymmetries and pure
     – Managers take firm public only during exceptional years
     – Managers have incentive to improve current performance
       at expense of future profitability
     – Purchasers look at strength of current performance and
       future growth — only strong companies had ability to go
       public and experience normal mean reversion following
– Mian and Rosenfeld (1993)
  • 85 reverse LBOs during 1983-1989
  • Significant positive CAR measured for three-year
    period beginning one day after SIPO
  • CARs using Comparable Firm Index for first three
    years was 4.65%, 21.96%, and 21.05%
  • 39% of sample firms taken over within three years
    after SIPO
  • Most takeovers during second year
  • Firms taken over outperformed comparable
    investments over 100%
  • Sample not taken over, CAR nearly zero
  • 79% of acquired firms had gone public with an active
    investor — reflects desire of main investor to liquidate
– Holthausen and Larcker (1996)
  • 90 reverse LBOs during 1983-1988
  • Firms outperformed their industries for four years
    following reverse LBO
  • Firm increased capital expenditure subsequent to
    offering — firms were cash constrained while
    under LBO but reduced leverage after SIPO
    facilitated efficient investments
  • Working capital increased after offering
  • Firm performance decreased with declines in
    level of equity ownership by management and
    other insiders
• No evidence that performance after SIPO
  related to changes in leverage
• Firms still public three years after SIPO
  experienced median decline in ownership by
  management insiders of 15% and by
  nonmanagement insiders of 20%
• Board structure moved toward standard
  patterns of non-LBO firms after SIPO
 Correction Period 1991-1992
• Background
  – LBO activity in 1991 dropped to $6.8 billion,
    l0.4% of $65.7 billion in 1989
  – Opler (1992) — LBOs in 1985-1989 period
    had operating improvements comparable to
    those in earlier period
  – Kaplan and Stein (1993)
     • LBOs formed in latter half of 1980s did not
       perform as well
     • Many experienced financial distress
• Deteriorating quality of LBOs in second
  half of 1980s
  – Relatively high prices paid
     • Dollar volume of funds available exceeded
       number of good prospects
     • Multiples of price to expected cash flows rose
     • Extreme winner's curse — substantial difference
       between winning price and next highest bid
  – Weakened financial structure
     • Deal promoters required more cash up front,
       weakening structure and incentives of later LBOs
• Public high-yield debt substituted for both private
  subordinated debt and "strip" financing —
  raised costs of reorganizing
• Commercial banks took smaller positions;
  reduced commitments, shortened maturities,
  required accelerated principal repayments
• Coverage of debt service requirements declined
  — less than 1 in some cases
• Asset sales and immediate improvement of
  profitability margins were required to cover
  interest and other financial outlays in first year of
  the LBO
  • High-yield bonds with either zero-coupons or
    interest payments consisting of more of same
    securities (payment-in-kind) were utilized
  • Cash requirements for debt service were
    postponed for several years
– Legislative and regulatory changes —
  • Required S&Ls to liquidate high-yield bonds
    from portfolio holdings and prohibited further
    investment in high-yield bonds
  • Prices of high-yield debt were impacted
– Economic downturn of 1990-1991
        Role of Junk Bonds

• Junk bonds are high-yield bonds either
  rated below investment grade or unrated
  – S&P ratings: rated below BBB
  – Moody's ratings: rated below Baa3
• Characteristics
  – Size of market
     • Between 1970 and 1977, junk bonds represented
       3-4% of total public straight debt bonds
        – Prior to 1977, high-yield bonds were "fallen angels,”
          investment grade bonds whose ratings had been
          subsequently lowered
        – First issuer of bonds rated below investment grade was
          Lehman Brothers in 1977
     • By 1985 share had risen to 14.4% of total public
       straight debt bonds
        – Drexel Burnham Lambert became industry leader in
          junk bond issues
        – Drexel had 45% of market in 1986 and 43.2% through
          November 1987
  • Share of yearly new public bond issues had risen
    from 1.1% in 1977 to almost 20% by 1985
  • FIRREA, enacted in 1989, caused temporary
    losses but by 1993 junk bond market achieved
    record high returns and size of market reached
    new highs
– Default rates 10 years after issuance as high
  as 20-30%
– Average recovery rate after default about 40%
  of original par value
– Promised yield spread over 10-year Treasury
  bonds about 4.5% during 1978-1994
– Realized return spread about 2%
• Use of high-yield bonds
  – Make financing available to high risk,
    growth firms
  – Finance takeovers
  – Yago (1991)
    • One-fourth of proceeds from issuing junk
      bonds in 1980-1986 used for acquisition
    • Three-fourth of proceeds used to finance
      internal corporate growth
• Savings and loan industry
  – High-yield financing was not fundamental
    cause of problems in S&L industry during the
  – Total investment in junk bonds amounted to
    1% or less of total assets in industry
  – S&L basic problems due to
    • Changing nature of financial markets
    • S&L industry had negative net worth of over $100
      billion by 1980, prior to era of high-yield financing
    • 90% of firms in S&L industry suffered losses in
      1980 and 1981
• Role of Michael Milken
  – Saul (1993) set forth his views of illegal acts
    by Milken
     • Securities parking
        – Violation of Williams Act
        – Entails having associates hold securities in their
          accounts to avoid triggering Rule 13(d) filing requirement
     • Market stabilization
        – Milken guaranteed investment participants against losses
          on their high-yield bond investment during time required
          for markets to absorb them
        – He did not make public disclosure in high-yield offerings
          of securities taken as underwriting compensation
        – He made side payoffs to portfolio managers for investing
          institutional funds in his issues
• Market monopolization — Milken became
  dominant player of high-yield bond market
   – Financial competitors did not have Milken's network to
     be "highly confident" that it could successfully place a
     high-yield offering
   – No other firm was prepared to commit so much capital
     to inventory high-yield bonds in secondary market
   – Milken developed close relationships with client
     issuers, institutional customers, and employees
– Fischel (1995) presented a defense of
  • Milken was guilty only of being a tough and
    formidable competitor
  • Milken was not guilty of breaking any security
    law violations
  • Action against Milken as result of
     – Hysteria against "excesses of the 1980s"
     – Ability of government to invoke RICO
  • After most thorough investigations, government
    came up with nothing
 LBOs in the 1992-2000 Period

• Background
  – 1992-2000: Sustained economic growth —
    resurgence of LBOs
  – Size of aggregate LBO transactions moved to
    $62.0 billion in 1999 — almost as high as the
    peak of $65.7 billion in 1989
• Resurgence of LBOs
  – Favorable economic environment
  – Change in LBO financial structure
    • Price to EBITDA ratios paid moved down to 5-6
      times compared to 7-10 multiples of late 1980s
    • Percentage of equity in initial capital structure
      moved up to 20-30% compared with equity ratios
      of 5-10% in late 1980s
    • Interest coverage ratios moved up — ratio of
      EBITDA to interest and other financial
      requirements moved to standard of 2 times
– Restructuring of intermediaries
  • LBO activity no longer dominated by Milken-Drexel
  • Main players were other investment banking
    houses, large commercial banks, and traditional
    LBO sponsors such as Kohlberg Kravis Roberts
– Innovative approaches developed by
  investment banking-sponsoring firms
  • Strategy of substituting sponsor equity for bank
  • Less pressure for immediate performance
    improvement or asset sales — deals structured so
    principal repayments sometimes not required until
    10 years after deal
• Partnership structures with members who had
  considerable previous managerial experience
• Joint deals between financial buyers and
  corporate strategic buyers to purchase companies
  on leveraged basis
• Increased use of syndication among banks to
  sponsor highly leveraged transactions
• Development of highly liquid secondary loan
  trading market
• Continuing close client-focused relationship by
  commercial banks
• Capital structure strategies tailored to
  characteristics of transactions
• Leveraged buildups
   – Identify fragmented industry characterized by small
   – Buyout firms purchase firm as platform for further
     leveraged acquisitions in same industry
   – Buyout firms include partners with industry expertise
• LBOs applied beyond mature slow-growing
  industries to high-growth technology-driven

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