Structuring and Selling the Deal

SOURCES OF CAPITAL ____________________
■ Debt: equity capital firms, banks, pension funds, seller of firm
■ Debt with equity kicker: same as above and add insurance companies
and rich people
■ Preferred stock: insurance companies
■ Convertible preferred stock: insurance companies or other corporations
■ Common stock: LBO or private equity firms, LBO funds, and
rich people
BID FOR ACQUISITION ____________________
Assume there are no agency costs and no costs of financial distress.
The objective of the private equity buyers is to maximize the
net value.
Let Assets = the total value of the firm including any outstanding
debt, but before new debt Bid = the amount of
the bid for the firm Bo = outstanding debt assumed by
new corporation VL = equal to cash raised by debt issue
to finance
acquisition
t = the corporate tax rate S = the value of
equity before refinancing
where
S = Assets - Bo
and the net to the equity investor with no new debt issued by the
firm but the Bo debt assumed is:
Net = S - Bid
But assume VL of maximum new debt is issued
where t = the corporate tax rate:
the investor (if maximum debt is issued, the value of the firm's stock
is zero).
Since Bid is set, the larger the value of VL (the value of the leveraged
firm), the larger the value of the equity of the investors (though
the value of the firm's stock equals zero). The investors receive cash
or the debt being issued.
Example 1
t = .35, S = Assets = $650,000, no initial debt
Assume $700,000 is Bid and $1,000,000 of the debt is issued.
VL = $1,000,000
Net = VL - B Net =
$1,000,000 - 700,000 = $300,000
The $1,000,000 of debt proceeds are given to the new shareholders
and they pay $700,000 for the firm.
The net gain is $300,000. This is the largest feasible Net and
$1,000,000 is the largest VL that is feasible, without other sources
of values. The maximization of VL is consistent with the maximization
of the buyer's value. The firm is being financed with 100 percent
debt.
Realistically less than maximum debt ($1,000,000) will be issued
and the net gain will be less than $300,000, unless there are
improvements in operations.
Example 2
Same assumptions as Example 1 but the firm (with Assets =
$650,000) initially has S = $260,000 and Bo = $390,000.
If the maximum amount of debt is issued, then $400,000 will be
given to the shareholders.
Assuming a $270,000 bid for the equity, the net gain to the
shareholders after the issuance of the debt is $130,000.
For the first example the bid was $50,000 larger than the initial
stock value, but $1,000,000 of the debt was issued.
For the second example, the bid was $10,000 larger than the
initial stock value but only $400,000 of the debt was issued (there is
already $390,000 of debt outstanding).
In the second example we assumed the firm's assets had a value
of $650,000. This number is normally hard to determine accurately
and is apt to be the measure that gives rise to a deal's being done.
The buyer and seller are likely to have different expectations and estimates
of value.
STRUCTURING A DEAL ___________________
To simplify the presentation we assume that the acquisition will be
financed by a mix of debt and common stock and that no other
types of capital are feasible.
There are two primary issues to be resolved:
1. The split between debt and equity
2. The percentage of equity to be kept by the deal's promoter and
the percentage to be given to the other equity contributors
Generally there is a maximum amount of debt that banks and
other debt sources are willing to provide. This maximum changes
through time but promoters of private equity deals normally have
a good idea of this maximum. The normal amount of debt can be
increased by adding an equity kicker to the debt security. This
kicker may be in the form of a conversion feature, warrants on
stock, or a bonus based on the firm's future earnings or cash
flows. But there must be recognition that the nominal amount
of hybrid debt of this nature is not all debt but a mix of debt
and equity.
The percentage of the equity to be given to the other equity
providers must result in an expected internal rate of return (IRR)
that is large enough to attract the equity. This implies that it is
necessary to estimate the firm's future value and split the value
among all the capital contributors so that each investor class can
compute the return that is expected to be earned and be pleased
with that return.
An Example
Assume that a firm can be acquired for $78,000,000 and the expected
cash-out date is three years. The firm's value at that time (the
sale price) is estimated to be $162,400,000. The underlying internal
rate of return (IRR) of the firm is
78(1 + IRR)3 = 162.4
IRR = .2769
The firm's underlying IRR of .2769 is reasonably impressive.
But assume $60,000,000 of debt costs .18 and that the payment of
the debt at time 3 would be $98,600,000.
60,000,000(1.18)3 = $98,600,000
Since the proceeds at time 3 from the sale of the firm are expected
to be $162,400,000 the return to the equity contributors is
$63,800,000.
162,400,000 - 98,600,000 = $63,800,000
The equity contributors of $18,000,000 earn
18(1 + IRR)3 = 63.8 IRR
= .525
Assume the equity contributors of $17,000,000 want a return of
.35 (the promoters contribute $1,000,000).
The $17,000,000 requires proceeds of $41,800,000 at time 3.
17(1.35)3 = $41.8 million
This leaves $22,000,000 for the promoters.
63,800,000 - 41,800,000 = $22,000,000
The promoters expect to earn an IRR of 1.8 or 180 percent on
their $1,000,000 investment.
1(1 + IRR)3 = 22
IRR = 1.80 or 180% per year
With the given assumptions, the equity contributors of
$17,000,000 to earn their .35 per year have to be awarded .655 of
the equity.
The promoters receive .345 of the equity and contribute 1/18 or
.056 of the equity capital.
Now assume that only $38,000,000 of .18 debt can be raised
(rather than $60,000,000). At time 3 the debt payment will be
$38,000,000(1.18)3 = $62,400,000 and the stockholders will net
$100,000,000.
162,400,000 - 62,400,000 = $100,000,000
While this is larger than the $63,800,000 previously available,
the amount of equity investment is now increased to $40,000,000.
The $39,000,000 of external equity now requires $96,000,000 at
time 3 to earn .35.
39(1.35)3 = $96.0 million
This leaves $4,000,000 of return at time 3 for the promoters.
The promoters investing $1,000,000 now earn an internal rate of
return of .587.
1(1 + IRR)3 = 4
IRR = .587
The promoters' IRR is reduced from 1.80 to .587 as a result of
reducing the amount of debt. The equity split is now .96 for the new
equity suppliers and .04 for the promoters (down from .345).
With the facts as given, the more debt at a cost of . 18 the better
for the promoters. However, we can expect the cost of debt to increase
as debt is substituted for equity; thus generalizations are not
feasible. The promoters must determine the cost of debt for the different
amounts of debt. Also, the equity return requirements must
be determined since the cost of equity capital will change as the percentage
of debt capital is changed. Asquith and Wizman (1990) give
data regarding bondholder returns in leveraged buyouts.
To simplify the presentation, we have assumed zero taxes. If
taxes are included the analysis must consider the fact that interest is
tax deductible each time period, thus will change the firm's terminal
value if there is reinvestment of the savings.
Some analysts predict the equity value at the end of the planning
horizon independent of the capital structure. This is faulty since the
equity value is affected by the capital structure. The model illustrated
assumed zero taxes and made no interim cash outlays to the
capital contributors; thus the firm's value at time 3 is affected by operations
and not by the capital structure decisions.
Obviously the promoter would like to keep as large a percentage
of ownership as is feasible. The percentage is limited by the firm's
prospects (the terminal value), the amount of debt that can be
raised, and the costs (required expected returns) of the debt and
other common stock investors. The percentage of ownership that is
kept by the promoters is the residual results of the requirements of
the investors that the promoters are trying to attract.
SELLING THE DEAL ______________________
For making capital budgeting decisions the net present value
method has several advantages over the use of the IRR method.
While the two methods will frequently lead to the same decision,
there are also situations where they lead to different decisions unless
they are carefully used.
In the present context the objective of the promoters is to sell a
deal to investors, and the easiest measure to understand and persuade
potential investors is an internal rate of return. It is more impressive
to be told the IRR over a three year period is .587 than that
the NPV is $626,000 (for the promoters) when the debt amount is
$38,000,000 and the equity is $40,000,000.
A Partial LBO
The conventional LBO buys 100 percent of the common stock. If
management is part of the LBO group, it will own a significant percentage
of the private equity capital. The main problems are raising
the private equity and accomplishing the LBO without attracting
competition.
Now assume management has a different strategy. The corporation
will repurchase its own shares. The stockholders who want
cash receive it by selling some of their stock and having the gain on
the stock sale taxed at a capital gains rate.
Assume that management currently owns or has rights (options)
to 20 percent of the firm's 1,000,000 outstanding shares. The firm
repurchases 30 percent of the 1,000,000 outstanding shares. There
are 700,000 shares outstanding after the share repurchase. If management
does not sell any of their shares, they will now own 28.57
percent of the shares (before the buyback they owned 20 percent).
Obviously, if the firm continues the buyback strategy, and if
management does not sell any of its shares, its percentage of ownership
will increase. In a few years management will have the same
percentage of ownership that it would have obtained with an immediate
LBO. An important advantage of the partial LBO strategy is
that management's investment is highly liquid compared to an investment
in a LBO. We will discuss this strategy in greater depth in
Chapter 9.
CONCLUSIONS__________________________
After valuing the target firm and deciding on the amount to be bid
there remains the decision to split the capital needs among the different
forms of capital. In this chapter we limit the choice to either
debt or equity. The next calculation is to determine the
percentage of equity that must be allocated to the external investors
so that the investors can expect to earn the return they require
given the alternative returns available, the risks of the
enterprise being financed, and the amount of debt (and other senior
securities) being issued.
It is important to remember that the amount (or value) of equity
at the termination date will depend on the amount of debt
being used.
QUESTIONS AND PROBLEMS _______________
1. Why are insurance companies more likely to buy preferred stock
than individuals?
2a. Assume the market capitalization of a firm's stock is $6,500,000
and there is $10,000,000 of debt outstanding. How much additional
debt can be issued if the $6,500,000 is accepted as being
reasonable? There is a .35 corporate tax rate.