Financing the Deal: Private Equity, Hedge Funds, and Other Sources of Financing,No one spends other peoples money as carefully as they spend their own. Milton Friedman,Learning Objectives,Primary Learning Objective: To provide students with a knowledge of how M and Common LBO capital structures.,How are M&A Transactions Commonly Financed?,Borrowing Options: Asset based or secured lending Cash flow or unsecured lenders (senior and junior debt) Long-term financing (junk bonds, leveraged bank loans, convertible debt) Bridge financing Payment-in-kind,Financing M&As: Borrowing Options,Financing M&As: Equity Options,Financing M&As: Seller Financing,Seller defers a portion of the purchase price Advantages to seller: Buyer may be willing to pay sellers asking price since deferral will reduce present value Makes sale possible when bank financing not available (e.g., 2008-2009) Advantages to buyer: Shifts operational risk to seller if buyer defaults on loan Enables buyer to put in less cash at closing,Financing M&As: Cash on Hand and Selling Redundant Assets,“Cash on hand” represents cash in excess of normal operating requirements on the acquirer or targets balance sheet. Targets excess cash can be used to buy target firms outstanding shares. Redundant assets are those owned by the acquirer or target firm that are not considered germane to the acquirers business strategy.,Financial Buyers/Sponsors,In a leveraged buyout, all of the stock, or assets, of a public or private corporation are bought by a small group of investors (“financial buyers aka financial sponsors”), often including members of existing management and a “sponsor.” Financial buyers or sponsors: Focus on ROE rather than ROA. Use other peoples money. Succeed through improved operational performance, tax shelter, debt repayment, and properly timing exit. Focus on targets having stable cash flow to meet debt service requirements. Typical targets are in mature industries (e.g., retailing, textiles, food processing, apparel, and soft drinks),Role of Private Equity and Hedge Funds in Deal Financing,Financial Intermediaries Serve as conduits between investors/lenders and borrowers Pool resources and invest/lend to firms with attractive growth prospects Lenders and Investors of “Last Resort” Buyers of about one-half of private placements Source of funds for firms with limited access to credit markets Providers of Financial Engineering1 and Operational Expertise for Target Firms Leverage drives need to improve operating performance to meet debt service Improved operating performance enables firm to increase leverage Private equity owned firms survive financial distress better than comparably leveraged firms Pre-buyout announcement date shareholder returns often exceed 40% due to investor anticipation of operational improvement and tax benefits Post-buyout returns to LBO shareholders exceed returns on S&P 500 due to improved operating performance (better controls, active monitoring, willingness to make tough decisions) 1Financial engineering describes the creation of a viable capital structure that magnifies financial returns to equity investors.,Leveraged Buyouts (LBOs),Finance a substantial portion of the purchase price using debt. Frequently rely on financial sponsors for equity contributions Target firm management often equity investors in LBOs Management buyouts (MBOs) are LBOs initiated by management,LBOs As Financing Strategies,LBOs are a commonly used financing strategy employed by private equity firms to acquire targets using mostly debt to pay for the cost of the acquisition Target firm assets used as collateral for loans Most liquid assets collateralize bank loans Fixed assets secure a portion of long-term financing Post-LBO debt-to-equity ratio substantially higher than pre-LBO ratio due to debt incurred to buy shares from pre-buyout private or public shareholders Debt-to-equity ratio also may increase even if pre-and post-LBO debt remains unchanged if the targets excess cash and the proceeds from sale of target assets used to buy out target shareholders (Why? Assets decline relative to liabilities shrinking the targets equity),Impact of Leverage on Financial Returns,1Tax shelter in 50% and 20% debt scenarios is $2 million (I.e., $5 x .4) and $3.2 million (i.e., $8 x .4), respectively. 2If EBIT = 0 under all three scenarios, income before taxes equals 0, ($5), and ($8) and ROE after tax in the 0%, 50% and 80% debt scenarios = $0 / $100, ($5) x (1 - .4) / $50 and ($8) x (1 - .4) / $20 = 0%, (6)% and (24)%, respectively. Note the value of the operating loss, which is equal to the interest expense, is reduced by the value of the loss carry forward or carry back.,LBOs Impact of Target Firm Employment, Innovation, and Capital Spending,Net reduction in employment at firms several years after undergoing LBOs is 1% Employment at target firms declines about 3% in existing operations compared to other firms in the same industry But employment at