Faculty of Business

International
Mergers and
Acquisitions IMA301 – FPT University
Chapter 13

Financing the Deal:

Private Equity,
Hedge Funds, and
Other Sources of
Financing

No one spends other people’s money

2 as carefully as they spend their own.
— Milton Friedman
 Exhibit 1: Course Layout: Mergers,
Acquisitions, and Other
Restructuring Activities

Part I: M&A Part II: M&A Process Part III: M&A Part IV: Deal Part V: Alternative
Environment Valuation and Structuring and Business and
Modeling Financing Restructuring
Strategies

Ch. 1: Motivations for Ch. 4: Business and Ch. 7: Discounted Ch. 11: Payment and Ch. 15: Business
M&A Acquisition Plans Cash Flow Valuation Legal Considerations Alliances

Ch. 2: Regulatory Ch. 5: Search through Ch. 8: Relative Ch. 12: Accounting & Ch. 16: Divestitures,
Considerations Closing Activities Valuation Tax Considerations Spin-Offs, Split-Offs,
Methodologies and Equity Carve-Outs

Ch. 3: Takeover Ch. 6: M&A Ch. 9: Financial Ch. 13: Financing the Ch. 17: Bankruptcy
Tactics, Defenses, and Postclosing Integration Modeling Basics Deal and Liquidation
Corporate Governance

Ch. 10: Private Ch. 14: Applying Ch. 18: Cross-Border

Company Valuation Financial Models to Transactions
Deal Structuring
3
 Chapter
Objectives

▫ Advantages and disadvantages of

LBO structures
▫ How LBOs create value
▫ Leveraged buyouts as financing
strategies
▫ Factors critical to successful LBOs
▫ Common LBO capital structures.
4
The role of public and private financial
markets
▪ Financial markets bring together borrowers
and lenders.
▫ Regulated and standardized public markets
or informal private markets.
▪ Public markets are those in which stocks
or bonds are bought and sold using
standard contracts subject to the disclosure
rules established by organized exchanges
and government agencies.
▪ Private markets are those where
contracts are negotiated directly (rather
than on exchanges) between the parties
involved.
5
How are M&A transactions commonly
financed?
Financing Options: Borrowing

▪ 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

6
How are M&A transactions commonly
financed?
Financing Options: Borrowing
Alternative Forms of Borrowing

Type of Security Backed By Lenders Loan Up to Lending Source

Secured Debt Liens generally on 50-80% depending Banks, finance and

Short-Term (<1Yr.) receivables and on quality life insurance
inventory companies; private
Intermediate Term Liens on Land and Up to 80% of equity investors;
(1-10 Yrs.) Equipment appraised value of pension and hedge
equipment; 50% of funds
real estate

Unsecured Debt Cash generating Life insurance

(Subordinated incl. capabilities of the companies, pension
seller financing) borrower funds, private
Bridge Financing equity and hedge
Payment-in-Kind funds;
target firms
7
How are M&A transactions commonly
financed?
Financing Options: Long-term

▪ Junk bonds are high-yield bonds that credit-

rating agencies have deemed either below
investment grade or have not rated
▪ Leveraged loans are unrated or
noninvestment-grade bank loans and include
second mortgages, which typically have a
floating rate and give lenders less security
than first mortgages
▪ Transferring default risk from lenders to
investors
8
How are M&A transactions commonly
financed?
Financing Options: Common and Preferred Equity

Alternative Forms of Equity

Equity Type Backed By Investor Types

Common Stock Cash generating Life insurance
capabilities of the firm companies, pension
funds, hedge funds,
private equity, and
angel investors

Preferred Stock Cash generating Same as above

--Cash Dividends capabilities of the firm
--Payment-in-Kind

9
How are M&A transactions commonly
financed?
Financing Options: Seller Financing

▪ Seller defers a portion of the purchase price (i.e.,

accepts a promissory note from the buyer)
▪ Advantages to seller:
▫ Buyer may be willing to pay seller’s 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

10
How are M&A transactions commonly
financed?
Financing Options: Cash on hand and selling redundant assets

▪ “Cash on hand” represents cash in excess

of normal operating requirements on the
acquirer or target’s balance sheet.
▪ Target’s excess cash can be used to buy
target firm’s outstanding shares.
▪ Redundant assets are those owned by the
acquirer or target firm that are not
considered germane to the acquirer’s
business strategy.
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 How are M&A transactions commonly
financed?
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 people’s 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, excess cash, and
unencumbered assets.
▫ Typical targets are in mature industries (e.g.,
12
 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 (i.e., security sales in
non-public markets)
▫ 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
13 1 ▫ Post-buyout returns to LBO shareholders exceed returns on S&P 500
Financial engineering describes the creation of a sustainable capital structure that magnifies financial returns to equity investors.
Impact of tax reform on M&A financing

▪ Internal Financing
▫ Favorable law
▫ Unfavorable law
▪ External Financing
▫ Debt financing less
attractive

14
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 target’s excess cash and the proceeds from
15
sale of target assets are used to buy out target
shareholders (Why? Assets decline relative to
Factors critical to successful LBOs

▪ Target Selection
▫ Firms with little debt, redundant assets, and
predictable cash flow
▫ Firms that are poorly performing with potential
to generate cash flow
▫ Firms with significant agency problems
▫ Firms whose management is competent and
motivated
▫ Firms in attractive industries
▫ Firms that are large-company operating
divisions
▫ Firms without change-of-control covenants
▪ Not Overpaying
▪ Improving Operating Performance
16
Common Characteristics of 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

17
LBO’s Impact on 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 new ventures increases
about 2%
▫ Employment at private firms may increase
▪ LBOs often increase R&D and capital
spending relative to peers
▪ Operating performance particularly for
private firms undergoing LBOs improves
significantly due to increased access to
18 capital
LBO’s Impact of Leverage on Financial
Returns
Impact of Leverage on Return to Shareholders
All-Cash 50% Cash/50% 20% Cash/80%
Purchase Debt Debt
($Millions) ($Millions) ($Millions)
Purchase Price $100 $100 $100
Equity (Cash Investment by Financial $100 $50 $20
Sponsor)
Borrowings 0 $50 $80

Earnings Before Interest and Taxes (EBIT) $20 $20 $20

Interest @ 10%1 0 $5 $8

Income Before Taxes $20 $15 $12

Less Income Taxes @ 40% $8 $6 $4.8

Net Income $12 $9 $7.2

After-Tax Return on Equity (ROE)2 12% 18% 36%

1
Tax 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.
2
If EBIT = 0 under all three scenarios, income before taxes equals 0, ($5), and ($8) and ROE after taxes in the 0%, 50% and 80% debt scenarios = $0 / $100,
[($5)
19 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.
 Discussion Questions

1. Define the financial concept of leverage.

Describe how leverage may work to the
advantage of the LBO equity investor?
How might it work against them?
2. What is the difference between a
management buyout and a leveraged
buyout?
3. What potential conflicts might arise
between management and shareholders
in a management buyout?

20
LBO’s Advantages and Disadvantages
▪ Advantages include the following:
▫ Management incentives,
▫ Better alignment between owner and manager
objectives (reduces agency conflicts),
▫ Tax savings from interest expense and depreciation
from asset write-up,
▫ More efficient decision making under private
ownership,
▫ A potential improvement in operating performance,
and
▫ Serving as a takeover defense by eliminating public
investors
▪ Disadvantages include the following:
▫ High fixed costs of debt raise the firm’s break-even
point,
▫ Vulnerability to business cycle fluctuations and
competitor actions,
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▫ Not appropriate for firms with high growth prospects
How LBOs Create Value

Factors Contributing
to LBO Value Creation

Buyouts of Public Buyouts of Private

Firms Firms

Key Factor: Alleviating Key Factor: Provides

Agency Problems Access to Capital

Factors Common to
LBOs of Public and
Private Firms
• Tax Deferral (Tax
Shield)
• Debt Reduction
• Operating Margin
Improvement
• Timing of the Sale
of the Firm
22
Tax Shield Example: Depreciation Times
Marginal Tax Rate
Income Statement

Case 1 (No Asset Write- Case 2 (Asset Write-Up)1

Up)
Revenue $100 $100
Depreciation 0 50
Income Before Taxes 100 50
Taxes @34% 34 17
Income After Taxes $66 $33

Key Points: 1. Tax savings of $17 between Case 1 and Case 2 equals
depreciation times tax rate or $50 x .34 = $17 (tax shield)
2. Case 1 Operating Cash Flow2 = $66
Case 2 Operating Cash Flow = $33 + $50 = $83
3. Case 2 operating cash flow > Case 1 by $17 or the amount
of tax savings/tax shield.

Assumes asset write-up results in additional depreciation.

1
23
Assumes capital spending and the change in working capital and changes in financing activities are zero.
2
LBOs create value by reducing debt and
increasing margins thereby increasing
potential exit multiples
Firm
Value

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Debt Reduction & Reinvestment Increases Free Cash Flow and In turn Builds Firm Value

Debt Debt Reduction Reinvest in Firm Reinvestment

Reduction Adds to Free
Adds to Free Cash Flow by
Cash Flow by Improving
Reducing Operating
Interest & Free Cash Flow Margins
Principal
Repayments
Tax Shield Adds to Free Cash Flow

Tax
Shield1

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

24
Tax shield = (interest expense + additional depreciation and amortization expenses from asset write-ups) x marginal tax rate.
1
LBO value is maximized by reducing debt,
improving margins, and properly timing exit
Case 1: Case 2: Case 3:
Debt Reduction Debt Reduction + Margin Debt Reduction + Margin
Improvement Improvement + Properly
Timing Exit

LBO Formation Year:

Total Debt $400,000,000 $400,000,000 $400,000,000
Equity 100,000,000 100,000,000 100,000,000
Transaction/Enterprise Value $500,000,000 $500,000,000 $500,000,000

Exit Year (Year 7) Assumptions:

Cumulative Cash Available for
Debt Repayment1 $150,000,000 $185,000,000 $185,000,000
Net Debt2 $250,000,000 $215,000,000 $215,000,000
EBITDA $100,000,000 $130,000,000 $130,000,000
EBITDA Multiple 7.0 x 7.0 x 8.0 x
Enterprise Value3 $700,000,000 $910,000,000 $1,040,000,000
Equity Value4 $450,000,000 $695,000,000 $825,000,000

Internal Rate of Return 24% 31.2% 35.2%

Cash on Cash Return5 4.5 x 6.95 x 8.25 x
1
Cumulative cash available from LBO inception to exit for debt repayment increases between Case 1 and Case 2 due to improving margins and
lower interest and principal repayments reflecting the reduction in net debt.
2
Net Debt = Total Debt – Cumulative Cash Available for Debt Repayment = $400 million - $185 million = $215 million
3
Enterprise Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year
4
Equity Value = Enterprise Value in 7th Year – Net Debt
5
The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return, because it
accounts for the time value of money.
25
Common LBO Deal Structures
▪ Direct merger: Target firm merged directly into
the firm controlled by the financial sponsor

▪ Subsidiary merger: Target firm merged into a

acquisition subsidiary wholly-owned by the
parent firm which in turn is controlled by the
financial sponsor

▪ A reverse stock split: Used when a firm is short of

cash to reduce the number of shareholders
below 300 which forces delisting of the firm from
public exchanges. Majority shareholders retain
their shares after the reverse split reduces the
number of shares outstanding; minority
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shareholders receive a cash payment.
Common LBO Deal Structures
Direct Merger
Financial Sponsor
(Limited Partnership
Fund)

Equity
Contribution

Target Merges with

Acquirer Acquirer (Acquirer
Survives)
(Controlled by Target Firm
Financial Sponsor)
Target
Loan Stock

Lender Target Firm

Acquirer Cash
(Loan Secured by and Stock Shareholders
Target’s Assets)

Key Point: Target merged into Acquirer with Acquirer surviving.

27
Common LBO Deal Structures
Subsidiary Merger

Financial Sponsor
Limited Partnership Fund

Equity
Contribution
Parent
(Controlled by Financial Target Firm
Sponsor)

Merger Sub Merger Sub Merges

Equity Shares Into Target (Target
Contribution Survives)
Loan Merger Sub
Guarantee Cash & Shares Target Firm
Lender Merger Sub Shareholders

Loan Target Firm Shares

Key Point: Merger Sub merged into Target with Target surviving as a wholly
owned subsidiary of the parent firm.
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Typical LBO Capital Structure
Common
Equity (10%)

Equity (25%)

Preferred
Equity (15%)

Purchase Revolving
Price Credit (5%)

Term Loan A

Senior
Debt (75%) Secured Debt Term Loan B
(40%)

Term Loan C

2nd Mortgage
Sub Debt
Debt/Junk
Bonds (30%)
Mezzanine
Debt & PIK
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Application: Cox Enterprises Takes Cox
Communications Private
In an effort to take the firm private, Cox Enterprises announced a proposal to buy the remaining
38% of Cox Communications’ shares not currently owned for $32 per share. Valued at $7.9 billion
(including $3 billion in assumed debt), the deal represented a 16% premium to Cox
Communication’s share price at that time. Cox Communications is the third largest provider of
cable TV, telecommunications, and wireless services in the U.S, serving more than 6.2 million
customers. Historically, the firm’s cash flow has been steady and substantial.

Cox Communications would become a wholly-owned subsidiary of Cox Enterprises and would
continue to operate as an autonomous business. Cox Communications’ Board of Directors formed
a special committee of independent directors to consider the proposal. Citigroup Global Markets
and Lehman Brothers Inc. committed $10 billion to the deal. Cox Enterprises would use $7.9
billion for the tender offer, with the remaining $2.1 billion used for refinancing existing debt and
to satisfy working capital requirements.
Cable service firms have faced intensified competitive pressures from satellite service
providers DirecTV Group and EchoStar communications. Moreover, telephone companies continue
to attack cable’s high-speed Internet service by cutting prices on high-speed Internet service over
phone lines. Cable firms have responded by offering a broader range of advanced services like
video-on-demand and phone service. Since 2000, the cable industry has invested more than $80
billion to upgrade their systems to provide such services, causing profitability to deteriorate and
frustrating investors. In response, cable company stock prices have fallen. Cox Enterprises stated
that the increasingly competitive cable industry environment makes investment in the cable
industry best done through a private company structure.
Discussion Questions:
1. What is the equity value of the proposed deal?
2. Why did the board feel that it was appropriate to set up special committee of independent
board directors?
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3. Why does Cox Enterprises believe that the investment needed for growing its cable business is
 Quick Review

An investor group acquired all of the

publicly traded shares of a firm. Once
acquired, such shares would no longer
trade publicly. Which of the following terms
best describes this situation?
a. Merger
b. Going private transaction
c. Consolidation
d. Tender offer
e. Joint venture

31
 Things to remember

▪ M&As commonly are financed through debt, equity, and

available cash on balance sheet or some combination.
▪ LBOsUse big
make theimage
most sense for firms having stable cash flows,
significant amounts of unencumbered tangible assets, and
strong management teams.
▪ Successful LBOs rely heavily on management incentives to
improve operating performance and a streamlined decision-
making process resulting from taking the firm private.
▪ Tax savings from interest and depreciation expense from
writing up assets enable LBO investors to offer targets
32
substantial premiums over current market value.
▪ Excessive leverage and the resultant higher level of fixed
expenses makes LBOs vulnerable to business cycle
fluctuations and aggressive competitor actions.
 Thank you for your
attention!

End of Chapter