concentrated ownership + LBO Flashcards
problem with a firm with only dispersed shareholders
low incentive to monitor the firm. low incentive to incur cost to improve the firm
how to fix a firm with only many small shareholders
hire monitor ; the board
ensure skin in the game of managment
What are the key costs and benefits of block ownership, including family ownership?
Benefits:
Solves the Free-Rider Problem:
Block owners have the incentive and ability to monitor management closely.
Longer Investment Horizon:
Block ownership (including family ownership) is persistent, promoting stability.
Alignment with “Family Values”:
Emphasis on long-term goals rather than short-term financial results.
Family Engagement in Management:
Active involvement in decision-making (can be positive or negative).
Political Connections:
Block or family ownership may shield the firm from external interference.
Costs:
Limits External Financing:
Relies on the financial resources of the block owner, restricting growth opportunities.
Under-Diversification:
Block owners may have excessive concentration in one firm, leading to risk.
Conflicts Between Controlling and Minority Shareholders:
Risk of entrenchment, where controlling owners prioritize their interests over others.
Control Over Growth:
Blockholders may excessively value control, hindering value creation or innovation.
Generational Transition Challenges (for family firms):
Problems in passing leadership and ownership to the next generation.
what is the free rider problem in the context of dispersed shareholders
low incentive to monitor the firm, to incur cost to improve it
how to avoid financing constraint and still have the control as a blockhowner
separate economic right from voting writhe via dual share class and other
problem that arise when large share holders gets compansated with a no voting right share
the insider can sell its no voting rights share will keeping its initial control rights. creating a missalignment between control and economic interest
What problems arise when control rights and cash-flow rights are separated?
Controlling Minority Structures:
Shareholders with minimal cash-flow rights exercise disproportionate control (via dual-class shares, pyramids, etc.).
Governance Issues:
Misalignment of interests weakens monitoring and “good governance.”
Incentive Problems:
Resource diversion and lack of effective management oversight.
Undermines Accountability:
The separation removes the incentive for blockholders to align with long-term shareholder value.
why is the lack of diversification of a controlling owner in the company a possible danger for minority owners
the controling owners might persuit value destructive ventures to gains diversification.
might be overconcervative, yielding low returns
How does management expect to succeed in an LBO, and what changes do they implement when acquiring a business?
Back (Answer):
Operating Improvements:
Focus on efficiency gains:
Cost-cutting measures.
Better working capital (WC) management.
Changes in investment policies.
Selling unproductive assets.
Inject new capital if needed, not just downsizing.
Contrast with M&A: less scope for “operating synergies.”
Governance Improvements:
Large equity stake by the LBO firm creates strong monitoring incentives.
Management faces pressure due to high leverage and interest expense, requiring cash flow generation.
Change in control imposes a discipline effect, similar to M&A transactions.
Gains from Leverage:
High leverage generates tax savings through tax shields.
High leverage is temporary; sellers aim to eventually sell at a premium to capture gains.
what is cash sweep
mecanism to ensure that execc fcf are use to repay the principal
What are the characteristics of the debt used in an LBO?
Back (Answer):
Senior Secured Debt (Asset-Based):
Typically secured by fixed assets (PP&E, real estate) or liquid assets (inventory, accounts receivable).
Rule of thumb: Up to 5x EBITDA.
Features:
Floating interest rates.
Stringent covenants (e.g., max leverage, minimum interest coverage).
Often unrated and divided into tranches (A, B, C).
Goal: To maximize this type of debt.
Unsecured Debt:
Junior to senior secured debt.
Includes high-yield bonds, mezzanine financing, and subordinated PIK (Payment-In-Kind) notes.
Layers are ranked by seniority, determining repayment priority.
May use “Vertical Strip Financing”:
Lenders participate in multiple layers of the capital stack, making reorganizations easier if the company faces distress.
How is continuation value calculated in an LBO valuation for short vs. long exit horizons?
Back (Answer):
Short Exit Horizon:
Use multiples-based valuation (e.g., EBITDA multiples).
Reflects market conditions and comparable company valuations.
Long Exit Horizon:
Use perpetuity calculations, incorporating:
Assumptions about future debt repayment.
Tax shield benefits from debt affecting long-term cash flows.
What is the Capital Cash Flow (CCF) method, and when is it used?
Definition: The CCF method is similar to Adjusted Present Value (APV), but it discounts tax shields at the unlevered cost of equity (cost of assets) instead of the cost of debt.
CCF=FreeCashFlow(FCF)+InterestTaxShield(ITS)
Discount at the unlevered cost of equity.
Intuition:
Use when the leverage ratio is not constant, as WACC becomes unreliable.
Useful for LBOs or highly leveraged firms where tax shields are riskier.
Provides a “compressed APV” by integrating cash flows and tax shields.
What makes a good LBO firm?
- Firms with High Debt Capacity:
Cash Flows: Stable, repeatable, and predictable.
Industry: Mature, stable, and recession-proof.
CAPEX: Low and predictable.
Assets: Collateralizable to secure debt, with potential excess cash or liquid securities for debt repayment.
Leverage: Low pre-LBO leverage.
Non-Core Assets: Separable, allowing potential divestitures.
Market Position: Established, with strong branding, market share, and insulated from competitive pressures.
- Potential for Efficiency Gains (No Synergies Expected):
Opportunities for cost reductions.
Room for management improvements.
What are the key challenges and risks to consider in an LBO?
Back (Answer):
Complexity:
LBOs are complicated to value and require a deep understanding of financial and operational factors.
Value Creation:
LBOs don’t inherently create value. Success depends on improvements in the target firm’s financial structure or operations.
Management:
Management plays a critical role in implementing the required changes for the LBO to succeed.
Risk:
High Leverage: Increases the risk of bankruptcy and financial distress.
Stakeholder Conflicts:
Existing debtholders may lose value as new leverage is introduced.
Employees may oppose changes or cost-cutting measures.
