LBO

Question 1

What is an LBO?

Answer 1

M&A with a high debt use. Typically PE or Hedge occasionally strategic buyers. We repay the leverage with operating cashflow and obtain a higher IRR using the debt.

Question 2

What are the mechanics of an LBO?

Answer 2

Prior to this the structure will have lender approval.
1. create a new company for the equity sponsors - SPV
2. fund the new company with a mix of debt and equity - different types of debt can be used depending on the debt to equity ratio.
3. SPV purchases the target.
4. the SPV and target are merged.

Question 3

Who are the typical lenders?

Answer 3

Fi

Question 4

How do we organise financial debt?

Answer 4

We organise this into 3 tranches:
1. term A - Senior - Libor + 200 bps
2. term B - Junior to A - Libor + 250 bps
3. term C - Junior to A &B - Libor + 300 bps

Question 5

What are the factors considered by lenders?

Answer 5

Interest rates, market conditions, robustness of target’s business.

Question 6

What is paid in kind?

Answer 6

This is done using a Mezzainine loan - 50/50 debt to equity, to be repaid, equity option. They are the first one to sustain losses.

Question 7

What is the difference in return between Senior Lendors an Messanine Investors?

Answer 7

Senior lenders - Libor + spread - guarantees, holding period and repayment plan
Mezzanine investors - libor + spread + equity kicker - default probability, equity upside

Question 8

What is a cash sweep?

Answer 8

This isa financial covenant stating all free cash is used to repay debt.

Question 9

How do we determine the revenue growth of the business in this case?

Answer 9

The revenue needs to be used to cover interest expenses and principal payments.

Question 10

What is the debt service cover ratio?

Answer 10

operating cash flow / (interest expense + debt repayment) - defines the debt capacity.
Debt capacity is typically represented as a multiple of EBITDA - 3 - 7 EBITDA depending on the industry.

Question 11

When is a company ideal for an LBO?

Answer 11

startups - loss making so not suitable
growth - cash hungry so not suitable
maturity - established with a solid cashflow so a good target - these are the only viable options
decline - demand is dry, too much insecurity

Good targets:
- excess cash
- stable cashflow
- non-core assets
- low leverage
- solid management
- acquisition price - attractive valuation

Question 12

What is the different between an MBO and MBI?

Answer 12

management buy in and management buy out. Management buy out is when the LBO occurs with the existing managers and management buy ins is when the existing managers depart for new management.

Question 13

What is the affordable price of an LBO?

Answer 13

1. desired IRR
2. target debt capacity
3. value at exit

Question 14

How do we price an LBO?

Question 15

What are the sources of value in an LBO?

Answer 15

The first benefit is the paying off of the interest and the loan is tax deductible therefore providing a tax shield.
- deleverage: repay as much debt as possible
- arbitrage: opportunistic strategy, target is undervalued or market conditions will improve,
- growth: active management is growing the business
most LBOs use a mix of these strategies

Question 16

Dell - LBO case study

Answer 16

This was an MBO case. Silver lake and Lenders involved. Being a private company means you do not have to worry about short term stock performance. Making this more suitable for a private firm.

Dell is broader than PCs, it is a service provider. Unique position to be involved in: PCs, Cloud and Enterprise solutions.

Corporate clients want to deal with a single provider for simplicity.

1. They took the company private
2. They boosted R&D spending
3. Largest acquisition with EMC added scale to infrastructure, VMWare, Pivotal, RSA and scale.

Financial side:
What made dell suitable for an LBO?
- strong operating cashflow
- No existing leverage

Sources
10.75 bn by lenders
2 bn by microsoft
6.2 bn excess cash
9.1 bn existing debt
4.5 bn from Michael Dell
1.25 bn from silver Lake
total -> 33.8 bn

Uses
24.6 equity owners
9.1 carried existing debt
0.1 bn legal and advisory

2013 LBO - 3y of repayment - 2016 EMC acquisition - 67bn deal - publically traded tracking stock VmWare where dell owned 53% - 2018 2y later retired the tracking stock - 2021 VmWare spin off this helped to deleverage the business.

Aftermath of the deal: leverage was required to make the company private, 41% VmWare and 52% of Dell for michael dell

low interest rates, high tech valuations and a knowledgeable CEO.