LEVERAGED BUYOUT

INTRODUCTIONA Leveraged Buy-Out can be defined as a transaction in which

group of private investors, typically including management, purchases a significant and controlling equity stake in a public or non public corporation or a corporate division, using significant debt financing, which it raises by borrowing against the assets and/or cash flows of the target firm taken private.

CONCEPTIn a leveraged buyout, a company is acquired by a specialized

investment firm using a relatively small portion of equity and a relatively large portion of outside debt financing.

The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company.

Typically, leveraged buyout uses a combination of various debt instruments from bank and debt capital markets.

CHARACTERISTICS OF LBO Primary high debt

High debt often implicates high interest payment and hence LBO transaction prefers mature company which has stable cash flow generation.

Incentive and private ownershipDuring the period of LBO, company would be private

ownership, even though it used to be the listed stock company, their stock would be stopped trade. After a few years, PE funds would consider to exit, company going public again, trade sales, and merger & acquisition are normally chose as “happy ending” of LBO transaction.

MOTIVATION/RATIONALE FOR LBO Tax shield

If company has more debt, they would gain more tax benefit.

Conglomerate discount It provides sufficient financial support and high quality

management team to company for business division development.

Free cash flowEach company needs free cash flow to support new profitable

project, when company is impossible to gain internal financing, debt will be the optimal choice due to cheaper cost.

STAGES OF LBOInitial stages

Identification of investment funds. Construction of an in-house team with all the required

competencies. Meeting between management team and selected investment

fund.

After the fund has been selected Construction of business plan through an iterative consultation

procedure. Refinement and computation of acquisition price parameters Definition of target valuation range.

Post-valuation Financial engineering and search for the right equity-debt mix on

basis of valuation range and cash-flow and EBIT forecasts. Search for lead bank to manage debt syndication.

Debt packaging and structuring into senior debt and mezzanine debt.

Negotiation of lending rates with banks.

Negotiation with seller Negotiation, usually via a bank. Agreements on acquisition price and financial arrangements Signing of deal at the “closing” meeting.

LBO CANDIDATE CRITERIASpecific criteria for a good LBO candidate include:

Steady and predictable cash flow Divestible assets Clean balance sheet with little debt Strong management team Strong, defensible market position Viable exit strategy Limited working capital requirements Synergy opportunities Minimal future capital requirements Potential for expense reduction Heavy asset base for loan collateral

SUCCESSFUL FACTORS FOR LBOSuccessful LBO depend on some key factors such as

The prospect firms of LBO only focus on mature companies who have steady cash flow generation but few profitable opportunities for long-term development.

LBO candidates should be checked by financial statement, in order to figure out whether company has capability to fulfill debt obligation.

Furthermore LBO target firm should hold tangible assets much more than intangible, because company with a lot of tangible assets could be gain more tax benefit from high debt capital structure, and tangible asset would be much easier to sell under any buyout intention.

A qualified management team is another crucial factor for a successful LBO. Because managers’ diligence would positively affect company financial performance which is relative to sustain stable cash flow for high interest payment and debt obligation

The selection of exit strategy is relative to managers’ diligence effect as well, there are many ways to exit LBO transaction

NEGATIVE IMPACT OF LBO The most obvious risk associated with a leveraged buyout is that

of financial distress. Weak management at the target company or misalignment of

incentives between management and shareholders can also pose threats to the ultimate success of an LBO.

Leverage can induce firms to choose overly risky projects as they Over-optimistically forecasts of the revenues of the target company

In addition, an increase in fixed costs from higher interest payments can reduce a leveraged firm’s ability to weather downturns in the business cycle.

Too much debt would bring high interest payment, and company would be much easier to meet financial distress or bankruptcy in this kind of capital structure.