chp. 9 leveraged buyout
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Introduction
Leveraged buyout (LBO) is a financial
engineering product of the takeover
and corporate restructuring wave of
1980s in the US .
For domestic acquisition in India
LBOs are not practiced.
However, Indian companies have been
successfully resorting to the LBOs for
the overseas acquisition.
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LBO-Leveraged Buyout Acquisition of another company involving significant
amount of borrowed money to meet the cost of
acquisition
Without having to commit a lot capital
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Occurs when a financial sponsor gains control of amajority of a target company's equity equity through
the use of borrowed money or debt .
A leveraged buyout is a strategy involving the
acquisition of another company using a significant
amount of borrowed money (bonds or loans) to meet
the cost of acquisition.
The purpose of leveraged buyouts is to allow
companies to make large acquisitions without having
to commit a lot of capital
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Leveraged Buyout And Going Private
Leveraged buyout (LBO) simplistically means mobilizingborrowed funds based on the security of assets and cash flows ofthe target company (before its takeover) and using those fundsto acquire the target company.
This debt financing maturity period is 10 or more years where itis raised by issuing normally junk bond
Junk bond means with high interest rate bonds havingspeculative in nature. Normally small group of individual
investors or institutional investors like commercial banks,investing banks, financial institutions & mergers specialist firminvesting in such debt financing.
These are four characteristics/steps in a typical or classicalleveraged buyout.
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LBO Characteristics Investors are outside financial group or managers or
executives of company Results in significant increase of equity share
ownership by managers
Turnaround in performance is usually associated with
formation of LBO Typical LBO operation
Financial buyer purchases company using high levelof debt financing
Financial buyer replaces top management New management improves operations
Financial buyer makes public offering of improvedfirm
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Leveraged Buyout And Going Private
Characteristics/steps in a
typical or classical leveraged
buyout.
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Incorporation of a
privately/wholly ownedcompany to act as a special
purpose vehicle (SPV) for
acquisition of a target
company.
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Mobilization of borrowed
funds in the SPV, based onthe security of assets and
cash flows of the target
company (before its
takeover).
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Acquisition of the entire or
near entire share capital of
the target company.
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Merger of the target company into the
SPV. This last move, which is also a
critical step in the leveraged buyout, has
two effects:
It brings the assets of the target
company and the loans
It makes the target company goprivate, i.e., the target company gets
unlisted.
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Criticisms of LBO Risk of solvency
Overall increase in market interest rate will make
borrowing costly for other borrowers Fear of remove in the minds of efficient & experience
employees
There will be clash between short term and long term
objective
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Process/stages in LBO Raising of finance more than 50% borrowed capital
Conversion in private
Restructuring of business activity
Reverse LBO
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Types of LBO
Sponsored LBOs
Non Sponsored LBOs
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Leveraged Buyout And Going Private
The first major LBO by an Indian companywas acquisition of Tetley by Tata Tea in
early 2000. in this case, Tata Tea set up a
SPV in the UK in the form ofTata Tea (GB)
Limited.
The SPV, in turn mobilized GBP 235 million
by way of long-term debt on the security of
the assets and cash flows of the Tetley and
acquired 100 per cent of Tetley at the cost
of the GBP 271 million, taking it private.
The acquisition of Corus Plc by Tata Steel
Limited is also a case of leveraged buyout.
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Management Buyout
When the professional management or non-promoter
management of a company carries out a leveraged
buyout of the company from its promoters, the same is
called as Management buyout or MBO.
Partners in growth
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Example
As on 31 March 2005, the balance sheet of XYZ Corporation
The paid-up capital consisted of 5 crore shares of Rs 10 each. The companys
sales were very stablerather stagnantbut the profitability was very good.
Its pre-tax cost of borrowing was just 10 per cent per annum. It used to charge
depreciation on straight line basis in its books. The current average rate of
book depreciation was 10 per cent. With regard to depreciation for income tax
purpose for the year 200405, the same worked out to Rs 3 crore only.
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Thus, earning per share (EPS) in 2004-05 worked out to Rs.4.4 per
share, with a healthy return on net worth (RONW) of 22 per cent. Thecompanys professional management team and particularly its MD
were rearing to go for leveraged investments in the new lines of
business.
However, its seventy-three-year old promoter was not interested in
taking any risk.
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The management team decided that it would itself take overthe company and take it to the next higher path of growth andapproached an investment banker to help them.
The investment banker estimated that the promoter, who washolding 40 per cent stake (2 crore shares) would be happy toexit at a price of Rs 35 per share which he had never seen in
last so many years. Public offer for 35 per cent and delistingoffer for balance 25 per cent will go through for Rs 40 and Rs44 per share respectively.
The investment banker confirmed that he can arrange forborrowed funds at the debt equity ratio of roughly 3:1 by
securing the debt on the assets of XYZ Limited.This meant that management team had to invest Rs 50 crores,whereas, Rs 145 crores would come in the form of long-termloans. The management team had decided to go ahead.
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The balance sheet of XYZ Holdings Limited
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After this, the management team decided to merge XYZLimited with XYZ Holdings Limited and change the
name of the merged entity to XYZ Limited.
Management, now in the shoes of the owners, decidedto invests Rs 100 crores in a new but synergistic line of
business that promised Rs 100 crore turnover in the
first year itself.
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The post merger balance sheet of XYZ Limited
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