Financing Options: Borrowing

There are two basic types of debt financing: recourse and nonrecourse loans. In recourse lending, the lender can pursue the borrower for all debt owed in the event of default. After liquidating the assets pledged to secure the loan, the lender can collect any amount of loan that exceeds the value of the collateral by filing a lawsuit and obtaining a judgment against the borrower. For a nonrecourse lending, the lender must accept the proceeds generated by selling the collateral, and they cannot collect any amount owed in excess of the proceeds of the collateral. Borrowers generally want nonrecourse loans, while lenders favor recourse loans. Lenders may be willing to grant a borrower a nonrecourse loan but only at a higher rate of interest and only when the borrower is viewed as a good credit risk.

An acquirer or financial sponsor may tap into an array of alternative sources of borrowing, including asset- and cash flow-based lending, long-term financing, and leveraged bank loans. Each of these types of borrowing is explained in more detail below.

Types of Long-Term Financing

The attractiveness of long-term debt is its relatively low after-tax cost and the potential for leverage to improve financial returns. Too much debt increases the risk of default and reduces a firm’s ability to finance unanticipated opportunities. Since the late 1970s, there has been an increase in firms exhibiting low to no leverage in the United States. Firms without any debt have increased from about 7% in 1977 to about 20% in 2010; firms with < 5% debt as a percent of total capital increased from 14% in 1977 to about 35% in 2010.¹⁴ Why? Firms tend to value the flexibility low leverage allows in financing unforeseen investment opportunities over the tax benefits debt provides.

Another reason for the secular decline in corporate leverage is increased active monitoring of managers by institutional owners, with institutional ownership of US equities increasing from 9.4% in 1980 to 42.9% in 2009. Active monitoring has partially replaced the historical role interest payments have played in forcing managers to use cash to repay interest and principal rather than making problematic investments.¹⁵ The declining role of leverage in restraining managerial behavior may accelerate due to the 2017 US tax law limiting the tax deductibility of interest. The notable exception to this trend may be merging firms, whose cash flows are relatively uncorrelated. Such firms tend to increase leverage following completion of the deal, as more stable total cash flows better enable the combined firms to pay interest and principal on the incremental debt.¹⁶

Long-term debt issues are classified as senior or junior in liquidation. Senior debt has a higher-priority claim to a firm’s earnings and assets than junior debt. Unsecured debt also may be classified according to whether it is subordinated to other types of debt. In general, subordinated debentures are junior to other types of debt, including bank loans, because they are unsecured and backed only by the overall creditworthiness of the borrower.

Convertible bonds convert, at some predetermined ratio (i.e., a specific number of shares per bond), into shares of stock of the issuing company. It normally has a relatively low coupon rate. The bond buyer is compensated primarily by the ability to convert the bond to common stock at a substantial discount from the stock’s market value. Current shareholders will experience earnings or ownership dilution when the bondholders convert their bonds into new shares.

A debt issue is junior to other debt depending on the restrictions placed on the firm in the indenture, a contract between the firm that issues the long-term debt and the lenders. The indenture details the nature of the issue, specifies the way in which the principal must be repaid, and stimulates affirmative and negative covenants. Debt issues often are rated by various credit-rating agencies according to their relative degree of risk. The agencies consider such factors as a firm’s earnings stability, interest coverage ratios, debt as a percent of total capital, the degree of subordination, and the firm’s past performance in meeting its debt service requirements.¹⁷

Financing Options: Common and Preferred Equity

Some common equity pays dividends and provides voting rights while other common shares have multiple voting rights. When new common shares are issued, shareholders’ proportional ownership in that company is reduced. Commonly referred to as dilution, the value of existing shares may also decline unless offset by improved earnings expectations. Dilutive situations can arise as a result of conversion of options or other convertible debt and preferred securities²¹ into common shares, secondary common share issues²² to raise capital, or share exchanges in mergers. The net effect of all three is to increase the number of new shares outstanding and for a given level of earnings to lower earnings per share and potentially the firm’s share price.

Common shareholders sometimes receive rights offerings that allow them to maintain their proportional ownership in the company in the event that the company issues another stock offering.²³ Common shareholders with rights may, but are not obligated to, acquire as many shares of new stock as needed to maintain their proportional ownership in the company. Rights are short-term instruments that usually expire within 30–60 days of issuance. The exercise price of rights is always set below the firm’s current share price.

Although preferred stockholders receive dividends rather than interest, their shares often are considered a fixed income security. Dividends on preferred stock are generally constant over time, like interest payments on debt, but the firm is generally not obligated to pay them at a specific time.²⁴ In liquidation, bondholders are paid first, then preferred stockholders, and lastly common stockholders. To conserve cash, LBOs frequently issue paid-in-kind (PIK) preferred stock, where dividends are paid in the form of more preferred stock.²⁵

How shares are issued varies by country. In the United States and a few other countries, management, with some exceptions, typically needs only board approval to issue common stock.²⁶ In most countries, however, by law or stock exchange rules, shareholders usually vote to approve equity issuances. When shareholders approve issuances, average announcement returns tend to be positive. When managers issue stock without shareholder approval, returns on average are negative, reflecting differences between shareholder and management objectives.²⁷

Publicly traded US companies often ask for authorization to issue a number of shares in their articles of incorporation (also called charters) far greater than the number of shares outstanding to finance future opportunistic investments. To issue authorized shares, a US firm’s board must approve a resolution stating the number of shares to be issued, to whom, and the amount to be paid for the shares detailed in a stock subscription agreement. Exchange listing standards restrict the ability of boards to issue authorized shares, requiring shareholder approval of directors’ and officers’ equity compensation plans, major issuances for acquisitions, and share issuances involving related parties and for changes in control. Outside the US, authorizations for new share issues are typically much smaller (10%–30% of current shares outstanding) than for US firms, are for limited periods (usually 1–5 years), and also usually require existing shareholders be given preemptive rights (i.e., a rights offering) to subscribe to new issuances to avoid dilution.

Seller Financing

Seller financing can “close the gap” between what sellers want and what a buyer is willing to pay. It involves the seller’s deferral of a portion of the purchase price until some future date—in effect, providing a loan to the buyer. A buyer may be willing to pay the seller’s asking price if a portion is deferred because the buyer recognizes that the loan will reduce the present value of the purchase price. The advantages to the buyer include a lower overall transaction risk (because of the need to provide less capital at the time of closing) and the shifting of operational risk to the seller if the buyer ultimately defaults on the loan to the seller.²⁸

Earnouts and warrants represent forms of seller financing. With the earnout, the seller agrees to defer a portion of the purchase price contingent on realizing a future earnings target or some other performance measure. Warrants may be issued to the seller enabling them to purchase an amount of the acquirer’s common stock at a stipulated exercise price, which is usually higher than the price at the time the warrant is issued. Warrants may be converted over a period of many months to many years enabling the warrant holder to participate in the upside potential of the business. Table 13.1 summarizes the alternative forms of financing. For more detail on earnouts and warrants, see Chapter 11.

Asset Sales

Acquirers may choose to finance a portion of the purchase price paid for a target firm by divesting nonstrategic acquirer and target assets. The proceeds may be used to reduce leverage incurred in financing the deal, buyback equity issued to raise funds in advance of the takeover, or to augment working capital for the combined firms.

Capital Structure Theory and Practice

Two popular theories describe how firms select the appropriate capital structure (i.e., debt versus equity): the trade-off theory and the pecking order theory. The trade-off theory posits a trade-off between tax savings (or tax shield) and financial risk. Since interest payments are tax deductible, borrowing is initially cheaper than equity financing. By taking on more debt, the firm can lower its weighted average cost of capital (WACC) by increasing the amount of debt relative to equity in its capital structure. But as debt increases relative to equity so does the risk of default which pushes up the WACC. According to the pecking order theory, a firm initially prefers to finance itself from internally generated funds. As cash balances are reduced below some desired minimum level, the firm chooses to finance its expenditures through borrowing. Since equity represents the highest cost source of funds, the firm issues new equity only as a last resort.

Of the two theories, the pecking order theory is better able to explain how acquirers choose to finance deals, because it provides a specific prioritization of financing sources. The trade-off theory seems more suited to explaining highly leveraged transactions such as leveraged buyouts. This will be explained in more detail later in this chapter.

Neither theory is sufficient to explain the long-term decline in US corporate leverage (excluding nonfinancial and regulated firms) between 1980 and 2010, how excess cash balances impact abnormal financial returns and the link between such returns and how deals are financed. These are addressed next.

Some researchers argue that the decline in leverage is better explained by the cost-benefit trade-off of debt from the perspective of shareholders rather than the firm. Shareholders consider not only the tradeoff between the tax shield and the potential for financial distress of increased leverage but also how the proceeds from debt are to be used, as well as the impact on managing agency costs and dividend policy in determining the net benefit (cost) of issuing debt. Since 1980, the average annual value to equity investors of the firm issuing a dollar of new debt was $(0.28), implying equity investors viewed additional debt as an erosion of shareholder wealth²⁹ causing them to pressure managers to reduce firm leverage over time.

Nor do these theories explain adequately why some firms tend to hold larger excess cash balances than others and how such cash balances impact the performance of future investments, including M&As. Some argue that excess cash balances could reflect agency problems or management’s desire to entrench itself. Agency problems arise when shareholders want excess cash distributed to them while managers want excess balances to make large acquisitions to gain personal prestige and increased compensation commensurate with the increased size of their firm. Others counter noting that excess balances reflect management taking precautions to have cash on hand to exploit future investment opportunities and to hedge against risk. Recent research seems to support the precautionary motive for large cash balances as cash rich firms tend to exhibit higher announcement date returns than cash poor acquirers. Excess balances seem to relate more to management having better information than investors about future investment opportunities and M&A deal synergies than a desire to protect their positions.³⁰

Abnormal financial returns to acquirers appear to be influenced by the way a deal is financed. How a firm raises funds often signals investors how well the firm is doing. Using internally generated funds suggests the firm is generating substantial excess cash flows. If the firm chooses to use debt, management appears to be confident that it can meet its financial obligations. However, issuing new stock is generally viewed as negative since management believes its shares are overvalued and is seeking to raise money before the value of a firm’s shares fall. Investors often react by selling their shares in anticipation of declining future share prices. Consequently, abnormal returns to acquirers tend to be higher when cash or debt is used to finance the deal and lower when equity is used.³¹

Impact of Near Zero/Negative Interest Rates on M&As

Near zero or negative interest rates were still apparent on some countries’ government debt in 2018. As the global economy recovers, positive interest rates are expected to become the norm. However, near zero or negative rates could reappear during the next recession.

How will these developments affect business investment? Near zero or negative interest rates should, unless offset by other factors, stimulate business investment on such things as plant and equipment as well as on mergers and acquisitions. Why? Projects whose expected returns were not attractive when borrowing costs were higher now become viable. But in recent years, global business investment and M&A activity has been much lower than would have been expected in such a low interest rate environment. The stimulus that should have accompanied plunging borrowing costs has been blunted in part by declining business confidence as senior managers view the near zero/negative interest rate environment as portending continued sluggish growth, or worse, recession. Central banks seem to have exhausted all their tools in their effort to spur increased economic growth. Instead of reinvesting in their operations or seeking strategic transactions which can suppress near term reported earnings, firms often have opted to borrow to buy back their own stock to placate yield starved investors. This often is viewed as a less risky way of generating shareholder returns than reinvesting excess cash flow in the firm or buying other companies.

Low or negative interest rates have another insidious effect: they prop up so called “zombie companies.” Such firms are those that are hemorrhaging cash but are able to remain in business because they can meet their near term working capital requirements through borrowing. Thus, the low interest rate environment slows industry consolidation as these zombie firms would otherwise have sought to merge with more financially viable competitors or to reorganize under the protection of the bankruptcy court.

Financial Intermediaries

Private equity, hedge, and venture capital funds represent conduits between investors/lenders and borrowers, pooling their resources and investing in firms with attractive growth prospects. All three types of buyout funds limit investors’ ability to withdraw funds for a number of years. Both private equity and venture capital funds invest almost all of the funds provided by investors within 5 years, with more than one-half of new investments made during the first 2 years of the average fund’s lifetime.³²

All three typically exit their investments via sales to strategic buyers, IPOs, or another buyout fund. However, their roles in financing M&A activity differ in significant ways. Private equity firms use substantial leverage to acquire firms, remain invested for up to 10 years, and often take an active operational role in firms in which they have an ownership stake. While hedge funds also use leverage to acquire firms outright, they are more likely to provide financing for takeovers through short-term loans or minority equity stakes. Finally, venture capital funds’ primary role is to finance nascent businesses. Such investments often are critical for firms with limited access to capital to sustain internal growth and create employment opportunities.³³

Private equity, hedge, and venture capital funds usually are limited partnerships (for US investors) or offshore investment corporations (for non-US or tax-exempt investors) in which the general partner (GP) has made a substantial personal investment, giving the GP control. Partnerships offer favorable tax benefits, a finite life, and investor liability limited to the amount of their investment. Institutional investors, such as pension funds, endowments, insurance companies, and private banks, as well as high-net-worth individuals, typically invest in these types of funds as limited partners. Once a partnership has reached its target size, it closes to further investment, whether from new or existing investors.

While general partners may invest their own funds, most equity funds are raised from institutional investors. Successful private equity funds raise new funds every 3–5 years to remain in business. They must be able to demonstrate an ability to outperform alternative investments to grow. Venture capital funds whose GPs contribute large amounts of their own funds tend to invest more rapidly, concentrate their investments where they have greater expertise, and demonstrate greater success when they sell the fund’s investments. As their personal investment level rises they tend to slow the rate at which they invest and diversify their investments more which tends to moderate overall fund performance.³⁴

Relationships matter! For example, venture capital firms with directors on mature public company boards are able to raise larger sums of money than otherwise due to their enhanced networks, visibility, and credibility which enhance their fund raising activities. Moreover, the experience, knowledge, and expertise obtained through these directors have been shown to benefit venture capital company portfolios by enhancing the likelihood of successful exits of their investments.

Private equity, hedge, and venture capital funds’ revenue has both a fixed and a variable component. General partners (GPs) earn most of the private equity firm’s revenue through management fees, commonly equal to 2% of assets under management³⁵ and as much as 6% of the equity invested by the GPs.³⁶ Fee income tends not to vary over the business cycle or with the GP’s performance. General partners can also earn variable revenue from so-called carried interest,³⁷ or the percentage of profits, often 20%, accruing to the GP. The carried interest percentage may be applied without the fund’s having achieved any minimum financial return for investors or may be triggered only if a certain preset return is achieved, often 8%. Carried interest can exceed 20% of cumulative profits since general partners seldom share in the losses the partnership incurs. For example, if the partnership earns $40 million resulting in the general partners earning $8 million (i.e., 0.2 × $40 million) in the first year but loses $10 million in each of the next 2 years, the effective carried interest percentage over the 3 year period is 40% (i.e., $8 million/($40 million − $20 million)). Private equity funds also receive fees from their portfolio companies for completing transactions, arranging financing, performing due diligence, providing legal and consulting advice, and monitoring business performance. There is evidence that the presence of carried interest where the GP is rewarded for a successful investment outcome as a result of carried interest (but not penalized for failure) encourages them to engage in excessive risk taking.³⁸

Lenders and Investors of Last Resort

Since 1995, hedge funds and private equity funds have participated in more than half of the private equity placements (i.e., sales to a select number of investors rather than the general public) in the United States. Contributing more than one-fourth of the total capital raised, hedge funds have consistently been the largest single investor group in these types of transactions.³⁹ Such investments have frequently allowed firms in which hedge and private equity firms invest to improve profitability, increase capital expenditures, and grow revenue faster than their peers.

Publicly traded firms using private placements tend to be small, young, and poorly performing. Often lacking reliable data, these firms have difficulty obtaining financing. Since security issues by such firms often tend to be relatively small, their limited trading volume and subsequent lack of liquidity make them unsuitable for the public stock exchanges. Therefore, such firms often undertake transactions called private investments in public equity (PIPES).⁴⁰ With few options, firms issuing private placements of equities often have little leverage in negotiating with investors. Therefore, many of the private placements grant investors repricing rights, which protect investors from a decline in the price of their holdings by requiring firms to issue more shares if the price of the privately placed shares decreases.

Hedge funds purchase PIPE securities that cannot be sold in public markets until they are registered with the SEC at discounts from the issuing firms and simultaneously sell short the securities of the issuing firms that are already trading on public markets. Although firms obtaining funding from hedge funds perform relatively poorly, hedge funds investing in PIPE securities perform relatively well, because they buy such securities at substantial discounts (affording some protection from price declines), protect their investment through repricing rights and short-selling, and sell their investments after a relatively short period. By being able to protect their investments in this manner, hedge funds are able to serve “as investors of last resort” for firms having difficulty borrowing.

Reflecting an inflow of cash seeking higher financial returns, private equity firms in recent years have lent aggressively directly to borrowers. The direct lending market consists of financial institutions such as pension funds, insurance companies and endowments which make loans without going through an intermediary such as a bank. These nonbanks, many of whom are private equity firms, held loans at the end of 2017 totaling more than $500 billion (as compared to about $300 billion in 2012) according to private equity firm Ares Management.⁴¹ Direct lenders, unlike banks, tend to hold loans in their own portfolios rather than selling them to other investors as is often the case with commercial banks. Such lenders concentrate on “middle-market” borrowers (i.e., those with annual EDITDA of less than $50 million) which often do not satisfy banks stricter lending criteria.

The US Dodd-Frank Act enacted in 2010 requires such funds with assets of $100 million or more to register with the SEC as investment advisers and to provide periodic reports to regulators. The burden of supplying quantities of data, screening potential investors more thoroughly, and implementing a rigorous compliance program adds to costs. It also reduces competitiveness versus funds not subject to disclosure of trading positions. Since the Act was enacted in 2010, US hedge funds have underperformed non-US funds. While Dodd-Frank has reduced fund risk, it may also have undermined performance. The reduction in risk has not been sufficient to compensate investors for poorer relative performance.⁴²

Providers of Financial Engineering and Operational Expertise for Target Firms

In this context, financial engineering describes the creation of a viable capital structure that magnifies financial returns to equity investors. The additional leverage drives the need to improve operating performance to meet debt service requirements; in turn, the anticipated improvement in operating performance enables the firm to assume greater leverage. In this manner, leverage and operating performance are inextricably linked.

Successful private equity investors manage the relationship between leverage and operating performance, realizing superior financial returns and operating performance on average relative to their peers. Private equity firms seem better able to survive financial distress than other, comparably leveraged, firms. These conclusions are supported by an examination of abnormal financial returns to both prebuyout shareholders, who benefit from the premium paid for their shares as a result of the leveraged buyout, and postbuyout shareholders.

Listed Versus Unlisted Fund Performance

In recent years, public listings of hedge funds, such as KKR and The Blackstone Group, have increased sharply, with such asset managers collectively controlling $2.38 trillion in 2017. These firms argue that going public allows them to improve investment performance by better incentivizing management through employee stock options and by investing funds raised in their IPOs in better technology and infrastructure. In contrast, public shareholders contend that a public listing exacerbates potential agency conflicts.

Potential conflicts exist between firm shareholders and fund investors, management and fund investors, and firm shareholders and fund investors. For privately held investment firms, founders/owners contribute a substantial share of their net worth with the funds managed by the firm, thus aligning their interests with those of other investors. Once public, the firm’s founders sell out to new shareholders who do not typically invest with those investing in the funds. This separates firm ownership from what is being invested. Founders who manage the firm may not reinvest their IPO proceeds in the funds managed by the now listed firm, thereby weakening the link between management and investment capital. The net result is that hedge funds managed by publicly listed firms on average underperform those firms that remain private by almost 3% annually.⁵⁷

Internal Financing

The new law favors internally generated funds by permanently reducing the corporate tax rate and accelerating capital cost recovery through 2022. The less favorable treatment of net operating losses will partially offset the dramatic boost given to after-tax operating cash flow from the reduction in the statutory tax rate to 21% from the previous maximum tax rate of 35%. Moreover, the move to a worldwide tax system in which only domestic profits are taxed (with safeguards to discourage shifting domestic profits to foreign operations) will allow firms to better manage their consolidated cash balances: overseas cash balances can be allocated to investment opportunities (including M&As) based more on economics and less on tax concerns.

The full cost of investment in certain tangible property and computer software generally will be immediately deductible if acquired and placed in service after September 27, 2017 and before January 1, 2023, even if acquired used. While this accelerated deduction remains in effect (through January 1, 2023 for most tangible property), acquirers may be more inclined to structure transactions as asset acquisitions (or those deemed asset acquisitions under Section 338 of the US tax code) in a manner beneficial to all parties. This is particularly true of privately owned acquirers who are generally less concerned about the potential for earnings per share dilution of the immediate write-off of tangible property and equipment. These deductions could shield an acquirer from taxes during the early years of the postdeal period as they would apply to tangible assets acquired in a taxable asset acquisition.

Under the new tax law, NOLs existing on January 1, 2018 and those created in subsequent years lose a significant amount of their value as the applicable statutory tax rate is now 21%, 14 percentage points lower than previously. NOLs arising in taxable years ending after December 31, 2017 that are not deductible in a taxable year can be carried forward indefinitely. NOL carrybacks have been eliminated. NOL deductions utilized in tax years up to 2022 would be limited to 90% of taxable income falling to 80% thereafter. While a target’s NOLs can still sweeten a buyout, their benefit to acquirers in the future will be less than in the past.

External Financing

Debt financing of takeovers is likely to become less attractive due to the limitation of net interest expense deductions to 30% of earnings before taxes, interest, depreciation and amortization (EBITDA) through the end of 2022 and earnings before interest and taxes thereafter. Interest on debt held on balance sheets prior to the enactment of the new law will be treated in the same way. However, that portion of net interest deductions not allowed because of the cap may be carried forward indefinitely to future taxable years. The mixture of limitations on net interest expense and NOLs means that highly leveraged firms are likely to become taxpayers sooner than they would have under the earlier tax law. During the first half of 2018, LBOs did recover from their earlier depressed levels as firms took advantage of attractive target firm prices and relatively low borrowing costs. However, in future years, private equity firms are likely to acquire smaller businesses financed with less debt.

The Private Equity Market Is a Global Phenomenon

About 1 in 10 cross-border deals are undertaken by private equity firms, and private equity’s share of total cross-border deals has been increasing over time. Such firms are in direct competition with multinational companies which have substantial advantages. These include larger synergistic opportunities, better access to capital markets both in their home and in the target’s countries, and typically a lower risk premium on borrowing. Despite these advantages, private equity firms have superior track records in reorganizing target firms to improve financial performance over multinational firms.⁶¹

LBO activity tends to be substantially larger in countries with stronger creditor protections providing low cost credit. Private equity investors in cross border deals structured as LBOs come from countries with strong creditor protections and acquire firms in countries with weak creditor protections where potential financial returns may be higher. Examples of strong creditor rights include the ability to seize collateral once bankruptcy reorganization has been approved, the requirement that creditors consent before a debtor firm can enter bankruptcy, whether secured creditors are paid first when a debtor firm is liquidated, and whether creditors are responsible for running a firm while the firm is in bankruptcy.⁶²

The ease with which the majority owner can squeeze out minority shareholders is another factor affecting cross border deals. The United States, the United Kingdom, and Ireland tend to be the less restrictive when it comes to squeezing out minority investors, while Italy, Denmark, Finland, and Spain are far more restrictive. Other factors such as exchange rates, a country’s political environment, and the potential for asset expropriation are discussed in detail in Chapter 18.

Sales to Strategic Buyers Represent the Most Common Exit Strategy

LBO financial sponsors and management are able to realize their expected financial returns on exiting the business. Constituting about 13% of total transactions since the 1970s, initial public offerings (i.e., IPOs) declined in importance as an exit strategy. At 39% of all exits, the most common ways of exiting buyouts is through a sale to a strategic buyer; the second most common method, at 24%, is a sale to another buyout or private equity firm in so-called secondary buyouts. The choice between IPOs and secondary buyouts depends heavily on debt and equity market conditions. IPOs tend to be used when the stock market is rising; secondary buyouts are more popular when debt is readily available and cheap.⁶³

Selling to a strategic buyer often results in the best price, because the buyer may be able to generate significant synergies by combining the firm with its existing business. However, selling to a private equity firm can provide an even more attractive price when the target is poorly performing and has few investment opportunities. Private equity firms often have greater expertise in managing underperforming firms and access to cheaper capital.

Buyout firms sometimes remain invested in a business portfolio for up to 10 years. They may sell businesses through secondary buyouts when their holding period comes to a close, and they have to pay off investors at the highest possible price and in the shortest possible time. Pressure to sell quickly often causes them to sell at depressed cash flow multiples making such businesses attractive to other buyout firms seeking new investment opportunities.⁶⁴ An IPO is often less attractive due to the requirement for public disclosure, the commitment of management time, the difficulty in timing the market, and the potential for valuing the IPO incorrectly. The original investors also can cash out while management remains in charge of the business through a leveraged recapitalization: borrowing additional funds to repurchase stock from other shareholders. This strategy may be employed once the firm has paid off its original debt.

Empirical studies show that strategic buyers of private equity-backed firms experience announcement-date abnormal returns of 1%–3%. Strategic acquirers of venture capital-backed firms, private equity investors who invest in firms at their earliest stage of development, display positive announcement-date returns of about 3%.

The Effects of LBOs on Innovation

LBOs tend to improve the rate of innovation.⁶⁵ Private equity firms’ expertise with respect to strategy development; operational, financial, and human resource management; marketing and sales; and M&As may create an innovative culture. They also play an important role in assessing incumbent management skills and those of their potential replacements.⁶⁶ Finally, LBO targets are more likely to implement innovative marketing programs (e.g., design, packaging, and promotion) to increase sales and market share.

Private firms or firms taken private through an LBO often demonstrate higher rates of unique, higher quality innovation than public firms as measured by the number of patent citations per firm even though public firms typically generate more patents overall. Why? Private firms tend to be more focused, less bureaucratic, and consequently more attractive to the most talented innovators than are public firms, and they are less prone to interference from the less sophisticated shareholders of public firms.⁶⁷ When firms go public, they tend to lose a lot of internal talent, often made rich as a result of the IPO, causing a substantial decline in the uniqueness of their innovation.⁶⁸

The Effects of LBOs on Employment Growth

After a buyout, employment in existing operations tends to decline relative to other companies in the same industry by about 3%. Employment in new operations tends to increase relative to other companies in the same industry by more than 2%. Therefore, the overall impact on employment of private equity transactions is a modest 1% decline. However, the picture varies by industry, with net job losses (gains less losses) concentrated in buyouts of retailers. Excluding retailers, the overall net employment change appears to be neutral or positive.⁶⁹

Employment growth following takeovers by buyout firms that are politically connected can contribute to subsequent employment gains of as much as 1.24% annually following a buyout as compared to a modest 0.33% for nonpolitically connected buyout firms. Political connections include a general partner, board member, or employee having a significant political position in the state or federal government or having a close relationship with people in such positions. This correlation could reflect an “exchange of favors.” Parallels include employment increases in election years and in states with high relative levels of corruption, as well as a politician’s reelection and firms in their districts receiving government contracts and grants.⁷⁰

The Changing Nature of Private Equity Firm Collaboration

To finance the increased average size of targets taken private in recent years, buyout firms started to bid for target firms as groups of investors.⁷¹ Often time-consuming to set up, such transactions were referred to as club deals. Critics of such tactics argued that banding together to buy large LBO targets could result in lower takeover premiums for target firms by reducing the number of potential bidders. By mitigating risk and allowing for a pooling of resources, supporters countered that clubbing could increase premiums.

The empirical evidence concerning how club deals impact target shareholders is mixed. For deals involving large private equity firms and relatively few bidders, club bidding may depress purchase premiums. However, when the number of independent bidders is high, there is little evidence of anticompetitive activity,⁷² and purchase premiums may be increased,⁷³ particularly when joining forces enables bidders to overcome capital constraints.⁷⁴ Still other researchers find no correlation between purchase premiums and club deals.⁷⁵

The nature of collaboration for private equity funds has changed in recent years. According to a survey conducted by research firm Preqin, nearly one third of buyout firms in 2014 offered more “coinvestment” opportunities than in 2013. Buyout firms have found that investing along with institutional investors who are also limited partners in the firm’s existing funds enables them to raise funds more easily when the opportunities arise. Advantages to limited partners include escaping management fees they would have incurred had they invested through a new fund and retaining the share of capital gains that would have accrued to the fund’s general partners. Moreover, their capital is invested more quickly than is normally the case with a new fund that raises financing in anticipation of finding new investment opportunities. However, returns to investors that coinvest with private equity funds have tended to underperform those that could have been earned had they invested as a limited partner in one of the private equity firm’s funds. It appears that the institutional investors are given the opportunity to coinvest only after the buyout funds have selected the most promising opportunities for their own investments.⁷⁶

Target Selection

Private equity investors often argue that their ability to find (or “source”) deals in which they have some insight not widely known in the industry provides significant value creation potential. For every hundred firms considered, the average private equity firm investigates in detail about 15, signs a purchase agreement with 8, and actually closes on 4.⁷⁷ Firms representing good LBO candidates are those that have little debt, tangible assets, predictable positive cash flow, and redundant assets. Competent and highly motivated management is always crucial to the eventual success of the LBO. Finally, firms in certain types of industries or that are part of larger firms often represent attractive opportunities.

Not Overpaying

Failure to meet debt service obligations in a timely fashion often requires that the LBO firm renegotiate the terms of the loan agreements with lenders. If the parties to the transaction cannot compromise, the firm may be forced to file for bankruptcy. Highly leveraged firms also are subject to aggressive tactics from major competitors, who understand that taking on large amounts of debt raises the breakeven point for the firm. If the amount borrowed is made even more excessive as a result of having paid more than the economic value of the target firm, competitors may gain market share by cutting product prices. The ability of the LBO firm to match such price cuts is limited because of the required interest and principal repayments.

Improving Operating Performance

Ways to improve performance include negotiating employee wage and benefit concessions in exchange for a profit-sharing or stock ownership plan and outsourcing services once provided by the parent. Other options include moving the corporate headquarters to a less expensive location, pruning unprofitable customers, and eliminating such perks as corporate aircraft.

Private equity investors are more likely than nonprivate equity investors to place representatives with relevant industry experience on the boards of firms in which they make minority investments. Firms with private equity investor representation on their boards are more likely to display higher announcement date returns and improved operating performance than firms without such representation.⁸²

Research shows that new owners choosing to retain their investment longer, such as private equity investors, have more time to put controls and reporting–monitoring systems in place, enhancing the firm’s competitive performance. Other factors contributing to postbuyout returns include professional management, willingness to make the difficult decisions, and often the private equity firm’s reputation.⁸³ Research also suggests that public to private to public IPOs (so-called reverse LBOs) tend to show greater post-IPO performance than initial public offerings. Why? Because investors can review the firm’s historical performance when it was public and benefit from any restructuring that had taken place while it was private.⁸⁴

Alleviating Public Firm Agency Problems

While access to liquid public capital markets enables a firm to lower its cost of capital, participating in public markets may create disagreements between the board and management on one hand and shareholders on the other, so-called agency problems. Public firms may be subject to conflicts between managers engaging in empire building and shareholders seeking higher financial returns. Improvements in corporate governance resolving such conflicts reduce borrowing costs and the likelihood of default.⁸⁵ The discipline imposed by leverage forces management to focus on improving performance. Public-to-private LBOs often engage in asset sales and reduced capital spending to improve performance rather than build empires.⁸⁶

Similar conflicts can arise when ownership is heavily concentrated. Majority shareholders may utilize their dominant voting positions to make decisions inconsistent with those desired by minority shareholders. For example, the majority shareholder wants to increase dividends while minority shareholders want to pursue a more aggressive investment strategy reinvesting excess cash flow. Sometimes conflicts between minority and majority shareholders can be eliminated by taking a firm private in which the majority shareholder buys out the minority shareholders. In countries where ownership often is highly concentrated, pretransaction minority shareholders often receive cumulative abnormal financial returns (the increase in the value of their shares prior to the deal announcement date) on their investment of 22% and a purchase price premium for their shares of 35%.⁸⁷

Private equity investors attempt to deal with agency conflicts through improved governance by appointing small boards of directors consisting of 5–7 members. The buyout firm often takes three board seats, with one or two going to management and the rest to outsiders. The industry knowledge of the private equity investors can be helpful in growing the business and the small size of the board makes it possible to be more nimble in decision making.

Providing Access to Capital for Private Firms

Agency problems are less significant for private than public firms due to the concentration of ownership and control. Private firms often undertake LBOs to gain access to capital and to enable owners and managers to take cash out of the business. Private firms having undergone LBOs tend to be more profitable and experience faster growth than their peers. Why? Because private equity investors introduce professional management methods, more aggressively monitor performance, and are willing to take actions to improve firm performance because of the need to satisfy principal and interest payments. Those private equity firms tending to specialize in certain industries or regions often demonstrate an ability to more readily raise capital for reinvestment in firms within their areas of expertise than more diversified buyout firms.⁸⁸

Creating a Tax Shield

So-called tax shields refer to the reduction in income taxes resulting from allowable deductions from taxable income such as depreciation and interest expense. Such tax savings, assuming other factors remain unchanged, increase the present value of the firm by boosting future operating cash flows. Table 13.3 illustrates how a tax shield resulting from an increase in depreciation reduces taxable income while increasing operating cash flow.

Historically, LBOs have not paid taxes for 5–7 years⁸⁹ following the buyout, due to the tax deductibility of interest and the additional depreciation resulting from the write-up of net acquired assets.⁹⁰ Profits are shielded from taxes until a substantial portion of the outstanding debt is repaid and the assets depreciated. LBO investors utilize cumulative free cash flow to increase firm value by repaying debt and improving operating performance. Recent changes in the US corporate tax rates reduce the value of NOLs and depreciation and caps on the deductibility of net interest expense mean LBOs may become taxpayers sooner than in the past.

Debt Reduction

When debt is repaid, the equity value of the firm increases in direct proportion to the reduction in outstanding debt—equity increases by $1 for each $1 of debt repaid—assuming the financial sponsor can sell the firm for at least what it paid for the company. Debt reduction contributes to cash flow by eliminating future interest and principal payments.⁹¹

Improvement in Operating Margin

When a firm reinvests cumulative free cash flow, profit margins can increase by a combination of revenue growth and cost reduction. Private equity investors tend to concentrate more on revenue growth as they focus on industries in which they have substantial experience and proprietary knowledge rather than on cost reduction.⁹² Revenue gains are achieved through new product introduction, better marketing, and through acquisitions. The margin increase augments cash flow, which in turn raises the firm’s equity value, if the level of risk is unchanged.

Timing the Sale of the Firm

LBOs may benefit from rising industry multiples while the firm is private. The amount of the increase in firm value depends on the valuation multiple investors place on each dollar of earnings, cash flow, or EBITDA when the firm is sold. LBO investors create value by timing the sale of the firm to coincide with the decline of the firm’s leverage to the industry average and with favorable industry conditions. This occurs when the firm assumes the risks of the average firm in the industry and when the industry in which the business competes is most attractive to investors, a point at which valuation multiples are likely to be the highest.⁹³

Table 13.4 illustrates how LBOs create value by “paying down” debt, in part using cash generated by tax savings, by improving the firm’s operating margins, and by increasing the market multiple applied to the firm’s EBITDA in the year in which the firm is sold.⁹⁴ Each case assumes that the sponsor group pays $500 million for the target firm and finances the transaction by borrowing $400 million and contributing $100 million in equity. The sponsor group is assumed to exit the LBO at the end of 7 years. In Case 1, all cumulative free cash flow is used to reduce outstanding debt. Case 2 assumes the same exit multiple as Case 1 but that cumulative free cash flow is higher due to margin improvement and lower interest and principal repayments as a result of debt reduction. Case 3 assumes the same cumulative free cash flow available for debt repayment and EBITDA as in Case 2 but a higher exit multiple.

Estimating Tax Deductible Interest Expense

Recall that recent US tax legislation limits the tax deductibility of net interest expense to 30% of EBITDA through the end of 2021 and to 30% of EBIT thereafter. The product of the interest rate on borrowed funds and a leverage multiple (i.e., debt to EBITDA or EBIT) that equals 30% or less implies that 100% of interest expense is tax deductible (see Eq. 13.1). If the product exceeds 30%, the excess over 30% will not be deductible (see Eq. 13.2). The requirement for full deductibility of interest expense can be expressed as follows:

$i\times D=0.3\times \mathrm{EBITDA},$

and

$i\times m\times \mathrm{EBITDA}=0.3\times \mathrm{EBITDA},$

therefore

$i\times m=0.3$

where i, D, and m are the rate of interest, debt, and the ratio of debt to EBITDA, respectively. If the following is true, some portion of interest expense will not be tax deductible:

$i\times m>0.3$

Dividing the results of Eq. (13.1) by Eq. (13.2) gives the share of total interest expense that will be tax deductible. For example, if a company borrows 5 times EBITDA at 6%, then 100% of interest expense will be tax deductible. Why? Because 0.06 × 5 = 0.30 × 100 = 30%. If the firm borrows 5 times EBITDA at 7%, total interest expense will exceed 30% of EBITDA (i.e., 5 × 0.07 = 0.35 × 100 = 35%). Consequently, only 85.7% of total interest expense will be tax deductible (i.e., 0.30/0.35 = 0.857 × 100 = 85.7%). Using these equations in this manner obviates the need to have an explicit estimate of EBITDA.

Common Deal Structures

Due to the epidemic of bankruptcies of cash flow-based LBOs in the late 1980s, the most common form of LBO today is the asset-based LBO. This type of LBO can be accomplished in one of two ways: the sale of assets by the target to the acquiring company, with the seller using the cash received to pay off outstanding liabilities, or a merger of the target into the acquiring company (direct merger) or a wholly owned subsidiary of the acquiring company (subsidiary merger). For small companies, a reverse stock split may be used to take the firm private. An important objective of “going private” transactions is to reduce the number of shareholders to below 300 to enable the public firm to delist from many public stock exchanges.

In a direct merger, the firm to be taken private merges with a firm controlled by the financial sponsor, with the seller receiving cash for stock. The lender will make the loan to the buyer once the security agreements are in place and the target’s stock has been pledged against the loan. The target then is merged into the acquiring company, which is the surviving corporation. In a subsidiary merger (see Fig. 13.3 in the end of chapter case study), the company (i.e., the Parent) controlled by the financial sponsor creates a new shell subsidiary (Merger Sub) and contributes cash or stock in exchange for the subsidiary’s stock.⁹⁷ The subsidiary raises additional funds by borrowing from lenders whose loans are collateralized by the stock of the target firm at closing. The subsidiary then makes a tender offer for the outstanding public shares and merges with the target, often with the target surviving as a wholly owned subsidiary of the parent. This may be done to avoid any negative impact that the new company might have on existing customer or creditor relationships. If 90% of the target firm’s shares can be acquired in the tender offer, the remaining shareholders can be squeezed out in a backend merger. The financial sponsor may negotiate a top up option (i.e., an option to buy as many shares as necessary to reach the 90% threshold) with the target firm’s board if there is concern the 90% figure cannot be reached in the tender offer.⁹⁸

A reverse stock split enables a firm to reduce its shares outstanding. The total number of shares will have the same market value after the reverse split as before, but each share will be worth more. Reverse splits may be used to take a firm private where a firm is short of cash. The majority shareholders retain their stock after the split, while the minority shareholders receive a cash payment. Intending to go private, MagStar Technologies used a reverse split in which each 2000 common shares was converted into 1 share of common, and holders of fewer than 2000 shares would receive cash of $0.425 per presplit share. The split reduced the number of shareholders to less than 300, the minimum required to list on many public exchanges.

Common Capital Structures

LBOs tend to have complicated capital structures consisting of bank debt, high-yield debt, mezzanine debt, and equity provided primarily by the financial sponsor (see Fig. 13.2). The degree of leverage used in LBOs is determined by borrowing costs, the reputation of the financial sponsor, tax benefits, and the potential for financial distress if the firm were unable to meet its obligations to pay interest and principal on a timely basis.

Collateralized bank debt is the most senior in the capital structure in the event of liquidation. Since such loans usually mature within 5–7 years, interest rates vary by a fixed amount over the London interbank offering rate. Bank credit facilities consist of revolving-credit and term loans. A revolving-credit facility is used to satisfy daily liquidity requirements, secured by the firm’s most liquid assets such as receivables and inventory. Term loans are usually secured by the firm’s longer-lived assets and are granted in tranches (or slices), denoted as A, B, C, and D, with A the most senior and D the least of all bank financing. While bank debt in the A tranche usually must be amortized or paid off before other forms of debt can be paid, the remaining tranches generally involve little or no amortization and are repaid at maturity. While lenders in the A tranche often sell such loans to other commercial banks, loans in the B, C, and D tranches usually are sold to hedge funds and mutual funds. Loans in B, C, and D tranches commonly are referred to as leveraged loans, reflecting their risk relative to loans in the A tranche.

The next layer of LBO capital structure consists of unsecured subordinated debt, also referred to as junk bonds. Interest is fixed and represents a constant percentage over the US Treasury bond rate. The amount depends on the credit quality of the debt. Often callable at a premium, this debt usually has a 7- to 10-year maturity range. As an alternative to high-yield publicly traded junk bonds, second mortgage or lien loans became popular between 2003 and mid-2007. Often called mezzanine debt, such loans are privately placed with hedge funds and collateralized loan obligation (CLO) investors. They are secured by the firm’s assets but are subordinated to the bank debt in liquidation. By pooling large numbers of first and second mortgage loans (so-called noninvestment-grade, or leveraged, loans) and subdividing the pool into tranches, CLO investors sell tranches to institutional investors such as pension funds. Such debt may be issued with warrants to buy equity in the firm.⁹⁹

The final layer of the capital structure consists of equity (common and preferred) contributed by the financial sponsor and management. Preferred stock offers a greater chance of recovering some of the sponsor’s investment in bankruptcy because holders of such equity are paid before common shareholders. Convertible preferred shares (or convertible debt) are employed to provide investors with some minimum rate of return as well as the opportunity to participate in any future appreciation of the common shares. Convertible securities include an option for the holder to convert such shares (or debt) into a fixed number of common shares any time after a predetermined date. Convertible securities also are used to minimize agency problems arising between investors and managers: investors want some amount of current income in the form of dividends or interest and management wishes to use all cash flow to pay off debt.

Discussion Questions

1. 1. What is the form of payment and form of acquisition used in this transaction? Speculate as to why they were these chosen?
2. 2. What are positive (or affirmation) and negative covenants? How can such covenants affect Abbott’s future investment decisions? Be specific.
3. 3. The deal is taxable to St. Jude shareholders to the extent that they realize a gain. The reason is that the reverse triangular merger structure used in this instance does not qualify as a tax free merger. Why?
4. 4. What is a bridge loan? What does it mean that they were unsecured? The terms of these bridge loans were to automatically terminate no later than July 27, 2017, at which point Abbott was to have its permanent long-term financing in place. What is “permanent financing?” Explain your answer.
5. 5. The merger is characterized as a reverse triangular merger. Speculate as to why this structure may have been chosen? Explain your answer.
6. 6. Abbott could have directly merged with St. Jude. Why was a wholly-owned merger sub created by Abbott to own St. Jude’s assets and liabilities instead? Explain your answer.

Solutions to these case study discussion questions are available in the Online Instructor’s Manual for instructors using this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).