The Art of the LBO
November 2004
Agenda
I.
An Overview of Leveraged Buyouts
II.
The Building Blocks
III.
Putting It All Together
IV.
How It Happens in Reality
2
1
I. An Overview of Leveraged
Buyouts
What Are LBOs?
What Is an LBO?
A L everaged BuyOut is the acquisition of an entire Company or
division
n Buyer (the “Sponsor”) raises debt and equity to acquire Target

Borrows majority of purchase price

Contributes proportionately small equity investment
n Buyer grows Company, improves performance

Relies on Company’s free cash flow and asset sales to
repay debt

Potentially makes add-on acquisitions

Later sells or IPOs all or a portion of the Company to exit
investment
4
2
What Is An LBO?
Typical Leveraged Buyout Structure
Current
Owners
Purchase
Price
High Yield
Bondholders Bonds
Equity
Investment
NewCo
(Merged Into
Target)
Bank
Loan
Acquiror
(LBO Firm)
Banks
Target
5
More Common Than You Think…
Some prominent LBOs:
Company
Sponsor
Size
Silver Lake
$2.0bn
TPG, Bain & GS
$1.6bn
Madison Dearborn Partners $1.5bn
KKR
$1.5bn
THLee
$1.1bn
Bain
$1.0bn
Blackstone
$700mm
6
3
Value of LBO Activity: 1997-2003
Global Announced Volume
($ Billions)
100
$81
$86
$85
$86
2002
2003
80
$60
60
40
$39
$43
20
0
1997
1998
1999
2000
2001
Source: GS F&P, Securities Data Co., Buyouts, Thompson Financial Securities Data
7
LBO Analysis – An Important Banker Tool
n M&A valuation
 Complements other valuation techniques
n Acquisition financing
 LBO
 Corporate acquisition
 “Staple-on” financing
n Dividend recapitalization
n Straight debt financings
n Complex merger plan analysis
 Cash flow impact vs. EPS
8
4
II. The Building Blocks
How Are LBOs Financed?
The Building Blocks
Types of Acquisition Financing
Bank Debt
(Senior)
~ 45%
High Yield Debt
(Subordinated)
~ 25%
Private
Equity
~ 30%
100%
10
5
How Are LBOs Financed?
Hypothetical Example
($ in millions)
12/31/2003
Revolving Credit Facility - 6 Years
$ 0.0
Tranche A Senior Term Loan - 6 Years
150.0
Tranche B Senior Term Loan - 8 Years
200.0
Total Senior Secured Debt
350.0
Senior Subordinated Notes due 2014
200.0
Total Debt
% of
Capitalization
550.0
Management Rollover Equity
Cum. Multiple
of LTM
EBITDA
43.8%
2.9x
68.8%
4.6x
50.0
Sponsor Cash Equity
200.0
Total Equity
Total Capitalization
250.0
31.3%
—
$800.0
100.0%
6.7x
LTM EBITDA = $120.0 million.
11
Comparing the Building Blocks
How the Pieces Differ
Ranking in Capital Structure
Cost
Structure of Coupon or Dividend
Maturity and Amortization
Callability and Prepayment
Fees to Underwriters
Ratings
Covenants and Legal Restrictions
Marketing and the Capital-Raising Process
Investor Base
12
6
Private Equity
Terminology
n Most junior money in the capital structure
n Typically no dividends
n Voting control at all times
n Co-investing with other sponsors
n Raised in the “alternative investment market”
 Portion from Sponsor – “put your money where your
mouth is”
 Pension funds, endowments, investment portfolios,
investment banks, commercial banks, “fund of funds ”
 Represents 5% to 10% of investors’ portfolios
n Net IRRs to LPs are generally 15-25%
13
Size of the Private Equity Market
US Fund Raising Activity
80
$63.3
($ Billions)
60
$55.4
40
$34.5
$34.6
$36.9
$24.0
$23.2
$18.4
20
$11.6
$17.0
$9.9
0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
YTD
Source: Buyouts Magazine
14
7
Average LBO Equity Contribution
45%
16%
40.6%40.0%
40
39.4%
37.8%
14
35.7%
12
31.6%
30.0%
30
22.0%25.2%
25
26.2%
Historical Single
B Default Rates (%)
Average Equity Contribution
to LBOs (%)
35
10
23.7% 22.9%
8
20.7%
20
6
13.4%
15
9.7%
4
10
7.0%
2
5
0
0
1987 1988 1989 19901991(a)1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
(a) No data for 1991
Source: Portfolio Management Data and Standard & Poor’s
15
...But Equity Alone Is Not Enough
Average Debt Multiples of Highly Leveraged Loans (a)
1987 — Second Quarter 2004
Using Leverage to Turbo-Charge Returns
10
9
8
7
6
5
8.8x
7.2x
6.7x
5.8x 5.7x
5.3x
5.0x
5.2x 5.3x 5.2x
5.3x
4.5x
4.5x
4.0x
4
3.7x 3.8x
4.0x
3
2
1
0
1987 1988 1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
YTD
Total Debt/EBITDA
(a) Criteria: Pre-1996: L+250 and higher; 1996 to date: L+225 and higher; Media and Telecom loans excluded; there
were too few details in 1991 to form a meaningful sample.
Source: Portfolio Management Data.
16
8
How Are LBOs Financed?
Hypothetical Example
($ in millions)
12/31/2003
Revolving Credit Facility - 6 Years
$ 0.0
Tranche A Senior Term Loan - 6 Years
150.0
Tranche B Senior Term Loan - 8 Years
200.0
Total Senior Secured Debt
350.0
Senior Subordinated Notes due 2014
200.0
Total Debt
550.0
Management Rollover Equity
Sponsor Cash Equity
Total Equity
Total Capitalization
% of
Capitalization
Cum. Multiple
of LTM
EBITDA
43.8%
2.9x
68.8%
4.6x
50.0
200.0
250.0
31.3%
—
$800.0
100.0%
6.7x
LTM EBITDA = $120.0 million.
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Leveraged Bank Debt
Terminology
Ranking
Interest Rate
Maturity
Callability
Fees to
Underwriters
Ratings
Senior secured, most senior debt in the capital structure
Floating, typically LIBOR + 250 bps and higher, quarterly payments
Varies with credit profile, typically 5-8 years, but before more junior debt
Typically prepayable at par
1.75% to 2.25%
Usually BB+ to B+ (rating agencies now rate bank loans)
Covenants
Maintenance covenants, set out in “Credit Agreement ”
Marketing
Sold via syndication process and confidential offering memorandum
(“bank book ”)
Process
Diligence, commitment, launch, syndicate, fund
18
9
Leveraged Bank Debt
Terminology
n Revolving Credit Facilities vs. Term Loans

Revolvers allow multiple drawings (like a credit card)

Term Loans are funded at closing
n Pro Rata Facilities

Consist of Revolvers and “A” Term Loans (“Term Loan A”)

Sold to traditional commercial banks

Same LIBOR spread, 5-6 year maturities, even amortization
n Institutional Tranches

Consist of “B”, “C” or “D” Term Loans

Sold to over 100 institutions and funds

Progressively higher spreads, 6-8 year maturities, minimal
front-end amortization
19
Leveraged Bank Debt
Only a Subset of the Broader Loan Market
$930 B
Total Loan Market
$329 B
Leveraged Loan
Market
$73 B
Sponsored
Loan
Source: Loan Pricing Gold Sheets, Buyouts Magazine, Standard & P oor’s - 2003
20
10
Leveraged Bank Debt
Historical Growth in the Market
350
$329
$300
$265
$256
$243
$ billions
250
$220
$216
$185
200
150
100
$71
$50
$49
1994
1995
50
$16
0
1993
1996
1997
1998
1999
2000
2001
2002
2003
Source: Portfolio Management Data 1993 -2000; Loan Pricing Corporation 2001-2003
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How Are LBOs Financed?
Hypothetical Example
($ in millions)
12/31/2003
Revolving Credit Facility - 6 Years
$ 0.0
Tranche A Senior Term Loan - 6 Years
150.0
Tranche B Senior Term Loan - 8 Years
200.0
Total Senior Secured Debt
Senior Subordinated Notes due 2014
Total Debt
Management Rollover Equity
Sponsor Cash Equity
Total Equity
Total Capitalization
350.0
% of
Capitalization
Cum. Multiple
of LTM
EBITDA
43.8%
2.9x
68.8%
4.6x
200.0
550.0
50.0
200.0
250.0
31.3%
—
$800.0
100.0%
6.7x
LTM EBITDA = $120.0 million.
22
11
High Yield Debt
Terminology
Ranking
Interest Rate
Maturity
Callability
Fees to
Underwriters
Ratings
Usually subordinated and/or unsecured
Fixed, expressed as a coupon, varies with credit quality, semiannual
payments
“Bullet ” maturity in 10 years
“10NC5” and 35% “Equity Clawback” now standard
2.5% to 3.0%
Usually B+ to CCC+
Covenants
Incurrence covenants, governed by the “Indenture”
Marketing
Sold via SEC Prospectus / 144A Offering Circular
Process
Diligence, documentation, roadshow, price, fund
23
Mezzanine Financing
Terminology
n Structure
 Rank / Return / Equity / “All-In”
n Investors
 “Mezz” buyers in the market
 Banks / Other financial institutions
n Issuer’s Perspective
 Leverage equity more; push risk / return profile
 Fill hole in cap structure
 Disclosure / Size
24
12
LBO Market Activity
n LBO activity continues to be very strong
n Extremely receptive financing markets
 Large amount of bank loan refinancings and new CLOs
 Substantial cash positions of high yield mutual funds
n Large corporations divesting assets to reduce debt
n Return of the jumbo LBO
$7.05 B
$4.75 B
$4.3 B
n Financial sponsors creating consortiums to cover large equity
investments and diversify risk
n Although the LBO market is back, sponsors remain disciplined
25
III. Putting It All Together
The Analysis
13
The Five Simple Steps of LBO Analysis
n Step #1: Evaluate the Story
 Is this a good debt story?
 What are the risks?
 What is the “real” EBITDA?
n Step #2: Construct Sources & Uses
n Step #3: Run the IRRs
n Step #4: Does the LBO work?
27
Step #1 – Understand the Story
Dig a Little Deeper
n Is this a good debt story?
 Stability of revenues: Cyclicality? Contracts?
Customers? Organic growth?
 Margins: Commodity risk? Supplier reliance? Pricing?
 Capex: Maintenance vs. discretionary?
 Working capital: Seasonality? Overall management?
 Management team: Track record? Acquisitions?
n What are potential risks and mitigants?
n Projections
 Are they realistic?
 How do they compare to historical?
28
14
Step #1 – Understand the Story
EBITDA Revisited
n What is the right time period to use?
n Don’t take EBITDA at face value – look for adjustments
n Common add-backs
 “Restructuring” charges
 Non-cash compensation
 Asset impairments
 Sponsor fees
 Money-losing businesses
n Are adjustments really non-recurring?
 Look at historical financials
 Use common sense
29
Step #2 – Construct Sources and Uses
Sources
Uses
Revolving Credit Facility
$ 0.0
Purchase Target Equity
Term Loan A
150.0
Refinance Existing Debt
Term Loan B
200.0
Transaction Costs
Total Senior Debt
Senior Subordinated Notes
Total Debt
Management Rollover Equity
Sponsor Cash Equity
Total Sources
$
250.0
525.0
25.0
350.0
200.0
550.0
50.0
200.0
$800.0
Total Uses
$800.0
30
15
Step #2 – Construct Sources and Uses
The Typical “Sources” of Funds
n Bank debt (“Senior” debt)

Start with 2.5x senior leverage

Price term loan @ LIBOR + 3.00%

Use 100% excess cash flow sweep
n Total debt

Start with 4.5x total leverage

Difference between total and bank is high yield debt

Minimum high yield size of $150mm

Price high yield @ 10.00%
n Equity contribution

Minimum 30% contribution

New sponsor cash equity vs. management rollover
31
Step #2 – Construct Sources and Uses
The Typical “Uses” of Funds
n Retire existing debt
 Existing covenants will typically prohibit post-LBO debt
levels
 Don’t forget tender/call premiums
n Pay transaction fees & expenses
 Bank debt fees: 1.75% to 2.25%
 High yield fees: 2.50% to 3.00%
 Don’t forget legal expenses
n Purchase target equity
 Make this the “plug” to balance Sources & Uses for now
32
16
Step #3 – Run the IRRs
n Calculate returns depending on future “exit strategy” in Years
3–5
n Typical exit analysis contemplates outright sale of company
 Make base case exit EBITDA multiple = entry multiple
n Deduct net debt in exit year to compute future equity value
n Allocate equity to owners based on ownership
 Financial sponsor vs. management
 Exercise of warrants if appropriate
33
Step #4 – Does the LBO Work?
Ask yourself the following questions:
n Do the senior and total debt multiples “make sense” in the
context of the overall purchase price multiple?
n Are the coverage ratios adequate?
 EBITDA / Interest Expense > 2.00x
 (EBITDA - Capex) / Interest Expense > 1.50x
n How is the bank debt amortizing?
 Is the bank debt completely repaid by year 7?
n What are the results after running more realistic and
downside cases?
n What are the expected credit ratings?
34
17
Step #4 – Does the LBO Work?
Iterate Until The LBO Works For All Constituencies
Debt Holders:
Feasibility
Equity Holders:
Attractiveness
35
Step #4 – Does the LBO Work?
How Does the Implied Valuation Compare?
n Triangulate with Other Enterprise Valuation Techniques
 Deal Comps
 Common Stock Comps
 Other Recent LBOs
n Can a financial sponsor beat a strategic?
 Synergy opportunities
 Merger plan analysis
36
18
IV. How It Happens In Reality
The Tension between Buyer and
Seller
The Scenario
n An attractive business is up for auction
n Your client is a large private equity player
n Tomorrow is the final bid deadline
n You believe your client is competing vs. a large corporation
and other financial sponsors
n The corporate can pay tomorrow in cash
n The seller wants to know you’re good for the money
n Your client wants guidance from you on:
 Maximum leverage
 Certainty of funds
 Financing conditions
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19
What Does the Seller Want?
n Seller generally wants to maximize selling price
n But not all bids are created equal — seller also wants
certainty
 How long between signing and closing?
 Sponsor generally needs to raise the debt in this period
 Compare with corporate buyer with available stock/cash
n Mere promise by buyer to raise the debt is insufficient
n Seller wants legal commitment
n Although Sponsor has committed financing, the letters
typically have “outs” that weaken the commitment
39
What Can the Buyer Do?
n Buyer must make seller comfortable that the financing risk is
minimal by providing committed financing
n Committed financing is usually comprised of a bank
commitment and a bridge commitment
 The bank commitment typically represents the senior
secured portion of the capital structure (i.e., “Bank Debt”)
 The bridge commitment typically represents the
subordinated portion of the capital structure (i.e., “High
Yield”)
n Sponsor typically has access from its own funds but check
absolute dollar size of equity needed
40
20
The Commitment Letters
n The bank and bridge commitments are comprised of four
letters
 Commitment letter that covers both facilities
 Fee letter for the bank facility
 Separate fee letter for the bridge facility
 Engagement letter for the take-out of the bridge facility
41
21