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Let's talk now about leverage buy outs.

That's the second major type of M&A deal that we're going to discuss in this

course, okay.

The first thing we're going to think about is how is a leverage buy out different

from a merger between two companies, right.

There are three specific facts about LBOs.

The first one is that the payment is always in cash and

typically financed by that issuance, okay.

So that's where the leverage in the name LBO comes from, right.

So we saw in the HP/Compaq deal that we just analyzed, for example,

HP paid for the deal using stock, so Compaq shareholders got stock.

In an LBO, the target shareholders are typically paid in cash,

almost always, okay.

The second specific fact is that

it's a case when a public firm is usually taken private.

What that means is that all the shares outstanding of the target are bought out.

That's where the B, the buy out in the name comes from.

And the third specific fact is that the acquirer in this case is not

another company, is not a competitor,

is not a company in a different stage of production.

The acquirer in this case is an investment company.

It's a company that invests money rather than produce something, okay.

And in this case, in the case of leverage buyouts,

we call these investment companies private equity firms, okay?

So this is a structure of a private equity partnership, a typical structure, okay?

You have the private equity firm that is managed by the general partner.

The general partner is gonna be the people who are actually managing the companies.

And then you have the limited partners that are providing capital

to the private equity fund.

And then the private equity fund is going to have a portfolio of investments, okay?

Just listing the main characteristics of the private equity partnership here.

So we have the general partners, those are the people who identify investments and

manage them.

And then we have the people who provide capital, okay, so

that's going to be equity capital.

There is gonna be investments made by the limited partners in this company and

then what the general partners do is to use this equity capital to go out,

to buy companies, and try to make money.

Of course, the general partners are going to make money as well, and

the way that this happens is through this 2/20 fee structure.

So the general partners keep 2% of the invested capital and 20% of profits.

What that means is that, for example, if the limited partners provide

$1 billion of equity to the private equity fund, the general partners get

to keep 2% of that billion annually as a fee just to manage the fund, okay.

So, of course, there are big dollars involved here.

And then the profits, this 20% of profits,

that happens when the private equity fund has a success with you, creates value,

the general partners keep 20% of the profit, okay?

So that's how the partnership is organized.

And when you look at the world these days,

there are many famous well-known companies that are managed by private equity funds.

That's why it's important for us to talk about leverage buy out, okay.

Companies like Dell, the computer company, Budweiser that makes beer, right, have

gone through LBOs very recently and are now managed by private equity firms, okay.

So, these are companies that now are private.

You're not gonna find data on stock prices for these companies, right?

And they happen to be managed by these private equity partnerships, okay.

So let's actually give an example of the leverage buyout of Dell, okay.

So, that's how a leverage buyout will work in terms of the numbers.

Prior to the announcement in January of 2013,

Dell was trading at $11 a share, okay.

And if you know something about Dell you will know that Dell was actually founded

by a guy called Michael Dell, okay,

who was the founder and is still the CEO of the company.

He's still the manager of the company.

At that time he owned 15% of the company's share, right?

He had a very large ownership of Dell

even before the leveraged buyout happened, okay.

The total equity value of the company was $19.3 billion and debt was 7 billion.

So that was the capital structure of the company

right before the leverage buyout was announced, okay.

And then Michael Dell came with this proposal together with Silver Lake,

which is the private equity fund involved in this deal

to buy out all the outstanding shares, right, other than Michael's.

So Michael was going to remain as the manager and owner of the company,

but all the other shareholders were going to be bought out at a 25% premium.

So the offer was $13.65 to the other shareholders, and

we can do the math here, right?

Dell had 1.757 billion shares outstanding, so if you check this,

the finance in this deal required $20.4 billion, okay,

cuz they only had to repurchase 85% of the shares, right.

You have 1.75 billion shares outstanding, and you're making an offer of $13.65.

So that requires them to raise $24 billion, okay?

So every time a leveraged buyout happens, raising the capital is a big issue, right,

and these are big dollars.

And remember, the private equity fund cannot use stock to pay for this deal.

They are usually private, so there's no stock to use, right.

So, how does the private equity fund finance the deal?

With a debt issuance, right?

That's the leverage in the leverage buy out mean.

In this case, there was a new debt issuance of $15 billion,

okay, that was provided by banks.

And an interesting fact in this LBO is that Microsoft actually helped provide

some of the financing as well, okay, some of the debt.

So Microsoft invested in the debt that helped finance this deal.

So they raised $15 billion of debt and

then Michael Dell also put in some of his own cash, okay.

At that time, if you read about this deal, Michael Dell was being questioned about,

is this really a good deal for shareholders, is this is gong to work.

So one way that he solved this problem is by paying with his own pocket, okay.

So put your money where your mouth is, right?

And so he actually took $750 million to pay for this deal.

Silver Lake also put cash, of course.

That's the equity.

Remember, that's private equity.

Silver Lake has equity that comes from the limited partners.

They invested $1.4 billion in this deal, okay.

And then the balance was funded with the company's own cash, So

let's try to figure out here every time a leverage buy-out happens,

there is a very significant change in the balance sheet of a company, okay?

We learned about balance sheets already, so it's easy for

us to figure this out, okay.

Pre-LBO, that's how the balance sheet looked like.

I gave you the data already.

Equity was 19.3, debt was 7.

So In a simplified world, of course,

we know in the real world there are gonna be many more items here, right,

other liabilities, but let's just use those two, right.

The assets would be 26.3.

Assets equal debt plus equity, okay?

So what happens after the LBO, right, there is a 25% premium, okay.

So the company's gonna be worth more, right.

Shareholders are getting a premium.

They are selling the shares at a premium, right.

How do you represent that?

We're gonna represent that by an increase in the asset value.

Okay, so the asset value is going to increase to $33 billion,

right, because that is the 26.3 x (1 + 25%), okay.

So the asset value increases because they always, Michael Dell and

Silver Lake are paying this premium to the shareholders of Dell to sell their

shares, okay.

And then what else happens?

Debt is going to increase as well, right,

because they are issuing $15 billion of debt to pay for this deal.

Who is going to pay for the debt?

The debt is going to be repaid using the cash flows of the company, okay.

So this debt is actually going to become

part of the balance sheet of the new Dell, okay.

So that goes to 22, that means that equity is going to go to 11, okay.

So notice what's going on.

There is a significant increase in the leverage ratio, right.

We learned about leverage ratios in Module 1.

So the leverage ratio is going from 7/ 26 to 22/33.

And these are market values, right.

So these are the right leverage ratios.

In Module 1, we talked about the fact that when

we measure leverage we have to use market value, okay.

The equity's much smaller, right?

The equity went down to 11 billion, but notice that now the equity's owned

solely by Michael Dell and Silver Lake, okay?

So the shareholders disappeared.

They took cash, they went home.

All the equity is now owned by Silver Lake and Michael Dell.

Okay, so if the deal works, the private equity company and

Michael can make a lot of money, okay.

So let's talk about that.

How do LBOs create value, right?

In this case, the value of assets increase by 25%, okay.

That's just because of the premium, the asset value has to increase, okay,

and this is not the only deal that this happens.

Actually, the average premium paid to target shareholders during this

time period that you have here, which is 1973 to 2006,

is 37%, okay, with a median of 32.

So, there are significant premiums in LBOs, as well, right?

In the beginning of this lecture, we've talked about synergies, right?

So now it's a question for you.

Are there synergies in leverage buy outs?

Where do the come from?

And the answer is, maybe, right?

Notice that here, there's no acquire.

That is the interesting fact about leverage buy outs.

The acquirer is a private investment company.

It's the private equity fund, okay?

So many of the rationales that we discussed do not exist for

a leverage buy out, right?

So increasing market power, vertical integration, right,

are going to be hard to achieve because the acquirer is not in the same business.

The acquirer is just an investment company,

it's just an investment fund, okay.

So how can we have 2 + 2 = 5, right?

How can we have 2 + 2 = 5?

These are the usual reasons that are cited.

So if you ask private equity funds, if you read the literature, those

are the reasons why we believe leveraged buy outs may add shareholder value, okay.

Since there are no synergies, you know real synergies between the two companies,

it has to come from some kind of restructuring.

Okay, so the private equity fund

either has to increase efficiency in the short-term, right, so

increase the operational performance of the firm by cutting costs a lot, right.

So you cannot rely on economies of scale, for example, so

you have to go there and really restructure this firm and cut costs,

or else you can try to engage in a longer term restructuring.

A major changing strategy that might make sense in the long term but

may be difficult to do under the scrutiny of public market, okay.

So, if you read about the Dell leverage buy out,

that's actually the reason that was given to this particular deal,

is that Dell wanted to engage in long-term restructuring to move away

from just selling computers and engage in a different long-term strategy.

But that would be difficult to do if you have to report earnings to

public markets on a quarterly basis.

Okay, so that is actually the particular specific rationale for

this specific buy out.

And then finally, the other reason why leveraged buy outs may add

value is because in some cases, the acquirer may be able to buy cheap assets.

Okay, and here it's interesting to think about Warren Buffet,

which if you think about Berkshire Hathaway which is Warren Buffet's company.

It's a very famous investment company in the US.

They work a little bit like a private equity fund, right.

Not all deals are financed by leverage, but really,

what Warren Buffet does is to find companies to buy and,

in many cases, not even change anything with the management.

So in order for Berkshire Hathaway to make money, you have to buy undervalued assets.

So buying cheap assets is another way that private equity funds can make

money, right?

Because private equity relies on all this restructuring,

a very important question that has been discussed recently is whether

private equity is actually good for the economy or not, okay.

And when you look at the evidence, what you see is that cutting costs

in many cases is actually equivalent to firing people.

So it looks like, when you look at employment and

private equity, it looks like employment goes down a lot

when companies are acquired by private equity funds.

There is usually layoffs, and,

as part of this restructuring to increase short-term profits,

there is usually significant amount of layoffs, okay.

So there is a very interesting recent article that looked at this issue, okay,

by these authors here at the bottom from the University of Chicago.

What they tried to measure is what happens to employment

following leveraged buy out using US data.

So this article uses data from the US, okay.

And what you can see here, the blue line, is the employment trajectory for

companies that are acquired by private equity firms, okay?

So you can see that employment was going up.

Date 0 here is the date of the leveraged buy out.

What happens is that there is a significant decline in employment, okay.

But the interesting that this article did

is to build what we think of as a control group, okay.

Try to think of a similar company

that looked similar to companies that were acquired by private equity but

which did not go through a leveraged buy out acquisition.

And what you see in this chart is that employment also went down for

those companies, okay.

So the bottom line really when you think about this is that

employment does go down for companies that are acquired by private equity, but

maybe they would have gone down anyway, okay.

It's the characteristic of the companies that are acquired by private equity that

explains the drop in employment and not necessarily the acquisition itself, okay.

The other fact that this paper found is that this falling employment

is partly compensated by job growth in new establishments, okay.

So, there is also this long-term restructuring aspect to leverage buy outs.

So what they find is that if you look at a longer term like two or

three years, you see that private equity funds also create new establishments and

then end up hiring people as well.

The total net effect Is a small decline,

it's a less than 1% decline in employment relative to this control firm, okay.

So the bottom line of this article is this idea that

perhaps private equity is not that bad for employment and

we may have been exaggerating this argument a little bit, okay.

Finally, let's go back to the Dell leveraged buy out, okay.

When we studied HP/Compaq we tried to look at stock prices, right,

what happened to HP stock prices in the years following the deal.

Unfortunately, we cannot do this for Dell, right.

Why?

Because the company is private now, right?

So if you go to Yahoo Finance and try to find data on the stock price of Dell,

the data is going to stop in 2013 because the company's private.

The company is not trading in stock markets anymore, okay.

So the only thing we can do here is to look at the qualitative evidence, right.

And here, so far, the qualitative evidence seems to be quite positive, okay.

So this is a recent article that I found,

which is based on data that we cannot verify.

But what the article claims is that Dell and Silver Lake already

made a value gain of 90% only a year after the leveraged buy out, okay.

Due to increasing cash flows, due to increasing performance,

they actually made a bunch already, okay,

so that particular leverage buy out seems to be working well for the company.

Leveraged Buyouts

Corporate Finance I: Measuring and Promoting Value Creation

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