ASSIGNMENT

Financial Engineering

CORPORATE RESTRUCTURING AND THE LBO

Submitted by:-
Harpreet Singh (Roll No. 05, Section A, MBA 2nd year)
Nikhil Peshawaria (Roll No. 19, Section B, MBA 2nd year)
Sara Bharat Buddhiraja (Roll No. 28, Section B, MBA 2nd year)
University Business School
Panjab University, Chandigarh

Submitted To:-
Prof. Parmjit Kaur
University Business School
Panjab University, Chandigarh
 TABLE OF CONTENTS
INTRODUCTION........................................................................................................................................................................3
CORPORATE RESTRUCTURING............................................................................................................................................4
TYPES OF CORPORATE RESTRUCTURING.....................................................................................................................................5
REASONS FOR CORPORATE RESTRUCTURING...........................................................................................................................6
CORPORATE RESTRUCTURING ACTIVITIES.................................................................................................................................7
1. EXPANSIONS................................................................................................................................................................................... 7
2. CONTRACTIONS.......................................................................................................................................................................... 13
3. OWNERSHIP AND CONTROL................................................................................................................................................ 14
EXAMPLES OF CORPORATE RESTRUCTURING........................................................................................................................15
LEVERAGED BUYOUTS (LBOS)..........................................................................................................................................17
HISTORY OF LEVERAGED BUYOUTS.............................................................................................................................................17
THE ECONOMIC AND FINANCIAL ENVIRONMENT THAT GAVE IMPETUS FOR LBOS............................................18
THE TOOLS FOR GOING PRIVATE: LEVERAGE BUYOUTS (LBOS)....................................................................................19
 JUNK BONDS................................................................................................................................................................................ 20
 PRIVATE PLACEMENTS.......................................................................................................................................................... 21
 BRIDGE FINANCING................................................................................................................................................................. 21
 VENTURE CAPITAL................................................................................................................................................................... 21
 MERCHANT BANKING............................................................................................................................................................. 22
WHY DEBT FINANCING IS USED FOR LBOS...............................................................................................................................22
SOURCES OF VALUE IN A LEVERAGED BUYOUT.....................................................................................................................23
SOURCE OF VALUE: HOW THE ACT OF TAKING FIRM PRIVATE CREATES VALUE..................................................24
EFFECT OF LBO ON DIFFERENT STAKEHOLDERS..................................................................................................................26
CRITICISM OF LBO................................................................................................................................................................................. 27
CHARACTERISTICS OF ATTRACTIVE TARGET COMPANIES FOR LBOS........................................................................27
EXAMPLE: A TYPICAL LEVERAGED BUYOUT............................................................................................................................28
EXAMPLES OF LBO................................................................................................................................................................................ 33
LBO IN INDIA........................................................................................................................................................................................... 33
LBO OUTSIDE INDIA............................................................................................................................................................................. 33
REFERENCES............................................................................................................................................................................35

Division of work between team members:

Name Work Done

Nikhil Peshawaria Corporate restructuring
LBOs – Till why debt financing is used for
Sara Bharat Buddhiraja
LBOs
LBOs – from why debt financing is used for
Harpreet Singh
LBOs till the end
 INTRODUCTION
Few financial engineering activities have attracted as much attention as has corporate
restructuring. Corporate restructuring is an umbrella term that includes mergers and
consolidations, divestures and liquidations, and various types of battles for corporate control. At
its most general level, the term corporate restructuring can and has been used to mean almost any
change in operations, capital structure, and/or ownership, that is not part of the firm's ordinary
course of business.

Our report focuses on the financial engineering involved in corporate restructuring. In particular,
we wish to highlight if restructuring generates value gains for shareholders (both those who own
the firm before the restructuring and those who own the firm after the re-structuring), how these
value gains might be achieved, and the sources of the value gains. It is the perception of value
gains, after all, that motivates the corporate restructuring, and it is the financial engineering
which makes the restructuring possible.

With this report, we also highlight the issues involving ownership and control in terms of
corporate restructuring. This leads logically to the subject of leveraged buyouts: both those by
corporate outsiders and those by corporate insiders. While corporate mergers, consolidations,
takeovers, and acquisitions have historically occurred in waves lasting from five to ten years and
going at least as far back as the late 1800s, the leveraged buyout is unmistakably a product of the
1980s. It was during the 1980s that many of the new tools which made leveraged buyouts
possible, including high yield or junk bonds, found favor. The 1980s also witnessed a more
accommodating regulatory environment and a tax environment more conducive to capital
formation and corporate restructuring.

In this report, we first introduce the term corporate restructuring. Then we proceed to explain the
reasons for corporate restructuring and the various activities which fall in the group of activities
termed as corporate restructuring. We then present a few examples of corporate restructuring.
Finally, we explain the concept of leverage buyout with a brief about the history behind the
emergence of leveraged buyouts and the tools required to carry out a leveraged buyout. We also
examine the various sources of value in a leveraged buyout along with some criticisms of LBO.
We present a hypothetical example of a typical leveraged buyout explaining the process of LBO
and then we also present some real life leveraged buyout examples.
 CORPORATE RESTRUCTURING
Corporate restructuring is the process of redesigning one or more aspects of a
company. Restructuring a corporate entity is often a necessity when the company has grown to
the point that the original structure can no longer efficiently manage the output and general
interests of the company. For example, a corporate restructuring may call for spinning off some
departments into subsidiaries as a means of creating a more effective management model as well
as taking advantage of tax breaks that would allow the corporation to divert more revenue to the
production process. In this scenario, the restructuring is seen as a positive sign of growth of the
company and is often welcome by those who wish to see the corporation gain a larger market
share.

The term corporate restructuring encompasses three distinct, but related, groups of activities
namely:
1. Expansions: This includes mergers and consolidations, tender offers, joint ventures, and
acquisitions
2. Contraction: This includes sell offs, spin offs, equity carve outs, abandonment of assets,
and liquidation
3. Ownership and control: Thisinclude the market for corporate control, stock repurchase
programs, exchange offers, and going private (whether by leveraged buyout or other
means).

All of these activities involve financial engineering.

TYPES OF CORPORATE RESTRUCTURING

The various activities involved in corporate restructuring can be broadly divided into types
which are as follows:-

1. Financial Restructuring:

Because of the adverse economic conditions, this form of restructuring may take place
due to a significant drop in total sales. Here, the corporate entity can change its debt
service schedule, holdings of equity, etc. All this is achieved to preserve the market share
and the company's profitability.
 Financial restructuring is more focused on assessing the capital structure of the company
and determining if high cash production is sufficient. Cashflows are the king for every
corporation and all attempts are made to boost cash flows as this will maximise
shareholder returns.

If a company has more debt relative to equity in its capitalization structure, then in
distressed/tough conditions, businesses cannot produce enough cashflows to repay their
creditors' interest payments. In such a situation, companies can restructure their debt either
by refinancing their debt at lower interest rates or by negotiating with their creditors either
to extend their repayment dates or to convert a portion of their outstanding debt into
equity. If creditors believe that the company's current situation is temporary and are
persuaded that interest repayments are preventing its current growth, then the creditors
will release the company from the cash crunch, enabling them to reinvest this cash in
growth initiatives. When troubled firms turn around and become profitable, creditors will
have a greater chance of collecting their pending payments. Companies typically involve
lenders and lawyers in financial restructuring activities.

Any of the other types of restructuring would be, by spin offs, break offs and divestitures,
a corporation looking to sell its business or a portion of its business. In these cases, by
selling a portion of its business that is no longer profitable or strategic, the company can
raise funds and can use those profits to either repay its debt or invest in strategic
acquisitions.

2. Organisational Restructuring:

Organizational restructuring involves changes in the organizational structure to increase

efficiencies. Organisational Restructuring implies a change in the organisational structure
of a company, such as reducing its level of the hierarchy, redesigning the job positions,
downsizing the employees, and changing the reporting relationships. This type of
restructuring is done to cut down the cost and to pay off the outstanding debt to continue
with the business operations in some manner.

Companies may also look at their talent pool and evaluate whether they have the right
abilities and profitably run the company. To suit them with the current business demand,
it will look at retraining their existing workers. In addition, organisations will also look at
recruiting new industry skills and actively controlling their turnover rate to stop the
turnover of highly qualified talent.
REASONS FOR CORPORATE RESTRUCTURING
Corporate restructuring is generally implemented in the following situations:

 Change in the Strategy: The management of the distressed entity attempts to improve

its performance by eliminating certain divisions and subsidiaries which do not align with
the core strategy of the company. The division or subsidiaries may not appear to fit
strategically with the company’s long-term vision. Thus, the corporate entity decides to
focus on its core strategy and dispose of such assets to the potential buyers.
 Lack of Profits: The undertaking may not be making enough profits to cover the cost of
capital of the company and may cause economic losses. The poor performance of the
undertaking may be the result of a wrong decision taken by the management to start the
division or the decline in the profitability of the undertaking might be due to the change
in customer needs or increasing costs.
 Reverse Synergy: This concept is in contrast to the principles of synergy, where the
value of a merged unit is more than the value of individual units collectively. According
to reverse synergy, the value of an individual unit may be more than the merged unit.
This is one of the common reasons for divesting the assets of the company. The
concerned entity may decide that by divesting a division to a third party can fetch more
value rather than owning it.
 Cash Flow Requirement: Disposing of an unproductive undertaking can provide a
considerable cash inflow to the company. If the concerned corporate entity is facing some
complexity in obtaining finance, disposing of an asset is an approach in order to raise
money and to reduce debt.

CORPORATE RESTRUCTURING ACTIVITIES

1. EXPANSIONS

Expansions include mergers, consolidations, acquisitions, and numerous other activities that
result in a corporation or its scope of operations being extended.
In the use of the terminology associated with corporate expansions, there is a lot of complexity.
There are legal differences between certain corporate combinations that constitute mergers and
those that constitute consolidations, for example. A merger theoretically requires a fusion of two
entities in such a way that only one survives. When one corporation is considerably larger than
the other, mergers appear to occur and the survivor is typically the larger of the two. In the other
side, a restructuring entails the formation of an entirely new corporation that holds the properties
of both the first two companies, and none of the first two survives. When the two firms are of
roughly equal size, this type of combination is most common. However, despite this legal
distinction, the terms merger and acquisition are sometimes used to describe every combination
of two companies interchangeably.

The various activities which fall in the group of activities termed as expansions are as follows:-
1. Mergers
2. Holding Companies
3. Joint Ventures
4. Acquisitions

1. MERGERS

A merger involves a combination of two firms such that only one survives. Mergers tend to
occur when one firm is significantly larger than the other and the survivor is usually the larger of
the two. Companies generally consider mergers due to gain access to a larger market and
customer base, reduce competition, and achieve economies of scale.

Types of Mergers:

A merger can take the form of a horizontal merger, a vertical merger, or a conglomerate merger.

 Horizontal Merger:

A horizontal merger involves two firms in similar businesses. The combination of two oil
companies, or two solid waste disposal companies, for example, would represent
horizontal mergers.

 Vertical Merger:

A vertical merger involves two firms involved in different stages of production of the
same end product or related end products. The combination of a waste removal and a
waste recycler or the combination of an oil producer and an oil refiner would be
examples of vertical mergers.

 Conglomerate Merger:
 A conglomerate merger involves two firms in unrelated business activities. The com
bination of an oil refiner and a solid waste disposal company would be an example of a
conglomerate merger.

Advantages of a Merger:

 Increases market share: When companies merge, the new company gains a larger
market share and gets ahead in the competition.

 Reduces the cost of operations:Companies can achieve economies of scale, such as bulk

buying of raw materials, which can result in cost reductions. The investments on assets
are now spread out over a larger output, which leads to technical economies.

 Avoids replication:Some companies producing similar products may merge to avoid

duplication and eliminate competition. It also results in reduced prices for the customers.

 Expands business into new geographic areas:A company seeking to expand its
business in a certain geographical area may merge with another similar company
operating in the same area to get the business started.

 Prevents closure of an unprofitable business:Mergers can save a company from going

bankrupt and also save many jobs.

2. HOLDING COMPANIES

Not all business expansions lead to the dissolution of one or more of the involved firms. For
example, holding companies oftenseek to acquire equity interests in other firms. The target firm
mayor may not become a subsidiary of the holding company (50+ percentownership) but, in
either case, continues to exist as a legal entity.

3. JOINT VENTURE

The joint venture, in which two separate firms pool some of their resources, is another such form
that does not ordinarily lead to the dissolution of either firm. Such ventures typically involve
only a small portion of the cooperating firms' overall businesses and usually have limited lives.
 4. ACQUISITIONS

The term acquisition is another ambiguous term. At the most general, it means an attempt by one
firm, called the acquiring firm, to gain a majority interest in another firm, called the target firm.
The effort to gain control may be: -

 a prelude to a subsequent merger

 to establish a parent subsidiary relationship
 to break-up the targetfirm and dispose of its assets
 or to take the target firm private bya small group of investors.

 Strategies to perform an Acquisition:

There are a number of strategies that can be employed in corporate acquisitions.

 Friendly Takeover:

In the friendly takeover, the acquiring firm will make a financial proposal to the target
firm's management and board. This proposal might involve the merger of the two firms,
the consolidation of the two firms, or the creation of a parent/subsidiary relationship. The
existing shareholders of the target firm would receive cash or stock of the acquiring firm,
or, in the case of a consolidation, stock in the new firm, in exchange for their stock in the
target firm. In a friendly takeover, management of the target firm usually retain their
positions after the acquisition is consummated.

 Hostile Takeover:

At the other extreme is the hostile takeover. A hostile takeover may or may not follow a
preliminary attempt at a friendly takeover. For example, it is not uncommon for an
acquiring firm to embrace the target firm's management in what is colloquially called a
bear hug. In this approach, the acquiring firm's board makes a proposal to the target firm's
board. The target firm's board is required to make a quick decision on the acquiring firm's
bid. The target firm's board may also be apprised of the acquiring firm's intent to pursue a
tender offer if the target firm's board does not approve the bid. In such a situation, the
acquiring firm looks to replace the non-cooperating directors. Whether made explicit or
not, it is understood that, in a hostile takeover, current management can expect to be
replaced by management of the acquiring firm's choosing.

 Defense Strategies against Hostile Takeovers:

The same M&A departments that advise acquiring firms on takeovers also advise target
firms on defenses against takeovers. These specialists have engineered a number of
strategies which often have bizarre nicknames such as shark repellents and poison pills
- terms which accurately convey the genuine hostility involved. In this same vain, the
acquiring firm itself is often described as a raider.

1. Greenmail: One such strategy is to employ a target block repurchase with an

accompanying standstill agreement. This combination is sometimes described as
greenmail. That is, the target firm agrees to buy back the acquiring firm's stake in the
target firm's stock (the target block repurchase) at a premium to the current market
price of that stock. In return, the raider is required to sign an agreement to the effect
that neither the raider nor groups controlled by the raider will acquire an interest in
the target firm for some specified period of time (the standstill agreement).

Other defenses against hostile takeovers include leveraged re capitalizations and

poison puts (versions of the "shark repellant" and "poison pill" strategies alluded to
above).

2. Leveraged Re-Capitalization: The leveraged re capitalization, or recap, strategy was

developed by Goldman Sachs in 1985 in an effort to fend off an attempted takeover
of Multimedia, Inc. The strategy is also known as a leveraged cash-out (LCO).In
this strategy, the firm borrows heavily (issues debt) and uses the funds obtained from
the issuance of debt to pay outside shareholders a large one-time cash dividend. At
the same time, the firm pays its inside shareholders (managers and employees) their
dividend in the form of additional shares of stock.
This has two simultaneous effects:

First, it increases the target firm's use of leverage and thereby decreases its
attractiveness to the acquiring firm-as the latter might have planned its own
leveraging up of the target firm's assets.
Second, the strategy concentrates stock in the hands of insiders thereby making it
more difficult for an outsider to gain a controlling interest.

Leveraged cash-outs bear more than surface similarities to leveraged buy-outs in that
both involve the use of a great deal of financial leverage in order gain control.

3. Poison Puts: Corporate takeovers and other types of change in successful

management often lead to a decline in the credit worthiness of the target company.
This can be highly expensive for the firm's bondholders and other creditors. One way
to deal with this is to grant debtholders protective poison put covenants which allow
 the debt holders to put the debt they hold back to the corporation or the acquiring firm
in the event of a transfer of control.
This can be highly expensive for the purchasing business and, thus, reduces the target
's attractiveness. Although poison places may seem to be a legitimate form of investor
security, this is not actually the case. Such places also give the bondholders the right
to position the bonds if and only if the acquisition is hostile and can, as such, exclude
friendly takeovers and management buy-outs, even if they occur as a reaction to an
earlier hostile takeover attempt. A acquisition can cause credit degradation, whether it
is friendly or hostile, and thus the poison places may be more for the protection of
current management than for the protection of debtholders.

4. White Knight: A very appealing defensive measure against a hostile takeoverattempt

is for the target firm's management to seek a white knight. A white knight is a second
acquiring firm with which the target firm can negotiate a more favorable and
"friendly" takeover.

5. Management Buyout (MBO): An alternative to the white knight is for management

itself to attempt a takeover-usually through a management-led leveraged buyout. A
management-led leveraged buyout is sometimes called amanagement buyout (MBO).

 Advantages of Friendly vs unfriendly Takeover:

There are several advantages to a friendly takeover relative to an unfriendly one, which
are as follows:-

 The target firm's resources are not wasted in an effort to fend off the acquiring firm.
 There is a greater chance that the management of the combination will have a more
harmonious working relationship and more easily meld the operations of the two
firms.
 Finally, employee morale, the importance of which is often underestimated, is less
likely to suffer in a friendly takeover than in an unfriendly one

2. CONTRACTIONS

Contraction, as the term implies, results in a smaller firm rather than a larger one. Corporate
contraction occurs as the result of disposition of assets. The disposition of assets, sometimes
called sell-offs, can take either of three broad forms:
 1. Spin-offs
2. Divestitures
3. Carve-outs

Spin-offs and carve-outs create new legal entities while divestitures do not

 SPINOFF

In a spin-off, some of the assets and liabilities are transferred from the parent company to a
new company formed for that purpose. Shares of the new company are then given to the
shareholders of the original firm on a proportional basis to their ownership in the original
firm. The initial shareholders have the same equity interest after the sale-off, but are now
split into two different entities. As they see fit, the shareholders are then free to sell their
stock or to retain it. The spin-off reflects a true transfer of control by establishing a new
company with its own properties, its own management, and separate ownership.

Example of Spin-off: This was the approach taken when American Telephone & Telegraph
(AT&T) was broken up into a group of individual regional phone companies.

 Variations of Spin-off:
There are a number of variations of the spin-off including the split-off and the split-up.

1. Split-off:In a split-off, some of the shareholders are given an equity interest in the
new firm in exchange for their shares of the parent company.

2. Split-up:In a split-up, all the assets of the parent company are divided up among
spin-off companies and the original parent ceases to exist.

Spin-offs, regardless of their form, may be and have been described as stock dividends. It
is important to observe that in all forms of spin-offs, the parent company receives no cash
from its transfer of assets to the new firm(s).

 DIVESTITURE

In contrast to the no-cash transfer of assets in a spin-off, a divestiture involves an out and out
sale of assets, usually for cash consideration. That is, the parent company sells some of the
firm's assets for cash to another firm. In most cases, the assets are sold to an existing firm so
that no new legal entity results from the transactions.
  EQUITY CARVE-OUT

An equity carve-out is an intermediate type of contraction between a spin-off and a

divestiture. It gives cash to the original business, but it also disperses assets and control of the
assets to the original company's non-owners.
The original business establishes a new business in this agreement and passes some of the
properties of the original company to the new company. In the new firm, the original firm
then sells shares. The holders of this equity may or may not be the same as the original firm's
owners. An equity carve-out adds capital to the business like a divestiture and, like a spin-off,
the equity carve-out creates a new legal entity.

3. OWNERSHIP AND CONTROL

Ownership and control is the third big field that the term corporate restructuring encompasses.
Currently, all expansion activities and contraction activities are closely connected to this. A
hostile takeover, for example, is carried out by gaining ownership and wresting power from the
existing board. Similarly, the new management will frequently embark on a complete or partial
liquidation plan involving the selling of assets once ownershipand/or power has been wrested
from the existing board.

STEPS TO MAKE TRANSFER OF OWNERSHIP AND/OR CONTROL

MORE DIFFICULT

Here are few steps that might be taken by currentmanagement to make the transfer of ownership
and/or the transfer of control more difficult.

Adoption of Anti-takeover Amendments:

One strategy often employed involves the adoption of antitakeover amendments to the corporate
bylaws in order to make an acquisition more difficult and more expensive. Some common
attempts include

1. Staggering the terms of the members of the board so that an acquiring firm must wait a
considerable period before replacing a sufficient number of board members to get its way
2. Supermajority voting provisions applied to matters involving merger-such as requiring a
75 or 80 percent favorable vote; and
 3. Providing current management with golden parachutes. The latter are sizeable
termination payments made to current management in the event that management is
terminated following a change in the control of the firm.

Current management starts off with a considerable advantage over dissident shareholders. First,
as a general rule, management nominates new board members who are often rubber stamped by
the majority of the firm's shareholders. The board, in turn, reap points management.

But dissident shareholders are not without weapons of their own. One such weapon is the proxy
contest.

Proxy Contest:
In a proxy contest, dissident shareholders attempt to secure the proxies of other shareholders in
an effort to install their own people on the board and to lessen the control of the incumbents.
Proxy contests are often used by major shareholders who lack a controlling interest but who
nevertheless wield enough weight as to have a reasonable prospect of attracting sufficient
proxies to swing a vote. Proxy fights, per se, do not involve a transfer of ownership but they do
involve an effort to alter control of the firm.

EXAMPLES OF CORPORATE RESTRUCTURING

1. TATA STEEL-CORUS

Tata Steel is one of the biggest ever Indian’s steel company and the Corus is Europe’s second
largest steel company. In 2007, Tata Steel’s takeover European steel major Corus for the
price of $12.02 billion, making the Indian company, the world’s fifth-largest steel producer.
Tata Sponge iron, which was a low-cost steel producer in the fast developing region of the
world and Corus, which was a high-value product manufacturer in the region of the world
demanding value products. The acquisition was intended to give Tata steel access to the
European markets and to achieve potential synergies in the areas of manufacturing,
procurement, R&D, logistics, and back office operations.

2. STERLITE- ASARCO

Sterlite is India’s largest non-ferrous metals and mining company with interests and
operations in aluminium, copper and zinc and lead. Sterlite has a world class copper smelter
and refinery operations in India. Asarco, formerly known as American Smelting and Refining
Company, is currently the third largest copper producer in the United States of America. In
 the year 2009, Sterlite Industries, a part of the Vedanta Group signed an agreement regarding
the acquisition of copper mining company Asarco for the price of $ 2.6 billion. The deal
surpassed Tata’s $2.3 billion deal of acquiring Land Rover and Jaguar. After the finalization
of the deal Sterlite would become third largest copper mining company in the world.

3. RELIANCE JIO RESTRUCTURING

The aim of this corporate restructuring exercise was to make Reliance JIO a NET DEBT FREE
company by 31 March, 2020. The restructuring was initiated when the boards of Reliance
industries Ltd. and its wholly owned subsidiary Reliance Jio Infocomm Ltd.,approved the
creation of a new digital platform holding company as well as a debt restructuring.

The restructuring activities were as follows:-

 Reliance Industries Limited will form a wholly owned subsidiary for digital platform
initiatives. This will hold digital businesses such as MyJio, JioTV, JioCinema, JioNews
and JioSaavn.
 RIL will invest Rs 1.08 lakh crore in this new digital platforms company via optionally
convertible preference shares.
 This new company will also acquire RIL’s equity investment of Rs 65,000 crore in RJIL
giving it a total capitalisation
 The restructuring will effectively insert a new company between RIL and Jio and will
result in the transfer of debt from the telecom subsidiary to parent RIL.

LEVERAGED BUYOUTS (LBOs)

The alternative to acquiring, or maintaining, power through proxy wars is to change the very
ownership structure. We have already discussed the more conventional ways in which ownership
is transferred to new parties through the merger or acquisition of companies, but the advent of
the leveraged buyout was the truly unique creation of the 1980s.
Leverage Buyout is the acquisition phase of a company in which the acquisition investment is
made partly by equity and partly by other debt instruments (borrowing). The company's purchase
or a part of the company is financed by debt. The properties of the purchased company are used
as collateral for the capital lent, often with the purchase company's assets. A financial buyer say
private equity fund invests small amount of equity, as compared to the total purchase price and
uses leverage also called gearing (using debt or other non-equity based source of funding) to
fund the remainder. LBOs involve  institutional investors and financial sponsors who make large
acquisitions, without committing all the capital required for the acquisition.
By issuing bonds or obtaining a loan that is backed by the assets of the purchase target or, for
that matter, the cash flow of the target, the financial sponsor raises debt to allow the timely
payment of interest and principal sum.

The leveraged buyout preserves the integrity of the firm as a legal entity but consolidates
ownership in the hands of a small group.

HISTORY OF LEVERAGED BUYOUTS

While corporate restructurings are not recent, they appear to take place in waves. The 1980s
witnessed a big wave. All the conventional ways of restructuring, including mergers ,
acquisitions, consolidations, spin-offs, divestitures, and proxy wars, were seen in the
restructuring wave of the 1980s. But it also saw the advent of a major new trend. In the 1980s,
many large publicly traded firms went private and most employed a similar strategy called a
leveraged buyout or LBO.

To make the leveraged buyout an enticing proposal, a variety of economic and financial
variables converged. What it lacked was the means. The emergence of junk bonds, bridge
financing, venture capital companies, and merchant banking, all of which are financial
engineering products, given the means are available. We begin by looking at the economic and
financial variables that created an atmosphere conducive to private life.

This section of the report will highlight the economic and financial factors that created an
environment conducive to going private i.e. employing leveraged buyout strategy.

THE ECONOMIC AND FINANCIAL ENVIRONMENT THAT GAVE IMPETUS FOR

LBOS

 DECLINE IN Q-RATIOS DUE TO INFLATION

A period of prolonged and accelerating inflation began in the 1960s and continued until the
early 1980s. This extended period of inflation had the effect of dramatically reducing the
ratio of the market value of U.S. corporations to the replacement cost of those corporations'
assets.
The ratio of market value to replacement cost of assets is sometimes called the q-ratio. When
the q-ratio is less than one, it is cheaper to buy capacity by acquiring a going firm than it is to
build capacity by purchasing real assets on one's own. Over the period from 1965 to 1981,
the average q-ratio of American industrial corporations declined from about 1.3 to about
0.5. The q-ratio did not start to rise again until 1982 when a bull market in U.S. equities
began.

 REDUCTION IN AVERAGE CORPORATION’S REAL LEVERAGE DUE TO

INFLATION

The inflation also had the effect of reducing the average corporation's real leverage. This
occurred because both the interest and principal on preexisting debt was not indexed for
inflation. Thus, in real terms, the inflation reduced both the amount of real debt on corporate
balance sheets and the cost of servicing the debt. The unintentional decline in the pre-1980s
use of leverage created opportunity in the 1980s for corporate managers to enhance equity
returns by leveraging up the firm or, more accurately,releveraging the firm. Any firm which
failed to leverage up on its own became a potential target for a takeover by others who would
leverage up once they had control.

 FAVORABLE CHANGES IN TAX LAW

Restructuring activity was also stimulated by a succession of favorable changes in tax law.
One piece of legislation was particularly conducive. This was the Economic Recovery Tax
Act (ERTA) of 1981.

ERTA permitted old assets to be stepped up, for depreciation purposes, upon purchase by
another firm and for the higher basis to be depreciated at an accelerated rate. It also enhanced
the role of Employee Stock Ownership Plans (ESOPs) by making deductible both the interest
and the principal on money borrowed from banks to purchase company stock for these plans.
A subsequent change in the tax law increased bank willingness to lend for this purpose by
allowing banks to deduct one-half the interest they received on these ESOP loans.

 CHANGING ATTITUDE OF GOVERNMENT

While not the consequence of new legislation, it also became clear in the 1980s that the
government had adopted a more permissive attitude toward horizontal and vertical business
 combinations. This new attitude stimulated interest in exploiting production and marketing
efficiencies made possible by product and market extensions.

 ECONOMIC GROWTH

The final economic factor setting the climate in the 1980s was real economic growth. In the
end, a merger, a consolidation, or a leveraged buyout can only be successful if:-

1. Its assets can be disposed of at a profit, or

2. The ongoing concern that has been acquired has healthy cash flows.

Beginning in 1982, corporate earnings grew rapidly and nearly continuously throughout the
decade. This earnings strength was sufficient to convince many that successful deals could be
engineered.

THE TOOLS FOR GOING PRIVATE: LEVERAGE BUYOUTS

(LBOS)

While the economic climate in the 1980s was undoubtedly right for a wave of mergers and
consolidations, leveraged buyouts, in which a small group of investors acquires most or all of a
firm's outstanding equity and then takes the firm private, required new and very special financing
tools. These tools soon appeared and were put to work quite aggressively. Most of these tools
were engineered by investment banks but are often coupled with secured acquisition loans from
banks. In addition to the bank-sourced acquisition loans, the principal tools that made leverage
buyouts possible are:-

1. Junk bonds
2. Private placements
3. Bridge financing
4. Venture capital, and
5. Merchant banking

 JUNK BONDS

Bonds that are valued below investment grade are junk bonds, also known as high-yield bonds.
Junk bonds carry a higher default risk than other bonds, but to make them attractive to investors,
they offer higher returns. Capital-intensive companies with high debt levels or young companies
who have yet to develop a good credit rating are the key issuers of such bonds.

You lend to the issuer in exchange for periodic interest payments when you purchase a bond.
The issuer is expected to refund the principal sum in full to the investors until the bond matures.
However, if the borrower has a high default risk, interest payments might not be disbursed as
expected. Thus, to compensate investors for the increased risk, such bonds give higher returns.

Probably the most contentious of the instruments used in leveraged buyouts is Junk Bonds. The
high-yield / high-risk portfolios reflect these bonds. Michael Milken of Drexel Burnham
Lambert's investment banking firm pioneered them and soon pushed Drexel into a bulge-bracket
position in the investment banking industry. Soon, other investment banks followed the lead of
Drexel into the high-yield market. By 1989, the $200+ billion junk bond market consisted of
more than 2,000 issues representing some 800 companies in 100 industries.

Many issues of junk bonds have a reset provision or belong to a category of deferred-payment
instruments. These are designed to enhance the bond yields to the investors—but at a higher cost
to the issuers. A reset provision forces the issuer toincrease the interest rate it pays to the
bondholders if the bond fails to trade at or above par by a stipulated date.

The two most frequent deferred-payment securities are the payment-in-kind (PIK) and a type of
zero-coupon bond.

 Payment-in-kind (PIK):A PIK holder receives additional bonds in lieu of cash

payments up until the cash out date when the investor receives more interest payments
from holding more bonds.

 Zero-coupon bond:In the zero-coupon bond, an investorbuys the bond at a discount

(typically about 35 to 40 percent) and begins collecting interest after several years into
the life of the bond.

 PRIVATE PLACEMENTS
Private placements represent issues of debt that are not offered to the general public. Instead,
they are placed with a small group of institutions such as insurance companies, pension funds,
and other sophisticated investors who do not need the protection afforded by registration with the
Securities and Exchange Commission.
The holders of privately placed debt usually earn a greater return than the holders of publicly
offered debt, all other factors being equal. Private placements can, however, be less costly for the
issuer (since the expensive registration process is avoided). In addition, because the due
diligence investigation needed for registration can be dispensed with, private placements can be
conducted far faster.

Private placements and offers of junk bonds vary from secured bank acquisition loans in that the
former are usually unsecured and subordinated debt forms. On the other hand, these investors
have a senior right to that of shareholders as debt holders. Since they stand between the banks'
secured debt and the very risky shareholder residual claims, private placements and junk bonds
used to fund leverage buyouts are sometimes referred to as mezzanine money.

 BRIDGE FINANCING
In bridge financing, as temporary financing, the investment bank provides a loan to the buyout
party before more permanent financing can be arranged. Although the investment bank earns
interest in its bridge financing, the primary incentive for the investment bank to provide bridge
financing is typically the M&A advisory fees and the subscription fees it collects from its other
participation in the transaction. If the offer can be closed before other parties have a chance to
counter the bid of the buyout party or the target company has the ability to pursue negotiating
tactics that can make the buyout more expensive, these payments are far more likely to be won.

The bridge loan allows the deal to be effected far more quickly and, therefore, with a greater
probability of success. The investment bank's intent is to retire the bridge loan as quickly as
possible and remove it from its books

 VENTURE CAPITAL
Venture capital firms can play several roles in a leveraged buyout: -

1. They can take and hold a portion of the privately placed debt.
2. They can act as members of the buyout group taking a portion of the equity.

It is rather typical for venture capital firms to take both debt and equity in the target firm. By
definition, venture capital firms specialize in taking substantial risks in their effort to earn
substantial rewards. Some have been immensely successful.

 MERCHANT BANKING
In merchant banking, the investment bank takes a portion of the target firm's equity on its own
books. That is, the investment bank becomes an equity partner in the leveraged buyout. In
merchant banking, the investment bank puts its own money at risk in the deal and it plays a very
high stakes game. This is far riskier than making bridge loans which are intended to be retired
quickly.

WHY DEBT FINANCING IS USED FOR LBOS

Following are the purposes of debt financing for LBOs:

 Increased use of debt increases the leverage which results in increased financial return to
the private equity sponsor. The debt in an LBO has a relatively fixed cost of capital, thus any
return in excess of this cost of capital flows to the equity investor.
 The benefit of tax shield is also applicable in case of high debt. Income flowing to equity
is taxed on the other hand, the interest payments to debt are not. Thus the capitalized value of
cash flowing to debt is greater than the same cash stream flowing to equity.
LBO Debt Financing is central to the structure and viability of private equity buyouts. Target businesses
are seldom acquired with the buyout company's equity alone. Private equity companies use debt to
finance a large proportion of each deal (in other words, they use leverage) to theoretically maximise
equity returns and increase the amount of transactions a particular fund may produce. For example, a
private equity firm could invest equity representing 30% of the purchase price in a buyout deal and
increase the remainder of the purchase price in the debt markets.It may use a combinationof bank loans
—often called “leveraged loans” because of the amount of the company’s capital structure they
represent—and high- yield bonds.

To protect investors, leveraged loans often carry covenants that may require orrestrict certain actions.
For instance, the covenants may require the company to maintainspecified financial ratios within certain
limits, submit information so that the bankcan monitor performance, or operate within certain
parameters. The covenants mayrestrict the company from further borrowing (in other words, no
additional bonds can be issued and no additional funds can be borrowed from banks or other sources),
orthey may impose limits on paying dividends or making operating decisions. Similarly,bond terms may
include covenants intended to protect the bondholders. One of thekey differences between leveraged
loans and high- yield bonds, however, is that leveraged loans are generally senior secured debt whereas
the bonds are unsecured in the case of bankruptcy. Even given covenants on the bonds, the bonds issued
to financean LBO are usually high- yield bonds that receive low quality ratings and must offerhigh
coupons to attract investors because of the amount of leverage used.

A typical LBO capital structure includes equity, bank debt (leveraged loans),and high- yield bonds.
Leveraged loans often provide a larger amount of capital thaneither equity or high- yield bonds.
SOURCES OF VALUE IN A LEVERAGED BUYOUT

The purchasing party consists of a limited number of individuals or companies in a traditional

leveraged buyout. This group acquires all or almost all of the outstanding stock of the target
company using the funding tools mentioned above, and then takes the target company private.
The buyout party may or may not include the target firm's current management. If it does, the
purchase is often defined as a buyout of management or MBO. Nonetheless, it is also a leveraged
acquisition. When finished, the LBO. The company, now private, may continue to work in its
original form or may sell off some or all of its properties. It could go public again in a few years
if it continues to work, or it could be sold privately to a new group of investors in a second
leveraged buyout. They are not uncommon routes for an LBO to take, as strange as these latter
courses might seem.

Cashing Out: If the LBO owners' intent in going public again or in selling to a new LBO group
is to get their money out, the strategy is called cashing out. Cashing out in an LBO does not
imply that the firm is in trouble (as it often does in sales of securities by managers in more
traditional corporate structures). It only implies that the extraordinary returns possible with an
LBO cannot continue without a re-leveraging of the firm.

They must make a tender offer for the stock of the company in order for the purchasing party to
acquire a majority interest in the target business. In all such situations, the purchasing party must
pay at its current market price for the stock at a premium. The fact that successful LBOs
frequently require premium bids ranging from fifty percent or more of the prevailing market
price just before the acquisition was launched and the fact that the buyout party hopes to benefit
greatly from taking the business private leads one to wonder about an LBO's source(s) of value.
How can it be, after all, that current shareholders can be bought out at a price significantly above
market (thus receiving excess value) and the buyers subsequently also earn significant profits
unless:-

1. The current market price significantly understates the current value of the firm,
2. Some value is created by taking the firm private, or
3. Value is transferred to the selling shareholders and the buyout groupfrom other interested
parties.

There is a good reason for this. Market efficiency was long an accepted tenet of academic
theory. This theoryholds that all competitive markets price assets efficiently. In its purest form,
the theory implies that a stock's current market price accurately reflects the value of all relevant
information concerning the firm. Thus, if the source of the value in an LBO is simply a
mispricing of the firm's stock, then the market could not have been efficient to begin with.

While evidence developed during the 1980s has demonstrated that markets may not be as
efficient as once believed, the evidence does not support mispricings on the scale necessary to
justify LBOs at the kinds of premiums they typically command. The source of the value must,
therefore, lie with one of the other two explanations.

SOURCE OF VALUE: HOW THE ACT OF TAKING FIRM PRIVATE

CREATES VALUE

Let's first consider the possibility that the act of taking the firm private creates value. There are
several possible ways in which value may be created: -
1. Reduction in Agency Cost
2. Efficiency Arguments
3. Tax Benefits

 REDUCTION IN AGENCY COST

The first harks back to the agency problem. The agency problemstems from the separation of
ownershipand control. That is, in a typical, publicly held corporation, management and
ownership are vested in different groups of people.

Theory holds that management will, at all times, make decisions and act in the best interests of
the owners for whom they work. After all, managers are agents of the owners. But practice will
often differ from theory and managers may be inclined to make suboptimal decisions particularly
if they perceive benefits to themselves from doing so. Indeed, they may even do this
unconsciously while convincing themselves that they are acting in the best interests of the
shareholders.

Suboptimal decisions can take many forms and range from the obvious—such as excessive perks
for management to the not so obvious—such as keeping unproductive assets rather than admit to
an earlier mistake.

Agency Cost:The difference in the firm's value when the owners are the managers and the firm's
value when the owners are not the managers represents the agency cost.

By taking the firm private, ownership and control become one and the same. This eliminates,
or greatly reduces, the agency costs and the reduction in agency costs is the source of the
value gain associated withthe LBO.
 EFFICIENCY ARGUMENTS

Another argument made for why going private can add to a firm's value concerns efficiency.
There are several dimensionsthe efficiency argument: -
1. Decision-making efficiency
2. Publication of sensitive information by public firm

1. Decision-making efficiency:The first is decision-making efficiency. That is to say, the

managers do not have to engage in extensive and time-consuming studies, prepare
detailed reports, and provide volumes of evidence to a skeptical board before making a
decision to either launch a major new project or to terminate an existing one. Further, for
those decisions involving approval of the firm's shareholders, the managers do not have
to convince a diverse body of shareholders and wait for the annual meeting before
gaining approval to take the firm in a new direction. The inefficiencies in the decision-
making process introduced by the separation of ownership and control decrease the value
of the firm which often loses the ability to move quickly in response to rapidly changing
circumstances surrounding the decision in question.

2. Publication of sensitive information by public firm:Another efficiency issue involves

the publication of sensitive information. A publicly held firm is required to publish
certain types of information which can include competitively sensitive material. A
nonpublic firm has no such requirement. In addition, the nonpublic firm does not have to
absorb the expense associated with periodic filing and compliance matters that are
required of a publicly held firm.

 TAX BENEFITS

The last potential source of value gain from going private involves tax benefits. This
particular benefit unquestionably exists.

 First, the asset step-up for depreciation purposes which was discussed earlier-in the
context of takeovers more generally-applies equally to leveraged buyouts.
 Second, the tax savings that accompanies the payment of interest (relative to dividends) is
considerable in leveraged buyouts since the source of the leverage is the considerable
debt that is employed
EFFECT OF LBO ON DIFFERENT STAKEHOLDERS

In addition to the firm's pre-buyout debtholders, others with a pre-existing stake in the firm-
sometimes described collectively as stakeholders-include:-
1. The firm's employees
2. Preferred stockholder
3. Federal and local government.

Effect of LBO on government: The latter derive tax revenues from the profits of the firm and
the payroll taxes of the employees. The loss of tax revenue was included in the value creation
argument and we do not consider it again.

Effect of LBO on firm’s employees: The stake of the employees of the company takes the form
of job obligations and pension benefits. For example, it is not uncommon for new owners of a
business to pursue a more desirable agreement with employees of the company or to trim excess
employees. On the other side, when new investors frequently see it in their own best interests to
offer workers an even greater stake in the company's fortunes as a potentially valuable
motivational tool, workers may also be major beneficiaries of leveraged buyouts.

Effect of LBO on debtholders: The real issue then is the effect of the buyout on the firm's
debtholders. The pre buyout debt holders of the firm may have protective covenants which are
activated in the event of a change in control or the issuance of additional debt. But, then again,
they may not.
Undoubtedly, the new debt released to fund the leveraged buyout is not nice for pre-buyout debt
buyers. The increased use of leverage by the company makes it that much more dangerous. All
other factors being equal, the rise in the company's risk decreases the firm's creditworthiness and
it can be assumed that the market price of the outstanding debt of the company will reflect this
decrease in creditworthiness. This is particularly likely to be the case if the new debt used to fund
the leveraged acquisition is not subject to the pre-purchase debt or if it has a shorter term than the
pre-purchase debt.

CRITICISM OF LBO

Critics of LBOs argue that a leveraged buyout can:-

1. Cause layoffs of the target firm's employees as the new management/owners streamline
the firm's operations
2. Damage the debt markets resulting in higher costs for debt capital all around,
 3. Force post lbo management to concentrate on short-term goals, e.g., to service the firm's
debt by reducing the advertising and research &development budgets to the detriment of
long-term growth
4. Result in bankruptcies due to the firms' inability to service their debts.

CHARACTERISTICS OF ATTRACTIVE TARGET COMPANIES

FOR LBOS

Private equity firms invest in companies across many sectors, although an individual firm may
specialize in a certain sector or sectors. Whatever the targeted sector(s), private equity firms look
forseveral characteristics, any one of which may make a company particularly attractiveas an LBO
target. The characteristics include the following:

 Undervalued/depressed stock price: In order to surpass its market price, the private equity firm
perceives the company's inherent value. Therefore, private equity companies are prepared to pay
a premium on the market price to obtain shareholder approval. Companies are trying to buy
assets or businesses cheaply, and can concentrate on companies that are out of favour in public
markets and have stock prices that reflect this view.

 Willing management and shareholders: Current leadership is searching for adequacy.

Management may have found opportunities, but it does not have access to the capital to make
major investments to drive long-term growth in new systems, staff , facilities, and so on. Present
shareholders may have limited access to capital and may welcome a partner in private equity.
Owners of family businesses may want to cash out. Private equity funds may provide time and
resources for management and investors to grow a business or turn it around.

 Inefficient companies: Private equity firms seek to generate attractive returnson equity by
creating value in the companies they buy. They achieve this goal byidentifying companies that
are inefficiently managed and that have the potentialto perform well if managed better.

 Strong and sustainable cash flow:Companies that generate strong cash floware attractive
because in an LBO transaction, the target company will be takingon a significant portion of debt.
Cash flow is necessary to make interest paymentson the increased debt load.

 Low leverage:Private equity firms focus on target companies that currentlyhave no significant
debt on their balance sheets. This characteristic makes iteasier to use debt to finance a large
portion of the purchase price.
  Assets:Private equity managers like companies that have a significant amountof unencumbered
physical assets. These physical assets can be used as security, and secured debt is cheaper than
unsecured debt.

EXAMPLE: A TYPICAL LEVERAGED BUYOUT

Now, we highlight the entire process involved in a typical leveraged buyout. The example we
present is hypothetical.

At the end of 1985, XYZ Corporation's balance sheet displayed $4 million of current assets, $12
million of depreciable capital assets, and $2 million of non-depreciable fixed assets. The
depreciable properties were absolutely depreciated, but were still in good shape and very
functional. It was estimated that the replacement cost of these properties was around $10 million.
The company had $1.5 million in current liabilities, $2.5 million in long-term debt, and $2
million in common stock equity (including retained earnings). There were 1 million common
outstanding shares. In Exhibit 1, the balance sheet is given.

Exhibit 1
XYZ Corporation

Balance Sheet (revised) - 1985

(all values in millions)

Liabilities & Equity Assets

Current Liabilities Current Assets

accruals 0.25 Cash 0.2
accounts payable 0.75 Marketable Securities 1.55
notes payable 0.5 Inventory 1.75
Receivables 0.5
1.5 4
Long term debt 2.5
Fixed Assets
Equity depreciable 12
Common Stock 0.5 less cum dep -12
Retained earnings 1.5 net 0
2 nondepreciable 2
 2
Total liabilities & equity 6 Total Assets 6

The company's sales were very steady and its revenues were very consistent. In light of this,
management recommended that the organisation raise its debt utilisation and decrease its equity
capital utilisation. The company's board opposed this on the grounds that the shareholders of the
company are too cautious to take kindly to a dramatic increase in leverage. The short-term notes
of the company had a cost of 10 percent at the time and its long-term debt had a cost of 12
percent. The interest cost for 1985 was $0.35 million as a result. Exhibit 2 appears as the profit
and loss statement of the company for 1985.

Exhibit 2
XYZ Corporation
Profit and Loss - 1985
(All values in millions)

Sales $15.00
Cost of Goods Sold 8
Gross Profit 7
Selling and administrative 5.5
Operating profit before depreciation 1.5
Depreciation 0
Operating profit 1.5
Interest Expense 0.35
Earning before taxes 1.15
Taxes ( 40%) 0.46
Earning after taxes 0.69

= earnings after taxes + depreciation

Cash Flow = $0.69 million + $ 0.00 million
= $0.69 million

In 1985, the firm's earnings per share (EPS) were $0.69 andthe firm's stock was selling at
about $8 a share or about 11.6 times earnings. Management had long believed that it could
improve the firm's performance if freed from the dictates of the overly conservative board.
Management, however, had been reluctant to attack the board's conservatism too aggressively
out of fear of losing their jobs.
Instead, management opted for different advantages, like items such as excessively expensive
offices and significant side benefits, instead of the decent pay and incentives that might follow
better results. Management obtained the services of a leading investment bank in the hopes of
taking the business private in late 1985, partially in response to reports that a takeover attempt by
a rival corporation was in the works. The management group formed a shell company on the
advice of the investment bank to serve as the legal entity making the acquisition. They named
this business XYZ Holdings.
With the aid of its investment banker, XYZ Holdings made a tender offer at $12 a share (17.4
times earnings) for all the stock of XYZ Corporation. In the end, XYZ Holdings' bid was
successful and all the stock was purchased at $12 a share (deemed a fair value by the firm's
investment bank). The two firms were then merged with the XYZ Holdings representing the
surviving entity.

The acquisition cost to XYZ Holdings was $12 million ($12 per share x 1 million shares). Of
this, $5 million was raised at a cost of 12 percent with the help of a secured bank-acquisition
loan and $4 million was raised at a cost of 18 percent via the selling of junk bonds. By putting up
$1.2 million of its own assets, the investment bank took a 40 percent equity stake and the
management company put up the remaining $1.8 million. Management maintained a buyout
option with the investment bank to purchase the equity of the investment bank after 5 years at a
price that would give an annual compounded return of about 40 percent to the investment bank.
(This translates to around $6.45 million in price).

Upon taking control, XYZ Holdings stepped-up the depreciable basis of the acquired assets to
$10 million. The revised balance sheet is given in Exhibit 3.

Exhibit 3
XYZ Holdings

Balance Sheet (revised) - 1985

(all values in millions)

Liabilities & Equity Assets

Current Liabilities Current Assets

accruals 0.25 Cash 0.2
accounts payable 0.75 Marketable Securities 1.55
notes payable 0.5 Inventory 1.75
1.5 Receivables 0.5
4
Long term debt 11.5
 Fixed Assets
Equity depreciable 10
Common Stock 3 less cum dep 0
Retained earnings 0 net 10
3 nondepreciable 2
12
Total liabilities & equity 16 Total Assets 16

The new owners relocated their offices to less costly quarters immediately and took other
measures to reduce the overhead costs of the company. The net result was to decrease the
marketing and operating costs of the company by $1.5 million a year. Management was still in a
position to recoup taxes charged by XYZ Corporation in previous years. In order to increase cash
flow, a decision was taken to depreciate the depreciable assets of the company using accelerated
methods. The company used all of the cash flow to withdraw its debt for the first four years. Its
higher-cost junk bonds were first retired. In the fifth year, a part of the cash flow was used to
retire debt, taking debt back to the amount at which it stood before the buyout. The earnings of
XXZ holdings over the next five years appear in Exhibit 4 together with the projections for the
sixth year (1991). The sixth year's earnings were considered sustainable with an 80 percent
dividend pay-out.

Exhibit 4
XYZ Holdings
Profit and Loss
(All values in millions)
1986 1987 1988 1989 1990 1991*
Sales $15.00 $15.00 $15.00 $15.00 $15.00 $15.00
Cost of Goods Sold 8 8 8 8 8 8
Gross Profit 7 7 7 7 7 7
Selling and administrative 4 4 4 4 4 4
Operating profit before depreciation 3 3 3 3 3 3
Depreciation 2.5 2.5 2.25 2 0.75 0
Operating profit before depreciation 0.5 0.5 0.75 1 2.25 3
Interest Expense 1.67 1.35 0.99 0.72 0.46 0.35
Earning before taxes -1.17 -0.85 -0.24 0.28 1.79 2.65
Taxes ( 40%) -0.47 -0.34 -0.1 0.11 0.72 1.06
Earning after taxes -0.7 -0.51 -0.14 0.17 1.07 1.59
Dividend 0 0 0 0 0 1.27
Cash Flow 1.8 1.99 2.1 2.17 1.82 1.59

Debt remaining
 Short Term (10%) 0.5 0.5 0.5 0.5 0.5 0.5
Long Term Bank (12%) 7.5 7.5 5.61 3.44 2.5 2.5
Bonds (18%) 2.2 0.21 0 0 0 0
Cumulative retained earnings -0.7 -1.21 -1.35 -1.18 0.64 0.96
*projected

At the end of five years, management exercised its right to buy out the investment bank's equity
interest in the firm at the agreed price of $6.45 million. Management then took the firm public
again in, what is called, a secondary initial public offering or SIPO and sold its equity interest at
15 times projected 1991 earnings. This brought the management group $23.85 million before
flotation costs and $22.25 million afterward. After deducting the $6.45 million paid to the
investment banking partner, the management team was left with $15.80 million on its initial
investment of $1.8 million.Thistranslates to an average annual compound rate of return of
about 54 percent.

Let's consider for a moment the sources of the gains generated by this LBO.

1. There were tax benefits from stepping-up the acquired assets of the firm, from the
deductibility of the interest on the funds used to finance a large portion of the original
purchase, and from the carryback of losses in 1986, 1987, and 1988.
2. There was a reduction in agency costs, apparent from the cost cutting in 1986 when
management gave up some of its perks (the fancy offices and some fringe benefits).
3. There were also the benefits afforded by the management group's extensive use of
leverage-which is not as high risk as it might first seem if we take into consideration the
stability of the firm's earnings and expenses.

Notice in our hypothetical LBO described above that it was not necessary for XYZ Holdings (the
post-buyout firm) to exhibit a significant immediate improvement in earnings in order for the
LBO to produce great value for the buyout group. Indeed, the buyout actually resulted in a sharp
deterioration in after-tax earnings for the first four years. The key to understanding the viability
of a leveraged buyout is clearly not profit but, rather, cash flow.

Cash Flow: Cash flow is the sum of earnings after taxes and noncash expenses. (Noncash
expenses include such things as depreciation, depletion, and the amortization of intangible
assets.)
The financial engineers who do the preliminary analysis andwho, in the end, structure the deal,
concentrate their energies on understanding the size, source, and stability of the target's cash
flows.

The cash flows will be used to reduce debt, acquire other assets (possibly other firms), and/or to
pay large cash dividends to the shareholder group. The financial engineer's job is largely one of
analyzing the cash flows and structuring a deal that can best exploit the cash flows.

EXAMPLES OF LBO

LBO IN INDIA

Following table shows the list of successful LBO by Indian company. The first being done by
Tata Tea in 2000 for UK based Tetley.

Target Company Country Indian Company Value

Tetley United Kingdom Tata Tea $271 million
Whyte & Mackay United Kingdom UB Group $550 million
Corus United Kingdom Tata Steel $11.3 billion
Hansen Transmissions Netherlands Suzlon Energy $465 million
American Axle USA Tata Motors $2 billion

LBO OUTSIDE INDIA

Hilton Hotel: The Blackstone Group acquired Hilton in a $26 billion leveraged buyout at the
height of the real estate bubble in 2007. Shortly after the agreement was struck, as the economy
slumped into recession, it seemed it could not have chosen a worse time , especially when some
of its partners, Bear Stearns and Lehman Brothers, fell apart. When the business went public in
2013, things turned around quickly, famously transforming the Hilton deal into the most
lucrative private equity deal ever. The founders who weathered the storm became famous,
making $12 billion in what many analysts say is the best-leveraged buyout of all time.
Blackstone sold its interest in the hotel chain in 2018. The private equity firm unloaded 15.8
million shares. Hilton estimated the sale would generate $1.32 billion.

PetSmart, Inc.: PetSmart's $9 billion takeover in 2014 is remarkable for being one of the
biggest leveraged buyouts since 2007. Among several interested investment parties, a consortium
led by the British buyout firm BC Partners was looking to increase the lagging revenues of the
company. Many thought that by devoting more resources to their online channels that had been
previously overlooked, PetSmart could easily increase its market share.

REFERENCES
1. Financial Engineering: A complete guide to financial innovation – John F. Marshall and
Vipul K. Bansal, PHI
2. https://medium.com/@ramkumar1984.rajachidambaram/understanding-corporate-
restructuring-and-why-it-is-rampant-in-the-current-business-environment-8a28aabb1155
3. https://www.wisegeek.com/what-is-corporate-restructuring.htm
4. https://corporatefinanceinstitute.com/resources/knowledge/deals/merger/

5. https://corporatefinanceinstitute.com/resources/knowledge/deals/merger/

6. https://www.bloombergquint.com/business/reliance-industries-devises-new-holding-
structure-for-jio-digital-businesses

7. http://www.greenworldinvestor.com/2013/03/14/list-of-successful-leverage-buyouts-by-
6-indian-companies/
8. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/junk-bonds/