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INTRODUCTION
A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or
“bootstrap” transaction) occurs, when a financial sponsor acquires a
controlling interest in a company’s equity and where a significant percentage
of the purchase price is financed through leverage (borrowed money).
It is a strategy involving the acquisition of another company using a
significant amount of borrowed money (bonds or loans) to meet the cost of
acquisition. It is nothing but takeover of a company using the acquired firm’s
assets and cash flow to obtain financing. In LBO, the assets of the company
being acquired are used as collateral for the loans in addition to the assets
of the acquired company. A LBO occurs when a financial sponsor gains
control of a majority of a target company’s equity through the use of
borrowed money or debt. The purpose of leveraged buyouts is to allow
companies to make large acquisitions without having to commit a lot of
capital.
Leveraged buyouts are risky for the buyers if the purchase is highly
leveraged. An LBO can be protected from volatile interest rates by an
Interest Rate Swap, locking in a fixed interest rate, or an interest rate cap
which prevents borrowing cost from rising above a certain level. LBOs also
have been financed with high-yield debt or Junk Bonds and have also been
done with the interest rate capped at a fixed level and interest costs above
the cap added to the principal. For commercial banks, LBOs are attractive
because these financings have large up-front fees. They also fill the gap in
corporate lending created, when large corporations begin using commercial
paper and corporate bonds in place of banks loans.
In an LBO, there is usually a ratio of 90% debt to 10% equity. Because
of this high debt-equity ratio, the bonds usually are not investment grade
402 Merger Acquisition and Restructuring

and are referred to as junk bonds. In 1980, several prominent buyouts led
to the eventual bankruptcy of the acquired companies. This was mainly due
to the fact that the leverage ratio was nearly 100% and the interest
payments were so large that the company’s operating cash flows were
unable to meet the obligation. In the US, specialised LBO firms provide
finance for acquisition against target company’s assets or cash flows.
Stages of LBO operation:
The following are the procedure involved in LBO operations:
 Arrangement of Finance
 Taking Private – The organising sponsor buys all the outstanding
shares of the company and takes it private or purchases all assets
of the company.
Firms of all sizes and industries may be the targets of a leveraged
buyout, but because of the importance of debt and the ability of the acquired
firm to make regular loan payments after the completion of a leveraged
buyout, some features of potential target firms make for more attractive
leverage buyout candidates, including:
 Low existing debt loads
 A multi-year history of consistent and reliable cash flows
 Hard assets (property, equipment, real-estate, inventory) that may
be used as collateral for new debt
 The potential for new management to make operational or other
improvements to the firm to boost cash flows
 Temporary market conditions that are depressing current valuation
or stock price
As a percentage of the purchase price for a leverage buyout target, the
amount of debt used to finance a transaction varies according to interest
rates, the financial condition and history of the acquisition target, market
conditions and the willingness of lenders to extend credit to the LBO’s
financial sponsors and the company to be acquired. Typically, the debt
portion of a LBO ranges from 50%-85% of the purchase price, but in some
very rare cases debt may represent up to 95% of the purchase price.
Between 2000-2005, debt averaged between 59.4% and 67.9% of the total
purchase price for LBOs in the United States.
Leveraged buyouts allow financial sponsors to make large acquisitions
without committing all the capital required for the acquisition. The use of
debt also significantly increases the returns to a LBO’s financial sponsor,
as cash flows from the target company, rather than the financial sponsors,
are used to pay down the debt used to purchase the company. This, in
combination with the fact that financial sponsors pay only a portion of the
original purchase price, means that a later sale of the company produces
significant returns for the financial sponsor.
Leveraged Buy-out 403

As transaction sizes grow, the equity component of the purchase price

can be provided by multiple financial sponsors “co-investing” to come up with
the needed equity for a purchase. Likewise, multiple lenders may band
together in a “syndicate” to jointly provide the debt required to fund the
transaction. Today, larger transactions are dominated by dedicated private
equity firms and a limited number of large banks with “financial sponsors”
groups.
In the recent years, the business and legal climates have changed
dramatically. Public companies as a whole recorded a loss in their market
capitalisation. The collapse in the market valuations has affected the
finances of being public. In particular, while a public company should still
generally be able to raise capital more easily than a private company, the
advantage is diminished if the company cannot easily tap the capital
markets at an acceptable price.
The recent developments have affected the costs and risks of staying
public. The increased costs and risks include the following:
Cost of Reporting: A publicly-owned company must file quarterly reports
with the SEC and/or various State officials. These reports can be costly,
especially for small firms.
Disclosure: Management may not like the idea of reporting operating
data, because such data will then be available to competitors.
Self-dealings: The owners/managers of closely-held companies have
many opportunities for self-transactions, which they may not want to disclose
to the public, although legal.
Inactive market, low price: If a firm is small, and its shares are not
traded frequently, then its stock will not really be liquid and the market
price may not be truly representative of the stock’s true value.
Control: Owning less than 50 per cent of the control could lead to a
loss of control for the owners/management. Against this background, two
financial developments have led to the increase in the number of going-
private transactions. First, large pools of capital are currently available for
going private transactions. Second, relatively low interest rates may permit
privatisations to be financed on attractive terms with borrowed funds.
This has led to increasing number of companies’ going private’ in recent
times.

‘Going-Private’ Transactions
The transformation of a public company into a privately held firm is
called a going-private transaction. In other words, it can be termed as the
repurchasing of some or all of a company’s outstanding stock by a private
investor or sometimes by the employees. Over the past few years, transactions
involving public companies turning private have grown dramatically world
over. One of the significant elements in a going-private transaction is
justice to minority or outside shareholders thus, avoiding allegations of
404 Merger Acquisition and Restructuring

security fraud against the controlling shareholders. But the most important
aspect of going-private is from where the money would come from.
Going-private requires a great deal of more financial planning than
going public. Most going-private deals are structured as Leveraged Buyouts
(LBOs) involving a company’s management, an equity player and a lender.
Let us look at leveraged buyout transactions in more detail.

Methods of Going-Private
A company can go private in a variety of ways, including a merger, a
tender offer and a reverse stock split. A privatisation typically commences
when a prospective buyer approaches a public company, which may form a
special committee to consider the proposal. The special committee retains
legal and financial advisors and negotiates with the prospective acquirer.
(1) In a going-private merger, the parties execute a merger agreement,
and the company sends its stockholders a proxy statement soliciting
votes on the merger. If all conditions to the merger are satisfied,
the parties file certificates of merger with the relevant states and
the public company merges with an entity formed by the buyer. As
a result of the merger and by operation of law, the shares of the
public company’s stock (other than shares owned by the buyer) are
converted into the right to assert appraisal rights or receive the
merger consideration. The merger consideration is the cash or stock
paid, to the stockholders. A merger typically leaves the surviving
corporation with one stockholder, a subsidiary of the buyer.
(2) In a tender offer, the acquirer purchases shares directly from the
public company’s stockholders. The acquirer sends the stockholders
a written offering document, the “offer to purchase,” and a letter of
transmittal, which stockholders use to tender shares. Tender offers
are commonly conditioned on the buyer’s holding at least 90 per
cent of each class of the company’s stock following the offer.
Ownership of at least 90 per cent of the stock permits the buyer to
complete a short-form merger, without a vote of stockholders or
soliciting proxies. In the short-form merger, the shares that were
not tendered are typically converted into the right to assert appraisal
rights or receive the same consideration that was paid to the
tendering stockholders. At the conclusion of the short-form merger,
the company typically has one stockholder, a subsidiary of the buyer.
(3) Companies can, but rarely ‘go-private’ through a reverse stock split.
In a reverse stock split, each outstanding share is converted into a
fraction of a new share, and stockholders receive certificates
representing whole shares and cash in lieu of fractional shares. For
example, in a 1-for-10,000 split, each stockholder who owned less
than 10,000 shares would receive cash only, each stockholder who
owned 10,000 shares would receive 1 new share, and each
stockholder who owned more than 10,000 shares would receive 1
new share for each 10,000 shares owned and cash for the remainder
Leveraged Buy-out 405

of his shares. A reverse stock split is generally affected by amending

the company’s certificate of incorporation; this requires the company
to distribute a proxy statement and permit stockholders to vote on
the amendment. A 1-for-10,000 split effectively cashes out holders
of less than 10,000 shares and reduces the number of stockholders.

Leveraged Buyout
The ideal mechanism to finance an acquisition or a going-private
transaction might be to use the cash held by the target in excess of normal
working capital requirements. However, having such huge amount of liquid
cash is difficult. Use of stock may be an appropriate way to minimise the
initial cash outlay, but such an option is hardly ever available in a buyout
by privately held firms. Venture capital funding may become an expensive
form of financing, since the firm might have to give up as much as 70 per
cent of the ownership in the acquired firm. The use of a public issue of long-
term debt to finance the transaction may minimise the initial cash outlay,
but it is subject to restrictions placed on how the business may be operated
by the’ investors buying the issue. For such reasons, asset-based financing
or a leveraged buyout has emerged as an attractive alternative to the use
of cash, stock, or public debt issues, if the target had sufficient tangible
assets to serve as security.
A leveraged buyout is a financing technique where debt is used to
purchase the stock of a corporation and it frequently involves taking a public
company private. It is used by a variety of entities, including the management
of a corporation, or outside groups, such as other corporations, partnerships,
individuals or investment groups. The leveraged buyouts are usually cash
transactions in which the cash is borrowed by the acquiring firm. The target
company’s assets are often used as security for the loans acquired to
finance the purchase. This type of lending is often called the asset-based
lending. Thus, capital-intensive firms with asset having high collateral
value can easily obtain such loans. Non-capital intensive firms (like the
service industries) having high enough cash flows to service the interest
payments on the debt can also obtain such loans.

History of LBOS
LBO transactions started when entrepreneurs in the 1950s and 1960s,
who were considering retirement, were often willing to sell their businesses
at or below the book value to the younger individuals who were willing to
expand the entrepreneur’s business. Such buyers only provided equity
amounting to 20-25 per cent of the purchase price and borrowed the
remainder from the commercial finance companies using the assets of the
target firm as a security to the borrowing. Most of these leveraged transactions
were of privately held, small to medium-sized businesses.
Later, in the 1960s, a bull market encouraged many businesses to go
public rather than to get involved in highly leveraged transactions. Hence,
LBO activity fell during the late 1960s. But, in the 1970s in the wake of
406 Merger Acquisition and Restructuring

rising bankruptcies and high P/E ratios, the public excitement for new
equity shares had subsided. New interest in LBOs emerged by the late
1980s. Conglomerates that were formed during the 1960s and early 1970s
began to divest many of their holdings which ranged in annual sales from
$5 million to more than $250 million. LBOs were commonly used to finance
these transactions.
The value and the number of LBOs increased significantly starting in
the early 1980s and peaking by the end of the decade. Larger companies
started to become the target of LBOs in mid-1980s. By 1980s LBOs attracted
much attention but were small compared to the mergers in terms of number
and volume.

Origins of the Leveraged Buyouts

The first leveraged buyout may have been the purchase by McLean
Industries, Inc. of Pan-Atlantic Steamship Company in January 1955 and
Waterman Steamship Corporation in May 1955. Under the terms of that
transaction, McLean borrowed $42 million and raised an additional $7
million through an issue of preferred stock. When the deal closed, $20
million of Waterman cash and assets were used to retire $20 million of the
loan debt. Similar to the approach employed in the McLean transaction, the
use of publicly traded holding companies as investment vehicles to acquire
portfolios of investments in corporate assets was a relatively new trend in
the 1960s popularised by the likes of Warren Buffett (Berkshire Hathaway)
and Victor Posner (DWG Corporation) and later adopted by Nelson Peltz
(Triarc), Saul Steinberg (Reliance Insurance) and Gerry Schwartz (Onex
Corporation). These investment vehicles would utilise a number of the same
tactics and target the same type of companies as more traditional leveraged
buyouts and in many ways could be considered a forerunner of the later
private equity firms. In fact it is Posner who is often credited with coining
the term “leveraged buyout” or “LBO”
The leveraged buyout boom of the 1980s was conceived by a number of
corporate financiers, most notably Jerome Kohlberg, Jr. and later his protégé,
Henry Kravis. Working for Bear Stearns at the time, Kohlberg and Kravis
along with Kravis’ cousin, George Roberts began a series of what they
described as “bootstrap” investments. Many of these companies lacked a
viable or attractive exit for their founders as they were too small to be taken
public and the founders were reluctant to sell out to competitors and so a
sale to a financial buyer could prove attractive. Their acquisition of Orkin
Exterminating Company in 1964 is among the first significant leveraged
buyout transactions. In the following years, the three Bear Stearns bankers
would complete a series of buyouts including Stern Metals (1965), Incom (a
division of Rockwood International, 1971), Cobblers Industries (1971), and
Boren Clay (1973) as well as Thompson Wire, Eagle Motors and Barrows
through their investment in Stern Metals. By 1976, tensions had built up
between Bear Stearns and Kohlberg, Kravis and Roberts leading to their
departure and the formation of Kohlberg Kravis Roberts in that year.
Leveraged Buy-out 407

Leveraged Buyouts in the 1980s

In January 1982, former US Secretary of the Treasury, William Simon
and a group of investors acquired Gibson Greetings, a producer of greeting
cards, for $80 million, of which only $1 million was rumoured to have been
contributed by the investors. By mid-1983, just sixteen months after the
original deal, Gibson completed a $290 million IPO and Simon made
approximately $66 million. The success of the Gibson Greetings investment
attracted the attention of the wider media to the nascent boom in leveraged
buyouts. Between 1979 and 1989, it was estimated that there were over
2,000 leveraged buyouts valued in excess of $250 million
During the 1980s, constituencies within acquired companies and the
media ascribed the “corporate raid” label to many private equity investments,
particularly those that featured a hostile takeover of the company, perceived
asset stripping, major layoffs or other significant corporate restructuring
activities. Among the most notable investors to be labelled corporate raiders
in the 1980s included Carl Icahn, Victor Posner, Nelson Peltz, Robert M.
Bass, T. Boone Pickens, Harold Clark Simmons, Kirk Kerkorian, Sir James
Goldsmith, Saul Steinberg and Asher Edelman. Carl Icahn developed a
reputation as a ruthless corporate raider after his hostile takeover of TWA
in 1985. Many of the corporate raiders were one-time clients of Michael
Milken, whose investment banking firm, Drexel Burnham Lambert helped
raise blind pools of capital with which corporate raiders could make a
legitimate attempt to takeover a company and provided high-yield debt
financing of the buyouts.
One of the final major buyouts of the 1980s proved to be its most
ambitious and marked both a high water mark and a sign of the beginning
of the end of the boom that had begun nearly a decade earlier. In 1989,
KKR closed in on a $31.1 billion dollar takeover of RJR Nabisco. It was, at
that time and for over 17 years, the largest leverage buyout in history. The
event was chronicled in the book (and later the movie), Barbarians at the
Gate: The Fall of RJR Nabisco. KKR would eventually prevail in acquiring
RJR Nabisco at $109 per share, marking a dramatic increase from the
original announcement that Shearson Lehman Hutton would take RJR
Nabisco private at $75 per share. A fierce series of negotiations and horse-
trading ensued, which pitted KKR against Shearson Lehman Hutton and
later Forstmann Little and Co. Many of the major banking players of the
day, including Morgan Stanley, Goldman Sachs, Salomon Brothers, and
Merrill Lynch were actively involved in advising and financing the parties.
After Shearson Lehman’s original bid, KKR quickly introduced a tender offer
to obtain RJR Nabisco for $90 per share—a price that enabled it to proceed
without the approval of RJR Nabisco’s management. RJR’s management
team, working with Shearson Lehman and Salomon Brothers, submitted a
bid of $112, a figure they felt certain would enable them to outflank any
response by Kravis’s team. KKR’s final bid of $109, while a lower dollar
figure, was ultimately accepted by the board of directors of RJR Nabisco.
At $31.1 billion of transaction value, RJR Nabisco was by far the largest
leveraged buyouts in history. In 2006 and 2007, a number of leveraged
408 Merger Acquisition and Restructuring

buyout transactions were completed that for the first time surpassed the
RJR Nabisco leveraged buyout in terms of nominal purchase price. However,
adjusted for inflation, none of the leveraged buyouts of the 2006 – 2007
period would surpass RJR Nabisco.
By the end of the 1980s, the excesses of the buyout market were
beginning to show, with the bankruptcy of several large buyouts including
Robert Campeau’s 1988 buyout of Federated Department Stores, the 1986
buyout of the Revco drug stores, Walter Industries, FEB Trucking and Eaton
Leonard. Additionally, the RJR Nabisco deal was showing signs of strain,
leading to a recapitalisation in 1990, that involved the contribution of $1.7
billion of new equity from KKR.
Drexel Burnham Lambert was the investment bank most responsible for
the boom in private equity during the 1980s due to its leadership in the
issuance of high-yield debt.
Drexel reached an agreement with the government in which it pleaded
nolo contendere (no contest) to six felonies – three counts of stock parking
and three counts of stock manipulation. It also agreed to pay a fine of $650
million – at the time, the largest fine ever levied under securities laws.
Milken left the firm after his own indictment in March 1989. On February
13, 1990 after being advised by Secretary of the Treasury Nicholas F. Brady,
the SEC, the NYSE and the Federal Reserve, Drexel Burnham Lambert
officially filed for Chapter 11 bankruptcy protection.

Age of the Mega-buyout 2005-2007

The combination of decreasing interest rates, loosening lending standards
and regulatory changes for publicly traded companies (specifically the
Sarbanes-Oxley Act) would set the stage for the largest boom private equity
had seen. Marked by the buyout of Dex Media in 2002, large multi-billion
dollar U.S. buyouts could once again obtain significant high yield debt
financing and larger transactions could be completed. By 2004 and 2005,
major buyouts were once again becoming common, including the acquisitions
of Toys “R” Us, The Hertz Corporation, Metro-Goldwyn-Mayer and SunGard
in 2005.
As 2005 ended and 2006 began, new “largest buyout” records were set
and surpassed several times with nine of the top ten buyouts at the end
of 2007 having been announced in an 18-month window from the beginning
of 2006 through the middle of 2007. In 2006, private equity firms bought 654
U.S. companies for $375 billion, representing 18 times the level of transactions
closed in 2003. Additionally, U.S.-based private equity firms raised $215.4
billion in investor commitments to 322 funds, surpassing the previous
record set in 2000 by 22% and 33% higher than the 2005 fund raising total
The following year, despite the onset of turmoil in the credit markets in
the summer, saw yet another record year of fund raising with $302 billion
of investor commitments to 415 funds. Among the mega-buyouts completed
during the 2006 to 2007 boom were: Equity Office Properties, HCA, Alliance
Boots and TXU.
Leveraged Buy-out 409

In July 2007, turmoil that had been affecting the mortgage markets,
spilled over into the leveraged finance and high-yield debt markets. The
markets had been highly robust during the first six months of 2007, with
highly issuer friendly developments including PIK and PIK Toggle (interest
is “Payable In Kind”), and covenant light debt widely available to finance
large leveraged buyouts. July and August saw a notable slowdown in issuance
levels in the high yield and leveraged loan markets with only few issuers
accessing the market. Uncertain market conditions led to a significant
widening of yield spreads, which coupled with the typical summer slowdown
led to many companies and investment banks to put their plans to issue
debt on hold until the autumn. However, the expected rebound in the
market after Labor Day 2007, did not materialise and the lack of market
confidence prevented deals from pricing. By the end of September, the full
extent of the credit situation became obvious as major lenders including
Citigroup and UBS AG announced major writedowns due to credit losses.
The leveraged finance markets came to a near standstill. As 2007 ended
and 2008 began, it was clear that lending standards had tightened and the
era of “mega-buyouts” had come to an end. Nevertheless, private equity
continues to be a large and active asset class and the private equity firms,
with hundreds of billions of dollars of committed capital from investors are
looking to deploy capital in new and different transactions.

Rationale
The purposes of debt financing for leveraged buyouts are two-fold:
(1) The use of debt increases (leverages) the financial return to the
private equity sponsor. Under the Modigliani-Miller theorem, the
total return of an asset to its owners, all else being equal and within
strict restrictive assumptions, is unaffected by the structure of its
financing. As the debt in an LBO has a relatively fixed, albeit high,
cost of capital, any returns in excess of this cost of capital flow
through to the equity.
(2) The tax shield of the acquisition debt, according to the Modigliani-
Miller theorem with taxes, increases the value of the firm. This
enables the private equity sponsor to pay a higher price than would
otherwise be possible. Because income flowing through to equity is
taxed, while interest payments to debt are not, the capitalised value
of cash flowing to debt is greater than the same cash stream flowing
to equity.
Germany currently introduces new tax laws, taxing parts of the cash
flow before debt interest deduction. The motivation for the change is to
discourage leveraged buyouts by reducing the tax shield effectiveness.
Historically, many LBOs in the 1980s and 1990s focused on reducing
wasteful expenditures by corporate managers whose interests were not
aligned with shareholders. After a major corporate restructuring, which
may involve selling off portions of the company and severe staff reductions,
the entity would likely be producing a higher income stream. Because this
410 Merger Acquisition and Restructuring

type of management arbitrage and easy restructuring has largely been

accomplished, LBOs today focus more on growth and complicated financial
engineering to achieve their returns. Most leveraged buyout firms look to
achieve an internal rate of return in excess of 20%.

Management Buyouts
A special case of such acquisition is a management buyout (MBO),
which occurs when a company’s managers buy or acquire a large part of
the company. The goal of an MBO may be to strengthen the managers’
interest in the success of the company. In most cases, the management will
then make the company private. MBOs have assumed an important role in
corporate restructurings, beside mergers and acquisitions. Key considerations
in an MBO are fairness to shareholders, price, the future business plan,
and legal and tax issues. One recent criticism of MBOs is that they create
a conflict of interest—an incentive is created for managers to mismanage
(or not manage as efficiently) a company, thereby depressing its stock price,
and profiting handsomely by implementing effective management after the
successful MBO.
 Current price of the target company understate the original value
of the firm so some values are created by taking the firm private
 The values so created is transferred to the shareholders and buyout
groups from parties involved in such an operation
 Consumer non-durable goods and manufacture sector
MBO is the form of corporate divestment by way of ‘going-private’
through management’s purchase of all outstanding shares. It is a special
case of acquisition which occurs when the managers of a company buy or
acquire a large part of the company. In this form of acquisition, company’s
existing managers acquire a large part of all of the company. It occurs when
the manager’s executives of a company purchase controlling interest in a
company from the existing shareholders. In many cases, the company will
already be a private company, but if it is public then the management will
take it private.
In most cases, the management will buyout all the outstanding
shareholders and then take the company private because it feels it has the
expertise to grow the business better if it controls the ownership. Quite
often, management will team up with a venture capitalist to acquire the
business because it is a complicated process that requires significant
capital.

Criticisms
The LBO form of restructuring is criticised under the following ground:
 Heavy Deployment of Debt
 Employees of Target company are threatened of loosing their jobs
Leveraged Buy-out 411

 Long-term growth of restructured firm is disrupted due to new

management
 Degree of bankruptcy is more

Purpose of MBO
What drives managers to become owners of the business they have run
under the direction and control of a parent? A survery of MBO managers
by “ WRIGHT et.al.” (1991), revealed a number of reasons of which the most
important was the desire to run one’s own business. In order of importance
managerial motivation in MBOS is as follows:
 Opportunity to control lown business
 Long-term faith in company
 Better financial rewards
 Opportunity to develop own talents
 Absence of head office constraints
 To save their jobs, either if the business has been scheduled for
closure or if an outside purchaser would bring in its own management
team
 Feat of redunancy
 To maximise the financial benefits they receive from the success
they bring to the company by taking the profits for themselves
 To ward-off aggressive buyers
 Fear of new owner ofter anticibated acquisition
The goal of an MBO may be to strengthen the manager’s interest in
the success of the company. In most cases, the management will then take
the company private. MBOs have assumed an important role in corporate
restructurings besides mergers and acquisitions. Key considerations in an
MBO are fairness to shareholders, price, the future business plan, and legal
and tax issues.

Benefits
MBO generate value to a corporate under the following way:
 It provides an excellent opportunity for management of undervalued
companies to realise the intrinsic value of the company.
 Lower Agency Cost: Cost associated with conflict of interest between
owner and managers
 Source of tax savings: Since interest payments are tax deducible,
pushing up gearing rations to fund a management buyout can provide
large tax covers
412 Merger Acquisition and Restructuring

Ideal MBO Candidates

The companies having the following situation are the ideal candidates
for MBO:
 Stable predicable earnings
 Undervalued by market
 Minimal sales fluctuations

Structure of an MBO:

Since managers do not have the financial resources to buyout their

companies on their own, the financial structure of an MBO depends on the
capital supplied by specialist capital providers and banks. Management
provides a small part of the equity. Institutions which specialise in MBO
financing, such as venture capital firms, provide additional equity. Further
funding is provided by debt, which falls into two types: senior “debt” and
“mezzanine debt”.
In some MBOs, equity has also been raised from the employees by the
formation of an employee share ownership plan, (ESOP). Contribution from
the company towards the purchase of its shares by an ESOP is corporation
tax free. Moreover, the plan can borrow money to buy shares, and the
contribution from the company can then be used to pay interest and repay
the borrowing. Thus, an ESOP is a tax-efficient method of raising funds to
finance equity.
Senior debt has priority in payment of interest and repayment of
principal. It is a secure debt and if it is a term loan, has a pre-arranged
repayment schedule. The interest rate is normally a floating rate at a
margin of 2-3 per cent over LIBOR (London Inter-Bank Offer Rate). Some
part of the Senior debt may be short-term. Mezzanine debt, as the name
suggests, is junior or subordinated to senior debt in terms of interest
payment and capital repayment. It is not secured and is, therefore, more
risky. Both debt components rank above equity.
The mezzanine layer is often in the form of preference shares or
convertible loan stock or convertible preference shares. In the United
Kingdom, some firms specialise in providing mezzanine or intermediate
finance. The interest rate is generally 4-5 percent above LIBOR. Interest
rate margins for both senior and mezzanine debt depend on the general
level of interest rates, the demand for debt and the competition among
banks.
Institutional equity providers earn their reward from the return realised
at the time of exiting the MBO. Exit is the process of realisation of the
investment made in an MBO. Equity investors may expect an internal rate
of return (IRR) of 25-30%. Once again this return depends on the riskiness
of the MBO, demand for funds and competition among institutional equity
providers, and the lead time to exit. The following case provides an example
of such a structure:
Leveraged Buy-out 413

Financing the DRG Litho Supplies MBO, 1991

DRG Litho Supplies Ltd. was bought out by the management team from
DRG Plc after it was taken over in a contested bid by Pembridge Investments
in 1989. The total financing needed was:
Price payable to vendor £20.70m
Working capital 1.65m
Fees 1.00m
23.35m
This was provided by:
Management equity £0.50m
Institutions: share capital 7.35
Mezzanine: 4.00
Senior debt: Term loan 7.00
Overdraft and short term 4.50
23.35m

SOURCE: Ernst and Young 1991 MBO guide

In larger deals, the number of institutional equity and debt providers
increases substantially as a mechanism for spreading risk. To the senior
lenders, the mezzanine and equity provide a cushion. In the above case,
senior debt of £11.5 million is backed by £11.85 million of equity and
mezzanine. However, the larger the mezzanine, greater the cash outflow,
the smaller will be the retained earnings owing to interest payment and
the smaller the resulting net worth. Senior lenders are therefore wary of
too much mezzanine, although it ranks behind the Senior debt.
Mezzanine lenders often demand an ‘equity kicker’ or ‘sweetener’ to
compensate them for the high risk they run. An equity kicker is an equity
warrant, and it enables the mezzanine holder to partake of the upside
potential of an MBO by exercising the warrants, and to receive shares in
the company. When there is a financing gap after tapping all the above
sources, sometime vendor the farm of inseured loan notes or preference
shares or convertibles. Vendar financing also demonstrates goodwill towards
the management. When the MBO maintains some trading links with the
erstwhile parent such as a supplier vendor financing smoothens such links.

Failures
Some LBOs in the 1980s and 1990s resulted in corporate bankruptcy,
such as Robert Campeau’s 1988 buyout of Federated Department Stores and
the 1986 buyout of the Revco drug stores. The failure of the Federated
buyout was a result of excessive debt financing, comprising about 97% of
the total consideration, which led to large interest payments that exceeded
the company’s operating cash flow. In response to the threat of LBOs,
414 Merger Acquisition and Restructuring

certain companies adopted a number of techniques, such as the poison pill,

to protect them against hostile takeovers by effectively self-destructing the
company if it were to be taken over.
The inability to repay debt in an LBO can be caused by initial overpricing
of the target firm and/or its assets. Because LBO funds often add value
through the resale of assets or selling off business units, any initial
overpricing may directly result in insolvency as the expected cash flow is
not obtained to sufficiently repay the debt. Another reason is over optimistic
forecasts of the operating cash flows (or revenues) of the target company.
Capital structure in an LBO are often based on fairly tight margins, so that
any deviations from expected cash flows may result in financial distress,
costs and risky situations.

Elements of a Typical LBO Operation

A leveraged buyout transaction takes place as follows:
(1) The first stage in an LBO operation consists of raising the cash
required for the buyout and devising the management incentive
system. Usually around 10 per cent of the cash is put up by the
firm’s top managers and/or the buyout specialists. Managers also
receive incentive compensation in the form of stock option or warrants.
Hence, the percentage of equity share on the management will be
around 30 per cent. Other outside investors provide the remaining
equity.
Approximately 50 to 60 per cent of the required cash is raised by
borrowing against the company’s assets through secured bank loans. The
bank loan usually is taken from different commercial banks. This portion
of the debt is sometimes also taken from insurance companies, pension
funds or from limited partnerships specialising in venture capital investments
and leveraged buyouts. The remainder of the cash is obtained by issuing
senior and junior subordinated debt in a private placement or in a public
offering as high-yield notes or bonds like the junk bonds.
(2) The second stage of the transaction involves making the firm private.
The company can be made private, either in a stock purchase format
where all the shares of the company are bought or in an asset
purchase format where all the assets of the company are purchased.
In an asset purchase format, the buying group forms a new privately
held corporation. Some of the parts of the business are sold-off by
the new management to reduce the debt.
(3) In the third stage, the management tries to increase the profits and
cash flows by cutting operating costs and changing marketing
strategies. It may strengthen and restructure the production facilities,
change product quality, product mix, customer service, pricing, improve
inventory control and accounts receivable management. It may even
lay-off employees and reduce the expenditure on research and
development as long as these are necessary to meet the payment
on the huge borrowings.
Leveraged Buy-out 415

(4) In the fourth stage, the investor group may again take the company
public if it has become stronger and the goals of the group are
achieved. This process is called a reverse LBO and is achieved
through a public equity offering which is referred to as a Secondary
Initial Public Offering (SIPO). The purpose is to provide liquidity to
the existing shareholders.
The Candidates for implementation of LBO strategy are the possible
target firms threatened by takeover proposals from outside. The typical
targets include any of the following:
 If the company does not have shareholding more than 51%
 If the company is over leveraging with the debt components nearing
to Maturity
 If the company has diversified into unrelated areas and thus, facing
problems
 If the company is earning low operating profits due to poor
management and there is a possible of turnarounds.
 If the company is having an assest structure which is grossly under
utilised
 If the company’s present management is facing managerial
incompetence.

Aspects of LBO Financing

The RBI has to come out with guidelines for financing LBOS. Financing
Indian M&As needs a new orientation. It is high the Regulator realises that
absence of bank lending for corporate takover is serioulsy hampering the
growth of Indian M&A activity. The numerous financing cost raits that
continue should become a matter of great concear for contral balance. The
basic issue is that RBI continues to have archaic rules which do not allow
banks to finance corporate acquisitions. The work rational behind these
rules: Banks should stay away form financing speculative activities. “But
M&As are not speculative acfivities” accepted by many Banks and Managers.
They said “Acquisition of a starategic controlling stake in a company’s an
economies activity. It works creates value. That is why acquisition needs
to be financed like any stere economic activity. What is needed now is a
plan of action to enable public sector banks finance carporate acquisitions,
since these banks are guided by RBI’s lending norms, it is essential that
the central banks takes the initiative and frames clear and focussed
guidelines for M&A financing by bank’s. There are RBI guidelines setting
out sectoral funding linit to protect a banks portfolio Similar guidelines
should make takeover funding easier and transparent. As of now RBI is
expected to tell the banks to put in place transpoart leverged buyout rules
approved by their boards.
Two general categories of debt are used in LBOs-secured and unsecured
debt and they are often used together.
416 Merger Acquisition and Restructuring

Secured LBO Financing or Asset-based Lending

Under the asset-based lending, the borrower pledges certain assets as
collateral. Asset-based lenders look at the borrower’s assets as their primary
protection against the borrower’s failure to repay. Such loans are often
short–term, i.e., around 1-5 years in maturity and secured by assets that
can be easily liquidated such as accounts receivable and inventory. Secured
debt also called the asset-based lending contains two sub-categories: senior
debt and intermediate-term debt. In some small buyouts these two categories
are considered as one. In bigger deals there may be several layers of
secured debt, which vary according to the term of the debt and the types
of assets proposed as security.
Senior Debt
Senior debt consists of loans secured by liens on particular assets of
the company. The collateral which provides the risk protection required by
lenders includes such physical assets as land, plant and equipment, accounts
receivable and inventories. The level of the accounts receivable that the
firm averages during the period of the loan is assessed, based on which the
amount of loan to be lent is determined. Lenders usually will give 85 per
cent of the value of the accounts receivable and 50 per cent of the value
of the target inventories (excluding the work­­in­progress).
The process of determining the collateral value of the LBO candidate’s
assets is sometimes called qualifying the assets. Assets that do not have
collateral value such as accounts receivable that are unlikely to be collected
are called the unqualified assets.
Intermediate-term Debt
The intermediate-term debt is usually subordinate to senior debt. The
loan is often backed by the fixed assets; such as land, plant and equipment.
The collateral value of these assets is usually based on their liquidation
value. A debt backed-up by equipment usually has a term of six months to
one year and a debt backed by real estate will have a one- to two-year term.
Usually, the loan amount will be equal to 80 per cent of the appraised value
of equipment and 50 per cent of the value of real estate. However, these
percentages may vary depending on the area of the country and conditions
of the market. The collateral value depends not on the book-value of the
asset but on its auction value. If the auction value i.e., the liquidation value
is greater than the book value of assets, the firm’s borrowing capacity is
greater than what is reflected in the balance sheet.
Costs of Secured Debt
The costs of secured debt vary depending on the market conditions.
Secured debt rates are often quoted in relation to other interest rates such
as the prime lending rate. The prime rate is the rate which the bank
charges for their best customers. It often ranges between two and five
points higher than the prime rate for a quality borrower with quality assets.
Leveraged Buy-out 417

Unsecured LBO Financing

Leveraged buyouts are typically financed by a combination of secured
and unsecured debt. The unsecured debt also referred to as subordinated
and junior subordinated debt has a secondary claim on the assets of the
LBO target. Unsecured financing often consists of several layers of debt
each secondary (subordinate) in liquidation to the next most senior issue.
Those with the lowest level of security normally get the highest yields to
compensate for their higher level of risk.
It is also often called mezzanine financing, because it has both equity
and debt characteristics. It has more characteristics of a debt but it is also
like equity because lenders receive warrants that may be converted into
equity in the target. The warrant allows the holder to buy stock in the firm
at a pre-determined price within the defined time-period. When the warrant
is exercised the share of ownership of the previous equity holders is diluted.
Hence, this form of LBO financing is often used when there is no collateral.
The main advantage of the mezzanine layer financing is the profit potential
that is provided by either the direct equity interest or warrants or warrants
convertible into equity. The added return potential offsets the lack of
security that the secured debt has.
Unsecured LBOs are sometimes called cash flow LBOs because stable
cash flows can also act as an important source of protection. The more
regular the cash flows, the more assurance the lender has that the loan
payments will be made. These deals have a more long-term focus with a
maturity of around 10-15 years. On the contrary, secured LBOs might have
a financing maturity of only around 1-5 years. The cash flow LBOs allows
firms that are not in capital-intensive industries like the service industries
to be LBO candidates. Usually, lenders of an unsecured financing require
a higher interest rate as well as an equity interest. The equity interest may
be as low as 10 per cent or as high as 80 per cent of the company’s shares.
If the risk is higher this percentage will be even more.
Unsecured lenders are entitled to receive the proceeds of the sale of the
secured assets after the full payment has been made to the secured lenders.
In India in the absence of norms governing M&A financing, banks have
gone for asset financing. For example, Deutsche Bank partly financed the
acquisition of 25 per cent government holding in Videsh Sanchar Nigam
Ltd., (VSNL) by the Tatas. The foreign bank undertook the buyout deal by
placing debt instruments with mutual funds and FIIs. The Tatas raised the
required funds by leveraging their own balance sheet.

Structuring Leveraged Buyouts

The structure of the leveraged buyout is aimed at optimising the
relationship between a company’s capital structure and the equity values
realisable by both its current shareholders and prospective future
shareholders. The current shareholders receive an acquisition value that
418 Merger Acquisition and Restructuring

reflects the financial capabilities of the company and its ability to assume
a significant debt burden. New investors bear the risk of the ownership of
the leveraged company with the expectation of receiving an outstanding
return on their investment as compensation for the financial risk being
assumed.
Leveraged buyouts can be divided into three categories depending on
the probable mechanism for debt repayment and the realisation of value to
equity. They are:
(i) Bust-up LBOs
(ii) Cash Flow LBOs
(iii) Selective Bust-up/Cash Flow LBOs (Hybrid).

Bust-up LBOs
LBOs of this kind depend on the sale of assets of the acquired company
to generate returns for the equity investors. This type of LBO is usually
seen in acquisitions of diversified public companies where the equity markets
may not fully value the various sub-entities of the company. In such cases
the acquirer seeks a relatively short-term return based upon a rapid sale
of the individual parts of the firm to exploit the markets’ failure to recognise
the full value of a diversified business.
The finances of the bust-up transaction depend upon the value of the
assets of the various individual units. The greater the value of these assets,
the less equity is required to accomplish the transaction as the acquirer
can subsequently sell-off the various sub-entities to generate cash required
to retire the debt. These forms of leveraged buyout transaction are very
rare.

Cash Flow LBOs

Cash Flow LBOs is a second category of leveraged buyout which is the
most common in managementled transactions that requires repayment of
acquisition financing through the operating cash flows. Equity investors
receive the returns through the replacement of debt capital with equity and
also through any increase in the total market value of the company. This
type of LBO is similar to the purchase of a real estate property with
mortgage financing and equity. Returns are obtained when the value of the
property increases with an increase in rent (operating income) and when
the debt is replaced by equity as debt is retired from the income from
property.

Selective Bust-up/Cash Flow LBOs (Hybrid)

The third type of leveraged transaction is a hybrid of a bust-up and cash
flow techniques. It involves the purchase of a fairly diversified company and
the subsequent divestiture of selected units to retire a portion of the
acquisition debt. The acquirer gets the control of a smaller group of assets
Leveraged Buy-out 419

which are best suited for longer term leverage and have captured a premium
on the assets which have been sold.

Sources of LBO Financing

The primary sources of LBO financing are the different categories of
institutional investors such as life insurance companies, pension funds, etc.
Institutional investors either fund LBOs by direct investment or fund LBOs
indirectly through an LBO fund. Pools of funds are created by contributions
made by various institutional investors, to invest in various LBOs. By
investing in LBOs, institutional investors anticipate realisation of higher
returns than those available from other sources or forms of lending. Also,
by pooling the funds, they could achieve broader diversification and hence,
can reduce the risk. Diversification is designed to limit the exposure of
default to any one borrower.

Tata Tea - Tetley Deal - Not Everyone’s Cup of Tea

After a pitched battle against the MNCs in the domestic arena, not
many Indian companies would have thought of going global. Devour
competitor and destroy competition - the mantra that the global
conglomerates had been chanting so far, had not gone down well with
their Indian counterparts. But fortunately, that does not remain their
(MNCs) prerogative anymore. The war averse domestic companies are now
fast shedding their inhibitions. The roles, no doubt, have changed. And,
after fighting it out successfully in global commodities arena, it is time
now for the global teacup.
Taking the plunge in this global tea war now is India’s corporate giant
Tata Tea. Though it was not an easy decision to make, that too when the
competitor was of no less than a stature of Unilever, a global food and
beverage behemoth, but then Tata Tea had little choice - shape up or be
swamped. It chose the former. And, what else could have been a better
vehicle than Tetley for Tata Tea to piggy back on to take on the might
of global tea giants like Lever and Hillsdown. But that has not come to
it easily. After a long-drawn out battle first with Schroder Ventures,
followed by a bitter retreat in 1995, and then with Sara Lee, Tata Tea
finally tasted victory on March 10, 2000 when it finally bought out Tetley
for a staggering Rs. 2,135 crore (305 million pounds sterling). Such a deal
has never been heard or seen before in the Indian corporate world. What
makes the deal so special is the fact that it is the first-ever LBO
(Leveraged Buyout) by any Indian company. In fact, this also happens to
be the largest-ever cross-border acquisition by any Indian company.
420 Merger Acquisition and Restructuring

Leverage Buyout Structure

With a reserve of just around Rs. 400 crore in its kitty, it could not
have been possible for Tata Tea to go for such a gigantic acquisition on
its own. Or, even bringing such a colossal debt upon its own books could
have meant putting enormous pressure on the bottom-line. So, it went for
Leveraged Buyout or LBO (see box on LBO).
The deal had been structured in such a way that although Tata Tea
retained full control over the venture, the debt portion of the did not
affect its balance sheet. The deal had been tied up through a leveraged
buyout based on Tetley’s assets so that Tata Tea’s gearing was not
impaired as a result of it.
Tata Tea had created a Special Purpose Vehicle (SPV) - christened
as Tata Tea (Great Britain) ­to acquire all the properties of Tetley. The
idea of the (SPV, essentially, wasto ensure that Tata Tea’s balance sheet
did not suffer additional funding costs, while at the same time, allowing
it to benefit from the acquisition of the international brand. The SPV
hadbeen capitalised at 70 million pounds out of which Tata Tea had
contributed 60 million pounds; that include 45 million pounds raised
recently through its GDR issue. The US subsidiary of the company, Tata
Tea Inc., has contributed the balance 10 million pounds. The SPV had
leveraged the 70 million pounds equity 3.36 times to raise a debt of 235
million pounds to finance the deal.
The entire debt amount of 235 million pounds comprised 4 tranches
whose tenor varied from 7 to 9.5 years, with a coupon of around 11 per
cent, 424 basis points over the LIBOR. Of this, the Netherlands-based
Rabobank had provided 215 million pounds while venture capital funds
Mezzanine and Schroders each had contributed 10 million pounds.
The debt had been divided into four tranched, namely A, B, C and
D. While A, B and C are senior term loans, tranche D is a revolving loan
that had taken the form of recurring advances and letters of credit. Of
the four tranches, money from tranches A and B is meant for funding the
acquisition, while tranches C and D were meant for capital expenditure
and working capital requirements, respectively.
While tranche A was a 110 million pounds loan scheduled to be
retired in 2007 through semi­annual installments, tranche B was a 25
million pounds loan which matured in 2007 and will be paid back in two
equal installments at the end of 7.5 years and 8 years respectively.
Tranche C was a 10 million pounds loan, to be that matured in 2008, and
was repaid in two equal installments at the end of 7.5 years and 8 years
respectively. Tranche D was a 20 million pounds loan which, had been
made available through ‘advances, letters of credit, overdrafts and had
retired in 2007.
The debt had been raised against Tetley’s brands and physical assets.
The valuation of the deal had been done on the basis of future cash flows
Leveraged Buy-out 421

that the brand was expected to generate in the foreign market as well
as the synergy and benefits that Tata Tea received.
Though the actual cost of the Tetley takeover came to 271 million
pounds, Tata Tea had spent 9 million pounds on legal, banking and
advisory services and another 25 million pounds for Tetley’s working
capital requirements and additional funding plans; thereby swelling the
total acquisition cost to 305 million pounds. Since entire securitisation
was based on Tetley’s operations, Tata Tea’s exposure was limited to the
equity component only i.e., 70 million pounds.

Characteristics of an Ideal Leveraged Buy-out Candidate

Lenders often look for certain features in a business to identify whether
the business makes a good leveraged buyout candidate. Not all of the
following characteristics are necessary for the completion of a leveraged
buyout. However, the greater the number of these characteristics in a
target company and the stronger any individual characteristic is, the more
likely it is for the LBO to be successful.
Experienced Management Team
A strong management team consisting of a highly qualified chief executive
officer and chief financial officer are key components to an LBO. In a
leveraged situation, the company has little room for trial and error. Because
of this, lenders and investors will insist on having a management team that
has a long track record in the industry and knows how to meet projections
with few surprises. Lenders also like to see a management team that has
either been in a leveraged situation or who has had to meet projections on
a consistent basis.
Strong and Secure Cash Flow
Cash flow must be sufficient enough to fund both the company’s ongoing
operations and to service the debt. Future cash flows based on strong and
stable historical performance are most saleable to lenders. Projections that
need little explanation and that replicate past performance can withstand
the greatest scrutiny and will therefore produce the highest borrowing
capacity. To the extent these projections are based on changes in the
business, detailed assumptions with specific explanations should accompany
the first set of numbers presented to lenders. Prior explanation allows the
lender to follow the flow from start to finish with little guess work. This
type of presentation maximises the lender’s belief that the cash flows are
strong and secure and leaves a strong first impression. In addition to
supportable cash flow, cash flow with a significant depreciation component
is also desirable, because it can be used to pay down acquisition debt and
not to pay taxes.
Strong Asset Base
Because assets are used as collateral for financing, assets should have
significant value relative to the purchase price of the company. Machinery
422 Merger Acquisition and Restructuring

and equipment that have multiple uses or that can be easily converted for
alternative uses will derive a higher borrowing percentage than equipment
that is highly customised. Customised equipment is difficult to sell in a
downside situation and therefore, has a lower borrowing value. In addition,
accounts receivable and inventory that can be collected quickly or has a
high liquidation value are attractive to lenders. Finished inventory and raw
materials generally have higher advance rates than work-in-progress.
Generally, the more commodity-like the asset is, the higher the advance
rates will be.
Low Operating Risk
Because the financial risk of the business is high under an LBO, the
business cannot afford to have a bad year. Therefore, those companies that
have less operating risks are better LBO candidates. Companies with strong
market positions can usually weather downturns in the economy and thus,
have less operating risk. Companies with a diversified product, customer
base, or geographic market have less operating risk because the company’s
cash flow is less dependent on any single source of revenue. These companies
are better able to withstand the obsolescence of a product, loss of a
customer, or change in a region’s economy. Companies that have long-term
contracts with their customers or who have customers that would incur
high changeover costs if they switched suppliers also have less operating
risk.
Limited Debt on the Firm’s Balance Sheet
The lower the amount of debt on the firm’s balance sheet relative to
the collateral value of the firm’s assets, the greater the borrowing capacity
of the firm. If the firm’s balance sheet is already burdened by significant
financial leverage, it may be more difficult to finance the LBO. The already
existent debt limits the borrowing capacity of the company.
Equity Interests of Owners
The equity investment of managers or outside parties who are buying
the company acts as a cushion to protect lenders. The greater the cushion,
the more likely it is that secured lenders will not have to liquidate their
assets since the management would try its best to save the company in
tough times due to their equity investment.
Separable, Non-core Businesses
If the LBO candidate owns non-core businesses that can be sold-off
quickly to pay back a significant portion of the firm’s post-LBO debt, the deal
may be easier to finance. Deals that are dependent on the sale of most of
the businesses of the firm are referred to as breakup LBOs.
Other Factors
Lenders look for many other factors depending on the business of the
LBO candidate. The existence of unique or intangible factors may provide
Leveraged Buy-out 423

the impetus for a lender to provide financing when the lenders are indecisive
of the performance of the LBO candidate. A dynamic, growing and innovative
firm may provide lenders with sufficient incentives to ignore some
shortcomings.
Timing
Timing is often the most important element to take advantage of an
LBO opportunity. Below are some examples of situations where timing
makes a business a good buyout candidate.
Companies that Lack Strategic Fit with Parent
Often larger corporations that have multiple subsidiaries have businesses
that no longer fit with their strategic objectives. A common example is when
a company decides to focus on the marketing end of a business and decides
not to manufacture a product but rather to outsource it. This is a great
opportunity for an LBO, because the buyer can usually negotiate a long-
term supply agreement with the seller. This allows the buyer to purchase
the business based only on the cash flows from the supply agreement, thus
minimising the purchase price. In addition, it creates the base of business
necessary for the new company to grow and be competitive in the
marketplace.
There are many more reasons a parent corporation might decide to exit
a business, all of which might be valid for that owner. However, just
because the owner wants to exit the business based on its standards, it
does not mean it is a bad business to be in. Instead, it means that there
may be an excellent opportunity for someone to attempt a leveraged buyout.
Retiring Owner Situations
One of the most common reasons for the sale of a business is that the
owner wants to retire and there are no family members who want to take
over the business. Confronted with the decision to sell to a competitor, the
owner often turns to the management team to see if they have an interest
in purchasing the business. Selling to the management team can provide
a smooth transition for the owner and minimise the interruptions to the
business.
Companies that must be Sold because of Regulators
With the continued consolidation going on in many industries, the
Trade Commission is faced with the task of maintaining a competitive
environment for the consumers. In many cases, the trade commission may
order companies to divest assets in particular markets where the divesting
company has too much market share. Generally, the trade commission will
require the sale to be made to a qualified buyer who will continue to run
a competitive business and therefore promote competition in the market
place. This is a right kind of situation to attempt an LBO, because there
is a seller who must sell the business and who also wants to sell to the
least competitive buyer as possible. Selling to another big player in the
industry is usually not the seller’s first choice.
424 Merger Acquisition and Restructuring

Subsidiaries that Lack the Attention of the Parent Company

Often smaller divisions or units of larger corporations lack the attention
necessary to maximise their potential. Therefore, these divisions or units
appear to be much less valuable than they really are. This is an ideal time
for an LBO to be structured. With parent company management at
headquarters believing that they are selling a business with little potential,
the buyer can negotiate a bargain purchase, raise the necessary capital to
move the business in the right direction and generate the cash flows
necessary to pay off the transaction debt. Although the parent company is
usually the initiator of the transaction, management should not hesitate to
ask the parent company if it is willing to sell. Management teams are the
natural buyers in these situations and can usually find an equity sponsor
to back their ideas.
Good LBO candidates have experienced management teams, strong and
secure cash flows, a healthy asset base and low operating risk. In addition,
a business is a good LBO candidate when the owner believes it no longer
fits its strategic objectives; when the owner is considering retiring or estate
planning; when regulators are requiring the sale of the business; or when
the business lacks the attention of its parent. Combining the characteristics
of a good buyout candidate with proper timing will maximise the probability
of a successful transaction.

Sources of Gains in LBOs

The gains associated with a leveraged buyout transaction are mainly:
(i) Taxes;
(ii) Management incentives;
(iii) Wealth transfer effects;
(iv) Asymmetric information and under-pricing; and
(v) Efficiency considerations.
Taxes
The new company formed can operate without payment of any tax for
as long as five to six years. The high amount of leverage provides the
benefits of interest savings. Moreover, the asset set ups can provide higher
asset values for depreciation expenses.
Management Incentives and Agency Cost Effects
Management ownership is enhanced by the leveraged buyout or the
management buyout. Hence, there are more and stronger incentives for an
improved performance. Some investment proposals may require
disproportionate effort of managers. In such cases, the managers are given
disproportionate share of the proposal’s income. The going private buy-outs
facilitate compensation arrangements that induce managers to undertake
these proposals.
Leveraged Buy-out 425

A going-private transaction may eliminate certain costs incurred by

managers to defend their position to potential proxy contestants and to the
outside shareholders. In many buyouts the promoters retain a large stake
and their desire to protect their reputation as efficient promoters give them
the incentive to closely monitor post-buyout management. This will decrease
the information asymmetry between the managers and the shareholders.
The ownership resulting from the LBO represents reunification of ownership
and control, which reduces agency costs.
Finally, presence of internal cash accruals will encourage managers to
use more of these cash flows for self-expenditure rather than pay them to
the shareholders as dividends. However, an increase in debt through a
leveraged buyout commits the cash flows to debt payments. Hence, the
agency costs of the free cash flows will be decreased in the leveraged buy-
outs. In case of risk, averse managers increased debt will put pressure on
managers and gives them an incentive to perform to prevent bankruptcy,
since bankruptcy will cause a decline in their compensation and value of
human capital. Hence, an LBO is a debt bonding activity which bonds the
managers to meet newly set targets.
Wealth Transfer Effects
Payment of premium in the leveraged buyout transactions represent
wealth transfers to shareholders from other stakeholders like the
bondholders, preferred stockholders, employees and the government. Hence,
there is an increase in the value of the equity. The existing bondholders
are protected by the covenants in the event of change in control, new debt
issues, etc., to some extent but not completely. The new debt issue might
not be subordinated to the outstanding debt and the maturity of these debts
may be of shorter duration. Hence, there might not be an absolute security
for the outstanding debt.
Asymmetric Information and Under Pricing
Large premium paid in the LBO transactions indicate that the buyers
or the managers have more information on the value of the firm than the
public shareholders. The buyout proposal signals to the market that the
future operating income will be greater than what was expected and the
firm is less risky than what was perceived by the public.
Efficiency Considerations
Under a private ownership the decision process is more efficient.
Actions can be taken more promptly. Getting a new investment programme
started is critical for the success of a firm and it is easily achievable
under a private ownership. A public firm has to disclose information that
is vital and competitively sensitive to rival firms which a private firm
need not.
426 Merger Acquisition and Restructuring

Types of LBO risk

The risk of a leveraged buyout transaction may be a business risk and/
or an interest rate risk.
Business Risk
It refers to the risk that the firm going-private will not generate
sufficient earnings to meet the interest payments and other current
obligations of the firm. Cyclical downturn in the economy and competitive
factors within the same industry such as greater price and non-price
competition are some of the factors which affect the risk of the firm. Firms
that have cyclical sales or firms that are in very competitive industries are
not considered as good LBO candidates.
Interest Rate Risk
Risk that the interest rates will rise; increasing the firm’s current
obligations of interest payments is the interest rate risk. This is more
important for firms that has more variable rate debt. Increase in interest
rate could force a firm into bankruptcy even when it experiences greater
than anticipated demand and holds non-financial costs within reasonable
limits. The level of interest rates at the time of the LBO may be a guide
to the probability that rates will rise in the future.

Reverse LBO
A reverse LBO occurs when a company goes private in an LBO only
to be taken public again at a later date. This may be done if the buyers
who take the company believe that it is undervalued, perhaps because
of poor management. They may buy the firm and introduce various
changes, such as replacing senior management and other forms of
restructuring. If the new management converts the company into a more
profitable private enterprise, it may be able to go through the initial public
process again.

Leveraged Buyouts as White Knights

Managers in target firms have used LBOs as part of an anti-takeover
strategy, providing stockholders an offer that they may accept instead of the
hostile bid. This phenomenon became very common in the fourth merger
wave and declined with the overall slowdown in the LBO activity in the
1990s.

Management Buyouts and Management [MBOs and MIBs]

In a MBO, the parent seles a division or subsidiary to the incumbent
management or a private company is bought by incumbent management. In
MBI, a new management team replaces the incumbent management. Where
a public listed company is bought by its management, it is pertinent to note
that MBOs, MBIs have been significant in UK acquisitions in last few years
accounting for about 11% of the acquisitions.
Leveraged Buy-out 427

MBIs arise from a number of different sources. The vast majority of

them are disinvestments by UK and foreign parents of subsidiaries. Private
family owned companies are also often sold to managers. Companies in
receivership, or parts of those companies, are also brought by managers as
MBOs Receivership as a source of MBOs is obviously related to the state
of the economy and become more prominent is recession. Disinvestment in
recession tend to be detensive and drive by rationalisation and cost cutting,
where in boom time they are triggered more by strategic restrecturing.
A management buyout is a special type of a leveraged buyout where the
management decides that it wants to take its publicly traded company or
a division of the company, private. Since large sums are necessary for such
transactions, the management has to usually rely on borrowing to accomplish
such objectives. There should be a premium to be given above the current
market price to convince the shareholders to sell their shares.
Management buyouts have been an important aspect of a business.
However, the following points should be considered by managers before
going ahead with the management buyout.
 Management buyouts are risky and can result in the managers
losing their personal wealth as well as their jobs.
 When the new company becomes independent there are possibilities
of problems being encountered. For example, there are chances of
losing the customers if they consider the existing firm to be too
risky.
A management buyout can also be advantageous as follows:
 Though the risks are high the potential rewards are also high. The
returns to the shareholders can be high once the loans have been
repaid.
 Management buyouts are less risky than starting a new firm
altogether.
 Firms that have been subject to management buyouts tend to operate
at a higher level of efficiency. The separation of ownership and control
is effectively ended and managers and the shareholding employees
have greater incentive to improve the efficiency of the firm.
A management buy-in occurs when a group of outside managers buys
a controlling stake in a business. Management buy-in is particularly effective
when the existing management is weak and need to be replaced and when
more efficient managers are able to quickly gain new responsibilities.
However, employee resistance can be experienced when the new management
tries to impose new ways of running the business. Another disadvantage is
that the new management might concentrate on the short-term profitability
at the expense of securing the company’s long-term prosperity.
428 Merger Acquisition and Restructuring

Leveraged Cash Outs

lt is also known as leveraged recapitalisation. It is a defensive
reorganisation of the capital structure in which the outside shareholders
receive a large one-time cash dividend and inside shareholders i.e., the
management receives new shares of stock instead. The cash dividend is
largely financed with newly borrowed funds, leaving the firm highly leveraged
and with greater proportional ownership share in the hands of management
Illustration
Godrej Ltd. is a successful publicly - traded manufacturer of consumer
durables. It acquired a smaller company BPL Ltd. manufacturing glassware.
However, BPL did not fit into its mould and suffered for a number of years.
In the year 2010, a small group of disappointed executives of BPL began to
consider a leveraged buyout. Godrej was ready to consider the divestiture
as it was never comfortable with BPL product line. BPL has always had
stable production costs and good contribution margins which consistently
resulted in a strong and steady cash flow. Though the production equipment
was old it was in a good condition and its replacement cost exceeded its
book value. Till the acquisition by Godrej, BPL was always managed well and
had little debt.
The following financial information for 2009 is available for BPL:
Revenues Rs. 80 lakh
EBIT Rs. 12 lakh
Net Income Rs. 7.2 lakh
After negotiations the purchase price was settled for Rs. 30 lakh.
Because of the high replacement cost of its assets, its strong cash flow, and
its relatively unencumbered balance sheet, BPL was able to take on large
amount of debt. Banks supplied nearly Rs. 20 lakh of the senior debt at an
interest rate of 13 per cent. This was secured by finished goods inventory,
plant and equipment and was amortised over a five-year period. An insurance
company also provided a loan of Rs. 6 lakh in the form of subordinated debt.
Finally, the management of the company took an equity position of Rs. 4
lakh.
Estimate the value of the firm after the Leveraged buyout.
Solution
Amortisation Table of Bank Loan

Year Interest Principal Balance

1 2,60,000 3,08,666 16,91,334
2 2,19,873 3,48,793 13.42,541
3 1,74,530 3,94,136 9,48,405
4 1,23,293 4,45,373 5,03,032
5 65,394 5,03,032 -------
Leveraged Buy-out 429

* Rs. 20 lakh at 13%, annual payment X

20,00,000 = X PVIF Δ (13%, 5 yrs)
X = 20,00,000/3.517 = Rs. 5,68,666
Amortisation Table of Insurance Company Loan

Year Interest Principal Balance

1 78,000 92,600 5,07,400
2 65,962 1,04,638 4,02,762
3 52,359 1,18,241 2,84,521
4 36,988 1,33,613 1,50,908
5 19,618 1,50,908 -----

* Rs. 6 lakh at 13%, annual payment X

6,00,000 = X PVIF Δ (13%,5 yrs)
X = 6,00,000/3.517 = Rs. 1,70,600
The following proforma cash flow calculations are made on the basis of
a number of conservative assumptions. It is assumed that there is no
growth. The tax rate is assumed to be 36 per cent. Depreciation is calculated
on a straight-line basis over a period of 15 years.

Cash Flows Statement

Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
EBIT 12,00,000 12,00,000 12,00,000 12,00,000 12,00,000 12,00,000
- Interest 3,38,000 2,85,835 2,26,889 1,60,280 85,012
EBT 8,62,000 9,14,165 9,73,111 10,39,720 11,14,988
- Taxes @ 36% 3,10,320 3,29,100 3,50,320 3,74,300 4,01,396
Nl 5,51,680 5,85,065 6,22,791 6,65,420 7,13,592
+ Dep 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
CFBDR 7,51,680 7,85,065 8,22,791 8,65,420 9,13,592
-Principal Repaid 4,01,266 4,53,431 5,12,377 5,78,986 6,53,940
Cash Flow 3,50,414 3,31,634 3,10,414 2,86,434 2,59,652
Cushion
Equity 4,00,000 9,51,680 15,36,745 21,59,536 28,24,956 35,38,548
Debt 26,00,000 21,98,734 17,45,303 12,32,926 6,53,940 -----
Total Assets 30,00,000 31,50,414 32,82,048 33,92,462 34,78,896 35,38,548
% Debt 87% 70% 53% 36% 19% 0%
(CFBDR) - Cash flow before debt repayment.
430 Merger Acquisition and Restructuring

Leveraged Joint-venture
We have learnt that the leveraged buyouts have become increasingly
popular forms of acquisitions for management groups who intended to buy
private companies, divisions of public companies, or public companies in
going-private transactions. It is hardly ever used as an M&A device by the
publicly-held corporation. However, in situations where there are volatile
market conditions or where the transaction size is so huge that the
acquisition is apparently expensive and unaffordable, the LBO technique
can be used by public companies to make acquisitions that are otherwise
not possible. The use of leveraged joint venture as an M&A technique makes
this possible.
A leveraged joint-venture LBO attempts to overcome a major disadvantage
of a public company using an LBO to acquire a target company. The public
company, along with a passive financial partner can acquire the target
business through an LBO but does not have to show the related debt on
its balance sheet. It is still free to operate in the business, turn it around
and ultimately purchase and consolidate the entire operation when the debt
declines to a manageable level. A typical joint­ venture LBO is where one
partner is a publicly-owned corporation owning up to 50 per cent of the
acquired company’s voting stock and sometimes owns a large block of
preferred stock as well. The other passive partner is a leverage financing
buyout firm, or a investment bank, owning to the remainder of voting stock.
Sometimes the management of the acquired firm may also own some of the
common stock.
The acquired firm is usually managed and operated by the corporate
partner. A fee for the management services is paid to the corporate partner.

Leveraged Sell-out
A leveraged sell-out is a transaction which enables a company to raise
cash from the sale of one of its business units. The main difference
between the leveraged sell­out and a leveraged buyout transactions is that
the former transaction enables the seller to retain an interest in the equity
of the divested business.
When a company intends to sell 50 per cent or more of its holding in
its subsidiary, it can enter into an agreement with a financial partner (an
LBO fund or an investment bank) to restructure the subsidiary and obtain
the necessary buy-out financing. After the sale, both the corporate and the
financial partners own 50 per cent interest in the entity.

Divestment of Public Sector Enterprises - Indian Scenario

India’s public enterprises account for approximately 15 per cent of the
Gross Domestic Product (GDP) and 30 per cent of investment. The performance
of central public enterprises has been poor over the years and they place
a heavy burden on the Indian economy. Approximately 40 per cent of the
central public enterprises are constant loss-makers. The public enterprise
Leveraged Buy-out 431

sector requires a budget support of 0.5 per cent of the GDP. The present
rate of return on investment from the public enterprises is much lower than
that of private firms. Investments in the loss-making PSUs divert resources
from growth-enhancing public spending. The poor qualities of products and
the high cost of inputs, produced by public enterprises, is affecting India’s
industrial competitiveness. Their inefficiency is hampering growth, and
indirectly hindering the national effort to reduce poverty.
Meanwhile, over the period of time, the private sector companies did
well and performed better than firms in the public sector. The PSUs,
suffered losses due to various factors like inefficient management, inability
to adapt to the changing economic and market scenario and excessive
Government interference which prompted the Government to seriously
consider disposing them to the private players. These PSUs were constantly
incurring huge losses that necessitated the Government to step in time
and again with generous grants of funds from the Budget. The idea of
seriously disinvesting these PSUs cropped up around the late 1990s
when, in the midst of a severe economic crisis, the Government finally
decided that it was no longer feasible to continue providing ~ life-support
systems to them.
As on March 2001, the total Government investments in about 240
PSUs aggregated more than Rs. 1,10,000 crore. Of these, the profit-making
companies were around 120-130 in number while the others were all loss-
making, with the disease being acutely chronic and incurable in most
cases. This gave successive Finance Ministers a new topic to add to in their
annual Budget speeches ­ “Disinvestment of PSUs”. The main benefit from
disinvestment is that apart from unlocking investments in non-productive
assets, this amount can be productively utilised for investing in infrastructure
projects so that they lead to a higher growth in the economy. While the idea
raised a lot of hopes about the Government’s intention to exit from these
enterprises, hardly anything was done in this regard till the year 2000. The
progress of disinvestment in India has been a bit too slow considering the
giant strides that other developing countries made by transferring productive
assets to private investors, especially in infrastructure (power,
telecommunications and oil).

Current Status
A separate Disinvestment Commission was set up in 1996, by the then
Finance Minister, P Chidambaram and the same had been converted into
a full-fledged ministry with Arun Shourie as the then Divestment Minister,
to specifically identify the units for disinvestment in the public sector and
propose ways and means to sell them, either in part or in full to the private
players.
The Government finally made some concrete progress in the fiscal
2001-2002 by selling 51 per cent stake sale in Bharat Aluminum Company
(BALCO) to Sterlite Industries, despite strong opposition from the Chattisgarh
Government, 51 per cent stake in CMC to TCS, 74 per cent stake in
Hindustan Teleprinters to HFCL, 74 per cent stake in Paradeep Phosphates
432 Merger Acquisition and Restructuring

to Zuari Maroc Phosphates and a 25 per cent stake in Videsh Sanchar

Nigam Ltd. (VSNL) and around 34 percent stake in IBP to the Tata Group
and Indian Oil Corporation (IOCL) respectively. lt also managed to dispose
some of the hotel properties which were previously under the control of
Hotels Corporation of India (HCI). For the year 1999-2000 the Government
was able to sell only Modern Foods to Hindustan Lever Ltd., which netted
around Rs. 105 crore as against announcing its decision to garner Rs.
10,000 crore.
Some of the other PSUs lined up for disinvestment before in the fiscal
year 2002­2003 were Hindustan Zinc Ltd., IPCL, HPCL, some hotels of ITDc,
Mamti Udyog Ltd., JESSOPS and Hindustan Newsprint. Going by the flurry
of recent activities, the Government seems to be going in the right direction
while we can only hope that a good financial gain for these are not
sacrificed at the altar of serious political compulsions.

LBO and Corporate Governance

LBOs offer a useful format for effective governance of corporations.
They are not merely deals but represent an alternative model for corporate
ownership and control just as public ownership, venture capital ownership
and franchise arrangements. Temporary ownership by LBO firm can provide
an important bridge to better long term management and performance. LBO
model of ownership is quite adaptable to a wide business enterprise. The
unique aspect of LBO approach to ownership and governance is exemplified
by direct lines of communication between owners and top management,
managerial automony and willingness by owners to step in and direct
operations to solve chronic problems. Trust is built overtime in a variety of
ways including the alignment of intered through equity ownership and
incentive compensation.
In India, while attempting to put forward principles of best practice in
British Corporate Governance, the Cadbury Committee studied LBOs, venture
capital firms and relational investing (Warren Buffet) as different possible
models for best practices. Since LBOs are mainly seen as mere financial
transactions, their effect on governance is often ignored. But the fact is
finance and governance are closely related. Equity (corporate governance)
is a matter of constant negotiation. Debt and equity are not only two
different types of financial claims but represent alternative approaches to
check corporate performance and direct management governance. Equity
and debt are opposite ends of a range of potential governance management.
Debt is inflexible but leads to a simple and low cost administration while
equity is flexible and adoptive but complex and costly. The ideal form of
governance depends on the nature of the assets to be managed, the
transaction stream which these assets support and the growth opportunities.
A leveraged buyout (LBO) is one form of governance that is suitable for a
wide cross-section of business. It represents a young and still growing
organisational form in a market­ determined economy.
Leveraged Buy-out 433

Leveraged Buyouts in India

LBO financing is liked to emergy in India against the backdrop of the
Government. disinestment programme. The RBI neither prohibits nor
endorses M&A financing. Banks have lent money to some corporate which
have picked up public sector undertakings through dismiuestment route.
But this is more in nature of balance sheet financing, not leveraged buyout
financing. Indian banks have traditionally been doing either balance sheet
financing or assets based financing. Loan decisions are mainly taken on the
basis of the cash flow. In a leveraged buyout, a significant amount of
funding of the takeover of the controling interest in a company comes from
barrowed funds usually to 70% or more of the total purchase prise. As per
international buyout practies a torget company’s assets serve as aecurity
for the loans taken by the acquiring firm.The latter repays the loans out
of the cash flow of the acquired company through its profits or by selling
its assets. Globally many LBO have been financied through junk bonds, This
is not practics in India yet.
In the absence of clear rules governing M&A financing banks have gone
for assets financing. Deutsche Bank for instance part financed the Tata’s
acquisction of a 25% Government. holding in VSNL. The foueigh bank
undertook the buyout deal by placing debt instrument with mutual funds
and foreign institutional inves tors. The Tatas raised the required funds by
leveraging their own balance sheet. Generally, 3 fucture are considered for
LBO:
 As acquiring company must have the ability to borrow significant
sums againt its assets
 It should also be able to retain or attract a strong management team
and enhance value of each investment
 The ability of a company to support a LBO depends on whether it
can service the principal and intrest paymat obligations.
Traditionally, public sector banks have stayed away from M&A financing
because there are no clear guidelines for this. However, leveraged buyout
financing is likely to emerge in India against the backdrop of the government’s
divestment programme. Till a couple of years ago, banks were reluctant to
sponsor any Leveraged Buyout (LBO). But, as the divestments accelerated,
most banks have come forward to fund the acquisitions. Now banks have
realised that funding an acquisition of a running company is safer than
funding a new company. Unlike the foreign practice of funding based on the
acquiree balance sheet, in India, banks fund acquisitions relying on the
acquirer’s balance sheet and the cash flows that the company can receive
after the acquisition. The recent exemptions on the utilisation of the foreign
reserves raised in the form of External Commercial Borrowings (ECBs),
American Depository Receipts (ADRs) and Global Depository Receipts (GDRs),
have created a new channel of funds for the companies going for acquisition.
One instance of a leveraged buyout by an Indian company with international
funds is Tata Tea’s £271 million acquisition of Tetley.
434 Merger Acquisition and Restructuring

Due to the determined drive to big-ticket divestments from Arun Shourie,

most banks were open to the funding acquisitions, at least funding for the
PSUs being disinvested. Although so far the interest is only in PSU
disinvestment bankers say that the experience gained here could pave the
way for creating a formal system of financing takeovers even in the private
sector. The move by the RBI that loans for acquisitions of divested PSUs will
not come under the 5 per cent cap on exposure to loans against shares has
encouraged banks to provide loans for acquisitions. Among the domestic
players, ICICI has been the first to do such deals and has funded Sterlite
and Piramal in their acquisitions.

Warburg, Newbridge bid for Punjab Tractors

Public sector banks which have avoide this kind of financing with a few experence.
On the ofter hand foreign banks, which have the expertise and experence, have
taken the lead infinancing LBO. The Govt. has ruled that MNCs will have to bring
funds from abroad rather than raise money from local banks for acquisitions.

With financial investors like Warburg Pincus and Newbridge Capital joining the race
for the Punjab Tractors (PTL) stake, the deal could well be the first leveraged buy-out
(LBO) corporate India has ever seen.

The Punjab Government plans to sell 23.5 percent stake held by the Punjab State
Industrial Development Corporation in PTL.

So far, corporates in India have raised funds for buyouts by leveraging their own
balance sheets. The acquisition of a strategic stake in PTL, which would give the
successful bidder management control of the company, is expected to cost upward of
Rs. 650 crore, an amount most bidders would find hard to raise on the strength of
their own balance sheets.

The companies that have put in bids for PTL include Mahindra and Mahindra, Eicher,
Escorts, the Eicher Group, John Deere, TAFE, SAME Tractors and Ford New Holland.
Though Warburg Pincus and Newbridge are putting in independent bids, it is
understood that they may partner with successful bidders as financial investors in
the event of their own bids not being accepted.

The successful bidder for PTL will have to come out with open offers for two of PTL’s
associate companies as well- Swaraj Mazda and Swaraj Engines. PTL holds 34 per
cent in Swaraj Engines and 29 per cent in Swaraj Mazda. Under the SEBl’s takeover
code, the change in promoters in PTL will trigger off the open offer clause for the two
PTL associate companies. The successful bidder will also have to make an open offer
for a further 20 per cent in PTL, taking its stake to 43.5 per cent.

Investment bankers say Shipping Corporation of India (SCI) and Nalco are also strong
candidates for an LBO, given the cost of acquisition involved. While a strategic
investor in SCI would have to pay upwards of Rs. 1,000 crore, in the case of Nalco
it would be about Rs. 3,000 crore.

Source: www.ecollomictimes, December 7, 2002.

Leveraged Buy-out 435

Lenders have to evaluate whether the cash flows that accrue to the
acquirer after the purchases are enough to repay the debt raised for the
takeover. The cash flows could arise out of forward integration of the
acquired company or by way of dividend. All this requires heavy financial
structuring. For this reason, the target company’s cash flows, debt profile,
shareholding pattern, etc., are to be understood properly. Hence, LBOs can
be selectively used in PSUs, which have low leverages in their capital
structure. Bank of Dnerica financed Guyarat Dombuya for acquiring DLF
cement and also funded rfrasim for acquiring the brand of costs viyela. But
such M&A financing deals are few. The only financial institution taking
some interstist in funancing M&A deals is ICICI. The French cement major,
laforge peutly fincnced its takeover of TISCOS cement dicision through
loans from DCICI and HDFC. Meanwhile laforge is planning to part finance
its acquistion of Raymond’s cement division through domestic loans. After
all money is fungible. So, Banks and FIs should provide financial assistance
to campories for various purposes and LBO is vertainly one economic
purpose which needs funding.
Multiple Choice Questions
(1) Which of the following terms is given to an acquisition of all the
stock or assets of a previously public company by a small group of
investors financed largely by borrowing?
(a Going Private.
(b) Management Buy-out.
(c) Management Buy-in.
(d) Leveraged Recapitalisation.
(e) Leveraged Buyout.
(2) A division or subsidiary of a public corporation acquired from the
parent company by a purchasing group led by an executive of the
parent company or members of the unit’s management is called the:
(a) Leveraged Buyout.
(b) Going Private.
(c) Management Buyout.
(d) Management Buy-in.
(e) None of the above.
(3) In which of the following types of LBO transactions do target
shareholders simply sell their stock and all interests in the target
corporation to the buying group?
(a) Asset Purchase Format.
(b) Stock Purchase Format.
(c) Cash Purchase Format.
436 Merger Acquisition and Restructuring

(d) Both (a) and (c) above.

(e) All of the above.
(4) LBO is a purchase aprinate company with
(a) Borrowed fund (b) capital funds
(c) Own funds (d) all of above
(e) None of above
(5) When company managers acquire a large part of the company it is
called
(a) MBI (b) MBO
(c) LBO (d) all of above
(e) None of above
(6) Leveraged Buyout is Undertaken by
(a) Stock purchase format (b) Assets purchase format
(c) Both (i) and (ii) above (d) Either (i) or (ii) above
(e) None of above
(7) Investor in LBOs are referred to as financial buyers who hold their
investment for
(a) 3 to5 years (b) 5 to7 years
(c) 7 to 9 years (d) 9 to11 years
(e) 11 to 13 years
(8) Temporary ownership by an LBO firm can provide an important
bridge to better long term:
(a) Management (b) Performance
(c) Both (i) and (ii) (d) Either(i) or (ii)
(e) None of above
(9) LBO represents bonding activity of
(a) Debt (b) Equity
(c) Debt and Equity (d) Debt or Equity
(e) None of above
10 The Purchase Price in LBOs should be slightly above than
(a) Debt (b) Equity
(c) Book (d) Preferance
(e) Debenture
Leveraged Buy-out 437

(11) In a LBO, a significant amount of the takeover of the controlling

interest comes from
(a) Own found (b) Mutal fund
(c) Capital fund (d) Borrowed fund
(e) All of above
(12) LBO financing is likely to emerge in India against the backdrop of
the Goverments
(a) Investment Programme (b) Disinvestment Programme
(c) Economic Program (d) All of above
(e) None of above
(13) In a Management Buy In; a new management team replaces the
(a) Incumbent Management (b) Indumbent Mmanagement
(c) Inccummbent Management (d) Incumbbent Management
(e) Incumbennt Management
(14) Disinvestment in a recession tends to be dedensive and driven by
rationalisation and cost cutting whereas in boomtime they are
triggrred by strategic
(a) Replacement (b) Replanning
(c) Restructuring (d) All of above
(e) None of above
(15) Senior debt has priority in payment of
(a) Interest (b) Principal
(c) Interest and Principal (d) Intrest or Principal
(e) None of above
(Answer1) e; 2) c; 3) b; 4) a, 5) b; 6) d;
7) b; 8) c; 9) a, 10) c; 11) d; 12) b,
13) a; 14) c; 15) c.)
Theory Questions:
(1) Explain the concept of LBO and state how it is undertaken
(2) How is LBO an alternative model for Corporate Governance?
(3) Explain different stages of LBO operation
(4) Discuss the methodlogy of financing LBOs and with partucular
reference to India
(5) Explain the managerial motinations of an MBOs
(6) Explain the development stages of LBOs since 1950 with examples
438 Merger Acquisition and Restructuring

(7) What do you mean by MBO?; Explain its benefit

(8) Discuss the structure of an MBO in details
(9) Describe different elements of a LBO operation
(10) Explain Financing aspect of LBO indetail
(11) Write different characteristics of an Ideal LBO candidates
(12) Discuss different sources of gains in LBOs
(13) Distinguish between MBOs and MBIs
(14) Explain different types of LBO risk and its failure
(15) Explain leveraged cashouts with suitable Illustration

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