1. Prof. Ian Giddy New York University Structuring LBO Financing

2. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 2 Leveraged Buy-Outs LBO is a transaction in which an investor group acquires a company by taking on an extraordinary amount of debt, with plans to repay the debt with funds generated from the company or with revenue earned by selling off the newly acquired company's assets l Leveraged buy-out seeks to force realization of the firm’ potential value by taking control (also done by proxy fights) l Leveraging-up the purchase of the company is a "temporary" structure pending realization of the value l Leveraging method of financing the purchase permits "democracy" in purchase of ownership and control--you don't have to be a billionaire to do it; management can buy their company.

3. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 3 Leveraged Financing Leveraged Finance is the provision of bank loans and the issue of high yield bonds to fund acquisitions of companies or parts of companies by l an existing internal management team (a management buy-out), l an external management team (a management buy-in), or l a third party (a leveraged acquisition).

4. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 4 M&A and Leverage n Leveraged buyout? Company has unused debt capacity n Leveraged recapitalization? n Takeover?

5. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 5 Corporate Restructuring l Divestiture—a reverse acquisition—is evidence that "bigger is not necessarily better" l Going private—the reverse of an IPO (initial public offering)—contradicts the view that publicly held corporations are the most efficient vehicles to organize investment.

6. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 6 Going Private A public corporation is transformed into a privately held firm l The entire equity in the corporation is purchased by management, or managment plus a small group of investors l These account for about 20% of public takeover activity in recent years in the United States. l Can be done in several ways :  "Squeeze-out"—controlling shareholders of the firm buy up the stockholding of the minority public shareholders  Management Buy-Out—management buys out a division or subsidiary, or even the entire company, from the public shareholders  Leveraged Buy-Out (LBO)

7. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 7 LBOs, Agency Costs and Free Cash Flow l "Free cash flow" is cash-cow type earnings in excess of amounts required to fund all positive-NPV projects l Payout of free cash flow, to stockholders, reduces the amount of resources under managment's discretion. Forces management to go out into the markets and justify raising funds l Thus debt has a disciplining role. “Safe” managers choose less debt.

8. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 8 Seagate 1. Show, with a diagram, the restructuring that resulted in the Seagate LBO 2. How would the buyers create value? 3. How would they realize that value?

9. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 9 Seagate 1998 SEAGATE VERITAS 40% for $1.8b

10. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 10 Seagate 2000 SEAGATE VERITAS 40% worth $22b 100% worth $16b Seagate shareholders Distribution taxable at 39.2%?

11. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 11 Seagate Nov 2000 VERITAS Seagate shareholders SEAGATE Disk drive business 109m Veritas shares (worth $18.7b) NEWCO 128m Veritas shares (worth $22b) $2b cash Management, Chase, Goldman Silver Lake Partners Cost $1.65b after tax

12. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 12 Seagate NEWCO Disk drive business Equity $1b Debt $1b Management, Chase, Goldman

13. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 13 Typical LBO Sequence Company gets bloated or slack and stock price falls LBO offer made LBO completed Restructuring  Efficiencies  Divestitures  Financial ? years3-9 months5-7 years IPO or sale of company

14. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 14 Can the Financing Work?

15. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 15 Can the Financing Work?

16. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 16 LBO Financing NEWCO Disk drive business Equity $0.25b Senior debt $1b What securities? What returns? What investors? Mezzanine

17. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 17 The Financing Spectrum Expected Return Risk Senior secured debt Equity Senior unsecured debt Subordinated debt Preferred equity Convertible debt

18. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 18 What Are The Alternatives? l Asset-backed or cash flow-backed debt l Senior debt l Subordinated debt l Subordinated debt with upside participation l Subordinated debt with equity option l Preferred equity l Restricted shares l Common stock

19. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 19 Subordinated High Yield Debt l “Junk bonds” – like equity, but allow increased financial leverage l Tax advantage over equity l Big market in USA (institutional investors) and increasing in Europe l Leveraged loans favored by certain commercial banks l Often used in connection with M&A and LBOs l Behave like equity – and often have equity participation

20. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 20 Sub Debt -- Motivations l Optimization of financial leverage l Regulatory-driven capital requirements l Rated asset securitizations (senior-sub structure in asset-backed securities) l Insider or supplier-credit subordination (eg in project finance) l Work-outs and restructurings (existing borrowers agree to seniority of new loans, to buy time)

21. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 21 Sub Debt’s Big Problem: High Interest! Solutions l Deep discount subordinated debt l Subordinated debt with equity warrants l Convertible subordinated debt l Participating subordinated debt l Puttable subordinated debt

22. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 22 Convertibles Conversion Value Straight Bond Value Market Value Market Premium V a l u e o f C o n v e r t i b l e B o n d ($) 0 Price Per Share of Common Stock

23. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 23 Warrants Theoretical Value Market Value Market Premium V a l u e o f W a r a n t ($) 0 Price Per Share of Common Stock ($)

24. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 24 Preferred Equity l Legally a form of equity l Claim senior to ordinary equity l May have fixed dividend, or may be “participating” l But cannot trigger liquidation if payment missed l Par value determines liquidation claim

25. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 25 Convertible Preferred l Used by venture capital firms l Permit investors to participate in growth l But give preference in liquidation if the venture fails l And disguise share value (tax!) l A variant – PERCS* give issuer right to convert into common stock *Preferred equity redemption cumulative stock

26. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 26 Preferred Stock: Pros and Cons Advantages l No dilution of control l Dividends conditional on availability of earnings l Omission cannot force liquidation Disadvantages l Higher after-tax cost than debt l Lower return on equity l Limited investor interest

27. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 27 Motivations for Issuing Hybrid Bonds l Company has a view l There are constraints on what the company can issue l The company can arbitrage to save money l Always ask: given my goal, is there an alternative way of achieving the same effect (e.g., using derivatives?)

28. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 28 Why Use a Hybrid? Motivations for Hybrids Linked to business risk Linked to market risk Cannot hedge with derivatives Driven by investor needs Company hedges Company does not hedge Debt or equity are Not good enough

29. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 29 Case Study: Le Meridien l What kind of financing package would enable Royal Bank to beat other commercial and investment banks in the Meridien deal? Who are potential rivals, and what strengths might give them a competitive edge? l If RBS offers sale-and-leaseback financing, what should be the structure and terms of the deal, terms that make sense for the client as well as for the bank? l If RBS offers equity participation, what form should this take? Common stock or mezzanine finance? Or should the bank avoid the risks of an equity investment? l Would asset-backed securities be suitable as a financing source for this acquisition?

30. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 30 Case Study l The John Case LBO Proposal l Devise a recommended financing plan John Case (owner) BuyersVC Investors

34. Copyright ©2002 Ian H. Giddy Corporate Financial Restructuring 34 Contact Info Ian H. Giddy NYU Stern School of Business Tel 212-998-0426; Fax 212-995-4233 Ian.giddy@nyu.edu http://giddy.org