1. Financing the Deal: Private Equity, Hedge Funds, and Other Sources of Financing

2. No one spends other people’s money
as carefully as they spend their own.
—Milton Friedman

3. Part IV: Deal Structuring and Financing
Exhibit 1: Course Layout: Mergers, Acquisitions, and Other
Restructuring Activities
Part IV: Deal Structuring and Financing
Part II: M&A Process
Part I: M&A Environment
Ch. 11: Payment and Legal Considerations
Ch. 7: Discounted Cash Flow Valuation
Ch. 9: Financial Modeling Techniques
Ch. 6: M&A Postclosing Integration
Ch. 4: Business and Acquisition Plans
Ch. 5: Search through Closing Activities
Part V: Alternative Business and Restructuring Strategies
Ch. 12: Accounting & Tax Considerations
Ch. 15: Business Alliances
Ch. 16: Divestitures, Spin-Offs, Split-Offs, and Equity Carve-Outs
Ch. 17: Bankruptcy and Liquidation
Ch. 2: Regulatory Considerations
Ch. 1: Motivations for M&A
Part III: M&A Valuation and Modeling
Ch. 3: Takeover Tactics, Defenses, and Corporate Governance
Ch. 13: Financing the Deal
Ch. 8: Relative Valuation Methodologies
Ch. 18: Cross-Border Transactions
Ch. 14: Valuing Highly Leveraged Transactions
Ch. 10: Private Company Valuation

4. Learning Objectives
Primary Learning Objective: To provide students with a knowledge of how M&A deals are financed and the role of private equity and hedge funds in this process.
Secondary Learning Objectives: To provide students with a knowledge of
Advantages and disadvantages of LBO structures;
How LBOs create value;
Leveraged buyouts as financing strategies;
Factors critical to successful LBOs; and
Common LBO capital structures.

5. How are M&A Transactions Commonly Financed?
Borrowing Options:
Asset based or secured lending
Cash flow or unsecured lenders (senior and junior debt)
Long-term financing (junk bonds, leveraged bank loans, convertible debt)
Bridge financing
Payment-in-kind

6. Financing M&As: Borrowing Options
Alternative Forms of Borrowing
Type of Security
Backed By
Lenders Loan Up to
Lending Source
Secured Debt
Short-Term (<1Yr.)
Intermediate Term
(1-10 Yrs.)
Liens generally on receivables and inventory
Liens on Land and Equipment
50-80% depending on quality
Up to 80% of appraised value of equipment; 50% of real estate
Banks, finance and life insurance companies; private equity investors; pension and hedge funds
Unsecured Debt (Subordinated incl. seller financing)
Bridge Financing
Payment-in-Kind
Cash generating capabilities of the borrower
Life insurance companies, pension funds, private equity and hedge funds;
target firms

7. Financing M&As: Equity Options
Alternative Forms of Equity
Equity Type
Backed By
Investor Types
Common Stock
Cash generating capabilities of the firm
Life insurance companies, pension funds, hedge funds, private equity, and angel investors
Preferred Stock
--Cash Dividends
--Payment-in-Kind
Same as above

8. Financing M&As: Seller Financing
Seller defers a portion of the purchase price
Advantages to seller:
Buyer may be willing to pay seller’s asking price since deferral will reduce present value
Makes sale possible when bank financing not available (e.g., )
Advantages to buyer:
Shifts operational risk to seller if buyer defaults on loan
Enables buyer to put in less cash at closing

9. Financing M&As: Cash on Hand and Selling Redundant Assets
“Cash on hand” represents cash in excess of normal operating requirements on the acquirer or target’s balance sheet.
Target’s excess cash can be used to buy target firm’s outstanding shares.
Redundant assets are those owned by the acquirer or target firm that are not considered germane to the acquirer’s business strategy.

10. Financial Buyers/Sponsors
In a leveraged buyout, all of the stock, or assets, of a public or private corporation are bought by a small group of investors (“financial buyers aka financial sponsors”), often including members of existing management and a “sponsor.” Financial buyers or sponsors:
Focus on ROE rather than ROA.
Use other people’s money.
Succeed through improved operational performance, tax shelter, debt repayment, and properly timing exit.
Focus on targets having stable cash flow to meet debt service requirements.
Typical targets are in mature industries (e.g., retailing, textiles, food processing, apparel, and soft drinks)

11. Role of Private Equity and Hedge Funds in Deal Financing
Financial Intermediaries
Serve as conduits between investors/lenders and borrowers
Pool resources and invest/lend to firms with attractive growth prospects
Lenders and Investors of “Last Resort”
Buyers of about one-half of private placements
Source of funds for firms with limited access to credit markets
Providers of Financial Engineering1 and Operational Expertise for Target Firms
Leverage drives need to improve operating performance to meet debt service
Improved operating performance enables firm to increase leverage
Private equity owned firms survive financial distress better than comparably leveraged firms
Pre-buyout announcement date shareholder returns often exceed 40% due to investor anticipation of operational improvement and tax benefits
Post-buyout returns to LBO shareholders exceed returns on S&P 500 due to improved operating performance (better controls, active monitoring, willingness to make tough decisions)
1Financial engineering describes the creation of a viable capital structure that magnifies financial returns to equity investors.

12. Leveraged Buyouts (LBOs)
Finance a substantial portion of the purchase price using debt.
Frequently rely on financial sponsors for equity contributions
Target firm management often equity investors in LBOs
Management buyouts (MBOs) are LBOs initiated by management

13. LBOs As Financing Strategies
LBOs are a commonly used financing strategy employed by private equity firms to acquire targets using mostly debt to pay for the cost of the acquisition
Target firm assets used as collateral for loans
Most liquid assets collateralize bank loans
Fixed assets secure a portion of long-term financing
Post-LBO debt-to-equity ratio substantially higher than pre-LBO ratio due to debt incurred to buy shares from pre-buyout private or public shareholders
Debt-to-equity ratio also may increase even if pre-and post-LBO debt remains unchanged if the target’s excess cash and the proceeds from sale of target assets used to buy out target shareholders (Why? Assets decline relative to liabilities shrinking the target’s equity)

14. Impact of Leverage on Financial Returns
Impact of Leverage on Return to Shareholders
All-Cash
Purchase
($Millions)
50% Cash/50%
Debt
20% Cash/80%
Purchase Price
$100
Equity (Cash Investment by Financial Sponsor)
$50
$20
Borrowings
$80
Earnings Before Interest and Taxes (EBIT)
10%1 $5 $8
Income Before Taxes
$15
$12
Less Income 40% $6
$4.8
Net Income $9
$7.2
After-Tax Return on Equity (ROE)2
12%
18%
36%
1Tax shelter in 50% and 20% debt scenarios is $2 million (I.e., $5 x .4) and $3.2 million (i.e., $8 x .4), respectively.
2If EBIT = 0 under all three scenarios, income before taxes equals 0, ($5), and ($8) and ROE after tax in the 0%, 50% and 80% debt scenarios = $0 / $100, [($5) x (1 - .4)] / $50 and [($8) x (1 - .4)] / $20 = 0%, (6)% and (24)%, respectively. Note the value of the operating loss, which is equal to the interest expense, is reduced by the value of the loss carry forward or carry back.

15. LBO’s Impact of Target Firm Employment, Innovation, and Capital Spending
Net reduction in employment at firms several years after undergoing LBOs is 1%
Employment at target firms declines about 3% in existing operations compared to other firms in the same industry
But employment at new ventures increases about 2%
Employment at private firms may increase
LBOs often increase R&D and capital spending relative to peers
Operating performance particularly for private firms undergoing LBOs improves significantly due to increased access to capital

16. Discussion Questions
Define the financial concept of leverage. Describe how leverage may work to the advantage of the LBO equity investor? How might it work against them?
What is the difference between a management buyout and a leveraged buyout?
What potential conflicts might arise between management and shareholders in a management buyout?

17. LBO Advantages and Disadvantages
Advantages include the following:
Management incentives,
Better alignment between owner and manager objectives (reduces agency conflicts),
Tax savings from interest expense and depreciation from asset write-up,
More efficient decision processes under private ownership,
A potential improvement in operating performance, and
Serving as a takeover defense by eliminating public investors
Disadvantages include the following:
High fixed costs of debt raise the firm’s break-even point,
Vulnerability to business cycle fluctuations and competitor actions,
Not appropriate for firms with high growth prospects or high business risk, and
Potential difficulties in raising capital.

18. How LBOs Create Value Factors Contributing to LBO Value Creation
Buyouts of Public Firms
Buyouts of Private Firms
Key Factor: Alleviating Agency Problems
Key Factor: Provides Access to Capital
Factors Common to LBOs of Public and Private Firms
Deferring Taxes
Debt Reduction
Operating Margin Improvement
Timing of the Sale of the Firm

19. Reinvestment Adds to Free Cash Flow by Improving Operating Margins
LBOs Create Value by Reducing Debt and Increasing Margins Thereby Increasing Potential Exit Multiples
Firm Value
Year Year Year Year Year Year Year 7
Debt Reduction & Reinvestment Increases Free Cash Flow and In turn Builds Firm Value
Debt Reduction
Reinvest in Firm
Debt Reduction Adds to Free Cash Flow by Reducing Interest & Principal Repayments
Reinvestment Adds to Free Cash Flow by Improving Operating Margins
Free Cash Flow
Tax Shield Adds to Free Cash Flow
Tax Shield1
Year Year Year Year Year Year Year 7
1Tax shield = (interest expense + additional depreciation and amortization expenses from asset write-ups) x marginal tax rate.

20. LBO Value is Maximized by Reducing Debt, Improving Margins, and Properly Timing Exit
Case 1:
Debt Reduction
Case 2:
Debt Reduction + Margin Improvement
Case 3:
Debt Reduction + Margin Improvement + Properly Timing Exit
LBO Formation Year:
Total Debt
Equity
Transaction/Enterprise Value
$400,000,000
100,000,000
$500,000,000
Exit Year (Year 7) Assumptions:
Cumulative Cash Available for
Debt Repayment1
Net Debt2
EBITDA
EBITDA Multiple
Enterprise Value3
Equity Value4
$150,000,000
$250,000,000
$100,000,000
7.0 x
$700,000,000
$450,000,000
$185,000,000
$215,000,000
$130,000,000
$910,000,000
$695,000,000
8.0 x
$1,040,000,000
$825,000,000
Internal Rate of Return
24%
31.2%
35.2%
Cash on Cash Return5
4.5 x
6.95 x
8.25 x
1Cumulative cash available for debt repayment increases between Case 1 and Case 2 due to improving margins and lower interest and principal repayments reflecting the reduction in net debt.
2Net Debt = Total Debt – Cumulative Cash Available for Debt Repayment = $400 million - $185 million = $215 million
3Enterprise Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year
4Equity Value = Enterprise Value in 7th Year – Net Debt
5The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return, because it accounts for the time value of money.

21. Common LBO Deal Structures
Direct merger: Target firm merged directly into the firm controlled by the financial sponsor
Subsidiary merger: Target firm merged into a acquisition subsidiary wholly-owned by the parent firm which in turn is controlled by the financial sponsor
A reverse stock split: Used when a firm is short of cash to reduce the number of shareholders below 300 which forces delisting of the firm from public exchanges. Majority shareholders retain their shares after the reverse split reduces the number of shares outstanding; minority shareholders receive a cash payment.

22. Direct Merger Target Firm Target Firm Shareholders Lender
Financial Sponsor (Limited Partnership Fund)
Equity Contribution
Target Merges with Acquirer
Acquirer
(Controlled by Financial Sponsor)
Target Firm
Loan
Target Stock
Lender
Target Firm Shareholders
Acquirer Cash and Stock

23. Subsidiary Merger Financial Sponsor Limited Partnership Fund
Equity Contribution
Parent
(Controlled by Financial Sponsor)
Target Firm
Merger Sub Shares
Merger Sub Merges Into Target
Equity Contribution
Loan Guarantee
Merger Sub Cash & Shares
Lender
Merger Sub
Target Firm Shareholders
Loan
Target Firm Shares

24. Typical LBO Capital Structure
Common Equity (10%)
Equity (25%)
Preferred Equity (15%)
Purchase Price
Revolving Credit (5%)
Term Loan A
Debt (75%)
Senior Secured Debt (40%)
Term Loan B
Term Loan C
2nd Mortgage Debt
Sub Debt/Junk Bonds (30%)
Mezzanine Debt & PIK

25. Case Study: Cox Enterprises Takes Cox Communications Private
In an effort to take the firm private, Cox Enterprises announced a proposal to buy the remaining 38% of Cox Communications’ shares not currently owned for $32 per share. Valued at $7.9 billion (including $3 billion in assumed debt), the deal represented a 16% premium to Cox Communication’s share price at that time. Cox Communications is the third largest provider of cable TV, telecommunications, and wireless services in the U.S, serving more than 6.2 million customers. Historically, the firm’s cash flow has been steady and substantial.
Cox Communications would become a wholly-owned subsidiary of Cox Enterprises and would continue to operate as an autonomous business. Cox Communications’ Board of Directors formed a special committee of independent directors to consider the proposal. Citigroup Global Markets and Lehman Brothers Inc. committed $10 billion to the deal. Cox Enterprises would use $7.9 billion for the tender offer, with the remaining $2.1 billion used for refinancing existing debt and to satisfy working capital requirements.
Cable service firms have faced intensified competitive pressures from satellite service providers DirecTV Group and EchoStar communications. Moreover, telephone companies continue to attack cable’s high-speed Internet service by cutting prices on high-speed Internet service over phone lines. Cable firms have responded by offering a broader range of advanced services like video-on-demand and phone service. Since 2000, the cable industry has invested more than $80 billion to upgrade their systems to provide such services, causing profitability to deteriorate and frustrating investors. In response, cable company stock prices have fallen. Cox Enterprises stated that the increasingly competitive cable industry environment makes investment in the cable industry best done through a private company structure.
Discussion Questions:
1. What is the equity value of the proposed deal?
Why did the board feel that it was appropriate to set up special committee of independent board directors?
Why does Cox Enterprises believe that the investment needed for growing its cable business is best done through a private company structure?
Is Cox Communications a good candidate for an LBO? Explain your answer.
How would the lenders have protected their interests in this type of transaction? Be specific.

26. Things to Remember…
M&As commonly are financed through debt, equity, and available cash on balance sheet or some combination.
LBOs make the most sense for firms having stable cash flows, significant amounts of unencumbered tangible assets, and strong management teams.
Successful LBOs rely heavily on management incentives to improve operating performance and a streamlined decision-making process resulting from taking the firm private.
Tax savings from interest and depreciation expense from writing up assets enable LBO investors to offer targets substantial premiums over current market value.
Excessive leverage and the resultant higher level of fixed expenses makes LBOs vulnerable to business cycle fluctuations and aggressive competitor actions.