Mergers and acquisitions

1. LBO – Leveraged Buy out
• Borrowed funds used to pay for all or most of the purchase
price of the acquisition of the company
• In a typical LBO, a group of investors purchase an
underperforming firm by raising an unusually large amount of
debt relative to the equity
• Investors could be firm’s managers with P.E. players and a
Venture Capital firm
• The strategy is to restructure the firm, improve its
performance and increase the cash flows in order to repay a
large part of the initial debt within a certain amount of time
• It is also a kind of a Arbitrage operation since one buys an
undervalued company improves its short term performance
and then selling it at a higher price

2. • Investors in LBOs are Financial investors
• LBO firms are generally taken to the public or
divested to corporate buyer
Typical Capital structure – a) Senior Bank debt
(secured by target’s assets )
b) Subordinated (Unsecured debt )
c) Preference stock
Common stock / equity

3. • In recent times a few common strategies have
evolved :
High technology buyouts
Joint venture LBOs in which the buyout specialist
shares equity ownership with a strategic buyer
Consortium buyouts where several PE firms buy
out target
PIPE – Private equity firms take minority stake in
Public Listed companies

4. • LBOs are either asset based or cash flow based
• Asset based ones – sale of assets by the target to the
acquiring company or merger of the target into the
acquiring company or into a W.O.S. of the acquiring
company
• Starts with a LOI between buyer and seller
• Acquirer is asked for a Commitment letter from a
recognized lender for loans required to fund the acquisition
• This letter allows the lender to have access to the target
company’s records for credit evaluation
• Closing is conditioned upon the acquirer’s ability to obtain
financing

5. • A properly structured LBO should have a Balance Sheet
that indicates solvency at the time of the closing
• Cash flows should be enough and Off-balance sheet
items cash impact needs to be quantified and included
in the projections
• Important feature in a LBO is the SPV
• Here the acquiring company could float a SPV which is
a 100 % subsidiary with a minimum equity capital
• This SPV leverages this equity to gear up significantly
higher debt to buyout the target company
• This debt is paid off by the SPV thru the target
company’s own cash flows

6. • MBOs – Special type of LBO which occurs
when the management of a company decides
to take over its publicly held company or a
division of the company and consequently
make it private
• To convince stockholders to sell managers
must be able to offer them a premium above
the current market price

7. • Reasons for an MBO – a) Opportunity to
control own business
B) Long term faith in the company
C) Better financial rewards
D) Opportunity to develop own talent
E) Absence of HO constraints
F) Fear of redundancy

8. • Process of a LBO – a) Decision to divest
b) Decision to purchase – managers of the division attempt to buyout
c) Financial analysis of division – book value, liquidation value,
replacement value of assets
d) Determination of purchase price
e) Investment by the division management
f) Group of investors – lenders put together for providing finance for
the LBO
g) External equity investment – done in conjunction with the division
management , investors, cash flow analysis
h) Cash flow analysis
i) Financing is committed

9. • Features of a LBO candidate –
 Stable cash flows
 Stable management
 Scope for cost reduction
 Equity interest of owners – act as a cushion to protect the lenders
 Debt capacity – lower the debt on the Balance sheet of the firm,
greater may be the borrowing capacity of the firm
 Non core business – if this can be sold to pay off a large part of the
firm’s post LBO debt, it is easier to finance such a deal
 Intangible factors – Dynamic, innovative and growing co. is
preferable

10. • Major sources of target companies –
Family run (sale) of private companies
Divestiture of SBUs by large companies
Conversion of public company to private
company
Bankruptcy

11. • Financial and Risk evaluation – An LBO
transaction makes sense when the Present
value (PV) of the FCF (Future Cash flows) to
the firm – (PV fcff) discounted at the WACC
equals to exceeds the total of the investment
comprising Id (Debt), Ie (Common equity), Ip
(Preference stock) i.e.
• ((PV fcff – (Id+Ie+Ip)) >= 0

12. LIST OF BUYOUTS BY INDIAN COMPANIES
Acquirer
Company
Target
Company Country of Target
Deal Size
Dr. Reddy's Lab. Betapharm Arzneimittel Germany USD 570 mn
Suzlon Energy EVE Holding Belgium USD 565 mn
Tata Coffee Eight o'clock coffee USA USD 220 mn
Tata Steel Corus Anglo-Dutch USD 12.9 billion
UB Group Whyte & Mackay Glasgow 270 mn Sterling

13. • In an LBO it is possible to do justice to the common equity investors but
not to other investors like debt, preference
• An LBO deal makes sense to common equity investors if the PV of the
FCFE exceeds the value of the equity investment in the deal and the PV of
FCFF exceeds the total cost of the deal, equity plus debt and preferred
stock
• These conditions suggest that the firm has achieved returns which exceed
the minimum returns required by equity investors as well as debt and
preferred stock holders
• Hierarchy of funding / financing alternatives –
1. Senior Debt (Secured by firm’s assets – Accounts receivable, fixed assets)
2. Mezzanine financing – unsecured
3. Junior debt / subordinated debt
4. Equity

14. Case Study – Tata Corus
• On Jan 30 2007 Tata Steel acquired 100 % stake in Anglo-
Dutch steelmaker at 608 pence per share (cumulatively
valued @ US $ 12.9 billion)
• It was a all-cash deal
• Motivation – Tata steel may become the world’s 5 th largest
steel manufacturer from 56 th.
• Some of the synergies which were present between Tatas and
Corus were : - i) Corus was facing a situation of high costs due
to inc. raw material prices and Tata was one of the lowest
cost steel producers of the world
ii) Expectation of technology transfer and R & D capabilities
iii)Strong cultural fit between two organizations

15. • For acquisition purposes a SPV, a wholly owned subsidiary
called Tata Steel UK was set up by Tata Steel.
• Tata Steel appointed Credit Suisse, ABN Amro and Deutsche
Bank to arrange bridge financing
• Sources of finance for the acquisition – a) Equity capital (Tata
Steel) – USD 4.10 billion
B) Long term debt from a Consortium of banks – USD 6.14 billion
C) Quasi-Equity funding at Tata Steel Asia Singapore – USD 1.25
billion
D) Long term capital funding at Tata Steel Asia Singapore – USD
1.41 billion

16. • Post acquisition in 2011 the company started deleveraging. It repaid Rs.
4200 crores of borrowings
• In the same year there was reduction in interest on term loans arising out
of repayments
• Also the D/E went up from 0.84 in 2006-07 to 1.55 in 2010-11
• Int. coverage ratio went down from 16.38 in 2006-07 to 4.58 in 2010-11
• Corus (Europe) continued to do well in 2011 despite a domestic slowdown
in India
• Conclusion – i)LBOs essentially magnifies returns to shareholders and
reduces WACC as interest is tax deductible
ii) It could also add to the risk if in case the company is not able to pay
interest & principal, in such cases the LBO may fail and the company may
go bankrupt if the cash flows are insufficient to meet the interest
payments