Lecture 6
Going Private and Leveraged Buyouts
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Introduction
Going private — transformation of a public corporation into a privately held firm
Leverage buyout (LBO) — purchase of a company by a small group of investors using a high percentage of debt financing
Investors are outside financial group or managers or executives of company
Management buyout (MBO) — leveraged buyout performed mainly by managers or executives of the company
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Results in significant increase of equity share ownership by managers
Turnaround in performance is usually associated with formation of LBO
Typical LBO operation
Financial buyer purchases company using high level of debt financing
Financial buyer replaces top management
New management makes operating improvements
Financial buyer makes public offering of improved company at higher price than originally purchased
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Characteristics of Leveraged Buyouts
Leverage buyout activity
Reached peak during 1986-1989
Largest LBO was RJR Nabisco in 1988 with purchase price of $ million
Total purchase price of 20 largest LBOs formed during 1983-1995 was $ billion
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Buyout group may include incumbent management and may be associated with
Buyout specialists, ., Kohlberg Kravis Roberts & Co.
Investment bankers
Commercial bankers
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Management buyouts (MBOs)
Investor group dominated by incumbent management
Segment acquired from parent company
LBO transaction may be reversed with future public offering
Aim is to increase profitability of company and thereby increase market value of firm
Buyout group seeks to harvest gain within three- to five-year period
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Three Major Stages of Leveraged Buyouts
The 1980s
Economic and financial environments favorable to M&A activity and LBOs
For 1986-1989,
LBO activity reached peak
LBOs accounted for % of total dollar value of completed mergers
Premiums paid were at highest levels — mean of % and median of %
Price earning ratios paid — mean of
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Early 1990s
LBOs declined from peak total of $ billion in 1989 to $ billion in 1991
Decline due to
Economic and legislative changes
Unsound LBO transactions of late 1980s
For 1990-1992,
LBOs accounted for % of total dollar value of completed mergers
Sharp decline in relative premiums paid — mean of % and median of %
Sharp decline in price earning ratios paid — mean of
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Post-1992
LBOs reached $ billion in 1999
Revival of LBOs due to new developments in nature of LBO transactions and market participants
For 1993-1998,
LBOs accounted for % of total dollar value of completed mergers
Relative premiums paid for LBOs slightly below 1986-1989 levels — mean of % and median of %
Price earning ratios paid — mean of
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LBOs in the 1980s
Characteristics
Debt financing
Highly leveraged — up to 90% of purchase price
Debt secured by assets of acquired firm or based on expected future cash flows
Paid off either from sale of assets or from future cash flows generated by operations
Acquired company became privately held
Firm expected to go public again after three to five years
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General economic and financial factors
Same as factors stimulating mergers
Sometimes LBOs and MBOs were responses to threat of unwanted takeovers
Sustained economic growth between 1982-1990
Earlier inflation
GNP implicit price deflator during 1968-1982 increased by no less than 5%
Caused q-ratio to decline sharply — cheaper to buy capacity in financial markets than in real asset markets
Provided opportunities to realize tax savings through recapitalization
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Financing innovations — high-yield bonds (junk bonds) made public financing available to companies below investment grade
Legislative factors, especially taxes
Succession of laws that deregulated financial institutions
Economic Recovery Tax Act (ERTA) of 1981
General Utilities doctrine
Legislative changes affecting ESOPs — encouraged MBOs
Change in antitrust climate - beginning in 1980
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Elements of a typical LBO operation
First stage — raise cash required for buyout and devise management incentive systems
Financing
About 10% of cash is put up by investor group headed by company's top managers and/or buyout specialist
About 50-60% of required cash through secured bank loans
Rest of cash by issuing senior and junior subordinated debt
Private placement with pension funds, insurance companies, venture capital firms
Public offerings of "high-yield" notes or bonds (junk bonds)
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Management incentives
Managers receive stock price-based incentive compensation in form of stock options or warrants
Incentive compensation plans based on measures such as operating performance
Second stage — organizing sponsor group takes company private
Stock-purchase — buys all outstanding shares of company
Asset-purchase — purchases all assets of company and forms new privately held corporation
New owners sell off parts of acquired firm to reduce debt
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Third stage — management strives to increase profits and cash flows
Cut operating costs
Cut spending in research and development
Cut new plants and equipment as long as provisions for capital expenditures are adequate and satisfy lenders
Increase revenues by changing marketing strategies
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Fourth stage — reverse LBOs
Investor group may take improved company public again through public equity offering (secondary initial public offering - SIPO)
Create liquidity for existing stockholders
Muscarella and Vetsuypens (1990)
72 reverse LBOs in 1976-1987
86% of firms use offering proceeds to lower company's leverage
Equity participants realized median annualized rate of return of % on equity investment by time of SIPO
Median length of time between LBO and SIPO was 29 months
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Conditions and circumstances of going-private buyouts in the 1980s
Typical target industries
Basic, nonregulated industries
Predictable and/or low financing requirements
Predictable/stable earnings
High-tech industry less appropriate
Shorter history of profitability
Greater business risk
Fewer leveragable assets
Command high P/E multiples well above book value
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Lehn and Poulsen (1988)
Half of 108 LBOs during 1980-1984 were in five industries:
Retailing
Textiles
Food processing
Apparel
Soft drinks
Consumer nondurable goods
Low income elasticity of demand
Sales fluctuate less with GNP
Mature industry with limited growth opportunities
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Other target characteristics
Track record of capable management
Strong market position within industry to enable it to withstand economic fluctuations and competition
Highly liquid balance sheet
Little debt, either short or long term
Large unencumbered asset base — for collateral
High proportion of tangible assets with fair market value above net book value
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Leverage factors
Increase return on equity (ROE) and cash flows to retire debt
Attractions for lenders
Interest rates only 3-5 points above prime rate
Company and collateral characteristics
Large amounts of cash/cash equivalents
Undervalued assets (hidden equity)
Could liquidate some subsidiaries to raise funds
High prospective rates of return on equity especially for lenders such as venture capitalists and insurance companies with equity participation
Confidence in management group spearheading LBO
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Management factors
Record of capability
Betting reputation and personal wealth on success of LBO
Highly motivated by potential large personal gains from stock ownership
Sources of MBO targets
Divestitures of divisions by public companies
Private companies with low growth records
Public corporations selling at low P/E multiples representing large discounts from book values
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Empirical results
DeAngelo, DeAngelo, and Rice (1984)
72 firms making 72 initial and 9 subsequent going-private proposals during 1973-1980
Relatively small firms measured by median market value of total equity
$6 million for 45 pure going-private sample
$15 million for 23 LBOs
Pre-offer management ownership high
Mean of 45% and median of 51% for 72 going-private sample
Mean of 32% and median of 33% for 23 LBOs
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Stockholder wealth effects
At announcement: +22%, significant
CAR for window [-40,0]: over +30%
Measured as average premium over market (two months before proposal): Over +56% for 57 cash payment proposals
Withdrawal of going-private announcements (18 firms)
Negative return at announcement: -9%
Offset by positive 13% return (Days -40 through 0) for net effect of +4%
Cumulative effect rises to +8% (Days 0 through +40)
Explanations for positive impact of withdrawal:
Information effect — permanent upward revaluation of firm's prospects
Probability that management might revive proposal
Possibility that another acquirer might step in to make offer
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Lowenstein (1985)
28 MBOs during 1979-1984
Each valued at over $100 million at winning bid
Management ownership fraction very small
Pre-offer: % (median); % (mean)
Post-offer: % (median); % (mean)
Premium over market price 30 days before announcement:
58% (median); 56% (mean)
Premiums rose with number of bids — three or more bids, premium = 76% (median), 69% (mean)
Premium over management bid in 11 successful third-party bids relatively small — 8% (median), 14% (mean)
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Lehn and Poulsen (1988)
Sample of LBOs in 1980-1984
Substantial leverage increases in 58 firms
Average pre-LBO debt/equity ratio of
Average post-LBO debt/equity ratio of
Wealth effect for 92 LBOs (Days -20 through +20) = over +20%, significant
Average premium (relative to stock price 20 days before announcement) = 41% for 72 all cash-offer LBOs
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Hite and Vetsuypens (1989)
151 divisional MBOs
Small but significant wealth gain to parent company shareholders
Mean abnormal return during two-day period surrounding announcement = %
Abnormal return translates into % for full LBO (mean sale price of division about % of market value of average seller)
Gains lower than those found for LBOs
Interpretation
Divisional MBOs reallocate ownership of corporate assets to higher-valued uses
Parent company shareholders share in expected benefits of change in ownership structure
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Muscarella and Vetsuypens (1990)
45 divisional buyouts which subsequently went public
Average period from buyout to public offering was 34 months
Mean abnormal return of % to seller in two days around announcement
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Sources of gains in LBOs during the 1980s
Tax benefits — can enhance already viable transaction
Specific tax benefits
Interest tax shelter from high leverage
Asset step-up provides higher asset value for depreciation expenses; especially accelerated depreciation on assets involving little recapture — more difficult under Tax Reform Act of 1986
Tax advantages of using ESOP as LBO vehicle
Lowenstein (1985)
Most of premium paid is financed from tax savings
New companies may operate tax-free up to six years (LBO often sold at this point anyway when debt/equity ratio declines from 10 times to 1 or under)
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Kaplan (1989a,b)
Value of tax benefits
Assuming a 46% tax rate and permanent new debt, median value of tax benefit at times premium
30% tax rate and new debt with maturity of eight years, median value of tax benefits at times premium
For firms that used step-up basis of their assets — median value of tax benefit at times premium
Large and predictable tax benefits result from buyout
Small portion attributed to unused debt capacity or inefficient use of tax benefits prior to buyout
Implies that large portion of tax benefits attributable to buyout
Prebuyout shareholders capture most of tax benefits
ESOP loans infrequently used due to nontax costs
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Management incentives and agency cost effects
Argument for: Increased ownership stake provides increased incentives for improved performance
Profitable investments that require disproportionate effort of managers may only be undertaken if managers are given disproportionate share of profits
Concentrated ownership aligns managers and shareholders' interest, reducing agency costs
Debt from LBO commits cash flows to debt payment, reducing agency costs of free cash flows
Debt puts pressure on managers to improve firm performance to avoid bankruptcy
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Arguments against:
In DeAngelo et al. study, management already held large stake before buyout
Internal and external controls are sufficient to align managers' interests to shareholders
Empirical evidence consistent with management incentive rationale
Increased ownership share of management
Management incentive plans
Operating performance of LBO firms improved
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Wealth transfer effects
Payment of premiums in LBO transactions may represent wealth transfer to shareholders from other stakeholders
Wealth transfer from existing bondholders and preferred stockholders
Reduction in value of firm's outstanding bonds and preferred stock due to
Large increase in debt
Bond covenants may not protect existing bondholders in event of control changes and debt issue
In bankruptcy proceedings, "absolute priority rule" for senior security may not be strictly followed
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Lehn and Poulsen (1988) — no evidence that bondholders and preferred stockholders lose value at time of LBO announcement
Travlos and Cornett (1993)
Significant bondholder losses at announcement of going-private proposals
Losses small relative to gains to prebuyout shareholders
Anecdotal evidence
Lawsuit filed against RJR Nabisco by large bondholders
Charged that $5 billion in highly rated bonds lost nearly 20% in market value
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Warga and Welch (1993)
Empirical results greatly influenced by source of bond price data
Use trader-quoted data from major investment bank as opposed to exchange-base data
Properly aggregated returns among correlated bonds using S&P data source find no significant loss to bondholder wealth
Using trader-quoted data, there is a risk-adjusted bondholder loss of 6%; but losses account for a very small percentage of shareholder gains
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Wealth transfer from current employees to new investors
Management turnover in buyout firms lower than in average firm; sometimes new management team is brought in after LBO
Number of employees grows more slowly in LBO firm than others in same industry and sometimes even decreases — may result from postbuyout divestitures and more efficient use of labor
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Tax benefits in LBO constitute subsidy from public and loss of revenue to government
Premia paid in LBOs positively related to potential tax benefits
Net effect of LBO on government tax revenues may be positive
Shareholders pay capital gains taxes on sale of their stock in LBO tender offer
LBO investor group pays capital gains taxes when firm goes public at a later date
Improved profitability — firms pay more corporate taxes
Many of tax benefits from increased leverage could be realized without LBOs
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Asymmetric information and underpricing
Managers or investor groups have more information on value of firm than public shareholders
Large premium in buyout proposal signals that future operating income will be larger than previously expected or firm is less risky than previously perceived
Investor group believes new company worth more than purchase price — prebuyout shareholders receive less than adequately informed shareholders
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Kaplan (1991) — informed persons (managers and directors) do not participate in buyout even though they typically hold large stakes (median share of 10% compared to % held by management participants)
Smith (1990)
MBO proposals that fail due to board/stockholder rejection, withdrawal, or higher outside bid are not followed by increase in operating returns
Indirect evidence that asymmetric information cannot explain improved performance of bought-out firms
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Other efficiency considerations
More efficient decision process as private firm
No need to justify new programs with detailed studies and reports to board of directors, more speedy actions can be taken
Public firms have to publish reports that can disclose valuable information to competitors
Stockholders' servicing costs and other related expenses do not appear to be a major factor in going private
Alternatively, perhaps LBOs performed well because of favorable stock market/economic conditions
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Evidence on postbuyout equity values
Muscarella and Vetsuypens (1990)
Median change in firm value for 41 reverse LBOs was 89% for entire period between LBO and subsequent SIPO — mean rate was %
Median annualized rate of return was %
Total shareholder wealth change positive and significantly correlated with fraction of shares owned by officers and directors
Correlation between size-adjusted measure of salary and shareholder wealth positive and significant
Change in equity values were associated with improvement in accounting measures of performance
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Kaplan (1991)
For 21 buyouts, median excess return to postbuyout investors (both debt and equity) is % above return on S&P 500
Excess return close to premium earned by prebuyout shareholders
Excess return to postbuyout investors significantly related to change in operating income, not to potential tax benefits
Prebuyout shareholders capture most of tax benefits that become publicly known at time of LBO
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Degeorge and Zeckhauser (1993)
Reverse LBO experienced industry adjusted rise in operating performance of % during year before SIPO
Same firms experience industry-adjusted decline in operating performance of % in year following SIPO
Reason: Information asymmetries and pure selection
Managers take firm public only during exceptional years
Managers have incentive to improve current performance at expense of future profitability
Purchasers look at strength of current performance and future growth — only strong companies had ability to go public and experience normal mean reversion following SIPO
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Mian and Rosenfeld (1993)
85 reverse LBOs during 1983-1989
Significant positive CAR measured for three-year period beginning one day after SIPO
CARs using Comparable Firm Index for first three years was %, %, and %
39% of sample firms taken over within three years after SIPO
Most takeovers during second year
Firms taken over outperformed comparable investments over 100%
Sample not taken over, CAR nearly zero
79% of acquired firms had gone public with an active investor — reflects desire of main investor to liquidate ownership
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Holthausen and Larcker (1996)
90 reverse LBOs during 1983-1988
Firms outperformed their industries for four years following reverse LBO
Firm increased capital expenditure subsequent to offering — firms were cash constrained while under LBO but reduced leverage after SIPO facilitated efficient investments
Working capital increased after offering
Firm performance decreased with declines in level of equity ownership by management and other insiders
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No evidence that performance after SIPO related to changes in leverage
Firms still public three years after SIPO experienced median decline in ownership by management insiders of 15% and by nonmanagement insiders of 20%
Board structure moved toward standard patterns of non-LBO firms after SIPO
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Correction Period 1991-1992
Background
LBO activity in 1991 dropped to $ billion, % of $ billion in 1989
Opler (1992) — LBOs in 1985-1989 period had operating improvements comparable to those in earlier period
Kaplan and Stein (1993)
LBOs formed in latter half of 1980s did not perform as well
Many experienced financial distress
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Deteriorating quality of LBOs in second half of 1980s
Relatively high prices paid
Dollar volume of funds available exceeded number of good prospects
Multiples of price to expected cash flows rose sharply
Extreme winner's curse — substantial difference between winning price and next highest bid
Weakened financial structure
Deal promoters required more cash up front, weakening structure and incentives of later LBOs
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Public high-yield debt substituted for both private subordinated debt and "strip" financing — raised costs of reorganizing
Commercial banks took smaller positions; reduced commitments, shortened maturities, required accelerated principal repayments
Asset sales and immediate improvement of profitability margins were required to cover interest and other financial outlays in first year of the LBO
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High-yield bonds with either zero-coupons or interest payments consisting of more of same securities (payment-in-kind) were utilized
Cash requirements for debt service were postponed for several years
Legislative and regulatory changes — FIRREA
Required S&Ls to liquidate high-yield bonds from portfolio holdings and prohibited further investment in high-yield bonds
Prices of high-yield debt were impacted downward
Economic downturn of 1990-1991
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Role of Junk Bonds
Junk bonds are high-yield bonds either rated below investment grade or unrated
S&P ratings: rated below BBB
Moody's ratings: rated below Baa3
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Characteristics
Size of market
Between 1970 and 1977, junk bonds represented 3-4% of total public straight debt bonds
Prior to 1977, high-yield bonds were "fallen angels,” investment grade bonds whose ratings had been subsequently lowered
First issuer of bonds rated below investment grade was Lehman Brothers in 1977
By 1985 share had risen to % of total public straight debt bonds
Drexel Burnham Lambert became industry leader in junk bond issues
Drexel had 45% of market in 1986 and % through November 1987
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Share of yearly new public bond issues had risen from % in 1977 to almost 20% by 1985
FIRREA, enacted in 1989, caused temporary losses but by 1993 junk bond market achieved record high returns and size of market reached new highs
Default rates 10 years after issuance as high as 20-30%
Average recovery rate after default about 40% of original par value
Promised yield spread over 10-year Treasury bonds about % during 1978-1994
Realized return spread about 2%
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Use of high-yield bonds
Make financing available to high risk, growth firms
Finance takeovers
Yago (1991)
One-fourth of proceeds from issuing junk bonds in 1980-1986 used for acquisition financing
Three-fourth of proceeds used to finance internal corporate growth
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Savings and loan industry
High-yield financing was not fundamental cause of problems in S&L industry during the 1980s
Total investment in junk bonds amounted to 1% or less of total assets in industry
S&L basic problems due to
Changing nature of financial markets
S&L industry had negative net worth of over $100 billion by 1980, prior to era of high-yield financing
90% of firms in S&L industry suffered losses in 1980 and 1981
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Role of Michael Milken
Saul (1993) set forth his views of illegal acts by Milken
Securities parking
Violation of Williams Act
Entails having associates hold securities in their accounts to avoid triggering Rule 13(d) filing requirement
Market stabilization
Milken guaranteed investment participants against losses on their high-yield bond investment during time required for markets to absorb them
He did not make public disclosure in high-yield offerings of securities taken as underwriting compensation
He made side payoffs to portfolio managers for investing institutional funds in his issues
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Market monopolization — Milken became dominant player of high-yield bond market
Financial competitors did not have Milken's network to be "highly confident" that it could successfully place a high-yield offering
No other firm was prepared to commit so much capital to inventory high-yield bonds in secondary market trading
Milken developed close relationships with client issuers, institutional customers, and employees
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Fischel (1995) presented a defense of Milken
Milken was guilty only of being a tough and formidable competitor
Milken was not guilty of breaking any security law violations
Action against Milken as result of
Hysteria against "excesses of the 1980s"
Ability of government to invoke RICO
After most thorough investigations, government came up with nothing
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LBOs in the 1992-2000 Period
Background
1992-2000: Sustained economic growth — resurgence of LBOs
Size of aggregate LBO transactions moved to $ billion in 1999 — almost as high as the peak of $ billion in 1989
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Resurgence of LBOs
Favorable economic environment
Change in LBO financial structure
Price to EBITDA ratios paid moved down to 5-6 times compared to 7-10 multiples of late 1980s
Percentage of equity in initial capital structure moved up to 20-30% compared with equity ratios of 5-10% in late 1980s
Interest coverage ratios moved up — ratio of EBITDA to interest and other financial requirements moved to standard of 2 times
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Restructuring of intermediaries
LBO activity no longer dominated by Milken-Drexel
Main players were other investment banking houses, large commercial banks, and traditional LBO sponsors such as Kohlberg Kravis Roberts
Innovative approaches developed by investment banking-sponsoring firms
Strategy of substituting sponsor equity for bank debt
Less pressure for immediate performance improvement or asset sales — deals structured so principal repayments sometimes not required until 10 years after deal
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Partnership structures with members who had considerable previous managerial experience
Joint deals between financial buyers and corporate strategic buyers to purchase companies on leveraged basis
Increased use of syndication among banks to sponsor highly leveraged transactions
Development of highly liquid secondary loan trading market
Continuing close client-focused relationship by commercial banks
Capital structure strategies tailored to characteristics of transactions
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Leveraged buildups
Identify fragmented industry characterized by small firms
Buyout firms purchase firm as platform for further leveraged acquisitions in same industry
Buyout firms include partners with industry expertise
LBOs applied beyond mature slow-growing industries to high-growth technology-driven industries
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