LBO General Discussion Leveraged Finance - Introduction - PowerPoint Presentation

1. LBO General Discussion

2. Leveraged Finance - IntroductionLeveraged Finance simply means funding a company or business unit with more debt than would be considered normal for that company or industry.Higher-than-normal debt implies that the funding may be riskier, and therefore more costly, than normal borrowing -- higher credit spreads and fees. It is often also more complex with covenants and waterfalls.Hence leveraged finance is commonly employed to achieve a specific, often temporary, objective: to make an acquisition, to effect a buy-out, to repurchase shares or fund a one-time dividend, or to invest in a self sustaining, cash-generating asset.

3. Leveraged Buyout ProcessA group takes over control of a company (sometimes with hostile takeovers).Use high level of leverage and multiple debt layers to take controlOnce in control, improve operations – increase EBITDA, divest unrelated businesses to generate cash for transaction, re-sell the new company for a profit.High amortization assures self-restraint on behalf of the borrower.In a typical LBO, capital expenditures do not exceed depreciation by much.By changing the relative participation of debt and equity in the capital structure, an LBO redistributes returns and risks among providers of capital.

4. Typical LBO Structure – Earlier DataDivide by EBITDA in Computing EV/EBITDA and Debt/EBITDAIncremental Debt to EBITDA ratioThis totals 7-8 x EBITDA4-6

5. 5PRINCIPAL LBO FINANCING TIERSTypeCommentsCommercial mortgage 1st lien against real estate 70 – 90% of property valueRevolving line of credit Interest-only loan secured primarily by accounts receivable and inventory (prime collateral)Mezzanine debt “Cash-flow” loans, with possible deferrals in early years Zero-coupon bonds May include “equity kickers”Seller note Unsecured interest-bearing note typically repaid within 3 – 7 yearsContingent payments Additional payments due only if revenues or earnings milestones are metSenior equity Special class of common or preferred stock issued to LBO sponsor with liquidation preference and possible preferred returnCommon stock Typically issued to management and possible minority interest retained by seller Purchase of management equity may be financed, in part, by nonrecourse noteBridge loan Temporary loan to be repaid within 6 – 12 months from permanent financing

6. Leveraged Buyout Modeling6

7. Use of Mezzanine Debt to Meet Objectives and Restrictions of Equity and Senior Debt LBO General PointsAn 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 assetsLeveraged buy-out seeks to force realization of the firm’s potential value by taking control (also done by proxy fights)Leveraging-up the purchase of the company is a "temporary“ structure pending realization of the valueLeveraging 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.Raise money to pay for buyout premiumGet as much as possible from the senior lendersGet as little as possible from the equity investorsTailor the terms of the mezzanine to be serviced from the expected cash flow.

8. Leveraged Buyout General CharacteristicsLeverage ranges from 6:1 to 12:1. Debt to EBITDA ranges from 3.5 times to 6 times or even more.Investors seek equity returns of 20 percent or more – focus is on equity IRR rather than free cash flow.Average life of 6.7 years, after which investors take the firm public. Bank amortizes senior debt over 3-7 years.CharacteristicsStrong and stable cash flowsLow level of capital expendituresStrong market positionLow rate of technological changeRelatively low market valuation

9. J-Curve or Hockey Stick and LBO’sThe return depends on the holding period:If the LBO would be sold early on, the LBO would have a low rate of return because of the premium used in the acquisition and the fact that EBITDA has not increasedEventually, the return increases as the EBITDA grows and cash flow is used to pay of debtEvaluate the optimal holding period for the LBO with alternative possible EBITDA scenarios.

10. Some General LBO Statistics

11. Return on Alternative Investments

12. Equity Returns for TollroadsThe following slide shows returns

13. Private Equity ReturnsPIIRRVCBuyoutsVCBuyouts25th percentile0.370.510.21%1.29%50th percentile0.640.816.34%9.60%75th percentile0.991.0914.95%18.31%Source: Phlippou and Zollo (2006).The authors conclude that the returns earned from PE raised between 1980 and 1996 lags the S&P 500 by around 3.3% per annum. Manager selection is absolutely critical, but comparisons are difficult since evidence on returns is opaque

14. EV/EBITDA Multiples in LBO’s

15. EV/EBITDA by Size and Type

16. EV/EBITDA by Industry

17. Private Companies Sell At A Small DiscountMedian P/E Multiples: Public vs. Private DealsMultiplesSource: Mergerstat (U.S. Only)Disclaimer: Data is continually updated and is subject to change

18. Liquidity Determines Valuation PremiumMedian Transaction Multiples by Deal SizeMultiplesSource: Mergerstat (U.S. Only)Disclaimer: Data is continually updated and is subject to change

19. Debt to EBITDA

20. Leveraged Buyout Modeling20

21. Source: S&P LCD; issuers with pro forma adjusted EBITDA of more than $50mm; as of 12/31/06Note: Includes each year, the top 20% leveraged loans by initial Debt/EBITDATop 20% most aggressive loansTotal LeverageSenior LeverageFirst-Lien LeverageTotal Leverage (All Deals)Highly Leveraged Loans

22. Average Equity Contribution to LBOsSource: S&P LCDEquity as a Percent of Total Sources

23. Leveraged Buyout Modeling23

24. Illustration of Some MultiplesMultiples for a couple companies are shown belowWhich multiple best reflects value for the various companies – note the EV/EBITDA is most stable

25. Example of Computation of Multiples from Comparative DataJPMorgan also calculated an implied range of terminal values for Exelon at the end of 2009 by applying a range of multiples of 8.0x to 9.0x to Exelon's 2009 EBITDA assumption. Note that the median is presented before the mean

26. Investment Banker Analysis of Multiples

27. Premiums in Private Equity versus M&A

28. Private Equity Marketglobal fundraising from since 1998 estimated at more than $1,000 billionUS represents about two-thirdsEurope represents about one-quarter; not much left for the rest of the world, but some signs that the focus is spreading Eastabout two-thirds of the equity raised for private equity is devoted to buy-outs (in both Europe and US)but these are highly leveraged – often with only 30% equity in capital structure; so the value of transactions is much larger than the equity figures suggestmoney is pouring into buy-out funds: $96 billion was committed to US funds alone in the first half of 2006funds are getting bigger: Blackstone recently raised a $15.6 billion fund; TPG raised $15 billion; Permira raised €11 billion …secondary deals are on the rise: in 2005, 28% of all buy-out deals were between PE houses, amounting to over $100 billion (Dealogic)

29. Debt Capacity

30. Computation of Debt CapacityComputation of debt capacity cannot be reduced to a simple formula:Re-calculate the debt capacity under many scenarios.Stress tests should include price and volume pressure resulting from unfavorable competitive or macro-economic pressures.Need assurance on cash flows in the first couple of years.The debt is an important signal along with the equity investment of managers.LBO financing is expressed in terms of debt to EBITDASecured financing 3 x EBITDAHigh yield2.5 to 3.5 x EBITDA IncrementalEquity 1.5 to 2 x EBITDATotal Transaction Value7 to 8 x EBITDA

31. Debt Capacity MethodBalance sheet approachMarket value of debt as percentage of market value of the firmCompare with industry averageFree cash flow approachIs there enough cash flow to pay more interest comfortably?How much more interest?How much more debt?Debt/EDITDA, EBIT/Interest, other measures

32. Debt Capacity and Interest CoverDespite theory of probability of default and loss given default, the basic technique to establish bond ratings continues to be cover ratios,\.

33. Changing LBO Structure from 1980’s to 2000’sNote the reduction in senior debt and the increase in High Yield and Mezzanine Debt

34. Credit Rating Standards and Business RiskAbout 5 x EBITDA for BBB with Business Risk of 4

35. Bond Ratings and Yield Spread

36. Example of Rating SystemMap of Internal Ratings to Public Rating Agencies

37. SPRThe credit spread (s) can be characterized as the default probability (P) times the loss in the event of a default (R).The Credit TriangleS = P (1-R)Credit Spread on Debt FacilitiesThe spread on a loan is directly related to the probability of default and the loss, given default.

38. EXPECTED LOSS$$=Probability of Default(PD)%xLoss Severity Given Default(Severity)%Loan EquivalentExposure(Exposure)$$xThe focus of grading tools is on modeling PDWhat is the probability of the counterparty defaulting?If default occurs, how much of this do we expect to lose?If default occurs, how much exposure do we expect to have?Borrower Risk Facility Risk RelatedExpected Loss Can Be Broken Down Into Three Components

39. Defaults versus Long-term AverageMoody's Speculative Grade Trailing 12-Month Default Rates Actual Jan. 2000 to Aug. 2002 / Forecasted Sept. 2002 to Feb. 20036.2%6.7%7.1%7.7%7.7%7.9%8.5%8.8%9.0%9.6%9.8%10.5%10.7%10.5%10.3%10.3%10.5%10.3%10.1%10.0%10.0%10.0%10.0%9.3%8.8%9.8%0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%9.0%10.0%11.0%12.0%Jan-01Feb-01Mar-01Apr-01May-01Jun-01Jul-01Aug-01Sep-01Oct-01Nov-01Dec-01Jan-02Feb-02Mar-02Apr-02May-02Jun-02Jul-02Aug-02Sep-02Oct-02Nov-02Dec-02Jan-03Feb-03Months%3.77%*Note: *Long run annual default rate is 3.77%Moody’s Forecast of Default Rates

40. Probability of DefaultThis chart shows rating migrations and the probability of default for alternative loans. Note the increase in default probability with longer loans.

41. Recovery ratesEstimating recovery ratesThere is no market or highly illiquid marketImmediately upon announcement of default, after some reasonable period for information to become available, or after a full settlement has been reached Recovery rates of bondSubordinated classes are appreciably different from one another in recovery realizationDifference between secured vs. unsecured senior is not statistically significant Recovery rates of bank facilitiesBank facilities( loans, commitments, letter of credit) are senior to all public senior bondsBankruptcy law and practices differs from jurisdiction to jurisdiction Distribution of recovery ratesConsistently wide uncertaintyBeta distribution

42. Default Rates on Alternative Types of DebtProject Finance recovery rate estimated to be 75%

43. Recovery Rates

44. LBO Exit

45. Discussion of LBO ExitOnce increase the EBITDA through increasing efficiency, exit through selling the companyJ-curve or hockey stick – pay a premium and the return goes down before EBITDA increasesExit often measured with EV/EBITDA multiples If increased EBITDA, the multiple should be lower than the acquisition multiple in theoryIncreased stability may imply higher multiplesMezzanine debt equity kickers come when the company is sold

46. LBO Exit Possibilities

47. Splitting Terminal ValueProvide Incentives to managementHurdle rate of returnSharing of Excess ReturnUse future value factorsComplex when multiple cash inflows rather than a single cash inflow

48. Subordinated Debt

49. Alternative Types of Financing for LBO’s

50. Waterfall ExampleOperating ExpensesCapital ExpenditureTIFIA Interest PaymentsTIFIA Scheduled AmortizationSenior Debt Interest and Hedging CostsScheduled Repayment of Bank LoanRepayment of Bank Loan (through cash sweep)Equity DistributionsAgency Fee and TIFIA Service FeeDeposit to Extraordinary Maintenance and Repair Reserve (requirement of the ARCA)Interest Payment on Affiliate Subordinated Note (“ASN”)Amortization of ASN

51. Payment in Kind NotesPIK notes are fixed-income securities that pay interest in the form of additional bonds rather than cash. Like zero-coupon bonds, they give a company breathing room before having to make cash outlays, offering in return rich yields.Example: In 2005, Wornick Co., a Cincinnati supplier of packaged meals controlled by Veritas Capital Fund, raised $26 million in 13.875% senior PIK notes through CIBC World Markets. Some deals are floaters: Innophos's 10-year, noncaii-2 notes were priced to yield 800 bp over LIBOR.Some PIKs have the added risk of being issued at the holding company level, meaning they are subordinated and rely on a stream of cash from the operating company to pay them down.PIK notes tend to receive ratings at the lower tier of the junk spectrum. Examples: the Norcross deal was rated Caal/B-; Warner Music and K&F were rated Caa2/B-; and Innophos came at B3/B-.

52. Mezzanine DebtMezzanine debt is issued with a cash pay interest rate of 12 to 12 1/2 percent and a maturity ranging from five to seven years. The remainder of the required 18 to 20 percent all-in-return consists of warrants to buy common stock, which the investor values based on the outlook of the company, or incremental interest paid on a "pay-in-kind" or PIK basis.The fee for raising the money runs between two and three percent of the transaction.Deal sizes typically range from three million to $25 million but can go as high as $150 million.Source: Bank of America

53. Mezzanine DebtHigh-yield or “junk” bonds5- to 15-year maturity (although may be a demand loan)PrepaymentMay be prohibited during lockout periodMay require a penalty during years immediately following lockout periodInterestGenerally fixed at a substantial premium over Treasuries, although may be floating ratePayment-in-kind (PIK) provision allows issuer to pay interest to bondholders by issuing more bondsZero-coupon bonds don’t pay a cash coupon, but are issued at discount and accrete to par value at maturity

54. Issuers of High Yield Bonds"Fallen angels" are the classic issuer of junk bonds. These are former investment-grade companies that are experiencing hard times, which cause their credit to drop from investment-grade to lower ratings."Rising stars" are emerging companies that have not yet achieved the operational history, the size or the capital strength required to receive an investment-grade rating. These companies may turn to the bond market to obtain seed capital. A start-up company that qualifies for a single-B rating should have about the same risk level as a going concern with the same rating. High-debt companies (which may be blue chip in size and revenues) leveraged with above-average debt loads that may cause concern among rating agencies. Leveraged buyouts (LB0s) create a special type of company that typically uses high-yield bonds to buy a public corporation from its shareholders.Capital-intensive companies turn to the high-yield market when they are not able to finance all their capital needs through earnings or bank borrowings. For example, cable TV companies require large amounts of capital to acquire, expand or upgrade their systems.Foreign governments and foreign corporations, often less familiar to domestic investors, may rely on high-yield bonds to attract capital.

55. Covenants and Events of Default for High Yield DebtHigh yield bonds have a "standard" covenant package intended to maintain the credit quality of the issuer and its group and the unencumbered movement of cash up the issuer's group and ensure that the issuer deals on an arm's length basis with its group companies. The covenants will include limitations on the ability of the issuer and other group companies from incurring further indebtedness, making certain "restricted payments" (such as dividends and other distributions to shareholders, intra-group loan repayments and investments)asset transfersgranting liens over its property and assetsentering into non-arm's length transactions with group companies."Events of default" include any default in the payment of principal or interest (usually following a specified grace period), any breach of covenant and the instigation of insolvency or other related proceedings against the issuer or the group.

56. Spreads on High Yield BondsPromised Yields on Treasuries and High Yield Bonds2.812.941.233.893.985.043.104.515.4610.064.558.2410.505.863.753.283.674.183.163.455.395.979.447.278.563.743.14-2.004.006.008.0010.0012.0014.0016.0018.0020.00197819791980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004Spread10-Year Treasury BondHigh Yield

57. High Yield Defaults and Economic Indicators

58. Buyouts and Real EstateCI Buyout shops like The Blackstone Group, Permira, Apollo and CVC Capital Partners have long coveted real estate because they can use the buildings as guarantees against hefty bank loans.Rich property assets were one of the main drivers behind the leveraged acquisition of U.S.-based toy retailer Toys R Us Valuable real estate has also driven most of Europe's big retail deals in the past two years, with department stores Selfridges, Debenhams, Harvey Nichols, Bhs and Arcadia all taken private.Another factor luring private financiers to property is the expected introduction of real estate investment trusts, or REITs. REITs are listed property funds which can carry out their investment activities tax free provided they pay out a high proportion of their profits in the form of taxable dividends.

59. Buyout Examples

60. LBO Example – MediMedia – 1980’sRevolver and senior debtAmount $32 millionTerm 7 yearsRate LIBOR + 2.25%Mezzanine DebtAmount $15 millionTerm 8 yearsRate LIBOR + 3.25%Vendor NoteAmount $11 MillionEquityAmount $11 Million

61. LBO Example – Revco Late 1986SourcesBank Term Loans 455,000Senior Subordinated 400,000Subordinated 210,000Junior Subordinated 91,145Common Stock 93,750Exchangable Preferred 130,200Convertible Preferred 85,000Junior Preferred 30,098Investor Common 34,276Cash of Revco 10,655Total Sources 1,448,799UsesPurchase of Common Stock 1,253,315Repayment of Debt 117,484Fees and Expenses 78,000Total Uses 1,448,799Common equity to total financing – 2.41%Cash Flow/Cash Interest 87%Required Asset Sales $255 millionFirst three years of principal payments -- $305 million

62. LBO Example – Revco Drug StoresPoor stock performance before the LBOTaken private at $1.4 billion in 1986 – one of the largest LBO’sPremium of 48% compared to year earlier stock priceComplex capital structure with 9 layers of debt and preferred stockCollapsed 19 months after going privateMaintained capital expenditures

63. LBO of Ashell Tranche 1: US$288.478 Term Loan A 05 Oct 2005-04 Oct I 2012 AIS: 225 bps/NATranche 2: US$180.299m Term Loan B 05 Oct 2005-04 Oct 2013 AIS: 275 bps/NATranche 3: US$180.299m Term Loan C 05 Oct 2005-04 Oct 2014 AIS: 325 bps/NATranche 4: US$64.392m Revolver/Late >= 1 Yr. 05 Oct 2005¬04 Oct 2012 AIS: 225 bps/NATranche 5: US$193.177m Revolver/Line >= 1 Yr. 05 Oct 2005-04 Oct 2012 AIS: 225 bps/NATranche 6: US$80.49m Term Loan 05 Oct 2005 AIS:500 bps/NATranche 7: US$159.693m Other Loan 05 Oct 2005 HIS:1025 bps/NA

64. TRW Payment in Kind Note ExampleIn March 2003, Blackstone Group acquired TRW Automotive from Northrop Grumman for $4.7 billion.Part of the debt financing was a 600 million, 8% pay-in-kind note payable to a subsidiary of Northrop Grumman Corporation Valued at $348 million on a 15-year life using a 12% discount rate As of September, 2004, the accreted book value totaled $417 million, and accreted face-value was $678 millionThat month TRW Automotive repurchased the Seller Note and settled various contractual issues stemming from the acquisition, for a net amount of $493.5 million.

65. WoodstreamBrockway Moran & Partners purchased Woodstream Corp., a maker of wild animal cage traps, rodent control devices and pesticides, from Friend Skoler Co. LLC. The $100 million purchase price is equivalent to between 6.5 and 7x EBITDA.Of the equity, Brockway contributed 85% of the total, with management chipping in 10%. Lenders Antares Capital Corp. and Allied Capital Corp. fill in the remaining 5%. Total equity represents approximately 40% of the purchase price.On the debt side, Antares led a $58 million senior facility, along with Merrill Lynch and GE Capital Corp. The senior debt component also contains a revolver to be used in the future as working capital (and not included in the $100 million purchase price). CIT Private Equity and Denali Advisors LLC provided a subordinated note in the amount of $17 million.

66. Woodstream DebtSenior debt: Libor + 3.50%, 4 year amortizationSubordinated notes:7% cash interest7% pay-in-kind interestWarrants to purchase 5% of the company's equity at $0.05 per shareRepayment after 5 years or at exit eventFees 1.5%Equity 27% required return

67. Equity Office Properties Blackhawk Parent will cause an aggregate of approximately $19.3 billion to be paid to our common shareholders. In addition, our operating partnership will use commercially reasonable efforts to commence tender offers to purchase up to all of the senior notes and it will use reasonable best efforts to redeem all of the redemption notes. there were approximately $8.4 billion aggregate principal amount of senior notes, $51.5 million aggregate principal amount of redemption notes and $1.5 billion aggregate principal amount of exchangeable notes outstanding. Our revolving credit facility will also be repaid and our mortgage loan agreements and secured debt will be repaid or remain outstanding. an aggregate principal amount of approximately $5.4 billion of consolidated indebtedness under our revolving credit facility, mortgage loan agreements and secured debt.  In connection with the execution and delivery of the merger agreement, Blackhawk Parent obtained a debt commitment letter from Goldman Sachs Mortgage Company, Bear Stearns Commercial Mortgage, Inc. and Bank of America, N.A. providing for debt financing in an aggregate principal amount of up to the lesser of (a) $29.6 billion Blackhawk Parent obtained an equity bridge commitment letter from Goldman, Sachs & Co., Bear Stearns Commercial Mortgage, Inc. and BAS Capital Funding Corporation for an equity investment in an aggregate amount of up to $3.5 billion. It is expected that in connection with the mergers, affiliates of The Blackstone Group will contribute up to approximately $3.2 billion of equity to Blackhawk Parent, which amount will be used to fund the remainder of the acquisition costs that are not covered by the debt and equity bridge financing. Common equity was 16.6% of the total transaction value

68. LBO History

69. Finance Theory and LBO’sDesirable to adopt high leverage during a transition periodLeveraged buyouts – acquisitions financed mainly by borrowingLeveraged recapitalizations – companies borrow to retire most of their equityWorkouts – companies with excessive debt that have to be recapitalized in order to meet debt capacity.Jensen’s free cash-flow hypothesis.Managers spend excess cash at their discretion rather than in the interest of the firm.Debt reduces the agency cost and restores the valuation to the enterprise valueSponsor’s incentive from the equity investment that does not get paid until the debt is repaid.

70. General ConceptNew OwnersImprove OperationsDivest Unrelated BusinessRe-sell the Newly Made Company at a ProfitEarly Successes with High Yield Bonds1981 – 99 LBO’s1988 – 381 LBO’sDiscipline declined with increased dealsMade assumptions that growth and margins could reach levels never before achieved

71. LBO BubbleIn 1981, 99 LBO deals took place in the US; by 1988, the number was 381.Early on, LBO players grounded their deal activity in solid analysis and realistic economics. Yet as the number of participants in the hot market increased, discipline declined. The swelling ranks of LBO firms bid up prices for takeover prospects encouraged by investment bankers, who stood to reap large advisory fees, as well as with the help of commercial bankers, who were willing to support aggressive financing plans.

72. LBO Bubble - ContinuedWe have reviewed some financial projections that underpinned several high-profile LBO bankruptcies in the late 1980s. Many of these transactions were based on assumptions that the companies could achieve levels of performance, revenue growth, operating margins, and capital utilization never before achieved in their industry. The buyers of these companies typically had no concrete plans for executing the financial performance necessary to meet their obligations. In many such transactions, the buyers simply assumed that they could resell pieces of the acquired companies for a higher price to someone else.Why wouldn't investors see through such shoddy analyses?In many of these transactions, bankers and loan committees felt great pressure to keep up with their peers and generate high up-front fees, so they approved highly questionable loans. In other cases, each participant assumed someone else had carefully done the homework. Buyers assumed that if they could get financing, the deal must be good. High-yield bond investors figured that the commercial bankers providing the senior debt must surely have worked their numbers properly. After all, the bankers selling the bonds had their reputations at stake, and the buyers had some capital in the game as well. Whatever the assumption, however, the immutable laws of economics and value creation prevailed. Many deals went under.

73. LBO’s in the U.S. In the early 1980s inflation became under control. Investors rediscovered the confidence to innovate. A market for corporate control emerged, in which companies and private investors (corporate raiders) demonstrated their ability to successfully complete hostile takeovers of poorly performing companies. Once in control, the new owners often improve operations, divest unrelated businesses, and then resell the newly made-over company for a substantial profit. The emergence of high-yield bond financing opened the door for smaller investors, known as leveraged-buyout (LBO) firms, to take a leading role in the hostile-takeover game.

74. LBO Statistics3% to 6% of M&A activity in number of transactionsPeak in 1980’sSignificant increases in efficiencyLate 1980’s, 27 percent of LBO’s defaultedOpportunities to transfer wealth between groups

75. The Deal Decade, 1981-1989 (the fourth movement)Motivating forcesSurge in the economy and stock market beginning in mid-1982Impact of international competition on mature industries such as steel and auto Unwinding diversified firmsNew industries as a result of new technologies and managerial innovationsDecade of big dealsTen largest transactions Exceeded $6 billion eachSummed to $126.1 billionTop 10 deals reflected changes in the industryFive involved oil companies — increased price instability resulting from OPEC actionsTwo involved drug mergers — increased pressure to reduce drug pricesTwo involved tobacco companies — diversified into food industry

76. 1980s LBO WavePrior to 1980 managers were loyal to the firm, not shareholdersLittle managerial share ownership, stock compensationLittle external threat of takeoverCharacteristicsHighly levered deals: cash payment funded by borrowingHostileIndustry clustersNon Investment Grade Bond VolumeAs a % of Average Total Stock Market Capitalization1977 - 1999Going Private VolumeAs Percent of Average Total Stock Market Value1979 - 1999

77. The Deal Decade, 1981-1989 (Continued)Financial innovationsHigh yield bonds provided financing for aggressive acquisitions by raidersFinancial buyersArranged going private transactions Bought segments of diversified firms"Bustup acquisitions"Buyers would seek firms whose parts as separate entities were worth more than the wholeAfter acquisitions, segments would be divestedProceeds of sales were used to reduce the debt incurred to finance the transactionRise of wide range of defensive measures as a result of increased hostile takeovers

78. LBO Greed or Efficiency GainsLBOs shifted corporate governanceManagers had high equity stakesDebt disciplined manager decision makingClose monitoring from LBO investors, stong boardsFirst half of 1980sImproved operating profitsFew defaultsLast half of 1980s1/3 defaultedBut, operating profits improved from pre-LBO levels, just not enoughPrices paid in LBO deals were too highBy the end of the 1980s corporate raiders and LBOs were despisedSecurities fraudJunk bond market collapsedContested Tender Offers as % of Total1974 - 1999

79. Managers are more shareholder focusedHostile takeovers not as necessaryMore shares are owned by institutional investors (1980 <30 % to 2000 >50%)More monitoring and activism from shareholdersManagement stock ownership and stock compensation has increasedMore interested in creating stockholder valueCEO option grants increased x7 from 1980 – 1994Equity compensation = 50% in 1994, <20% in 1980Boards are more activeLasting Results from 1980s Takeovers

80. Value Created by LBO’s

81. Productivity Study of LBO’s

82. Productivity Study and LBO’s

83. LBO Modelling IssuesPerspective of Alternative PartiesCash Flow WaterfallModel the default points on alternative instrumentsModel the IRR on cash flows received by different instrumentsComplex Interest Structures with Payment in Kind and multiple interest ratesSources and Uses of FundsPro-Forma AnalysisIRR on Alternative Financial Instruments

84. Jordan Cement CaseThe owner of Jordan Cement wants to sell his family's company for $19 million. He is prepared to offer a vendor note at 10% p.a. for up to $2 million of the financing.A preliminary agreement for the sale has been reached between the Biriqadar family and the sponsors of the acquisition, Orascom and a European development bank. Together with management, the sponsors can contribute equity capital of $5.5million, and banks can provide a further $12 million.Create model with mezzanine debt

85. Fundamental Events of DefaultFundamental events of default includethe failure of the borrower to pay debt service;failure to comply with insurance requirements;entry of a final court judgment in excess of a significant dollar amount which is not paid or stayed after a certain period;abandonment of the project; bankruptcy of the borrower; failure of the sponsor to maintain ownership of the project (if the sponsor's ownership is a critical component of the evaluation of the project's credit risk).

86. Other Events of DefaultOther Events of Default Include:operational covenants, a merger or sale of assetsfailure to deliver noticesfailure to obtain or comply with governmental permits. Depends on MaterialityNegotiated ad hoc.Agreements should provide for a clear and adequately described mechanism for allowing the parties to deal with the defaulted project.

87. Exchange Ratios and M&A Modeling of Public Companies

88. IntroductionA key question for management is how an acquisition will effect earnings per share. While there are flaws with the logic of earnings accretion and dilution, consolidation analysis is often central to the M&A process. This section reviews issues associated with dilution and accretion effects of acquisitions.Translation of exchange ratios into implicit prices and premiumsCombined and standalone earnings per share with different growth estimatesProblems with momentum strategy.

89. Earnings and Financial Evaluation versus Standalone ValuationValuation analysis determines the value of the target on a standalone basisFinancial evaluation projects earnings and financial ratios for the combined company after acquisition using different purchase price and financing assumptionsEffects of issuing shares with dilutionEffects of debt and equity financingEffects of paying different premiums

90. Investment Banker Presentation on Merger Activity

91. Exchange Ratio ExamplesExamples of Share ExchangesIf the merger is completed, holders of Mobil common stock will receive, for each Mobil share, 1.32015 shares of Exxon Mobil common stock. Exxon Mobil will issue approximately 1.03 billion shares of Exxon Mobil common stock to Mobil shareholders.The exchange ratio of the business combination is 0.77 shares of Chevron Texaco common stock for each share of Texaco common stock.

92. Exchange RatioUsing a share exchange is equivalent to issuing shares rather than using debt.To evaluate exchange ratios, begin with stock prices before the merger or acquisition, to determine the number of shares of the new company that the existing shareholders will receive.Exchange Ratio = Target Share Price/Acquirer Share PriceFor example, if the target has a share price of 10 and the acquirer has a share price of 20, the exchange ratio is .5In this case, the target receives .5 shares of the new company for each share of the acquiring company.If a premium is part of a transaction, the target shareholders receive a higher exchange ratio. For example, if the premium is 25% in the above example, the target shareholders receiveExchange Ratio = Exchange Ratio x (1.25) = .625By receiving 25% more shares, the premium is realized.

93. Formula for Share ExchangeThe actual achieved premium should reflect the fact that the new company has a different value than the acquiring company:P = Value combined/(new shares)P = Value of acquirer + Value of target + Synergies/(new shares)Then the premium is evaluated against the new priceCan do something similar when a combination of shares and cash is used.

94. Example of Contribution Analysis in Share ExchangeLehman Brothers and Evercore analyzed the respective contributions of AT&T and BellSouth to the estimated calendar years 2006, 2007 and 2008 EBITDA and Net Income of the combined company based on estimates provided by AT&T management, and excluding the effect of expected synergies. This analysis indicated the following relative contributions of AT&T and BellSouth and the following implied exchange ratios: Should the exchange ratio correspond to EBITDA or Net Income

95. Stock OfferFixed exchange ratio# of acquirer shares to be exchanged for each target share is set at the time of the offerFloating exchange ratioValue to be paid is agreed upon at the time of offer, ratio floats until closingCollarUpper and lower limits on shares to be offered (floating)Upper and lower limits on price to be paid (fixed)Walk-awayTarget can walk from fixed if acquirer’s stock falls too lowAcquirer can walk from floating if it’s stock falls too low

96. Premiums

97. Premiums and ValuationWhile DCF valuation and other methods are important, there are expected premiums in the market. An alternative way to analyze a merger is to estimate market premiums and then see if the merger works.Some of the next slides illustrate how premiums are estimated from market data.The first slide show academic studies of price increases for target companies using event studies.

98. Premium Analysis in Mergers by Investment BanksLehman Brothers reviewed the premiums paid to stockholders in selected precedent transactions with an equity value greater than $1 billion for (1) all industries announced from 1998 to December 13, 2005 (691 transactions in total) and (2) comparable transactions in the utility sector

99. Empirical EvidenceTarget firms in a takeover receive an average premium of 30%.Note that once cannot precisely measure the date for computing the premiumBuyingcompaniesSellingcompaniesTIME AROUND ANNOUNCEMENT(days)Announcement date0-+CUMULATIVE AVERAGEABNORMAL RETURN (%)

100. Upward Trends in Control PremiumsThe following chart shows trends in control premiums. For the US the premium was 31% from 1996 to 2002 and for Europe it was 34% according to Anrzac.

101. Review of Other Transactions in the Industry

102. Investment Banker Analysis of Premiums

103. Investment Banker Analysis of Premiums

104. Example of Premium in Oil company MergersJ.P. Morgan's analysis showed that for transactions involving smaller companies with a relative market capitalization comparable to that of Mobil pre-announcement, a premium of 15% to 25% matched market precedent. The analysis indicated that, based on the closing share prices on November 30, 1998, the day prior to announcement of the merger, the implied premium paid to Mobil shareholders would be approximately 10%. The analysis also indicated that, based on closing share prices on November 24, 1998, two trading days before Exxon and Mobil issued a joint press release confirming that they were in discussions concerning a possible merger, the implied premium paid to Mobil shareholders would be approximately 20%.Morgan Stanley reviewed eleven selected comparable merger transactions and compared the implied premium to the relative market capitalization of the smaller entity. This analysis evidenced premiums in a range from 5.0% to 15.0% based on closing share prices on the day before the announcement of the transaction. The implied premium received by Amoco Shareholders upon receiving 40.0% ownership of the combined entity is 13.3%, also based on closing share prices on the day before announcement of the transaction. The premium received by Amoco Shareholders when measured over different time periods similarly matched the premiums indicated by comparable transactions when measured over the same time period.

105. Example of Premium in Oil Company MergersThe 17.7% premium represented by the exchange ratio on October 13 was somewhat below, but the 25.3% premium represented by the exchange ratio over the 30-day average relative trading price of Chevron and Texaco was in line with, premiums paid in comparable transactions reviewed by the board, which ranged from 23% to 33% based on the last closing share price of the applicable companies before the announcement or rumor of a transaction. For the Chevron/Texaco merger, the board considered the last-day premium and the 30-day premium (as well as premiums calculated over longer periods of time, as described above) because of the possibility that the one-day premium had been affected by leaks or market rumors concerning the possibility of a transaction between Chevron and Texaco;The current and historical market prices of Pennzoil-Quaker State common stock relative to the merger consideration, including (a) the fact that Pennzoil-Quaker State common stock had never traded over $16.50 per share, (b) the fact that the $22.00 per share merger consideration represented a 55.5% premium over the closing price of Pennzoil-Quaker State common stock four weeks earlier and a 42% premium over the closing price of Pennzoil-Quaker State common stock of $15.49 per share on March 22, 2002, the last trading day before the board's approval of the merger agreement and (c) the fact that the weighted average acquisition cost for holders of Pennzoil-Quaker State common stock since January 2001 was $12.88 per share;

106. Example of Premium Analysis

107. Example of Premium in Telecom      Precedent Transactions Premiums Analysis. Citigroup and Goldman Sachs reviewed certain publicly available information relating to certain selected precedent transactions since 1998 with transaction values in excess of $20 billion that Citigroup and Goldman Sachs deemed relevant. For each of the selected transactions, Citigroup and Goldman Sachs calculated the percentage premium or discount per share received by the target’s shareholders based on the closing price per share of the target’s common stock on the day before and the month before the announcement of the transaction and compared it to the premium to be paid to BellSouth shareholders based on the exchange ratio in the merger agreement of 1.325x and the closing stock prices of AT&T and BellSouth on March 3, 2006. The following table summarizes the results of this analysis:             1 Day 1 Month     Median for Precedent Transactions   15%   21% BellSouth/ AT&T   16%   29% As transaction is closer, the target share price increases.Exchange ratio premium depends on measurement

108. Exercise: Compute Premiums in Oil MergersOn November 25, 1998, the last full trading day before Exxon and Mobil issued a joint release confirming that they were in discussions concerning a possible combination, Exxon common stock closed at $72 11/16 and Mobil common stock closed at $78 3/8. On April 1, 1999, Exxon closed at $70 1/8 and Mobil closed at $87 3/8.

109. Example of Premium AnalysisPremiums Paid Analysis To assess the premium to be paid by Exelon to PSEG shareholders, Lehman Brothers reviewed selected historical transactions for the premiums paid to shareholders in such transactions. Lehman Brothers selected transactions with an equity value greater than $1 billion for (1) all industries announced from 1998 to December 16, 2004 (507 transactions in total), and (2) comparable transactions in the power and utility sector. The selected comparable historical transactions in the power and utility sector were the following: Proposed acquisition of UniSource Energy Corporation by Saguaro Acquisition Corp., a corporation whose indirect owners include investment funds affiliated with J.P. Morgan Partners, LLC, Kohlberg, Kravis, Roberts & Co., L.P., and Wachovia Capital Partners (announced November 2003) Energy East Corporation's acquisition of RGS Energy Group, Inc. (announced February 2001) Potomac Electric Power Company's merger with Conectiv (announced February 2001) FirstEnergy Corp.'s acquisition of GPU, Inc. (announced August 2000) PECO Energy Company's merger with Unicom Corporation (announced September 1999) Northern States Power Company's merger with New Century Energies, Inc. (announced March 1999) American Electric Power Company, Inc.'s merger with Central and South West Corporation (announced December 1997)

110. Premium Example  The premiums were calculated over the share price one-day prior, one-week prior and four-weeks prior to the selected historical transactions' respective announcement date. These premiums were then compared to the implied premium to be paid to PSEG shareholders over the price one-day prior to, one-week prior to, and for the four-weeks prior to December 16, 2004. The following table reflects the results of the analysis:

111. Synergies versus the PremiumsTotal potential cost savings and other synergies identified by the management of Exelon have been estimated at approximately $400 million in the first full year of operations following completion of the merger and approximately $500 million in the second full year of operations following completion of the merger. The management of PSEG estimated similar levels of synergies, giving effect to all expected improvements in the operating performance of nuclear generating units, including improvements reflected in PSEG's forward-looking financial information for 2005-2009. Related costs-to-achieve these synergies are currently estimated at approximately $450 million in the first full year of operations following completion of the merger and approximately $700 million over a period of four years following the merger. Identified plans for stand-alone cost reduction initiatives have also been recognized and deducted from the estimated potential cost savings in the amount of $5 million in the first full year of operations and $9 million in the second full year of operations. The impact of these planned initiatives will continue into the future and reduce identified merger synergies each year.

112. Share Exchange Model

113. Share Exchange AnalysisThe next few slide illustrate the process of computing accretion and dilution from a few market and earnings data items.This is a technique actually used in share exchange transactions as illustrated by the investment banker excerpts.

114. Example of Accretion and DilutionLehman Brothers and Evercore estimated that, based on the assumptions described above, the pro forma impact of the transaction on the earnings per share of AT&T, excluding the amortization of intangibles and integration costs would be approximately 1% dilutive in 2007, and then approximately 3%, 5% and 5% accretive in 2008, 2009 and 2010, respectively.

115. P/E Analysis with SynergiesPro Forma Merger Analysis. Goldman Sachs prepared a pro forma analysis of the financial impact of the merger. Using I/B/E/S International Inc. earnings estimates for 1999 and 2000, Goldman Sachs compared the earnings per share of Mobil common stock on a stand-alone basis and Exxon common stock on a stand-alone basis, to the earnings per share of the common stock of the pro forma combined company. Goldman Sachs performed this analysis based on the exchange ratio of 1.32015 and under three scenarios reflecting cost savings and operating synergies projected by the management of Mobil and Exxon to result from the merger:assuming Scenario I, the merger would be dilutive - that is, would represent a reduction - to both 1999 and 2000 earnings per share of Exxon common stock on a stand-alone basis and would be accretive-that is, would represent an addition - to 1999 and 2000 earnings per share of Mobil common stock on a stand-alone basis; and assuming Scenario II or Scenario III, the merger would be accretive in 1999 and 2000 to the earnings per share of Exxon common stock on a stand-alone basis and the earnings per share of Mobil common stock on a stand-alone basis.

116. P/E with SynergiesMorgan Stanley analyzed the pro forma Amoco EPS for fiscal years 1999 and 2000 based on IBES estimates as of August 10, 1998. The analysis showed, assuming $2 billion in synergies phased in over three years, on an equivalent share basis, that the Merger would be significantly accretive to Amoco Shareholders.J.P. Morgan performed an analysis comparing BP's and Amoco's price to earnings multiples ("P/E multiple") to those of Exxon and The Shell Transport & Trading Company plc ("Shell T&T") for the past five years. The source for these P/E multiples was the one year prospective P/E multiple estimates by IBES. Such analysis indicated that BP and Amoco had been trading in the recent past at a 20% to 25% discount to both Exxon and Shell T&T. J.P. Morgan's analysis indicated that if BP and Amoco were to be valued at P/E multiples comparable to those of Exxon and Shell T&T there would be significant enhancement of value to shareholders of BP and Amoco. J.P. Morgan pointed out that there could be no assurance that this value would be realized.

117. Discussion of P/E AnalysisJ.P. Morgan performed an analysis comparing Exxon's price to earnings multiples with Mobil's price to earnings multiples for the past five years. The source for these price to earnings multiples was the one and two year prospective price to earnings multiple estimates by I/B/E/S International Inc. and First Call, organizations which compile brokers' earnings estimates on public companies. Such analysis indicated that Mobil has been trading in the recent past at an 8% to 15% discount to Exxon. J.P. Morgan's analysis indicated that if Mobil were to be valued at price to earnings multiples comparable to those of Exxon, there would be an enhancement of value to its shareholders of approximately $11 billion. Finally, this analysis suggested that the combined company might enjoy an overall increase in its price to earnings multiple due to the potential for improved capital productivity and the expected strategic benefits of the merger. According to J.P. Morgan's analysis, a price to earnings multiple increase of 1 for Exxon Mobil would result in an enhancement of value to shareholders of approximately $10 billion.

118. Investment Banker Share Exchange Analysis

119. Investment Banker Earnings Combination Analysis

120. Investment Banker Earnings Analysis

121. P/E and SizeHigher trading multiples accorded to the equity of the "super-majors" in the securities markets (BP Amoco, ExxonMobil, and Royal Dutch/Shell), such as price-to-2001 estimated earnings multiples, as of October 13, 2000, of 17.0 for BP Amoco, 21.7 for ExxonMobil and 18.8 for Royal Dutch/Shell as compared to 13.7 for Chevron;

122. Tyco ExampleFounded in 1960 as a scientific research boutiqueTransformed in late 1960’s to a mini-conglomerate by acquiring 24 companies.Dennis Kozlowski, began as an auditor and became CEO in 1992.Acquisitions beginning in 1994:Kendall International – disposable medical suppliesADT Security services ($ 11.3 billion)CIT Group ($9.2 billion) Financial Services

123. Tyco ExcerptsDecember 1999We aim for sustained earnings growth of 20 percent, powered by increased revenues and earnings expansion…We spend hundreds of hours assessing the benefits and risks of each transaction we consider. We always ask: What’s the worst case scenario? We perform thorough due diligence every time, and we walk away from nine out of ten transactions we evaluate….We think we can double our earnings over the next three years.

124. Relative P/E Ratios – Tyco ExampleTyco’s sales soared from $19 billion to $36 billion. But most of the growth has come from acquisitions. The Company’s sales grew by 3% excluding acquisitions.Tyco Excerpts:Focus on steady percentage growth in EPS. To sustain a constant percentage rate of growth in EPS requires larger and larger absolute increases. This is called “momentum”Increasing number and dollar value of acquisitions.Avoidance of EPS dilution; focus on accretive acquisitions.Heavy reliance on accounting conventions that produce favorable results such as pooling of interests.Non-disclosure of $8 billion in acquisitions.

125. Momentum AcquiringAt the core of Tyco’s acquisition-growth story is a buoyant stock market that created a high priced acquisition currency and a feedback effect that together create a perceived momentum in the financial performance of the firm. The observed rate of growth in EPS influences investors to value the firm more highly. This increases the price/earning multiple. The firm issues new (higher priced) shares in an acquisition. If the acquisition is accretive, the EPS grows faster. The faster growth promotes a higher P/E ratio and the cycle continues.What is remarkable about the momentum story is that for a time it may mask an economic growth rate that is rather mundane. Tyco’s growth rate was probably in line with the manufacturing sector of the United States – 2 percent to 4 percent in real terms per year. But with momentum, low organic growth is offset by rapid growth from acquisition strategies that create a toxic exposure to unexpected trouble. The outcome is generally sudden and painful to investors.Robert Bruner

126. Leveraged Buyout Case Study

127. Leveraged Buyout Case StudyCompany Profile$91 million North Carolina based manufacturer and distributor of specialty dyestuffs for the textile, floorcovering and paper industriesEconomically source dye crudes over seas; quality test, mix, repackage and sell dye crudes to end userLargest independent distribution and processor of specialty dyes in U.S.Customer list included Fruit of Loom, Mohawk, International Paper, Sara Lee, Russel MillsThe current management team was previously employed by a specialty chemical company which passed on the opportunity to acquire the dyestuff manufacturer

128. Company ProfileHistory of Strong Sales Growth and Stable Cash FlowLeveraged Buyout Case Study

129. Leveraged Buyout Case StudyKey Investment Considerations:Superior Consolidation PlatformTechnical Marketing StrategyStrategically Positioned for Continued GrowthStrong Management TeamDiversified Customer and Supplier Base

130. Original Buyout StructureThe total purchase price of $61.6 million represented a 5.5 multiple of cash flow.XYZ advised the mgmt team on the structure and financing of the acquisition.The following table contains sources and uses:Leveraged Buyout Case Study

131. Leveraged Buyout Case StudyOriginal Buyout StructureThe following table depicts the pro forma capital structure:

132. Leveraged Buyout Case StudyOriginal Buyout StructureSenior Debt Terms:Working Capital line interest rate 9.7%Senior Term Debt interest rate 10.2%Senior Debt as a multiple of EBITDA: 2.8XSub Debt Terms:12.5% current payAttachable warrantsTotal Debt as a multiple of EBITDA: 4.3X

133. Leveraged Buyout Case StudyManagement’s InterestPurchased interest of 7% of common equityReceived carried interest of 23%Based on management projections and a 5X EBITDA exit multiple in 5 years, management anticipated:$27.4 mm in cash proceeds94% IRR

134. Leveraged Buyout Case StudyCase Study EpilogueIndustry ShiftDye industry severely impacted by declining textile mill output and increased paper mill raw material costsMill production decline consequences of retail shake out in 1995Industry experienced 8%-10% price compressionCompany unable to meet projections and debt amortizationNeeded additional liquidity to buy companies through the contraction and trough of the business cycleRefinancingXYZ recently completed a refinancing / acquisition financing which consisted of $40mm in senior debt and $5mm in equityHighly leveraged transaction total debt to EBITDA ratio of 6.7Senior debt multiple 3.2 times EBITDA

135. Project DyeFeesInitial Leveraged Buyout and financing $1,300,000Refinancing 800,000Total Fees $2,100,000XYZ retained to advise on additional equity private placements and buyside advisory in order to fund the company’s future growth strategy.