Exam 13: Financing the Deal

Which of the following tends to be true of LBOs

Asset based lenders will usually lend up to 100% if the book value of the LBO target's receivables.

Fraudulent conveyance laws are intended to prevent shareholders, secured creditors, and others from benefiting at the expense of unsecured creditors.

Case Study Short Essay Examination Questions Hollywood’s Biggest Independent Studios Combine in a Leveraged Buyout LBOs allow buyouts using relatively little cash and often rely heavily on the target firm’s assets to finance the transaction. Private equity investors often “cash out” of their investments by selling to a strategic buyer. ______________________________________________________________________________ The Lionsgate-Summit tie-up represented the culmination of more than four years of intermittent discussions between the two firms. The number of studios making and releasing movies has been shrinking amid falling DVD sales and continued efforts to transition to digital distribution. As the largest independent studios in Hollywood, both firms saw their cash flow whipsawed as one blockbuster hit would be followed by a series of failures. Film and TV program libraries offered the only source of cash flow stability due to the recurring fees paid by those licensing the rights to use this proprietary content. Lionsgate first approached Summit about a buyout in 2008 in an effort to bolster its film and TV library. However, it was not until early 2012 that the two sides could reach agreement. The time was ripe because Summit’s investors were looking for a way to cash in on the success of the firm’s Twilight movies series. Consisting of four films, this series had grossed $2.5 billion worldwide. On February 2, 2012, Lionsgate announced that it had reached an agreement to acquire Summit Entertainment by paying Summit shareholders $412.5 million in cash and stock for all of their outstanding shares and assumed debt of $506.3 million. According to the merger agreement, Lionsgate would provide administrative, production, and distribution services to Summit for a 10% servicing fee. Layoffs are expected at both firms as they merge redundant departments in their film operations, such as marketing, production, and distribution. The acquisition provides a windfall to Summit’s investors, including eBay cofounder Jeff Skoll’s film company Media and private equity fund Traverse Management. These investors had previously received a $200 million dividend as part of a recapitalization in early 2011 and gained handsomely from the sale to Lionsgate. Lionsgate is a diversified film and television production and distribution company, with a film library of 13,000 titles. The firm’s major distribution channels include home entertainment and prepackaged media (DVDs); digital distribution (on-demand TV) and pay TV (premium network programming). Summit, also a producer and distributor of film and TV content, has a less consistent track record in realizing successful releases, with the Twilight “franchise” its primary success. However, Summit does have strong international licensing operations, with arrangements in the United States, Canada, Germany, France, Scandinavia, Spain, and Australia. The acquisition also strengthens Lionsgate’s position as a leading content supplier and, controlling the Twilight and Hunger Games franchises, positions Lionsgate as a market leader for young adult audiences. The combination also results in cost and revenue synergies, more diversified cash flow streams, and greater access to international distribution channels. Figure 13.3 illustrates the subsidiary structure for completing the buyout of Summit Entertainment LLC. As is typical of such transactions, Lionsgate created a merger subsidiary (Merger Sub) and funded the subsidiary with its equity contribution of $100 million in cash and $69 million in Lionsgate stock, receiving 100% of the subsidiary’s stock in exchange. Merger Sub was further capitalized by a bank term loan of $500 million. Following a tender offer to Summit’s shareholders by Merger Sub, Merger Sub was merged into Summit Entertainment, with Summit surviving as a wholly owned subsidiary of Lionsgate in a reverse triangular merger. At closing, $284.4 million of Summit’s excess cash was used to finance the total cost of the deal. Lionsgate-Summit Legal and Financing Structure. Table 13.4 summarizes the sources of financing for the buyout and shows how these funds were used to pay for the deal. Lionsgate financed the total cost of the deal of $953.4 million (consisting of $412.5 million for Summit stock + the pretransaction term loan of $506.3 million + $34.6 million in transaction-related fees and expenses) as follows: $100 million in cash from Lionsgate and $69 million in Lionsgate stock + $284.4 million of the $310 million in cash on Summit’s balance sheet at closing + a new $500 million term loan. Summit’s $506.3 million term loan B was refinanced with the new term loan for $500 million as part of the transaction. The new term loan is an obligation of and is secured by the assets of Summit and its subsidiaries. It also is secured by a loan guarantee provided by Merger Sub, created by Lionsgate to consummate the transaction. The guarantee is secured by the equity in Summit held by Merger Sub. Lionsgate anticipates paying off the term loan well in advance of its 2016 maturity date out of future cash flows from new movie releases. Summit’s pretransaction net debt was $196.3 million (pretransaction term loan of $506.3 less total cash on the balance sheet of $310 million). Postclosing net debt increased to $474.4 million (postclosing term loan of $500 million less $25.6 million in total cash of the balance sheet). presents the key features of the new term loan B facility. Note how Summit’s assets are used as collateral to secure the loan. In addition, the lender has first priority on the proceeds from certain types of transactions, giving them priority access to such funds. Cash distributions are not possible until the loan is almost paid off, and even then the size of such distributions is limited. Finally, loan covenants require Summit to maintain a comparatively liquid position during the term of the loan. -Speculate as to why Lionsgate refinanced as part of the transaction the existing Summit Term Loan B due in 2016 that had been borrowed in the early 2000s.

With their cash hoards accumulating at an unprecedented rate, there was little that buyout firms could do but to invest in larger firms. Consequently, the average size of LBO transactions grew significantly during 2005. In a move reminiscent of the blockbuster buyouts of the late 1980s, seven private investment firms acquired 100 percent of the outstanding stock of SunGard Data Systems Inc. (SunGard) in late 2005. SunGard is a financial software firm known for providing application and transaction software services and creating backup data systems in the event of disaster. The company‘s software manages 70 percent of the transactions made on the Nasdaq stock exchange, but its biggest business is creating backup data systems in case a client’s main systems are disabled by a natural disaster, blackout, or terrorist attack. Its large client base for disaster recovery and back-up systems provides a substantial and predictable cash flow. SunGard’s new owners include Silver lake Partners, Bain Capital LLC, The Blackstone Group L.P., Goldman Sachs Capital Partners, Kohlberg Kravis Roberts & Co., Providence Equity Partners Inc. and Texas Pacific Group. Buyout firms in 2005 tended to band together to spread the risk of a deal this size and to reduce the likelihood of a bidding war. Indeed, with SunGard, there was only one bidder, the investor group consisting of these seven firms. The software side of SunGard is believed to have significant growth potential, while the disaster-recovery side provides a large stable cash flow. Unlike many LBOs, the deal was announced as being all about growth of the financial services software side of the business. The deal is structured as a merger, since SunGard would be merged into a shell corporation created by the investor group for acquiring SunGard. Going private, allows SunGard to invest heavily in software without being punished by investors, since such investments are expensed and reduce reported earnings per share. Going private also allows the firm to eliminate the burdensome reporting requirements of being a public company. The buyout represented potentially a significant source of fee income for the investor group. In addition to the 2 percent management fees buyout firms collect from investors in the funds they manage, they receive substantial fee income from each investment they make on behalf of their funds. For example, the buyout firms receive a 1 percent deal completion fee, which is more than $100 million in the SunGard transaction. Buyout firms also receive fees paid for by the target firm that is “going private” for arranging financing. Moreover, there are also fees for conducting due diligence and for monitoring the ongoing performance of the firm taken private. Finally, when the buyout firms exit their investments in the target firm via a sale to a strategic buyer or a secondary IPO, they receive 20 percent (i.e., so-called carry fee) of any profits. Under the terms of the agreement, SunGard shareholders received $36 per share, a 14 percent premium over the SunGard closing price as of the announcement date of March 28, 2005, and 40 percent more than when the news first leaked about the deal a week earlier. From the SunGard shareholders’ perspective, the deal is valued at $11.4 billion dollars consisting of $10.9 billion for outstanding shares and “in-the-money” options (i.e., options whose exercise price is less than the firm’s market price per share) plus $500 million in debt on the balance sheet. The seven equity investors provided $3.5 billion in capital with the remainder of the purchase price financed by commitments from a lending consortium consisting of Citigroup, J.P. Morgan Chase & Co., and Deutsche Bank. The purpose of the loans is to finance the merger, repay or refinance SunGard’s existing debt, provide ongoing working capital, and pay fees and expenses incurred in connection with the merger. The total funds necessary to complete the merger and related fees and expenses is approximately $11.3 billion, consisting of approximately $10.9 billion to pay SunGard’s stockholders and about $400.7 million to pay fees and expenses related to the merger and the financing arrangements. Note that the fees that are to be financed comprise almost 4 percent of the purchase price. Ongoing working capital needs and capital expenditures required obtaining commitments from lenders well in excess of $11.3 billion. The merger financing consists of several tiers of debt and “credit facilities.” Credit facilities are arrangements for extending credit. The senior secured debt and senior subordinated debt are intended to provide “permanent” or long-term financing. Senior debt covenants included restrictions on new borrowing, investments, sales of assets, mergers and consolidations, prepayments of subordinated indebtedness, capital expenditures, liens and dividends and other distributions, as well as a minimum interest coverage ratio and a maximum total leverage ratio. If the offering of notes is not completed on or prior to the closing, the banks providing the financing have committed to provide up to $3 billion in loans under a senior subordinated bridge credit facility. The bridge loans are intended as a form of temporary financing to satisfy immediate cash requirements until permanent financing can be arranged. A special purpose SunGard subsidiary will purchase receivables from SunGard, with the purchases financed through the sale of the receivables to the lending consortium. The lenders subsequently finance the purchase of the receivables by issuing commercial paper, which is repaid as the receivables are collected. The special purpose subsidiary is not shown on the SunGard balance sheet. Based on the value of receivables at closing, the subsidiary could provide up to $500 million. The obligation of the lending consortium to buy the receivables will expire on the sixth anniversary of the closing of the merger. The following table provides SunGard’s post-merger proforma capital structure. Note that the proforma capital structure is portrayed as if SunGard uses 100 percent of bank lending commitments. Also, note that individual LBO investors may invest monies from more than one fund they manage. This may be due to the perceived attractiveness of the opportunity or the limited availability of money in any single fund. Of the $9 billion in debt financing, bank loans constitute 56 percent and subordinated or mezzanine debt comprises represents 44 percent. The roman numeral II refers to the fund providing the equity capital managed by the partnership -In what ways is this transaction similar to and different from those that were common in the 1980s? Be specific.

If the LBO is structured as a direct merger in which the seller receives cash for stock, the lender will make the loan to the buyer once the appropriate security agreements are in place and the target's stock has been pledged against the loan. The target then is merged into the acquiring company, which is the surviving corporation.

According to fraudulent conveyance laws, if a new company is found by the court to have been inadequately capitalized to remain viable, the lender could be stripped of its secured position in the assets of the company or its claims on the assets could be made subordinate to those of the general creditors.

Junk bonds are high-yield bonds either rated by the credit-rating agencies as below investment grade or not rated at all.

LBO investors have become much more actively involved in managing target firms in recent years than they have in the past.

Which of the following characteristics of a firm would limit the firm's attractiveness as a potential LBO candidate?

Case Study. Sony Buys MGM Sony's long-term vision has been to create synergy between its consumer electronics products and music, movies, and games. Sony, which bought Columbia Pictures in 1989 for $3.4 billion, had wanted to control Metro-Goldwyn-Mayer's film library for years, but it did not want to pay the estimated $5 billion it would take to acquire it. On September 14, 2004, a consortium, consisting of Sony Corp of America, Providence Equity Partners, Texas Pacific Group, and DLJ Merchant Banking Partners, agreed to acquire MGM for $4.8 billion, consisting of $2.85 billion in cash and the assumption of $2 billion in debt. The cash portion of the purchase price consisted of about $1.8 billion in debt and $1 billion in equity capital. Of the equity capital, Providence contributed $450 million, Sony and Texas Pacific Group $300 million, and DLJ Merchant Banking $250 million. The combination of Sony and MGM will create the world's largest film library of about 7,600 titles, with MGM contributing about 54 percent of the combined libraries. Sony will control MGM and Comcast will distribute the films over cable TV. Sony will shut down MGM's film making operations and move all operations to Sony. Kirk Kerkorian, who holds a 74 percent stake in MGM, will make $2 billion because of the transaction. The private equity partners could cash out within three-to-five years, with the consortium undertaking an initial public offering or sale to a strategic investor. Major risks include the ability of the consortium partners to maintain harmonious relations and the problematic growth potential of the DVD market. Sony and MGM negotiations had proven to be highly contentious for almost five months when media giant Time Warner Inc. emerged to attempt to satisfy Kerkorian's $5 billion asking price. The offer was made in stock on the assumption that Kerkorian would want a tax-free transaction. MGM's negotiations with Time Warner stalled around the actual value of Time Warner stock, with Kerkorian leery about Time Warner's future growth potential. Time Warner changed its bid in late August to an all cash offer, albeit somewhat lower than the Sony consortium bid, but it was more certain. Sony still did not have all of its financing in place. Time Warner had a "handshake agreement" with MGM by Labor Day for $11 per share, about $.25 less than Sony's. The Sony consortium huddled throughout the Labor Day weekend to put in place the financing for a bid of $12 per share. What often takes months to work out in most leveraged buyouts was hammered out in three days of marathon sessions at law firm Davis Polk & Wardwell. In addition to getting final agreement on financing arrangements including loan guarantees from J.P. Morgan Chase & Company, Sony was able to reach agreement with Comcast to feature MGM movies in new cable and video-on-demand TV channels. This distribution mechanism meant additional revenue for Sony, making it possible to increase the bid to $12 per share. Sony also offered to make a $150 non-refundable cash payment to MGM. As a testament to the adage that timing is everything, the revised Sony bid was faxed to MGM just before the beginning of a board meeting to approve the Time Warner offer. -In what way do you believe that Sony's objectives might differ from those of the private equity investors making up the remainder of the consortium? How might such differences affect the management of MGM? Identify possible short-term and long-term effects.

Which of the following is not true about junk bonds?

Junk bonds are always high risk.

Premiums paid to LBO firm shareholders average

Investors in highly leveraged transactions who are primarily focused on relatively short-to-intermediate term financial returns are often called financial buyers.

An affirmative covenant is a portion of a loan agreement that specifies the actions the borrowing firm cannot take during the term of the loan.

Security provisions and protective covenants are included in loan documents to increase the likelihood that the interest and principal of outstanding loans will be repaid in a timely fashion. Which of the following is not true about security provisions and protective covenants?

LBO investors seldom sell assets to repay debt used to acquire the firm.

In an effort to take the firm private, Cox Enterprises announced on August 3, 2004 a proposal to buy the remaining 38% of Cox Communications' shares that they did not currently own for $32 per share. Cox Enterprises stated that the increasingly competitive cable industry environment makes investment in the cable industry best done through a private company structure. Why would the firm believe that increasing future levels of investment would be best done as a private company?

The loan agreement stipulates the terms and conditions under which the lender will loan the borrower funds.