Exam 13: Financing the Deal

Which of the following is not typically true of LBOs?

Asset based lending does not require the borrower to pledge assets as collateral underlying the loans.

Do you believe that Heinz is a good candidate for a leveraged buyout? Explain your answer.

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. -How did Time Warner's entry into the bidding affect pace of the negotiations and the relative bargaining power of MGM, Time Warner, and the Sony consortium?

The LBO that is initiated by the target firm's incumbent management is called a management buyout.

Under-performing operating units of large companies are often excellent candidates for LBOs.

What do you believe was the purpose of the $1.5 billion senior secured revolving loan facility, and the $2.1 billion second lien bridge loan facility as part of the deal financing package?

What are the primary ways in which a leveraged buyuot is financed?

Which of the following is not true about attractive LBO candidates?

Cerberus Capital Management Acquires Chrysler Corporation According to the terms of the transaction, Cerberus would own 80.1 percent of Chrysler's auto manufacturing and financial services businesses in exchange for $7.4 billion in cash. Daimler would continue to own 19.9 percent of the new business, Chrysler Holdings LLC. Of the $7.4 billion, Daimler would receive $1.35 billion while the remaining $6.05 billion would be invested in Chrysler (i.e., $5.0 billion is to be invested in the auto manufacturing operation and $1.05 billion in the finance unit). Daimler also agreed to pay to Cerberus $1.6 billion to cover Chrysler's long-term debt and cumulative operating losses during the four months between the signing of the merger agreement and the actual closing. In acquiring Chrysler, Cerberus assumed responsibility for an estimated $18 billion in unfunded retiree pension and medical benefits. Daimler also agreed to loan Chrysler Holdings LLC $405 million. The transaction is atypical of those involving private equity investors, which usually take public firms private, expecting to later sell them for a profit. The private equity firm pays for the acquisition by borrowing against the firm's assets or cash flow. However, the estimated size of Chrysler's retiree health-care liabilities and the uncertainty of future cash flows make borrowing impractical. Therefore, Cerberus agreed to invest its own funds in the business to keep it running while it restructured the business. By going private, Cerberus would be able to focus on the long-term without the disruption of meeting quarterly earnings reports. Cerberus was counting on paring retiree health-care liabilities through aggressive negotiations with the United Auto Workers (UAW). Cerberus sought a deal similar to what the UAW accepted from Goodyear Tire and Rubber Company in late 2006. Under this agreement, the management of $1.2 billion in health-care liabilities was transferred to a fund managed by the UAW, with Goodyear contributing $1 billion in cash and Goodyear stock. By transferring responsibility for these liabilities to the UAW, Chrysler believed that it would be able to cut in half the $30 dollar per hour labor cost advantage enjoyed by Toyota. Cerberus also expected to benefit from melding Chrysler's financial unit with Cerberus's 51 percent ownership stake in GMAC, GM's former auto financing business. By consolidating the two businesses, Cerberus hoped to slash cost by eliminating duplicate jobs, combining overlapping operations such as data centers and field offices, and increasing the number of loans generated by combining back-office operations. However, the 2008 credit market meltdown, severe recession, and subsequent free fall in auto sales threatened the financial viability of Chrysler, despite an infusion of U.S. government capital, and it’s leasing operations as well as GMAC. GMAC applied for commercial banking status to be able to borrow directly from the U.S. Federal Reserve. In late 2008, the U.S. Treasury purchased $6 billion in GMAC preferred stock to provide additional capital to the financially ailing firm. To avoid being classified as a bank holding company under direct government supervision, Cerberus reduced its ownership in 2009 to 14.9 percent of voting stock and 33 percent of total equity by distributing equity stakes to its coinvestors in GMAC. By surrendering its controlling interest in GMAC, it is less likely that Cerberus would be able to realize anticipated cost savings by combining the GMAC and Chrysler Financial operations. In early 2009, Chrysler entered into negotiations with Italian auto maker Fiat to gain access to the firm's technology in exchange for a 20 percent stake in Chrysler. -Which of the leading explanations of why deals sometimes fail to meet expectations best explains why the combination of Daimler and Chrysler failed?

Case Study. Private Equity Firms Acquire Yellow Pages Business Qwest Communications agreed to sell its yellow pages business, QwestDex, to a consortium led by the Carlyle Group and Welsh, Carson, Anderson and Stowe for $7.1 billion. In a two stage transaction, Qwest sold the eastern half of the yellow pages business for $2.75 billion in late 2002. This portion of the business included directories in Colorado, Iowa, Minnesota, Nebraska, New Mexico, South Dakota, and North Dakota. The remainder of the business, Arizona, Idaho, Montana, Oregon, Utah, Washington, and Wyoming, was sold for $4.35 billion in late 2003. Caryle and Welsh Carson each put in $775 million in equity (about 21 percent of the total purchase price). Qwest was in a precarious financial position at the time of the negotiation. The telecom was trying to avoid bankruptcy and needed the first stage financing to meet impending debt repayments due in late 2002. Qwest is a local phone company in 14 western states and one of the nation's largest long-distance carriers. It had amassed $26.5 billion in debt following a series of acquisitions during the 1990s. The Carlyle Group has invested globally, mainly in defense and aerospace businesses, but it has also invested in companies in real estate, health care, bottling, and information technology. Welsh Carson focuses primarily on the communications and health care industries. While the yellow pages business is quite different from their normal areas of investment, both firms were attracted by its steady cash flow. Such cash flow could be used to trim debt over time and generate a solid return. The business' existing management team will continue to run the operation under the new ownership. Financing for the deal will come from J.P. Morgan Chase, Bank of America, Lehman Brothers, Wachovia Securities, and Deutsche Bank. The investment groups agreed to a two stage transaction to facilitate borrowing the large amounts required and to reduce the amount of equity each buyout firm had to invest. By staging the purchase, the lenders could see how well the operations acquired during the first stage could manage their debt load. The new company will be the exclusive directory publisher for Qwest yellow page needs at the local level and will provide all of Qwest's publishing requirements under a fifty year contract. Under the arrangement, Qwest will continue to provide certain services to its former yellow pages unit, such as billing and information technology, under a variety of commercial services and transitional services agreements (Qwest: 2002). -Why would the buyout firms want Qwest to continue to provide such services as billing and information technology support? How might such services be priced?

Junk bonds have invariably proved to be a reliable source of low-cost financing in LBO transactions during the last 30 years.

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. -Do you believe that Summit is a good candidate for a leveraged buyout? Explain your answer.

TXU Goes Private in the Largest Private Equity Transaction in History-The Dark Side of Leverage Key Points The 2007/2008 financial crisis left many LBOs excessively leveraged. As structured, the TXU buyout (now Energy Future Holdings) left no margin for error. Excessive leverage severely limits the firm's future financial options. _____________________________________________________________________________ Before the buyout, TXU, a Dallas-based energy giant, was a highly profitable utility. Historically low interest rates and an overly optimistic outlook for natural gas prices set the stage for the largest private equity deal in history. The 2007 buyout of TXU was valued at $48 billion and, at the time, appeared to offer such promise that several of Wall Street's largest lenders --including the likes of Lehman Brothers and Citigroup-invested, along with such storied names in private equity as KKR, TPG, and Goldman Sachs. However, the price of gas plummeted, eroding TXU's cash flow. Since the deal closed in October 2007, investors who bought $40 billion of TXU's debt have experienced losses as high as 70% to 80% of their value. The other $8 billion used to finance the deal came from the private equity investors, banks, and large institutional investors. They, too, have suffered huge losses. Having met its obligations to date, the firm faces a $20 billion debt repayment coming due in 2014. Wall Street banks were competing in 2007 to make loans to buyout firms on easier terms, with the banks also investing their own funds in the deal. The allure to the banks was the prospect of dividing up as much as $1.1 billion in fees for originating the loans, repackaging such loans into pools called collateralized loan obligations, and reselling them to long-term investors such as pension funds and insurance companies. In doing so, the loans would be removed from the banks' balance sheets, eliminating potential losses that could arise if the deal soured at a later date. Furthermore, the deal appeared to be attractive as an investment opportunity because some banks put up $500 million of their own cash for a stake in TXU. The financial sponsor group, consisting of Kohlberg Kravis Roberts & Co, Texas Pacific Group, and Goldman Sachs, created a shell corporation, referred to as Merger Sub Parent, and its wholly owned subsidiary Merger Sub. TXU was merged into Merger Sub, with Merger Sub surviving. Each outstanding share of TXU common stock was converted into the right to receive $69.25 in cash. Total cash required for the purchase was provided by the financial sponsor group and lenders (Creditor Group) to Merger Sub. Regulatory authorities required that the debt associated with the transaction be held at the level of the Merger Sub Parent holding company so as not to leverage the utility further. Subsequent to closing, the new company was reorganized into independent businesses under a new holding company, controlled by the Sponsor Group, called Texas Holdings (TH). Merger Sub (which owns TXU) was renamed Energy Future Holdings. TH's direct subsidiaries are EFH and Oncor (an energy distribution business formerly held by TXU). EFH's primary direct subsidiary is Texas Competitive Electric Holdings, which holds TXU's public utility operating assets and liabilities. All TXU non-Sponsor Group-related debt incurred to finance the transaction is held by EFH, while any debt incurred by the Sponsor Group is shown on the TH balance sheet. This legal structure allows for the concentration of debt in TH and EFH, separate from the cash-generating assets held by Oncor and Texas Competitive Electric Holdings. Loan covenants limit EFH's and its subsidiaries' ability to issue new debt or preferred stock; pay dividends on, repurchase, or make distributions of capital stock or make other restricted payments; make investments; sell or transfer assets; consolidate, merge, sell, or dispose of all or substantially all its assets; and repay, repurchase, or modify debt. A breach of any of these covenants could result in default. Table 13.6 illustrates selected covenants in which certain ratios must be maintained either above or below stipulated thresholds. Note that EFH was in violation of certain covenants when you compare actual December 31, 2009 (the last year for which public information is available), ratios with required threshold levels. -December 31, 2009 -Threshold Level as of December 31, 2009 Things clearly have not turned out as expected. The firm faces an almost-untenable capital structure. The firm's debt traded at between 20 and 30 cents on the dollar throughout most of 2012. The $8 billion equity invested in the deal has been virtually wiped out on paper. Absent a turnaround in natural gas prices, EFH is left with seeking a way to reduce substantially the burden of the pending 2014 $20 billion loan payment with its lenders through a debt-for-equity swap or more favorable terms on existing debt or by pursuing Chapter 11 bankruptcy. EFH has posted eight consecutive quarterly losses. In December 2012, in an effort to extend debt maturities to buy time for a turnaround and to reduce interest expense, EFH exchanged $1.15 billion of new payment-in-kind notes (interest is paid with more debt) for existing notes with a face value of $1.6 billion. By any measure, this transaction illustrates the dark side of leverage. -Loan covenants exist to protect the lender. How might such covenants inhibit the EFH from meeting its 2014 $20 billion obligations?

RJR NABISCO GOES PRIVATE- KEY SHAREHOLDER AND PUBLIC POLICY ISSUES Background The largest LBO in history is as well known for its theatrics as it is for its substantial improvement in shareholder value. In October 1988, H. Ross Johnson, then CEO of RJR Nabisco, proposed an MBO of the firm at $75 per share. His failure to inform the RJR board before publicly announcing his plans alienated many of the directors. Analysts outside the company placed the breakup value of RJR Nabisco at more than $100 per share-almost twice its then current share price. Johnson's bid immediately was countered by a bid by the well-known LBO firm, Kohlberg, Kravis, and Roberts (KKR), to buy the firm for $90 per share (Wasserstein, 1998). The firm's board immediately was faced with the dilemma of whether to accept the KKR offer or to consider some other form of restructuring of the company. The board appointed a committee of outside directors to assess the bid to minimize the appearance of a potential conflict of interest in having current board members, who were also part of the buyout proposal from management, vote on which bid to select. The bidding war soon escalated with additional bids coming from Forstmann Little and First Boston, although the latter's bid never really was taken very seriously. Forstmann Little later dropped out of the bidding as the purchase price rose. Although the firm's investment bankers valued both the bids by Johnson and KKR at about the same level, the board ultimately accepted the KKR bid. The winning bid was set at almost $25 billion-the largest transaction on record at that time and the largest LBO in history. Banks provided about three-fourths of the $20 billion that was borrowed to complete the transaction. The remaining debt was supplied by junk bond financing. The RJR shareholders were the real winners, because the final purchase price constituted a more than 100% return from the $56 per share price that existed just before the initial bid by RJR management. Aggressive pricing actions by such competitors as Phillip Morris threatened to erode RJR Nabisco's ability to service its debt. Complex securities such as "increasing rate notes," whose coupon rates had to be periodically reset to ensure that these notes would trade at face value, ultimately forced the credit rating agencies to downgrade the RJR Nabisco debt. As market interest rates climbed, RJR Nabisco did not appear to have sufficient cash to accommodate the additional interest expense on the increasing return notes. To avoid default, KKR recapitalized the company by investing additional equity capital and divesting more than $5 billion worth of businesses in 1990 to help reduce its crushing debt load. In 1991, RJR went public by issuing more than $1 billion in new common stock, which placed about one-fourth of the firm's common stock in public hands. When KKR eventually fully liquidated its position in RJR Nabisco in 1995, it did so for a far smaller profit than expected. KKR earned a profit of about $60 million on an equity investment of $3.1 billion. KKR had not done well for the outside investors who had financed more than 90% of the total equity investment in KKR. However, KKR fared much better than investors had in its LBO funds by earning more than $500 million in transaction fees, advisor fees, management fees, and directors' fees. The publicity surrounding the transaction did not cease with the closing of the transaction. Dissident bondholders filed suits alleging that the payment of such a large premium for the company represented a "confiscation" of bondholder wealth by shareholders. Potential Conflicts of Interest In any MBO, management is confronted by a potential conflict of interest. Their fiduciary responsibility to the shareholders is to take actions to maximize shareholder value; yet in the RJR Nabisco case, the management bid appeared to be well below what was in the best interests of shareholders. Several proposals have been made to minimize the potential for conflict of interest in the case of an MBO, including that directors, who are part of an MBO effort, not be allowed to participate in voting on bids, that fairness opinions be solicited from independent financial advisors, and that a firm receiving an MBO proposal be required to hold an auction for the firm. The most contentious discussion immediately following the closing of the RJR Nabisco buyout centered on the alleged transfer of wealth from bond and preferred stockholders to common stockholders when a premium was paid for the shares held by RJR Nabisco common stockholders. It often is argued that at least some part of the premium is offset by a reduction in the value of the firm's outstanding bonds and preferred stock because of the substantial increase in leverage that takes place in LBOs. Winners and Losers RJR Nabisco shareholders before the buyout clearly benefited greatly from efforts to take the company private. However, in addition to the potential transfer of wealth from bondholders to stockholders, some critics of LBOs argue that a wealth transfer also takes place in LBO transactions when LBO management is able to negotiate wage and benefit concessions from current employee unions. LBOs are under greater pressure to seek such concessions than other types of buyouts because they need to meet huge debt service requirements. -Describe the potential benefits and costs of LBOs to shareholders, employers, lenders, customers, and communities in which the firm undergoing the buyout may have operations. Do you believe that on average LBOs provide a net benefit or cost to society? Explain your answer.

How do loan and security covenants affect the way in which a leveraged buyout is managed? Note the differences between positive and negative covenants.

Case Study. Private Equity Firms Acquire Yellow Pages Business Qwest Communications agreed to sell its yellow pages business, QwestDex, to a consortium led by the Carlyle Group and Welsh, Carson, Anderson and Stowe for $7.1 billion. In a two stage transaction, Qwest sold the eastern half of the yellow pages business for $2.75 billion in late 2002. This portion of the business included directories in Colorado, Iowa, Minnesota, Nebraska, New Mexico, South Dakota, and North Dakota. The remainder of the business, Arizona, Idaho, Montana, Oregon, Utah, Washington, and Wyoming, was sold for $4.35 billion in late 2003. Caryle and Welsh Carson each put in $775 million in equity (about 21 percent of the total purchase price). Qwest was in a precarious financial position at the time of the negotiation. The telecom was trying to avoid bankruptcy and needed the first stage financing to meet impending debt repayments due in late 2002. Qwest is a local phone company in 14 western states and one of the nation's largest long-distance carriers. It had amassed $26.5 billion in debt following a series of acquisitions during the 1990s. The Carlyle Group has invested globally, mainly in defense and aerospace businesses, but it has also invested in companies in real estate, health care, bottling, and information technology. Welsh Carson focuses primarily on the communications and health care industries. While the yellow pages business is quite different from their normal areas of investment, both firms were attracted by its steady cash flow. Such cash flow could be used to trim debt over time and generate a solid return. The business' existing management team will continue to run the operation under the new ownership. Financing for the deal will come from J.P. Morgan Chase, Bank of America, Lehman Brothers, Wachovia Securities, and Deutsche Bank. The investment groups agreed to a two stage transaction to facilitate borrowing the large amounts required and to reduce the amount of equity each buyout firm had to invest. By staging the purchase, the lenders could see how well the operations acquired during the first stage could manage their debt load. The new company will be the exclusive directory publisher for Qwest yellow page needs at the local level and will provide all of Qwest's publishing requirements under a fifty year contract. Under the arrangement, Qwest will continue to provide certain services to its former yellow pages unit, such as billing and information technology, under a variety of commercial services and transitional services agreements (Qwest: 2002). -Why did the buyout firms want a 50-year contract to be the exclusive provider of publishing services to Qwest Communications?

LBO investors will often use the target firm's cash in excess of normal working capital requirements to finance the transaction.

Case Study. Private Equity Firms Acquire Yellow Pages Business Qwest Communications agreed to sell its yellow pages business, QwestDex, to a consortium led by the Carlyle Group and Welsh, Carson, Anderson and Stowe for $7.1 billion. In a two stage transaction, Qwest sold the eastern half of the yellow pages business for $2.75 billion in late 2002. This portion of the business included directories in Colorado, Iowa, Minnesota, Nebraska, New Mexico, South Dakota, and North Dakota. The remainder of the business, Arizona, Idaho, Montana, Oregon, Utah, Washington, and Wyoming, was sold for $4.35 billion in late 2003. Caryle and Welsh Carson each put in $775 million in equity (about 21 percent of the total purchase price). Qwest was in a precarious financial position at the time of the negotiation. The telecom was trying to avoid bankruptcy and needed the first stage financing to meet impending debt repayments due in late 2002. Qwest is a local phone company in 14 western states and one of the nation's largest long-distance carriers. It had amassed $26.5 billion in debt following a series of acquisitions during the 1990s. The Carlyle Group has invested globally, mainly in defense and aerospace businesses, but it has also invested in companies in real estate, health care, bottling, and information technology. Welsh Carson focuses primarily on the communications and health care industries. While the yellow pages business is quite different from their normal areas of investment, both firms were attracted by its steady cash flow. Such cash flow could be used to trim debt over time and generate a solid return. The business' existing management team will continue to run the operation under the new ownership. Financing for the deal will come from J.P. Morgan Chase, Bank of America, Lehman Brothers, Wachovia Securities, and Deutsche Bank. The investment groups agreed to a two stage transaction to facilitate borrowing the large amounts required and to reduce the amount of equity each buyout firm had to invest. By staging the purchase, the lenders could see how well the operations acquired during the first stage could manage their debt load. The new company will be the exclusive directory publisher for Qwest yellow page needs at the local level and will provide all of Qwest's publishing requirements under a fifty year contract. Under the arrangement, Qwest will continue to provide certain services to its former yellow pages unit, such as billing and information technology, under a variety of commercial services and transitional services agreements (Qwest: 2002). -Why would it take five very large financial institutions to finance the transactions?

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. -Why did Lionsgate make an equity contribution in the form of cash and stock to the Merger Sub rather than making the cash portion of the contributed capital in the form of a loan?