Exam 13: Financing the Deal

HCA's LBO Represents a High-Risk Bet on Growth While most LBOs are predicated on improving operating performance through a combination of aggressive cost cutting and revenue growth, HCA laid out an unconventional approach in its effort to take the firm private. On July 24, 2006, management again announced that it would "go private" in a deal valued at $33 billion including the assumption of $11.7 billion in existing debt. The approximate $21.3 billion purchase price for HCA's stock was financed by a combination of $12.8 billion in senior secured term loans of varying maturities and an estimated $8.5 billion in cash provided by Bain Capital, Merrill Lynch Global Private Equity, and Kohlberg Kravis Roberts & Company. HCA also would take out a $4 billion revolving credit line to satisfy immediate working capital requirements. The firm publicly announced a strategy of improving performance through growth rather than through cost cutting. HCA's network of 182 hospitals and 94 surgery centers is expected to benefit from an aging U.S. population and the resulting increase in health-care spending. The deal also seems to be partly contingent on the government assuming a larger share of health-care costs in the future. Finally, with many nonprofit hospitals faltering financially, HCA may be able to acquire them inexpensively. While the longer-term trends in the health-care industry are unmistakable, shorter-term developments appear troublesome, including sluggish hospital admissions, more uninsured patients, and higher bad debt expenses. Moreover, with Medicare and Medicaid financially insolvent, it is unclear if future increases in government health-care spending would be sufficient to enable HCA investors to achieve their expected financial returns. With the highest operating profit margins in the industry, it is uncertain if HCA's cash flows could be significantly improved by cost cutting, if the revenue growth assumptions fail to materialize. HCA's management and equity investors have put themselves in a position in which they seem to have relatively little influence over the factors that directly affect the firm's future cash flows. -Having pledged not to engage in aggressive cost cutting, how do you think HCA and its financial sponsor group planned on paying off the loans?

Describe common strategies LBO firms use to exit their investment. Discuss the circumstances under which some methods are preferred to others.

The risk associated with overpaying is magnified for leveraged buyout transactions.

Because of their high liquidity, lenders often lend up to 100% of the book value of accounts receivable pledged as collateral in leveraged buyouts.

Lessons from Pep Boys’ Aborted Attempt to Go Private LBOs in recent years have involved financial sponsors’ providing a larger portion of the purchase price in cash than in the past. Financial sponsors focus increasingly on targets in which they have previous or related experience. Deals that would have been completed in the early 2000s are more likely to be terminated or subject to renegotiation than in the past. _____________________________________________________________________________________ It ain’t over till it’s over” quipped former New York Yankees’ catcher Yogi Berra, famous for his malapropisms. The oft-quoted comment was once again proven true in Pep Boys’ unsuccessful attempt to go private in 2012. On May 30, 2012, after nearly two years of discussions between Pep Boys and several interested parties, the firm announced that a buyout agreement with the Gores Group (Gores), valued at approximately $1 billion (including assumed debt), had collapsed, a victim of Pep Boys’ declining operating performance. The firm’s shares fell 20% on the news to $8.89 per share, well below its level following the all-cash $15-a-share deal with Gores announced in January 2012. The terms of the transaction also included a termination fee if either party failed to complete the deal by July 27, 2012. The failed transaction illustrates the characteristics and potential pitfalls common to contemporary LBOs. Pep Boys, a U.S. auto parts and repair business, operates more than 7,000 service bays in over 700 locations in 35 states and Puerto Rico. With its share price lagging the overall stock market in recent years, the firm’s board of directors explored a range of options for boosting the firm’s value and ultimately decided to put the firm up for sale. Gores was attracted initially by what appeared to be a low purchase price, stable cash flow, and the firm’s real estate holdings (many of the firm’s store sites are owned by the firm). Such assets could be used as collateral underlying loans to finance a portion of the purchase price. Furthermore, Gores has experience in retailing, having several retailers among their portfolio of companies, including J. Mendel and Mexx. The transaction reflected a structure common for deals of this type. Pep Boys had entered into a merger agreement with Auto Acquisitions Group (the Parent), a shell corporation funded by cash provided by Gores as the financial sponsor, and the Parent’s wholly owned subsidiary (Merger Sub). The Parent would contribute cash to Merger Sub, with Merger Sub borrowing the remainder from several lenders. Merger Sub would subsequently buy Pep Boys’ outstanding shares and merge with the firm. Pep Boys would survive as a wholly owned subsidiary of the Parent. The purpose of this reverse triangular merger was to preserve the Pep Boys’ brand name and facilitate the transfer of supplier and customer contracts. The Parent also was to have been organized as a holding company to afford investors some degree of protection from Pep Boys’ liabilities. The purchase price was to have been financed by an equity contribution of $489 million from limited partnerships managed by Gores and the balance by loans provided by Barclays Bank PLC, Credit Suisse AG, and Wells Fargo Bank. Upon learning that the Pep Boys’ reported earnings for the first quarter of 2012 would be well below expectations, Gores attempted to renegotiate the terms of the deal, arguing that Pep Boys had breached the deal’s agreements. With Pep Boys unwilling to accept a lower valuation, Gores exercised its right to terminate the deal by paying the $50 million breakup fee and agreed to reimburse Pep Boys for other costs it had incurred related to the deal. Pep Boys said the firm will use the proceeds of the breakup fee to refinance a portion of its outstanding debt. "Grave Dancer" Takes Tribune Corporation Private in an Ill-Fated Transaction At the closing in late December 2007, well-known real estate investor Sam Zell described the takeover of the Tribune Company as "the transaction from hell." His comments were prescient in that what had appeared to be a cleverly crafted, albeit highly leveraged, deal from a tax standpoint was unable to withstand the credit malaise of 2008. The end came swiftly when the 161-year-old Tribune filed for bankruptcy on December 8, 2008. On April 2, 2007, the Tribune Corporation announced that the firm's publicly traded shares would be acquired in a multistage transaction valued at $8.2 billion. Tribune owned at that time 9 newspapers, 23 television stations, a 25% stake in Comcast's SportsNet Chicago, and the Chicago Cubs baseball team. Publishing accounts for 75% of the firm's total $5.5 billion annual revenue, with the remainder coming from broadcasting and entertainment. Advertising and circulation revenue had fallen by 9% at the firm's three largest newspapers (Los Angeles Times, Chicago Tribune, and Newsday in New York) between 2004 and 2006. Despite aggressive efforts to cut costs, Tribune's stock had fallen more than 30% since 2005. The transaction was implemented in a two-stage transaction, in which Sam Zell acquired a controlling 51% interest in the first stage followed by a backend merger in the second stage in which the remaining outstanding Tribune shares were acquired. In the first stage, Tribune initiated a cash tender offer for 126 million shares (51% of total shares) for $34 per share, totaling $4.2 billion. The tender was financed using $250 million of the $315 million provided by Sam Zell in the form of subordinated debt, plus additional borrowing to cover the balance. Stage 2 was triggered when the deal received regulatory approval. During this stage, an employee stock ownership plan (ESOP) bought the rest of the shares at $34 a share (totaling about $4 billion), with Zell providing the remaining $65 million of his pledge. Most of the ESOP's 121 million shares purchased were financed by debt guaranteed by the firm on behalf of the ESOP. At that point, the ESOP held all of the remaining stock outstanding valued at about $4 billion. In exchange for his commitment of funds, Mr. Zell received a 15-year warrant to acquire 40% of the common stock (newly issued) at a price set at $500 million. Following closing in December 2007, all company contributions to employee pension plans were funneled into the ESOP in the form of Tribune stock. Over time, the ESOP would hold all the stock. Furthermore, Tribune was converted from a C corporation to a Subchapter S corporation, allowing the firm to avoid corporate income taxes. However, it would have to pay taxes on gains resulting from the sale of assets held less than ten years after the conversion from a C to an S corporation (Figure 1). The purchase of Tribune's stock was financed almost entirely with debt, with Zell's equity contribution amounting to less than 4% of the purchase price. The transaction resulted in Tribune being burdened with $13 billion in debt (including the approximate $5 billion currently owed by Tribune). At this level, the firm's debt was ten times EBITDA, more than two and a half times that of the average media company. Annual interest and principal repayments reached $800 million (almost three times their preacquisition level), about 62% of the firm's previous EBITDA cash flow of $1.3 billion. While the ESOP owned the company, it was not be liable for the debt guaranteed by Tribune. The conversion of Tribune into a Subchapter S corporation eliminated the firm's current annual tax liability of $348 million. Such entities pay no corporate income tax but must pay all profit directly to shareholders, who then pay taxes on these distributions. Since the ESOP was the sole shareholder, Tribune was expected to be largely tax exempt, since ESOPs are not taxed. In an effort to reduce the firm's debt burden, the Tribune Company announced in early 2008 the formation of a partnership in which Cablevision Systems Corporation would own 97% of Newsday for $650 million, with Tribune owning the remaining 3%. However, Tribune was unable to sell the Chicago Cubs (which had been expected to fetch as much as $1 billion) and the minority interest in SportsNet Chicago to help reduce the debt amid the 2008 credit crisis. The worsening of the recession, accelerated by the decline in newspaper and TV advertising revenue, as well as newspaper circulation, thereby eroded the firm's ability to meet its debt obligations. By filing for Chapter 11 bankruptcy protection, the Tribune Company sought a reprieve from its creditors while it attempted to restructure its business. Although the extent of the losses to employees, creditors, and other stakeholders is difficult to determine, some things are clear. Any pension funds set aside prior to the closing remain with the employees, but it is likely that equity contributions made to the ESOP on behalf of the employees since the closing would be lost. The employees would become general creditors of Tribune. As a holder of subordinated debt, Mr. Zell had priority over the employees if the firm was liquidated and the proceeds distributed to the creditors. Those benefitting from the deal included Tribune's public shareholders, including the Chandler family, which owed 12% of Tribune as a result of its prior sale of the Times Mirror to Tribune, and Dennis FitzSimons, the firm's former CEO, who received $17.7 million in severance and $23.8 million for his holdings of Tribune shares. Citigroup and Merrill Lynch received $35.8 million and $37 million, respectively, in advisory fees. Morgan Stanley received $7.5 million for writing a fairness opinion letter. Finally, Valuation Research Corporation received $1 million for providing a solvency opinion indicating that Tribune could satisfy its loan covenants. What appeared to be one of the most complex deals of 2007, designed to reap huge tax advantages, soon became a victim of the downward-spiraling economy, the credit crunch, and its own leverage. A lawsuit filed in late 2008 on behalf of Tribune employees contended that the transaction was flawed from the outset and intended to benefit Sam Zell and his advisors and Tribune’s board. Even if the employees win, they will simply have to stand in line with other Tribune creditors awaiting the resolution of the bankruptcy court proceedings. -Describe the firm's strategy to finance the transaction?

Why do you believe Berkshire Hathaway wanted to receive preferred rather than common stock in exchange for its investing $8 billion? Be specific.

Which of the following is generally not considered a characteristic of a financial buyer?

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. -What was the purpose of the pre-closing covenants and closing conditions as described in the merger agreement?

The promissory note commits the borrower to repay the loan, only if the assets when liquidated fully cover the unpaid balance.

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. -In your opinion, was the buyout proposal presented by Ross Johnson's management group in the best interests of the shareholders? Why? / Why not?

Which of the following are commonly used sources of funding for leveraged buyouts?

Premiums paid to LBO target firm shareholders often exceed 40%.

Typical LBO targets are in mature industries such as manufacturing, retailing, textiles, food processing, apparel, and soft drinks.

Firms with redundant assets and predictable cash flow are often good candidates for leveraged buyouts.

Financial buyers usually plan to hold onto acquired firms longer than strategic buyers.

Lessons from Pep Boys’ Aborted Attempt to Go Private LBOs in recent years have involved financial sponsors’ providing a larger portion of the purchase price in cash than in the past. Financial sponsors focus increasingly on targets in which they have previous or related experience. Deals that would have been completed in the early 2000s are more likely to be terminated or subject to renegotiation than in the past. _____________________________________________________________________________________ It ain’t over till it’s over” quipped former New York Yankees’ catcher Yogi Berra, famous for his malapropisms. The oft-quoted comment was once again proven true in Pep Boys’ unsuccessful attempt to go private in 2012. On May 30, 2012, after nearly two years of discussions between Pep Boys and several interested parties, the firm announced that a buyout agreement with the Gores Group (Gores), valued at approximately $1 billion (including assumed debt), had collapsed, a victim of Pep Boys’ declining operating performance. The firm’s shares fell 20% on the news to $8.89 per share, well below its level following the all-cash $15-a-share deal with Gores announced in January 2012. The terms of the transaction also included a termination fee if either party failed to complete the deal by July 27, 2012. The failed transaction illustrates the characteristics and potential pitfalls common to contemporary LBOs. Pep Boys, a U.S. auto parts and repair business, operates more than 7,000 service bays in over 700 locations in 35 states and Puerto Rico. With its share price lagging the overall stock market in recent years, the firm’s board of directors explored a range of options for boosting the firm’s value and ultimately decided to put the firm up for sale. Gores was attracted initially by what appeared to be a low purchase price, stable cash flow, and the firm’s real estate holdings (many of the firm’s store sites are owned by the firm). Such assets could be used as collateral underlying loans to finance a portion of the purchase price. Furthermore, Gores has experience in retailing, having several retailers among their portfolio of companies, including J. Mendel and Mexx. The transaction reflected a structure common for deals of this type. Pep Boys had entered into a merger agreement with Auto Acquisitions Group (the Parent), a shell corporation funded by cash provided by Gores as the financial sponsor, and the Parent’s wholly owned subsidiary (Merger Sub). The Parent would contribute cash to Merger Sub, with Merger Sub borrowing the remainder from several lenders. Merger Sub would subsequently buy Pep Boys’ outstanding shares and merge with the firm. Pep Boys would survive as a wholly owned subsidiary of the Parent. The purpose of this reverse triangular merger was to preserve the Pep Boys’ brand name and facilitate the transfer of supplier and customer contracts. The Parent also was to have been organized as a holding company to afford investors some degree of protection from Pep Boys’ liabilities. The purchase price was to have been financed by an equity contribution of $489 million from limited partnerships managed by Gores and the balance by loans provided by Barclays Bank PLC, Credit Suisse AG, and Wells Fargo Bank. Upon learning that the Pep Boys’ reported earnings for the first quarter of 2012 would be well below expectations, Gores attempted to renegotiate the terms of the deal, arguing that Pep Boys had breached the deal’s agreements. With Pep Boys unwilling to accept a lower valuation, Gores exercised its right to terminate the deal by paying the $50 million breakup fee and agreed to reimburse Pep Boys for other costs it had incurred related to the deal. Pep Boys said the firm will use the proceeds of the breakup fee to refinance a portion of its outstanding debt. "Grave Dancer" Takes Tribune Corporation Private in an Ill-Fated Transaction At the closing in late December 2007, well-known real estate investor Sam Zell described the takeover of the Tribune Company as "the transaction from hell." His comments were prescient in that what had appeared to be a cleverly crafted, albeit highly leveraged, deal from a tax standpoint was unable to withstand the credit malaise of 2008. The end came swiftly when the 161-year-old Tribune filed for bankruptcy on December 8, 2008. On April 2, 2007, the Tribune Corporation announced that the firm's publicly traded shares would be acquired in a multistage transaction valued at $8.2 billion. Tribune owned at that time 9 newspapers, 23 television stations, a 25% stake in Comcast's SportsNet Chicago, and the Chicago Cubs baseball team. Publishing accounts for 75% of the firm's total $5.5 billion annual revenue, with the remainder coming from broadcasting and entertainment. Advertising and circulation revenue had fallen by 9% at the firm's three largest newspapers (Los Angeles Times, Chicago Tribune, and Newsday in New York) between 2004 and 2006. Despite aggressive efforts to cut costs, Tribune's stock had fallen more than 30% since 2005. The transaction was implemented in a two-stage transaction, in which Sam Zell acquired a controlling 51% interest in the first stage followed by a backend merger in the second stage in which the remaining outstanding Tribune shares were acquired. In the first stage, Tribune initiated a cash tender offer for 126 million shares (51% of total shares) for $34 per share, totaling $4.2 billion. The tender was financed using $250 million of the $315 million provided by Sam Zell in the form of subordinated debt, plus additional borrowing to cover the balance. Stage 2 was triggered when the deal received regulatory approval. During this stage, an employee stock ownership plan (ESOP) bought the rest of the shares at $34 a share (totaling about $4 billion), with Zell providing the remaining $65 million of his pledge. Most of the ESOP's 121 million shares purchased were financed by debt guaranteed by the firm on behalf of the ESOP. At that point, the ESOP held all of the remaining stock outstanding valued at about $4 billion. In exchange for his commitment of funds, Mr. Zell received a 15-year warrant to acquire 40% of the common stock (newly issued) at a price set at $500 million. Following closing in December 2007, all company contributions to employee pension plans were funneled into the ESOP in the form of Tribune stock. Over time, the ESOP would hold all the stock. Furthermore, Tribune was converted from a C corporation to a Subchapter S corporation, allowing the firm to avoid corporate income taxes. However, it would have to pay taxes on gains resulting from the sale of assets held less than ten years after the conversion from a C to an S corporation (Figure 1). The purchase of Tribune's stock was financed almost entirely with debt, with Zell's equity contribution amounting to less than 4% of the purchase price. The transaction resulted in Tribune being burdened with $13 billion in debt (including the approximate $5 billion currently owed by Tribune). At this level, the firm's debt was ten times EBITDA, more than two and a half times that of the average media company. Annual interest and principal repayments reached $800 million (almost three times their preacquisition level), about 62% of the firm's previous EBITDA cash flow of $1.3 billion. While the ESOP owned the company, it was not be liable for the debt guaranteed by Tribune. The conversion of Tribune into a Subchapter S corporation eliminated the firm's current annual tax liability of $348 million. Such entities pay no corporate income tax but must pay all profit directly to shareholders, who then pay taxes on these distributions. Since the ESOP was the sole shareholder, Tribune was expected to be largely tax exempt, since ESOPs are not taxed. In an effort to reduce the firm's debt burden, the Tribune Company announced in early 2008 the formation of a partnership in which Cablevision Systems Corporation would own 97% of Newsday for $650 million, with Tribune owning the remaining 3%. However, Tribune was unable to sell the Chicago Cubs (which had been expected to fetch as much as $1 billion) and the minority interest in SportsNet Chicago to help reduce the debt amid the 2008 credit crisis. The worsening of the recession, accelerated by the decline in newspaper and TV advertising revenue, as well as newspaper circulation, thereby eroded the firm's ability to meet its debt obligations. By filing for Chapter 11 bankruptcy protection, the Tribune Company sought a reprieve from its creditors while it attempted to restructure its business. Although the extent of the losses to employees, creditors, and other stakeholders is difficult to determine, some things are clear. Any pension funds set aside prior to the closing remain with the employees, but it is likely that equity contributions made to the ESOP on behalf of the employees since the closing would be lost. The employees would become general creditors of Tribune. As a holder of subordinated debt, Mr. Zell had priority over the employees if the firm was liquidated and the proceeds distributed to the creditors. Those benefitting from the deal included Tribune's public shareholders, including the Chandler family, which owed 12% of Tribune as a result of its prior sale of the Times Mirror to Tribune, and Dennis FitzSimons, the firm's former CEO, who received $17.7 million in severance and $23.8 million for his holdings of Tribune shares. Citigroup and Merrill Lynch received $35.8 million and $37 million, respectively, in advisory fees. Morgan Stanley received $7.5 million for writing a fairness opinion letter. Finally, Valuation Research Corporation received $1 million for providing a solvency opinion indicating that Tribune could satisfy its loan covenants. What appeared to be one of the most complex deals of 2007, designed to reap huge tax advantages, soon became a victim of the downward-spiraling economy, the credit crunch, and its own leverage. A lawsuit filed in late 2008 on behalf of Tribune employees contended that the transaction was flawed from the outset and intended to benefit Sam Zell and his advisors and Tribune’s board. Even if the employees win, they will simply have to stand in line with other Tribune creditors awaiting the resolution of the bankruptcy court proceedings. -Comment on the fairness of this transaction to the various stakeholders involved. How would you apportion the responsibility for the eventual bankruptcy of Tribune among Sam Zell and his advisors, the Tribune board, and the largely unforeseen collapse of the credit markets in late 2008? Be specific.

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. -The new company, Chrysler Holdings, is a limited liability company. Why do you think CCM chose this legal structure over a more conventional corporate structure?

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. -Do you believe that MGM is an attractive LBO candidate? Why? Why not?

High growth firms with high reinvestment requirements often make attractive LBO targets.

Pacific Investors Acquires California Kool in a Leveraged Buyout Pacific Investors (PI) is a small private equity limited partnership with $3 billion under management. The objective of the fund is to give investors at least a 30-percent annual average return on their investment by judiciously investing these funds in highly leveraged transactions. PI has been able to realize such returns over the last decade because of its focus on investing in industries that have slow but predictable growth in cash flow, modest capital investment requirements, and relatively low levels of research and development spending. In the past, PI made several lucrative investments in the contract packaging industry, which provides packaging for beverage companies that produce various types of noncarbonated and carbonated beverages. Because of its commitments to its investors, PI likes to liquidate its investments within four to six years of the initial investment through a secondary public offering or sale to a strategic investor. Following its past success in the industry, PI currently is negotiating with California Kool (CK), a privately owned contract beverage packaging company with the technology required to package many types of noncarbonated drinks. CK's 2003 revenue and net income are $190.4 million and $5.9 million, respectively. With a reputation for effective management, CK is a medium-sized contract packaging company that owns its own plant and equipment and has a history of continually increasing cash flow. The company also has significant unused excess capacity, suggesting that production levels can be increased without substantial new capital spending. The owners of CK are demanding a purchase price of $70 million. This is denoted on the balance sheet (see Table 13-15 at the end of the case) as a negative entry in additional paid-in capital. This price represents a multiple of 11.8 times 2003's net income, almost twice the multiple for comparable publicly traded companies. Despite the "rich" multiple, PI believes that it can finance the transaction through an equity investment of $25 million and $47 million in debt. The equity investment consists of $3 million in common stock, with PI's investors and CK's management each contributing $1.5 million. Debt consists of a $12 million revolving loan to meet immediate working capital requirements, $20 million in senior bank debt secured by CK's fixed assets, and $15 million in a subordinated loan from a pension fund. The total cost of acquiring CK is $72 million, $70 million paid to the owners of CK and $2 million in legal and accounting fees. As indicated on Table 13-15, the change in total liabilities plus shareholders' equity (i.e., total sources of funds or cash inflows) must equal the change in total assets (i.e., total uses of funds or cash outflows). Therefore, as shown in the adjustments column, total liabilities increase by $47 million in total borrowings and shareholders' equity declines by $45 million (i.e., $25 million in preferred and common equity provided by investors less $70 million paid to CK owners). The excess of sources over uses of $2 million is used to finance legal and accounting fees incurred in closing the transaction. Consequently, total assets increase by $2 million and total liabilities plus shareholders' equity increase by $2 million between the pre- and postclosing balance sheets as shown in the adjustments column.hasi¹ Delta;Total assets = ΔTotal liabilities + ΔShareholders' equity: $2 million = $47 million -$45 million = $2 million. Revenue for CK is projected to grow at 4.5 percent annually through the foreseeable future. Operating expenses and sales, general, and administrative expenses as a percent of sales are expected to decline during the first three years of operation due to aggressive cost cutting and the introduction of new management and engineering processes. Similarly, improved working capital management results in significant declines in working capital as a percent of sales during the first year of operation. Gross fixed assets as percent of sales is held constant at its 2003 level during the forecast period, reflecting reinvestment requirements to support the projected increase in net revenue. Equity cash flow adjusted to include cash generated in excess of normal operating requirements (i.e., denoted by the change in investments available for sale) is expected to reach $8.5 million annually by 2010. Using the cost of capital method, the cost of equity declines in line with the reduction in the firm's beta as the debt is repaid from 26 percent in 2004 to 16.5 percent in 2010. In contrast, the adjusted present value method employs a constant unlevered COE of 17 percent. The deal would appear to make sense from the standpoint of PI, since the projected average annual internal rates of return (IRRs) for investors exceed PI's minimum desired 30 percent rate of return in all scenarios considered between 2007 and 2009 (see Table 13-13). This is the period during which investors would like to "cash out." The rates of return scenarios are calculated assuming the business can be sold at different multiples of adjusted equity cash flow in the year in which the business is assumed to be sold. Consequently, IRRs are calculated using the cash outflow (initial equity investment in the business) in the first year offset by any positive equity cash flow from operations generated in the first year, equity cash flows for each subsequent year, and the sum of equity cash flow in the year in which the business is sold or taken public plus the estimated sale value (e.g., eight times equity cash flow) in that year. Adjusted equity cash flow includes free cash flow generated from operations and the increase in "investments available for sale." Such investments represent cash generated in excess of normal operating requirements; and as such, this cash is available to LBO investors. The actual point at which CK would either be taken public, sold to a strategic investor, or sold to another LBO fund depends on stock market conditions, CK's leverage relative to similar firms in the industry, and cash flow performance as compared to the plan. Discounted cash flow analysis also suggests that PI should do the deal, since the total present value of adjusted equity cash flow of $57.2 million using the CC method is more than twice the magnitude of the initial equity investment. At $56 million, the APV method results in a slightly lower estimate of total present value. See Tables 13-14,13-15, and 13-16 for the income, balance-sheet, and cash-flow statements, respectively, associated with this transaction. Exhibits 13-1 and 13-2 illustrate the calculation of present value of the transaction based on the cost of capital and the adjusted present value methods, respectively. Note the actual Excel spreadsheets and formulas used to create these financial tables are available on the CD-ROM accompanying this book in a worksheet, Excel-Based Leveraged Buyout Valuation and Structuring Model. -What criteria did Pacific Investors (PI) use to select California Kool (CK) as a target for an LBO? Why were these criteria employed?