Exam 13: Financing the Deal: Private Equity, hedge Funds, and Other Sources of Funds

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

LBO capital structures are often very complex,consisting of bank debt,subordinated unsecured debt,preferred stock,and common equity.

Case Study Short Essay Examination Questions 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. and Answers: -Cite examples of economies of scale and scope?

Loan agreements commonly have cross-default provisions allowing a lender to collect its loan immediately if the borrower is in default on a loan to another lender.

Borrowers often seek revolving lines of credit that they can draw upon on a daily basis to run their business.

LBO exit strategies involving selling to a strategic buyer usually result in the best price as the buyer may be able to generate significant synergies by combining the firm with its existing business.

Case Study Short Essay Examination Questions 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?

Case Study Short Essay Examination Questions "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). Figure 13.1 Tribune deal structure. 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. : -What is the acquisition vehicle,post-closing organization,form of payment,form of acquisition,and tax strategy described in this case study?

Bridge financing is usually expected to be replaced within two years after the closing date of the LBO transaction.

Which of the following is not typically true of LBOs?

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 is generally not true about leveraged buyouts?

Case Study Short Essay Examination Questions "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). Figure 13.1 Tribune deal structure. 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. : -Is this transaction taxable or non-taxable to Tribune's public shareholders? To its post-transaction shareholders? Explain your answer.

The management team of a privately held firm found a lender who would lend them 90 percent of the purchase price of the firm if they pledged the firm's assets as well as their personal assets as collateral for the loan.This purchase would best be described by which of the following terms?

An indenture is a contract between the firm that issues the long-term debt securities and the lenders.

Case Study Short Essay Examination Questions Financing Challenges in the Home Depot Supply Transaction Buyout firms Bain Capital, Carlyle Group, and Clayton, Dubilier & Rice (CD&R) bid $10.3 billion in June 2007 to buy Home Depot Inc.'s HD Supply business. HD Supply represented a collection of small suppliers of construction products. Home Depot had announced earlier in the year that it planned to use the proceeds of the sale to pay for a portion of a $22.5 billion stock buyback. Three banks, Lehman Brothers, JPMorgan Chase, and Merril Lynch agreed to provide the firms with a $4 billion loan. The repayment of the loans was predicated on the ability of the buyout firms to improve significantly HD Supply's current cash flow. Such loans are normally made with the presumption that they can be sold to investors, with the banks collecting fees from both the borrower and investor groups. However, by July, concern about the credit quality of subprime mortgages spread to the broader debt market and raised questions about the potential for default of loans made to finance highly leveraged transactions. The concern was particularly great for so-called "covenant-lite" loans for which the repayment terms were very lenient. Fearing they would not be able to resell such loans to investors, the three banks involved in financing the HD Supply transaction wanted more financial protection. Additional protection, they reasoned, would make such loans more marketable to investors. They used the upheaval in the credit markets as a pretext for reopening negotiations on their previous financing commitments. Home Depot was willing to lower the selling price thereby reducing the amount of financing required by the buyout firms and was willing to guarantee payment in the event of default by the buyout firms. While Bain, Carlyle, and CD&R were willing to increase their cash investment and pay higher fees to the banks, they were unwilling to alter the original terms of the loans. Eventually the banks agreed to provide financing consisting of a $1 billion "covenant-lite" loan and a $1.3 billion "payment-in-kind" loan. Home Depot agreed to assume the loan payments on the $1 billion loan if the investor firms were to default and to lower the selling price to $8.5 billion for 87.5 percent of HD Supply, with Home Depot retaining the remaining 12.5 percent. By the end of August, Home Depot had succeeded in raising the cash needed to help pay for its share repurchase, and the banks had reduced their original commitment of $4 billion in loans to $2.3 billion. While they had agreed to put more money into the transaction, the buyout firms had been successful in limiting the number of new restrictive covenants. Case Study : -Why did banks lower their lending standards in financing LBOs in 2006 and early 2007? How did the lax standards contribute to their inability to sell the loans to investors? How did the inability to sell the loans once made curtail their future lending?

There is some evidence that the Sarbanes-Oxley Act of 2002 has also been a factor in some firms going private as a result of the onerous reporting requirements of the bill.

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

Investors in LBOs are frequently referred to as financial buyers,because they are primarily focused on relatively short-to-intermediate-term financial returns.

Accounts receivable represent an undesirable form of collateral from the lender's point of view because they are often illiquid.