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

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: -What are the risks to this deal's eventual success? Be specific.

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

Case Study Short Essay Examination Questions Financing LBOs--The SunGard Transaction With their cash hoards accumulating at an unprecedented rate, there was little that buyout firms could do but to invest in larger firms. Consequently, the average size of LBO transactions grew significantly during 2005. In a move reminiscent of the blockbuster buyouts of the late 1980s, seven private investment firms acquired 100 percent of the outstanding stock of SunGard Data Systems Inc. (SunGard) in late 2005. SunGard is a financial software firm known for providing application and transaction software services and creating backup data systems in the event of disaster. The company's software manages 70 percent of the transactions made on the Nasdaq stock exchange, but its biggest business is creating backup data systems in case a client's main systems are disabled by a natural disaster, blackout, or terrorist attack. Its large client base for disaster recovery and back-up systems provides a substantial and predictable cash flow. SunGard's new owners include Silver lake Partners, Bain Capital LLC, The Blackstone Group L.P., Goldman Sachs Capital Partners, Kohlberg Kravis Roberts & Co., Providence Equity Partners Inc. and Texas Pacific Group. Buyout firms in 2005 tended to band together to spread the risk of a deal this size and to reduce the likelihood of a bidding war. Indeed, with SunGard, there was only one bidder, the investor group consisting of these seven firms. The software side of SunGard is believed to have significant growth potential, while the disaster-recovery side provides a large stable cash flow. Unlike many LBOs, the deal was announced as being all about growth of the financial services software side of the business. The deal is structured as a merger, since SunGard would be merged into a shell corporation created by the investor group for acquiring SunGard. Going private, allows SunGard to invest heavily in software without being punished by investors, since such investments are expensed and reduce reported earnings per share. Going private also allows the firm to eliminate the burdensome reporting requirements of being a public company. The buyout represented potentially a significant source of fee income for the investor group. In addition to the 2 percent management fees buyout firms collect from investors in the funds they manage, they receive substantial fee income from each investment they make on behalf of their funds. For example, the buyout firms receive a 1 percent deal completion fee, which is more than $100 million in the SunGard transaction. Buyout firms also receive fees paid for by the target firm that is "going private" for arranging financing. Moreover, there are also fees for conducting due diligence and for monitoring the ongoing performance of the firm taken private. Finally, when the buyout firms exit their investments in the target firm via a sale to a strategic buyer or a secondary IPO, they receive 20 percent (i.e., so-called carry fee) of any profits. Under the terms of the agreement, SunGard shareholders received $36 per share, a 14 percent premium over the SunGard closing price as of the announcement date of March 28, 2005, and 40 percent more than when the news first leaked about the deal a week earlier. From the SunGard shareholders' perspective, the deal is valued at $11.4 billion dollars consisting of $10.9 billion for outstanding shares and "in-the-money" options (i.e., options whose exercise price is less than the firm's market price per share) plus $500 million in debt on the balance sheet. The seven equity investors provided $3.5 billion in capital with the remainder of the purchase price financed by commitments from a lending consortium consisting of Citigroup, J.P. Morgan Chase & Co., and Deutsche Bank. The purpose of the loans is to finance the merger, repay or refinance SunGard's existing debt, provide ongoing working capital, and pay fees and expenses incurred in connection with the merger. The total funds necessary to complete the merger and related fees and expenses is approximately $11.3 billion, consisting of approximately $10.9 billion to pay SunGard's stockholders and about $400.7 million to pay fees and expenses related to the merger and the financing arrangements. Note that the fees that are to be financed comprise almost 4 percent of the purchase price. Ongoing working capital needs and capital expenditures required obtaining commitments from lenders well in excess of $11.3 billion. The merger financing consists of several tiers of debt and "credit facilities." Credit facilities are arrangements for extending credit. The senior secured debt and senior subordinated debt are intended to provide "permanent" or long-term financing. Senior debt covenants included restrictions on new borrowing, investments, sales of assets, mergers and consolidations, prepayments of subordinated indebtedness, capital expenditures, liens and dividends and other distributions, as well as a minimum interest coverage ratio and a maximum total leverage ratio. If the offering of notes is not completed on or prior to the closing, the banks providing the financing have committed to provide up to $3 billion in loans under a senior subordinated bridge credit facility. The bridge loans are intended as a form of temporary financing to satisfy immediate cash requirements until permanent financing can be arranged. A special purpose SunGard subsidiary will purchase receivables from SunGard, with the purchases financed through the sale of the receivables to the lending consortium. The lenders subsequently finance the purchase of the receivables by issuing commercial paper, which is repaid as the receivables are collected. The special purpose subsidiary is not shown on the SunGard balance sheet. Based on the value of receivables at closing, the subsidiary could provide up to $500 million. The obligation of the lending consortium to buy the receivables will expire on the sixth anniversary of the closing of the merger. The following table provides SunGard's post-merger proforma capital structure. Note that the proforma capital structure is portrayed as if SunGard uses 100 percent of bank lending commitments. Also, note that individual LBO investors may invest monies from more than one fund they manage. This may be due to the perceived attractiveness of the opportunity or the limited availability of money in any single fund. Of the $9 billion in debt financing, bank loans constitute 56 percent and subordinated or mezzanine debt comprises represents 44 percent. SunGard Proforma Capital Structure ¹The roman numeral II refers to the fund providing the equity capital managed by the partnership. Case Study : -SunGard is a software company with relatively few tangible assets.Yet,the ratio of debt to equity of almost 5 to 1.Why do you think lenders would be willing to engage in such a highly leveraged transaction for a firm of this type?

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 it take five very large financial institutions to finance the transactions?

A single asset is often used to collateralize loans from different lenders in LBO transactions.

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

LBOs normally involve public companies going private.

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

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

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

LBOs can be of an entire company or divisions of a company.

Divisions of larger companies are generally poor candidates for successful leveraged buyouts.

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

Case Study Short Essay Examination Questions 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. : -How might bondholders and preferred stockholders have been hurt in the RJR Nabisco leveraged buyout?

Premiums paid to LBO firm shareholders average

A term loan usually has a maturity of less than one year.

Case Study Short Essay Examination Questions 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. : -What do you believe were the major factors persuading the MGM board to accept the Revised Sony bid? In your judgment,do these factors make sense? Explain your answer.

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

Common exit strategies for LBOs include sale to a strategic buyer,an IPO,a leveraged recapitalization,or a sale to another buyout firm.

A negative loan covenant is a portion of a loan agreement that specifies the actions the borrowing firm agrees to take during the term of the loan.