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Private Equity: Understanding Leveraged Buyouts

Jake Cohen, Affiliate Professor of Accounting & Control and

Business Law at INSEAD

GLG Institute
October 19th
New York City
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GLG Institute
Professional Education On Anything. Anywhere.

Presenter Biography
Professor Jake Cohen is an Affiliate Professor of Accounting and Control and
Business Law at INSEAD and the Director of the INSEAD-PricewaterhouseCoopers Research
Initiative. Professor Cohen teaches courses in Financial Accounting, Corporate Financial
Reporting & Analysis, Financial Statements Analysis, Mergers & Acquisitions and Corporate
Restructurings, and Business Law in both INSEAD's Singapore and Fontainebleau, campuses.
Prior to teaching at INSEAD, he was a Senior Teaching Fellow in the Accounting & Management
group at the Harvard Business School and Professor at the Harvard Extension School in
Cambridge Massachusetts. At Harvard University, he taught courses in Business Analysis,
Valuation, and Creating Value through Corporate Restructuring, Mergers and Acquisitions, and
was recognized for outstanding teaching. Prior to teaching at Harvard for four years, he taught at
Syracuse University as an accounting professor, where he was named 'Professor of the Year' and
was selected as the graduation keynote speaker at the school's commencement ceremony. He
currently sits on the Syracuse University Accounting Department's Advisory Board.

Professor Cohen worked as a tax accountant at KPMG LLP in Philadelphia and as a mergers and
acquisition tax attorney for PricewaterhouseCoopers LLP in New York City. He currently consults
and trains investment bankers at such firms at The Blackstone Group, Credit Suisse, Bank of
America, Houlihan Lokey Howard & Zukin, and others. He has also tutored CEOs and Members
of Board of Directors of Fortune 500 companies, such as Aetna, Astra Zeneca, Jones Lang LaSalle,
and others.
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Table of Contents
 Financial buyers in mergers and acquisitions
 Identifying attractive buyout targets
 Understanding the drivers of private equity transactions
 Capital markets regulation
 Interest rates
 Risks and concerns in current buyout market
 Cases to discuss: Hertz, Toys R Us, Dunkin Donuts, Ducati, Coles,
Serena Software
What is Private Equity?

 Private equity is an asset class that has evolved substantially in the

last couple of decades.

 It is an alternative investment strategy that involves investing in

privately held companies.

 The key feature is the private nature of the securities purchased.

 Investments in private equity are illiquid.

 Investors in this marketplace must be prepared to invest for the long-

haul; investment horizons may be as long as 5 to 10 years.

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Private Equity Partnership Structure

 The predominant organization form of private equity investing is the

limited partnership structure.

 Limited partnership consist of limited partners (LP) and general

partners (GP).

 The LPs of the partnership are the investors, i.e., the main providers
of capital. These are typically wealthy individuals, endowments,
pension funds, and other institutional investors.

 The GP of the partnership are responsible for the day to day

management of the partnership’s investment, as well as general
liability for any lawsuit that may be brought against the fund. LPs
must not be actively involved in the day-to-day operations of the
funds if they are to maintain limited liability status.

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Structure

 An important element of limited partnerships is that the general

partners also commit investment capital to the fund. This ensures
that the GP and LP interests are well aligned.

 Private equity partnerships are typically self-dissolving entities that

have a life span of about 10 years. This limited life span highlights
the point that the funds must seek exits of their investments to realize
return for their investors.

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General Partner Compensation

 GPs of the partnership are compensated through a fixed management

fee, as a percentage of committed capital, and profit sharing of
investment gains known as carried interest, or simply, carry.

 While the fee and carry vary across partnerships, the 2-and-20 is a
standard that many funds gravitate towards.

 2-and-20 means that the annual management fee is 2% of the

committed capital, and when final investment gains are realized, 20%
of the profits go to the GP as their profit share.

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“Money Goes, Where Money is Treated Best”

 “Top quartile buyout funds have generated annual returns in excess

of 40% returns in the past 20 years. The average net annual returns
of the industry have been 13.3%, and the S&P 500 index has returned
12.1% per year”

 Source: Blaydon and Weinwright, “The balance between debt and added value,” Financial Times, September 29, 2006 8
Financial Buyers in Mergers & Acquisitions

LBO Percent of M&A

 LBO percent of M&A
30%
 2001 3%, 25%
 2002 9% 20%

Percentage
 2003 8% 15%

 2004 10% 10%

 2005 11% 5%

0%
 2006 25% 2001 2002 2003 2004 2005 2006
Year

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Industry players

Key US Players Key European Players

Bain Capital (Staples Inc.) Apax Partners (Tommy Hilfiger)

The Blackstone Group (Wyndham Int’l) Candover
The Carlyle Group (Dunkin Donuts) Cinven
Forstmann Little & Company (Revlon) CVC Capital Partners (Kwik-Fit)
Goldman Sachs Capital Partners Permira (HMV)
Hellman & Friedman (DoubleClick) Terra Firma Capital Partners
Hicks, Muse, Tate & Furst (Jimmy Choo) 3i
JP Morgan Partners
Kohlberg Kravis Roberts & Co. (RJR Nabisco)
Silver Lake Partners (Serena Software)
Texas Pacific Group (Ducati)
Warburg Pincus

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Recent Funds Announced

 Warburg Pincus $8 billion

 Goldman $8.5 billion

 Carlyle $10 billion

 Blackstone $15.6 billion

 KKR $16.5 billion (not yet closed)

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Private equity firms are external change agents

 Get companies to be more attentive to what their customers need

and what their shareholders need. Private equity threat companies
in the public markets to operate more leanly. Because if they don’t,
they could be taken over.

 Now with larger and larger funds as well as the growing trend of
club deals, buyout shops are able to go after the larger companies,
leading to those companies becoming more responsive – forced to
change given more shareholders activism.

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Classes within Private Equity

 Venture Capital

 Mezzanine Financing

 Leverage Buyouts

 Distressed investing

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Leveraged Buyouts (LBO)

 LBOs are a way to take a public company private, or put a company

in the hands of the current management, MBO.

 LBOs are financed with large amounts of borrowing (leverage),

hence its name.

 LBOs use the assets or cash flows of the company to secure debt
financing, bonds or bank loans, to purchase the outstanding equity
of the company.

 After the buyout, control of the company is concentrated in the

hands of the LBO firm and management, and there is no public stock
outstanding.

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Successful LBO Strategies

 Finding cheap assets – buying low and selling high (value arbitrage
or multiple expansion)

 Unlocking value through restructuring:

 Financial restructuring of balance sheet – improved combination
of debt and equity
 Operational restructuring – improving operations to increase
cash flows

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Value Creation

 Management incentives and agency cost effects

 Increased ownership stake may provide increased incentives for
improved performance
• Better aligns manager / shareholder interests
• Lower agency costs of free cash flows: debt from LBO
commits cash flows to debt
• Debt puts pressure on managers to improve firm
performance to avoid bankruptcy

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Value Creation

 Wealth transfer
 Wealth transfer from current employees to new investors – low
management turnover (but sometimes new mgmt. team), slower
growth in number of employees
 Tax benefits in LBO constitute subsidy from public and loss of
revenue to government – LBO premiums positively related to
tax benefit
• Net effect of LBO on government tax revenues may be
positive due to gains to shareholders and increased
profitability
• Many of tax benefits could be realized without LBOs

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Value Creation

 Asymmetric information and underpricing

 Managers, investor groups have better information on value of
firm than shareholders
 Large premium signals that future operating income will be
larger than expectations – investor group believes new company
is worth more than purchase price

 Other efficiency considerations

 More efficient decision process as private firm
 Influence of favorable economic environment

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Mortgage Analogy

19
Mortgage Analogy (cont.)

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Leverage Amplifier – the double edge sword

 Return on investment > cost of debt

 Cost of debt > Return on investment

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Apax Partners

 “Funds advised by Apax Partners look for companies that have

strong, established market positions and the potential to expand into
new markets. Our global presence and reach allows us to support
such initiatives effectively.”

 Source: Apax Partners website, http://www.apax.com/en/aboutus/index.html

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Bear Stearns Merchant Bank

 “BSMB focuses on designing capital structures for its investments

which minimize risk and prudently take advantage of leverage. In
addition, BSMB will customize transaction structures in order to help
address circumstances unique to specific situations. Following the
investment, BSMB provides value to the portfolio company in
numerous ways including: active board participation, helping
establish best practices, providing assistance in recruiting and
including the company in its portfolio-wide purchasing program
among other activities.”

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 Source: Bear Stearns Merchant Bank website, www.bsmb.com

Carlyle

 http://www.thecarlylegroup.com/eng/company/l3-company735.h
tml

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Disadvantages of Public Equity Financing

 Costs of compliance with rules and regulations

 Disclosure of competitive information

 Management's time spent on meeting statutory demands and

investor relations

 Greater scrutiny from the public and authorities

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 Capital Markets Regulation

 Securities and Exchange Commission (SEC)

 Department of Justice (DOJ)

 State Securities Commissions

 State Attorneys General

 Self-Regulatory Organizations (SROs) 26

Sarbanes Oxley Act - Sec. 404 – Management Assessment of
Internal Controls

 (a) RULES REQUIRED.—The Commission shall prescribe rules requiring each annual report
required by section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d))
to contain an internal control report, which shall—
(1) state the responsibility of management for establishing and maintaining an adequate
internal control structure and procedures for financial reporting; and
(2) contain an assessment, as of the end of the most recent fiscal year of the issuer, of the
effectiveness of the internal control structure and procedures of the issuer for financial
reporting.

 (b) INTERNAL CONTROL EVALUATION AND REPORTING.—With respect to the internal

control assessment required by subsection (a), each registered public accounting firm that
prepares or issues the audit report for the issuer shall attest to, and report on, the assessment
made by the management of the issuer. An attestation made under this subsection shall be made
in accordance with standards for attestation engagements issued or adopted by the Board. Any
such attestation shall not be the subject of a separate engagement.

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Regulation

 “Sarbanes Oxley makes companies act much more risk averse.

RegFD significantly restrained or constrained information that gets
out to the market.”

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Dunkin Donuts

 Dunkin' brands has been sold to a group of private equity firms for
$2.43 billion, Bain capital, the Carlyle Group and Thomas H. Lee
Partners. What was the reason to buy?

29
Serena Software

 Acquired by Silver Lake Partners. Silver Lake focuses exclusively on

large, technology companies that it feels are, underappreciated but
also have substantial unrecognized growth potential.

 “We felt that Serena was, underappreciated by the equity markets.

Really misunderstood.”

 “By taking the company private we can take a bit of a longer term
view on how to grow and run the company and invest a bit more
aggressively in areas we think will help us build a stronger, more
successful company and not have to focus on making earnings every
90 days.”

 Source: CNBC Interview of Serena Software CEO

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Beat by a Penny, Miss by a Penny

 “I think that, both on the sell side and the buy side analysts tend to
focus just on earnings and earnings is how the measuring stick for the
success, health or failure of a company.

 You make earnings or beat by a penny or two, obviously you know

what you're doing and your business is great. You miss by a penny,
there is something horribly wrong. It's just not that way. I think that,
truly understanding the value that certain technology provides to
companies, sometimes is just difficult to understand. Therefore, the
metric becomes just earnings.”

Source: CNBC Interview of Serena Software CEO

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 Investing in Technology

 Traditionally not an area of private equity investment

 Recently, private equity has entered this space

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Coles Myer

 “KKR, unable to engage the CML directors unless they are prepared to offer
more than $14.50. If KKR was prepared to offer that price (and that would
have depended on the outcome of its due diligence) it suggests that it
shares CML's view that there is potentially much more value in the group,
and believes that it is capable of unlocking it - where, to date, CML hasn't
succeeded.

 But any increase in the bid price would reduce the bidder's IRR (internal
rate of return) and mean a transfer of some of that value away from the

bidder and to CML shareholders.”

 Bryan Frith, “Hostility Looms as Coles and KKR bicker over the price,” The Australian, September 27, 2006

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Risks and Concerns in the Buyout Market

 Rising interest rates

 Higher asset valuation - overpayment
 Political backlash
 More regulation of Industry
 “US private equity shaken by revelation of price collusion probe”
October 11, 2006
 Economic slowdown
 Failure of exit strategy

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