Mergers & Acquisitions

MBO

Acquisition where a company's existing managers acquire a large part or all of the company from either the parent company or from the private owners

LBO

• Acquisition by small group of investors using large portion (around 2/3) of dept finance
• Equity comes from financial sponsor (or mgmt)
• ROE upon exit (through sale or IPO)
• High leverage to increase ROE
• Tax savings (DTS)
• CF used to pay down dept and increase equity
• Improve target's financial performance

1. Strong cash flows
2. Low capex requirements
3. Leading and defensible market position
4. Growth opportunities (stable industry)
5. Efficiency enhancement opportunities
6. Proven management team
7. Strong asset base
8. (Low valuation in the stock market)

1. Tax benefits

• DTS
• Asset step-up

2. Mgmt incentives and agency cost effects

• Alignment of manager /shareholder interests
• Lower agency costs of FCF (CF committed to debt)
• Financial sponsor will monitor mgmt
• Debt causes pressure to improvements

3. Wealth transfer

• From existing bondholders to shareholders
• From current employees to new investors
• From government (taxes) to LBO premiums (But: Profitability+, Net benefit?)

4. Asymmetric information and underpricing

• Mgmt has more information than shareholders
• Believe that company will be worth more than paid

5. Other efficiency considerations

• E.g. projects do not have to be justified by board of directors
• No disclosure of information necessary

See slide

1'000 investment, 500 FCF

Scenario I:

• 750 debt, 250 equity, debt repayment (equity +500), no growth in EV, sale price 1'000, IRR=24.6%, Cash return 3x

Scenario II:

• 750 debt, 250 equity, no debt repayment, equity +500, 50% growth in EV, sale price 1'500, IRR=24.6%, Cash return 3x

Scenario III:

• 75% equity, completely debt repayment and growth in EV, sale price 1'500, IRR=14.9%, Cash return 2x

Scenario IV:

• 25% equity, constant interest payment, increase debt and growth in EV, sale price 1'500, IRR=28.3%, Cash return 3.5x

⇒ IV > I = II > III

• Increasing firm's size
• Operational improvements
• Repositioning to other segments
• + Organic growth rate and profitability