Chapter 14: HIGHLY LEVERAGED TRANSACTIONS:
LBO Valuation and Modeling Basics
Examination Questions and Answers
1. An LBO can be valued from the perspective of common equity investors only or all those who supply funds,
including common and preferred investors and lenders. True or False
2. Conventional capital budgeting procedures are of little use in valuing an LBO. True or False
3. An LBO transaction makes sense from the viewpoint of all investors if the present value (of the cash flows to
the firm or enterprise value, discounted at the weighted-average cost of capital, equals or exceeds the total
investment consisting of debt, common equity, and preferred equity required to buy the outstanding shares of
the target company. True or False
4. It is impossible for a leveraged buyout to make sense to common equity investors but not to other investors,
such as pre-LBO debt holders and preferred stockholders. True or False
5. Once the LBO has been consummated, the firm’s perceived ability to meet its obligations to current debt and
preferred stockholders often deteriorates because the firm takes on a substantial amount of new debt. The
firm’s pre-LBO debt and preferred stock may be revalued in the market by investors to reflect this higher
perceived risk, resulting in a significant reduction in the market value of both debt and preferred equity owned
by pre-LBO investors. True or False
6. The cost of capital method attempts to adjust future cash flows for changes in the cost of capital as the firm
reduces its outstanding debt. True or False
7. The adjusted present value method values firm without debt and then subtracts the value of future tax savings
resulting from the tax-deductibility of interest. True or False
8. If the debt-to-equity ratio is expected to fluctuate substantially during the forecast period, applying
conventional capital budgeting techniques that discount future cash flows with a constant weighted average
cost of capital (CC) is appropriate. True or False
9. Many firms reduce their outstanding debt relative to equity and such changes in the capital structure distort
valuation estimates based on traditional DCF methods. True or False
10. The extremely high leverage associated with leveraged buyouts significantly increases the riskiness of the cash
flows available to equity investors as a result of the increase in fixed interest and principal repayments that
must be made to lenders. Consequently, the cost of equity should be adjusted for the increased leverage of the
firm. True or False
2
11. Since an LBO’s debt is to be paid off over time, the cost of equity decreases over time, assuming other factors
remain unchanged. Therefore, in valuing a leveraged buyout, the analyst must project free cash flows,
adjusting the discount rate to reflect changes in the capital structure. True or False
12. Projecting future annual debt-to-equity ratios depends on knowing the firm’s debt repayment schedules and
projecting growth in the market value of shareholders’ equity. True or False
13. For simplicity, the market value of common equity can be assumed to grow in line with the projected growth
in a firm’s account receivables. True or False
14. As the LBO’s extremely high debt level is reduced, the cost of equity needs to be adjusted to reflect the decline
in risk, as measured by the firm’s unlevered beta. True or False
15. Using the cost of capital method to value LBOs requires adjusting the firms unlevered beta in each period
using the firm’s projected debt-to-equity ratio for that period. True or False
16. Because the firm‘s cost of equity changes over time, the firm’s cumulative cost of equity is used to discount
projected cash flows. This reflects the fact that each period’s cash flows generate a different rate of return.
True or False
17. An LBO deal makes sense to common equity investors if the present value of free cash flow to equity exceeds
the value of the equity investment in the deal. True or False
18. The deal makes sense to lenders and noncommon equity investors if the present value of free cash flow to
equity investors exceeds the total cost of the deal. True or False
19. Some analysts suggest that the problem of a variable discount rate can be avoided by separating the value of a
firm’s operations into two components: the firm’s value as if it were debt free and the value of interest tax
savings. True or False
20. Using the adjusted present value method to value a LBA assumes the total value of the firm is the present
value of the firm’s free cash flows to lenders plus the present value of future tax savings discounted at the
firm’s unlevered cost of equity. True or False
21. The total value of the firm according to the adjusted present value method is the present value of the firm’s
free cash flows to equity investors plus the present value of future tax savings discounted at the firm’s
unlevered cost of equity. True or False
22. The unlevered cost of equity is often viewed as the appropriate discount rate rather than the cost of debt or a
risk-free rate because tax savings are subject to risk, since the firm may default on its debt or be unable to
utilize the tax savings due to continuing operating losses. True or False
23. The justification for the adjusted present value method reflects the theoretical notion that firm value should is
affected by the way in which it is financed. True or False
24. The justification for the adjusted present value (APV) method reflects the theoretical notion that firm value
should not be affected by the way in which it is financed. However, recent studies empirical suggest that for
LBOs, the availability and cost of financing does indeed impact financing and investment decisions. True or
False
25. In the presence of taxes, firms are often less leveraged than they should be, given the potentially large tax
benefits associated with debt. Firms can increase market value by increasing leverage to the point at which the
additional contribution of the tax shield to the firm‘s market value begins to decline. True or False
26. The tax benefits of higher leverage may be partially or entirely offset by the higher probability of default
associated with an increase in leverage. True or False
27. Increased borrowing by a firm will, other things equal, increase its tax liability. True or False
28. In using the adjusted present value method to value highly leveraged transactions, the analyst need not be
concerned about the costs of financial distress. True or False
29. The direct cost of financial distress includes the costs associated with reorganization in bankruptcy and
ultimately liquidation. True or False
30. Financial distress does not have a material indirect cost to firms able to avoid bankruptcy or liquidation. True
or False
31. In applying the adjusted present value method, the present value of a highly leveraged transaction should
reflect the present value of the firm without leverage plus the present value of tax savings plus the present
value of expected financial distress. True or False
32. The expected cost of and probability of occurring of financial distress are easily forecasted. True or False
33. Many analysts use the cost of capital method because of its relative simplicity. True or False
34. In the adjusted present value method, the levered cost of equity is used for discounting cash flows during the
period in which the capital structure is changing and the weighted-average cost of capital for discounting
during the terminal period. True or False
35. The present value of tax savings is irrelevant to the adjusted present value method. True or False
36. In discount projected tax savings in the adjusted present value method, the firm’s unlevered cost of equity
should be used, since it reflects a higher level of risk than either the WACC or after-tax cost of debt. Tax
savings are subject to risk comparable to the firm‘s cash flows in that a highly leveraged firm may default and
the tax savings go unused. True or False
37. To determine the total value of the firm using the adjusted present value method, add the present value of the
firm’s cash flows to equity, interest tax savings, and terminal value discounted at the firm‘s unlevered cost of
equity and subtract the present value of the expected cost of financial distress. True or False
38. Although the proposition that the value of the firm should be independent of the way in which it is financed
may make sense for a firm whose debt-to–capital ratio is relatively stable and similar to the industry’s, it is
highly problematic when it is applied to highly leveraged transactions. True or False
39. Without adjusting for the cost of financial distress, the adjusted present value method implies that the value of
40. The adjusted present value method implies that the firm should optimally use 100% debt financing to take
maximum advantage of the tax shield created by the tax deductibility of interest. True or False
41. The primary advantage of the cost of capital method is its relative computational simplicity. True or False
42. The adjusted present value approach takes into account the effects of leverage on risk as debt is repaid. True or
False
43. An LBO model is used to determine what a firm is worth in a highly leveraged transaction and is applied when
there is the potential for a financial buyer or sponsor to acquire the business. True or False
44. An LBO model helps define the amount of debt a firm can support given its assets and cash flows. True or
False
45. LBO analyses are similar to DCF valuations in that they require projected cash flows, present values, and
discount rates; however, LBO models do not require the estimation of terminal values. True or False
46. The DCF analysis solves for the present value of the firm, while the LBO analysis solves for the discount rate
or internal rate of return. True or False
47. While the DCF approach often is more theoretically sound than the IRR approach (which can have multiple
solutions), IRR is more widely used in LBO analyses since investors often find it more intuitively appealing,
that is, the higher an investment’s IRR, the better the investment’s return relative to its cost The IRR is the
discount rate that equates the projected cash flows and terminal value with the initial equity investment. True
or False
48. Financial buyers often will attempt to determine the highest amount of debt possible (i.e., the borrowing
capacity of the target firm) to maximize their equity contribution in order to maximize the IRR. True or False
49. An LBO analysis usually starts with the determination of cash available for financing a target firm’s future
debt obligations and the sources of such debt. True or False
5
50. The most important calculation to the financial sponsor in an LBO analysis is the IRR. True or False
1. Using the cost of capital method to value an LBO involves which of the following steps?
a. Projection of annual cash flows
b. Projection of annual debt-to-equity ratios
c. Calculation of a terminal value
d. Adjusting the discount rate to reflect changing risk.
e. All of the above
2. Using the cost of capital method to value an LBO involves all of the following steps except for which of the
following?
a. Adjusting the discount rate to reflect changing risk.
b. Adding the present value of future tax savings to the present value of annual free cash flows to
equity.
c. Calculating a terminal value.
d. Projecting annual debt-to-equity ratios.
e. Projecting annual cash flows.
3. Which of the following are steps often found in developing a LBO model?
a. Cash flow projections
b. Determining a firm’s borrowing capacity
c. Determining a financial sponsor’s equity contribution
d. A, B, and C
e. A and C only
4. Which of the following is not true about LBO models?
a. They rarely use IRR calculations
b. Borrowing capacity is relatively unimportant
c. The financial sponsor’s equity contribution is determined before the target firm’s borrowing capacity
d. A, B, and C
e. A and B only
5. Which of the following are often viewed as disadvantages of the adjusted present value method?
a. Ignores the effects of leverage on the discount rate as debt is repaid
b. Requires estimation of the cost and probability of financial distress
c. It is unclear how to define the proper discount rate
d. A and B only
e. A, B, and C
6. Which of the following is true of the cost of capital method of valuation?
a. It is generally more tedious to calculate than alternative methodologies
b. It requires the separate estimation of the present value of future tax savings
c. It adds the present value of the firm without debt to the present value of tax savings
d. It does not adjust the discount rate as debt is repaid
e. All of the above
7. Which of the following is true of the adjusted present value method of valuation?
a. Calculates the present value of tax benefits separately
6
b. Calculates the present value of the firm’s cash flow without debt
c. Adds A and B together
d. A, B, and C
e. A and B only
8. Which of the following is not true about the cost of capital method of valuation?
a. It does not adjust the discount rate for risk as debt is repaid.
b. It requires the projection of future cash flows
c. It requires the projection of future debt-to-equity ratios.
d. It requires the calculation of a terminal value
e. None of the above
9. An LBO can be valued from the perspective of which of the following?
a. Equity investors
b. Lenders
c. All those supplying funds to finance the transaction
d. A and B only
e. A, B, and C
10. The riskiness of highly leveraged transactions declines overtime due to which of the following factors?
a. Debt reduction assuming nothing else changes
b. Increasing discount rates
c. A rising unlevered beta
d. An unchanging cost of equity
e. An unchanging weighted average cost of capital
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
7
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 13.4).
Figure 13.4
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.
Lenders
Zell
Lenders
Zell
Tribune
Shareholders
ESOP
Tribune
Stage 1
Stage 2
$3.85 Billion
$.25 billion
$4 Billion
$.065 Billion
126 Million Shares
$4.2 Billion
121 Million Shares
$4.05
126 Million Shares
& Loan Guarantee
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.
Discussion Questions:
1. What is the acquisition vehicle, post-closing organization, form of payment, form of acquisition, and tax
strategy described in this case study?
2. Describe the firm’s strategy to finance the transaction?
3. Is this transaction best characterized as a merger, acquisition, leveraged buyout, or spin-off? Explain your
answer.
4. Is this transaction taxable or non–taxable to Tribune’s public shareholders? To its post–transaction
shareholders? Explain your answer.
5. 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.
9
Kinder Morgan Buyout Raises Ethical Questions
In the largest management buyout in U.S. history at that time, Kinder Morgan Inc.’s management proposed to take the
oil and gas pipeline firm private in 2006 in a transaction that valued the firm’s outstanding equity at $13.5 billion.
Under the proposal, chief executive Richard Kinder and other senior executives would contribute shares valued at $2.8
billion to the newly private company. An additional $4.5 billion would come from private equity investors, including
Goldman Sachs Capital partners, American International Group Inc., and the Carlyle Group. Including assumed debt,
the transaction was valued at about $22 billion. The transaction also was notable for the governance and ethical issues it
raised. Reflecting the struggles within the corporation, the deal did not close until mid–2007.
The top management of Kinder Morgan Inc. waited more than two months before informing the firm‘s board of its
desire to take the company private. It is customary for boards governing firms whose managements are interested in
buying out public shareholders to create a committee within the board consisting of independent board members to
solicit other bids. While the Kinder Morgan board did eventually create such a committee, the board’s lack of
awareness of the pending management proposal gave management an important lead over potential bidders in
structuring a proposal. By being involved early on in the process, a board has more time to negotiate terms more
favorable to shareholders. The transaction also raised questions about the potential conflicts of interest in cases where
investment bankers who were hired to advise management and the board on the “fairness” of the offer price also were
potential investors in the buyout.
Kinder Morgan‘s management hired Goldman Sachs in February 2006 to explore “strategic” options for the firm to
enhance shareholder value. The leveraged buyout option was proposed by Goldman Sachs on March 7, followed by
their proposal to become the primary investor in the LBO on April 5. The management buyout group hired a number of
law firms and other investment banks as advisors and discussed the proposed buyout with credit–rating firms to assess
how much debt the firm could support without experiencing a downgrade in its credit rating.
On May 13, 2006, the full board was finally made aware of the proposal. The board immediately demanded that a
standstill agreement that had been signed by Richard Kinder, CEO and leader of the buyout group, be terminated. The
agreement did not permit the firm to talk to any alternative bidders for a period of 90 days. While investment banks and
buyout groups often propose such an agreement to ensure that they can perform adequate due diligence, this extended
period is not necessarily in the interests of the firm’s shareholders because it puts alternative suitors coming in later at a
distinct disadvantage. Later bidders simply lack sufficient time to make an adequate assessment of the true value of the
target and structure their own proposals. In this way, the standstill agreement could discourage alternative bids for the
business.
A special committee of the board was set up to negotiate with the management buyout group, and it was ultimately
able to secure a $107.50 per share price for the firm, significantly higher than the initial offer. The discussions were
rumored to have been very contentious due to the board’s annoyance with the delay in informing them.1 Reflecting the
strong financial performance of the firm and an improving equity market, Kinder Morgan raised $2.4 billion in early
2011 in the largest private equity–backed IPO in history. The majority of the IPO proceeds were paid out to the firm’s
private equity investors as a dividend.
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
1 Berman and Sender, 2006
10
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
11
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
Pre-Merger Existing SunGard Debt Outstanding $Millions
Senior Notes (3.75% due in 2009) 250,000,000
Senior Notes (4.785 due in 2014) 250,000,000
Total Existing Debt Outstanding 500,000,000
Debt Portion of Merger Financing
Senior Secured Notes (≤ $5 billion) 5,000,000,000
$1 billion revolving credit facility with
6 year term
$4 billion term loan maturing in 7-1/2 years
Senior Subordinated Notes (≤$3 billion) 3,000,000,000
Payment-in–Kind Senior Notes (≤$.5 billion) 500,000,000
Receivables Credit Facility (≤$.5 billion) 500,000,000
Total Merger Financing (as if fully utilized) 9,000,000,000
Equity Portion of Merger Financing
Equity Investor Commitment ($Millions)
Silver Lake Partners II, LP1 540,000,000
Bain Capital Fund VIII, LP 540,000,000
Blackstone Capital Partners IV, L.P. 270,000,000
Blackstone Communications Partners I, L.P. 270,000,000
GS Capital Partners 2000, L.P. 250,000,000
GS Capital Partners 2000 V, L.P. 250,000,000
KKR Millennium Fund, L.P. 540,000,000
Providence Equity Partners V, L.P. 300,000,000
TPG Partners IV, L.P. 540,000,000
Total Equity Portion of Merger Financing 3,500,000,000
Total Debt and Equity 13,000,000,000
1The roman numeral II refers to the fund providing the equity capital managed by the
partnership.
Case Study Discussion Questions:
1. 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?
2. Under what circumstances would SunGard refinance the existing $500 million in outstanding senior debt after
the merger? Be specific.
12
3. In what ways is this transaction similar to and different from those that were common in the 1980s? Be
specific.
4. Why are payment-in-kind securities (e.g., debt or preferred stock) particularly well suited for financing LBOs?
Under what circumstances might they be most attractive to lenders or investors?
5. Explain how the way in which the LBO is financed affects the way it is operated and the timing of when
equity investors choose to exit the business. Be specific.
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.
Discussion Questions:
1. Does a hospital or hospital system represent a good or bad LBO candidate? Explain your answer.
13
2. 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?
practices.
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.
Discussion Questions:
1. Do you believe that MGM is an attractive LBO candidate? Why? Why not?
14
2. 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.
3. How did Time Warner’s entry into the bidding affect pace of the negotiations and the relative bargaining
power of MGM, Time Warner, and the Sony consortium?
4. 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.
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
15
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.
Discussion Questions:
1. In your opinion, was the buyout proposal presented by Ross Johnson’s management group in the best interests
of the shareholders? Why? / Why not?
2. What were the RJR Nabisco board’s fiduciary responsibilities to the shareholders? How well did they satisfy
these responsibilities? What could/should they have done differently?