21
Pep Boys, a U.S. auto parts and repair business, operates more than 7,000 service bays in over 700 locations in 35
states and Puerto Rico. With its share price lagging the overall stock market in recent years, the firm’s board of
directors explored a range of options for boosting the firm’s value and ultimately decided to put the firm up for sale.
Gores was attracted initially by what appeared to be a low purchase price, stable cash flow, and the firm’s real estate
holdings (many of the firm’s store sites are owned by the firm). Such assets could be used as collateral underlying loans
to finance a portion of the purchase price. Furthermore, Gores has experience in retailing, having several retailers
among their portfolio of companies, including J. Mendel and Mexx.
The transaction reflected a structure common for deals of this type. Pep Boys had entered into a merger agreement
with Auto Acquisitions Group (the Parent), a shell corporation funded by cash provided by Gores as the financial
sponsor, and the Parent’s wholly owned subsidiary (Merger Sub). The Parent would contribute cash to Merger Sub,
with Merger Sub borrowing the remainder from several lenders. Merger Sub would subsequently buy Pep Boys’
outstanding shares and merge with the firm. Pep Boys would survive as a wholly owned subsidiary of the Parent. The
purpose of this reverse triangular merger was to preserve the Pep Boys’ brand name and facilitate the transfer of
supplier and customer contracts. The Parent also was to have been organized as a holding company to afford investors
some degree of protection from Pep Boys’ liabilities. The purchase price was to have been financed by an equity
contribution of $489 million from limited partnerships managed by Gores and the balance by loans provided by
Barclays Bank PLC, Credit Suisse AG, and Wells Fargo Bank.
Upon learning that the Pep Boys’ reported earnings for the first quarter of 2012 would be well below expectations,
Gores attempted to renegotiate the terms of the deal, arguing that Pep Boys had breached the deal’s agreements. With
Pep Boys unwilling to accept a lower valuation, Gores exercised its right to terminate the deal by paying the $50
million breakup fee and agreed to reimburse Pep Boys for other costs it had incurred related to the deal. Pep Boys said
the firm will use the proceeds of the breakup fee to refinance a portion of its outstanding debt.
“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
22
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
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
23
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.
Financing LBOs—The SunGard Transaction
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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
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?
26
2. Under what circumstances would SunGard refinance the existing $500 million in outstanding senior debt after
the merger? Be specific.
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:
27
1. Does a hospital or hospital system represent a good or bad LBO candidate? Explain your answer.
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?
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.
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Discussion Questions:
1. Do you believe that MGM is an attractive LBO candidate? Why? Why not?
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
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?
30
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?
3. Why might the RJR Nabisco board have accepted the KKR bid over the Johnson bid?
4. How might bondholders and preferred stockholders have been hurt in the RJR Nabisco leveraged buyout?
5. Describe the potential benefits and costs of LBOs to shareholders, employers, lenders, customers, and
communities in which the firm undergoing the buyout may have operations. Do you believe that on average
LBOs provide a net benefit or cost to society? Explain your answer.
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).
31
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).
Discussion Questions:
1. Why was QwestDex considered an attractive LBO candidate? Do you think it has significant growth potential?
Explain the following statement: “A business with high growth potential may not be a good candidate for an LBO.
2. Why did the buyout firms want a 50-year contract to be the exclusive provider of publishing services to Qwest
Communications?
3. 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?
4. Why would it take five very large financial institutions to finance the transactions?
5. Why was the equity contribution of the buyout firms as a percentage of the total capital requirements so much
higher than amounts contributed during the 1980s?
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Cox Enterprises Offers to Take Cox Communications Private
In an effort to take the firm private, Cox Enterprises announced on August 3, 2004 a proposal to buy the remaining
38% of Cox Communications’ shares that they did not currently own for $32 per share. Cox Communications is the
third largest provider of cable television, telecommunications, and wireless services in the U.S, serving more than 6.2
million customers. Historically, the firm’s cash flow has been steady and substantial.
The deal is valued at $7.9 billion and represented a 16% premium to Cox Communication’s share price at that time.
Cox Communications would become a subsidiary of Cox Enterprises and would continue to operate as an autonomous
business. In response to the proposal, the Cox Communications Board of Directors formed a special committee of
independent directors to consider the proposal. Citigroup Global Markets and Lehman Brothers Inc. have committed
$10 billion to the deal. Cox Enterprises would use $7.9 billion for the tender offer, with the remaining $2.1 billion used
for refinancing existing debt and to satisfy working capital requirements.
Cable service firms have faced intensified competitive pressures from satellite service providers DirecTV Group and
EchoStar communications. Moreover, telephone companies continue to attack cable’s high-speed Internet service by
cutting prices on high-speed Internet service over phone lines. Cable firms have responded by offering a broader range
of advanced services like video-on-demand and phone service. Since 2000, the cable industry has invested more than
$80 billion to upgrade their systems to provide such services, causing profitability to deteriorate and frustrating
investors. In response, cable company stock prices have fallen. Cox Enterprises stated that the increasingly competitive
cable industry environment makes investment in the cable industry best done through a private company structure.
Discussion Questions::
1. Why did the board feel that it was appropriate to set up special committee of independent board directors?
2. Why does Cox Enterprises believe that the investment needed for growing its cable business is best done
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
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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 Discussion Questions:
1. Based on the information given it the case, determine the amount of the price reduction Home Depot accepted
for HD Supply and the amount of cash the three buyout firms put into the transaction?
2. 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?
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