...
Acknowledgements	  	  	  Before	   beginning	   this	   research	   report,	   I	   would	   like	   to	   express	   my	 ...
Table	  of	  Contents	  PART	  I	  –	  PLAYERS	  AND	  FUNDS	  TO	  BUILD	  AN	  LBO.	  .....................................
List	  of	  abbreviations.	  	         LPs:	  Limited	  Partnerships,	         LLPs:	  Limited	  Liability	  Partnerships	...
Today,	   every	   student	   who	   is	   looking	   for	   a	   job	   in	   investment	   banking	   law	   or	   corpo...
the	  borrower	  an	  interest	  rate	  of	  LIBOR	  and	  an	  additional	  amount	  of	  money	  which	  is	  called	  “...
Why	  do	  a	  leveraged	  buyout?	  The	  answer	  is	  quite	  simple:	  to	  build	  an	  LBO	  requires	  a	  very	  c...
economic	   slowdown,	   the	   number	   of	   LBO	   has	   decreased	   and	   today,	   the	   returns	   of	  investm...
PART	  I	  –	  PLAYERS	  AND	  FUNDS	  TO	  BUILD	  AN	                                          LBO.	  We	   need	   to	 ...
the	   duration	   of	   the	   fund.	   Of	   course,	   private	   equity	   funds	   have	   a	   large	   variety	   o...
sponsor,	   which	   may	   act	   as	   the	   “general	   partner”	   of	   the	   fund.	   This	   management	  company...
down	  debt,	  increase	  earnings	  and	  eventually	  be	  sold	  at	  greater	  multiple	  of	  earnings	  than	  it	  ...
The	   current	   owners	   should	   also	   have	   a	   keen	   sense	   of	   where	   the	   market	   for	   their	 ...
Concerning	  earn	  out	  payments	  in	  an	  LBO	  transaction,	  it	  is	  a	  contractual	  agreement	  by	  the	  inv...
The	  transaction	  between	  a	  lender	  and	  Newco	  would	  generally	  involve	  the	  negotiation	  of	   a	   loan...
The	  banks	  are	  motivated	  to	  assess	  the	  risk	  of	  lending	  correctly	  and	  set	  interest	  rates	  that	...
receives	   its	   equity	   if	   the	   borrowers	   business	   meets	   certain	   specified	   performance	  goals.	 ...
 	                     CHAPTER	  II	  –	  SOURCES	  AND	  USES	  OF	  FUNDS.	  Building	   a	   leveraged	  buyout	  is	  ...
Equity	   capital	   give	   legally	   the	   property	   of	   the	   holding	   to	   investors.	   This	   capital	  c...
The	   undrawn	   commitment	   fee	   is	   usually	   a	   fixed	   rate	   that	   is	   multiplied	   by	   the	  diff...
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO
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Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO

  1. 1.       MARKET MECHANISM, TAXSHIELD AND EXITING OF AN LBOResearch  report  drafted  by  Guillaume  ALLEGRE  Under  the  supervision  of  Jean-­‐François  Louit,  Partner  in  Scotto  &  Associés.  
  2. 2. Acknowledgements      Before   beginning   this   research   report,   I   would   like   to   express   my   appreciation   and  thanks  to  my  supervisor,  Partner  Jean-­‐François  Louit  who  has  been  a  great  advisor  for  me.  You  encouraged  me  in  my  research  and  help  me  in  order  to  construct  the  best  plan  I  can  find.  I  would  also  like  to  thank  Laurent  Durieux  who  has  been  so  precious  to  explain  what  I  have  to  look  for  in  order  to  draft  this  research  report.  I  can’t  thank  you  enough  for  encouraging  me  throughout  this  experience.  Your  advices  on  my  research  as  well  as  on  my  career  have  been  invaluable.    I   would   like   to   take   this   opportunity   to   thank   Partner   Richard   Schepard   and   all   his  associates  of  Bredin  Prat  Paris  Office  who  have  devoted  few  time  in  order  to  help  me  in  my  research  about  LBO  transactions.               2  
  3. 3. Table  of  Contents  PART  I  –  PLAYERS  AND  FUNDS  TO  BUILD  AN  LBO.  ..............................................................................................  9   CHAPTER  I  –  PLAYERS.   ................................................................................................................................................................  9   SECTION  I  –  Current  owners  and  investors.  .......................................................................................................................  9   I  –  The  investor  in  an  LBO  transaction.  .................................................................................................................................................................  9   A)  The  financial  impact  of  private  equity  funds.  .........................................................................................................................................  9   B)  Return  on  investor’s  investment.   ..............................................................................................................................................................  11   II  –  The  seller  of  the  company.  ................................................................................................................................................................................  12   A)  Different  alternatives  to  sell  a  company.  ...............................................................................................................................................  12   B)  Selling  a  company  through  an  LBO  transaction.  ................................................................................................................................  12   SECTION  II  –  Lenders,  debt  investors  and  existing  creditors.  ..................................................................................  14   I  –  Banks,  the  major  lenders.  ...................................................................................................................................................................................  14   II  –  The  unsecured  lenders.  ......................................................................................................................................................................................  16   III  –  The  risky  situation  of  existing  lenders.  .....................................................................................................................................................  17   CHAPTER  II  –  SOURCES  AND  USES  OF  FUNDS.  ..............................................................................................................  18   SECTION  I  –  Sources  of  funds.  ................................................................................................................................................  18   I  –  Equity  capital.  ..........................................................................................................................................................................................................  18   II  –  Tranches  of  debt.  ..................................................................................................................................................................................................  19   A)  First  lien  debt.  ...................................................................................................................................................................................................  20   B)  Second  lien  debt.  ..............................................................................................................................................................................................  20   C)  High  yields  and  junk  bonds.  ........................................................................................................................................................................  21   D)  Mezzanine  debt.  ...............................................................................................................................................................................................  22   SECTION  II  –  Uses  of  funds.  .....................................................................................................................................................  23   I  –  Structuring  an  LBO  transaction.  ......................................................................................................................................................................  23   II  –  Share  deal  and  purchase  agreement.  ...........................................................................................................................................................  24   A)  Acquisition  equity.   ...........................................................................................................................................................................................  24   B)  Target’s  net  debt.  .............................................................................................................................................................................................  25  PART  II  –  TAX  SHIELD  AND  STRATEGIES  FOR  EXITING  AN  LBO.  ...................................................................  26   CHAPTER  I  –  TAX  SHIELD  IN  AN  ACQUISITION  BY  LBO.   ............................................................................................  26   SECTION  I  –  Tax  aspects  in  the  world.  ...............................................................................................................................  27   I  –  Deductibility  of  interest  expenses.  .................................................................................................................................................................  27   II  –  Parameters  existing  in  France  in  order  to  reduce  taxes.  .....................................................................................................................  30   SECTION  II  –  Limitation  of  tax  leverage:  example  in  France,  The  Netherlands.  .............................................  32   I  –  Example  in  France.  ................................................................................................................................................................................................  32   A)  The  “Charasse  amendment”  followed  by  the  “Carrez  amendment”.  .........................................................................................  32   1  –  Charasse  amendment.  ............................................................................................................................................................................  33   2  –  Carrez  amendment.  .................................................................................................................................................................................  34   B)  Parent-­‐subsidiary  regime:  a  new  French  tax  on  dividend  distributions.  ................................................................................  35   II  –  The  Netherlands.  ..................................................................................................................................................................................................  36   CHAPTER  II  –  EXIT  ROUTES  IN  LBO  TRANSACTIONS.  ................................................................................................  37   SECTION  I  –  Exit  planning  considerations.  ......................................................................................................................  37   I  –  Initial  public  offering;  “Reverse  LBO”.  ..........................................................................................................................................................  37   II  –  Alternative  ways  for  exiting  an  LBO  .  ..........................................................................................................................................................  39   SECTION  II  –  Capital  gain,  carried  interest  and  tax  aspects.  ...................................................................................  40   I  –  Concept  of  carried  interest.  ...............................................................................................................................................................................  40   II  –  Comparison  between  the  USA  and  in  France.  ..........................................................................................................................................  41           3  
  4. 4. List  of  abbreviations.     LPs:  Limited  Partnerships,   LLPs:  Limited  Liability  Partnerships   LLCs:  Limited  Liability  Companies     LBOs:  Leveraged  Buyouts     PEF:  Private  Equity  Funds   EBITDA:  Earnings  Before  Interest,  Taxes,  Depreciation  and  Amortization   LIBOR:  London  Interbank  Offered  Rate   ESOP:  Employee  Stock  Ownership  Plan   SPA:  Share  Purchase  Agreement   SEC:  U.S.  Securities  and  Exchange  Commission   TEV:  Transaction  Enterprise  Value   ETR:  Effective  Tax  Rate   GAAR:  General  Anti  Avoidance  Rule   SPV:  Special  Purpose  Vehicle   IPO:  Initial  Public  Offering   CFC:  Controlled  Foreign  Corporation   CBTD:  Cross  Border  Tax  Differential   CPS:  Cash  Pooling  Scheme                   4  
  5. 5. Today,   every   student   who   is   looking   for   a   job   in   investment   banking   law   or   corporate  finance  is  probably  going  to  have  to  know  one  thing  or  two  about  companies  buying  others.    There   are   many   types   of   transactions   to   buy   a   company   but   one   of   them   will   be  especially  studied  during  this  research  report,  the  LBO.    An   LBO   or   leveraged   buyout   is   simply   put,   one   company   buying   another   one   and  using  for  this  a  large  amount  of  debt.  That’s  it.  So  why  all  the  fuss  about  this  type  of  transaction?   Why   today   the   international   press   speak   about   the   LBO   and   his   bad  economics  consequences?  Why  does  this  type  of  transaction  is  preferred  from  other  types  of  mergers  and  acquisitions?    In   fact,   the   answer   rests   in   the   inherent   risks   that   go   with   a   transaction   that   financed  primarily  with  borrowed  money  that  is  to  say  with  debt.  By  way  of  introduction,  there  are  few  specifics  things  that  we  need  to  mention  about  the  debt  used  in  a  leveraged  buyout  transaction.    At  first,  the  assets  of  the  target  very  often  secure  the  debt  that  we  use  to  acquire  the  target  company.  That’s  an  essential  point  in  every  LBO.  Indeed,  the  potential  buyer,  namely,  the  person  who  would  like  to  acquire  the  target,  does  not  necessarily  need  to  possess  the  financial  amount  to  purchase  this  target.    Indeed,   the   target   just   needs   to   have   enough   available   collateral   (in   the   form   of  assets)  to  allow  an  outside  purchaser  to  have  bank  debt  financing  in  order  to  pay  for  the  transaction  and  the  cost  that  has  been  stipulated.  This  plan  supposes  the  target’s  assets  secure  the  bank  debt.    The  second  point  to  mention  about  the  nature  of  the  debt  is  that  it  can  come  from  either  bonds  or  bank  loans  (these  notions  will  be  detailed  after).    If   the   case   of   bonds,   this   means   that   it’s   issued   and   sold   to   investors   in   capital  markets.    As  we  study  it  later,  the  high  levels  of  debt  associated  in  LBO’s  transactions  very  often  results   in   the   bonds   being   rated   as   junk   or   below   investment   grade.   We   easily  understand  that  as  credit  ratings  are  used  to  appreciate  the  risk  of  default,  loading  up  a  target  with  debt  will  naturally  increase  this  risk.    Moreover  and  to  continue  in  this  idea,  the  higher  the  risk,  the  higher  the  interest  rate  the  bank  or  the  market  is  going  to  demand  for  lending  the  money.    In   the   case   of   the   debt   is   structured   by   bank   loans,   financing   means   come   directly  from  banks  rather  than  buyers  of  bonds  in  capital  markets.  That’s  an  advantage  for  the  purchaser  in  terms  of  security  of  the  debt.  Bank  loans  included  interest  expenses,  which  will  be  often  calculated  as  a  variable  rate.  It’s  common  for  the  lender  to  charge     5  
  6. 6. the  borrower  an  interest  rate  of  LIBOR  and  an  additional  amount  of  money  which  is  called  “spread”.    The   LIBOR   is   the   short   term   for   London   Interbank   Offered   Rate.   Simply,   it’s   the  interest  rate  at  which  banks  offer  to  lend  funds  to  one  another  in  the  international  and  interbank  market.  It’s  set  every  day  approximately  at  11  AM,  by  a  certain  number  of  international  banks.  The   spread   is   an   indicator   of   the   risk   that   is   associated   with   the   borrower   and   the  seniority  of  the  loan  in  the  case  of  default.    Another   important   point   of   bank   loans   is   that   the   lending   is   often   syndicated  amongst   a   group   of   banks   in   order   to   decrease   the   amount   of   lending   exposure   to  any  borrower  that  is  to  say,  in  order  to  reduce  the  risk  of  bad  loans.  Indeed,  it’s  easily  to  understand  that  if  the  amount  of  loan  is  split  into  many  banks,  the  risk  of  a  default  scenario  is  consequently  reduced.    For  example,  if  a  bank  would  lend  an  amount  of  money  to  a  fund  in  order  to  buy  a  target  with  an  LBO  transaction,  this  bank  has  a  couple  of  choices.  On  the  one  hand,  the   bank   can   lend   $100   million   to   the   buyer   and   charge   an   interest   expense   of   LIBOR  plus  the  spread.  On  the  other  hand,  the  bank  can  lend  $10  million  to  the  investor  and  get  nine  other  banks  in  order  to  lend  the  remaining  amount  that  is  to  say  $90  million.  The  rate  of  interest  charged  will  still  be  LIBOR  and  the  same  spread.    Under   both   scenarios,   the   sum   of   money   that   the   bank   earned   from   interest   charged  is   the   same   but   there   is   a   reason   to   choose   the   second   possibility.   Indeed,   what  makes  this  option  the  better  is  about  a  default  scenario  namely  when  the  buyer  can’t  reimbursed  the  amount  granted.    If   the   bank   chooses   the   first   scenario   and   if   the   buyer   is   not   able   to   pay   back   its   loan,  the  bank  takes  on  solely  all  the  losses  associated  with  this  bad  loan.  By  contrast,  if  the  second   possibility   is   chosen,   the   losses   are   split   over   the   ten   lending   banks   and  interest  that  has  been  charged  is  still  coming  in  from  the  other  nine  banks  that  are  current  with  their  interest  payments.    In  general,  we  can’t  deny  the  fact  that  bank  loans  are  far  more  complicated  and  so,  multi  faceted  than  bonds.    There   are   many   different   types   of   loans,   including   term   loans,   revolving   credit  facilities,  but  the  most  important  thing  to  realize  is  that  these  banks  loans  can  have  floating   interest   rate   and   very   often   times,   these   loans   are   syndicated   amongst  several  lenders  as  we  said  it  above.    Contrary   to   banks   loans,   bonds   are   considered   as   fixe   rated   instruments   and  consequently,  sold  in  capital  markets.       6  
  7. 7. Why  do  a  leveraged  buyout?  The  answer  is  quite  simple:  to  build  an  LBO  requires  a  very  close  cooperation  between  the  equity  and  debt  providers  but  the  purpose  in  the  end  is  to  make  money.  Indeed,  any  LBO  has  for  essential  goal  to  achieve  the  higher  return  on  the  initial  equity  investment  of  the  investor.  For   example,   we   can   imagine   a   company   purchased   for   an   amount   of   $100   million.   If  the   investor   acquires   this   company   with   100%   equity   capital   and   later,   sold   it   for  $110   million.   In   this   case,   the   investor   just   made   a   10%   return   on   his   initial  investment.   Alternatively,   if   the   investor   is   able   to   obtain   a   (secured)   loan   for   $90  million   and   made   an   initial   equity   capital   investment   of   $10   million.   He   has   to   pay  interest  expense  on  the  loan  contracted,  which  happens  approximately  to  be   7%  per  year.    After   one   year,   if   the   investor   is   able   to   sell   the   company   for   $110   million,   he   will  have  to  pay  down  the  $90  million  loan  and  pay  $6,3  million  for  interest  expense.  He  is  left  with  approximately  $14  million  for  himself,  so  a  gain  of  $4  million  compared  with  the  first  investment.    However,  if  it’s  true  to  say  that  a  leverage  transaction  present  several  advantages  to  investors,   we   can’t   forget   that   at   the   same   time,   an   LBO   bring   significant   risks.   It’s  principally   the   ability   of   corporations   to   execute   restructuring   plans   (steps   post   LBO),  which  will  determine  if  a  company  can  sufficiently  handle  the  interest  burden.  Where  come  from  the  leverage  in  an  LBO?  Classically,  the  leverage  comes  from  the  following  three  factors.  At  first,  a  financial  leverage  that  is  to  say,  an  optimisation  of  the   costs   of   funds.   Secondly,   a   legal   leverage   namely,   the   possibility   to   take   the  control   of   the   target   with   minimal   equity   capital.   In   the   end,   a   fiscal   leverage.   On   this  point,  we  will  study  later  that  tax  shield  results  on  the  debt  financing.  Financial  and  fiscal  leverage  are  of  course,  greatly  reliant  on  the  ability  of  the  target  group   to   service   the   acquisition   finance.   Legal   leverage   is   organized   around  mezzanine  finance  or  quasi-­‐equity  (it’s  subordinated  loans  or  convertible  loans),  one  or   more   acquisitions   vehicles   and   dynamic   equity   instruments   and   other   vehicles  such  as  securitisation  (all  these  points  will  be  developed  later  in  the  report).      What   about   the   history   of   leveraged   buyouts?  LBOs   reached   a   peak   approximately   in  2005  but  the  first  big  leveraged  buyout  took  place  in  1955  when  McLean  Industries  Incorporation   bought   two   companies 1 .   The   amount   of   money   that   has   been  borrowed   was   $42   million   and   this   transaction   raised  a   great   return   of   investment.   A  new   leveraged   buyout   boom   took   place   in   1980,   particularly   in   1976   with   the  formation  of  KKR  (Kohlberg,  Kravis  and  Roberts),  a  private  equity  fund  specialised  in  leveraged   buyouts.   One   of   the   largest   LBO   is   certainly   the   acquisition   by   KKR   and  Goldman   Sachs   of   Energy   Future   Holdings   for   $44   million   in   2007.   Since   our   currently                                                                                                                  1  International  Chamber  of  Commerce  n°  MC-­‐F5876.     7  
  8. 8. economic   slowdown,   the   number   of   LBO   has   decreased   and   today,   the   returns   of  investment  are  more  modest  than  the  last  10  years.  Indeed,  the  crisis  has   resulted  in  a  diminution  of  gains  for  the  investors  who  would  purchase  a  company  by  an  LBO  transaction.  It’s  easily  understandable  because  a  lot  of   company   are   today   in   financial   troubles   and   we   know   that   leveraged   buyouts  comes  with  risks.    When  times  are  good  that  is  to  say,  when  a  company  is  producing  enough  earnings  to  pay  its  suppliers,  employees  and  the  others,  LBO  is  a  beautiful  thing.  But  in  times  of  trouble,  as  today  with  the  crisis,  when  the  target  acquired  is  not  generating  profits,  LBO  can  be  a  deathblow.  The  principal  risk  is  the  risk  of  bankruptcy  if  the  company’s  returns  are  less  than  the  cost  of  the  debt  financing.    Moreover,   about   a   certain   number   of   situations,   it’s   possible   that   investors   are   not  able  to  respect  their  interest  expense  obligation.  In  good  times,  leverage  seems  as  a  wonderful  idea  but  in  bad  times,  the  interest   burden  can  weigh  on  the  company;  it  becomes   a   weight   and   can   sink   the   company   in   an   ocean   of   debt.   In   the   case   of   a  bleak  economic  horizon,  it’s  very  possible  that  the  company  has  to  file  for  bankruptcy  and  will  be  liquidated  by  the  sale  of  its  assets.   So  what  is  the  situation  of  the  players  who  participated  in  the  LBO  transaction?      Obviously,   the   lenders   are   first   in   line   to   obtain   any   proceeds   from   this   sale.   They  recoup  a  portion  of  the  debt  they  granted  in  the  leveraged  transaction  so  their  losses  may  be  limited.  What  about  the  equity  investor?  Unfortunately  for  him,  he’s  wiped  out  for  his  initial  10%  (or  more)  equity  investment.    During   this   research   report,   two   parts   will   be   successively   dedicated   to   leveraged  buyouts.   In   the   first   part,   it   will   be   important   to   define   the   general   structure   of   an  LBO.   In   other   words,   our   attention   must   be   focused   on   two   aspects   of   this   type   of  transaction.  On  the  one  hand,  the  different  players  who  decide  to  build  an  LBO.  On  the  other  hand,  sources  and  uses  of  funds  which  are  used  within  this  transaction.                       8  
  9. 9. PART  I  –  PLAYERS  AND  FUNDS  TO  BUILD  AN   LBO.  We   need   to   distinguish   between   two   types   of   issues.   Who   are   the   main   actors   and  what  is  their  role  in  the  transaction?  Secondly,  where  are  the  funds  come  from  and  how  can  players  use  of  it?     CHAPTER  I  –  PLAYERS.  All  players  have  a  decisive  role  in  an  LBO.  They  can  be  split  into  two  categories.  There  is   the   seller   who   manages   the   target   and   who   must   decide   to   accept   or   not   the  purchase   offer.   But   the   principal   actor   in   this   transaction   will   definitely   be   the  investor.  It  can  be  an  individual  or  a  private  equity  group.       SECTION  I  –  Current  owners  and  investors.  Every  LBO  starts  with  the  investor  who  has  the  central  role.  Everything  starts  when  the   individual   or   private   equity   group   sees   an   opportunity   and   sets   the   process   in  motion.   So,   what   is   a   private   equity   fund   and   how   the   investor   can   realize   the  greatest  return  possible  on  his  initial  equity  investment?     I  –  The  investor  in  an  LBO  transaction.  Leveraged   buyouts   are   the   most   common   investment   strategy   used   by   private   equity  firms.    A)  The  financial  impact  of  private  equity  funds.  A  private  equity  fund  is  often  used  to  making  investments  and  profits.  Classically,  in  a  private  equity  deal,  an  investor  or  a  group  of  investors  buys  a  stake  in  a  company  that  he   has   chosen   with   the   hope   of   ultimately,   making   an   increase   in   the   value   of   his  initial  investment.    Today,  we  can  say  that  it  exists  a  private  equity  industry2,  which  is  a  major  force  in  the  world.    When  funds  take  the  control  of  the  company,  they  will  usually  take  the  company  off  the   market   if   the   company   isn’t   private   already,   go   through   a   certain   period   of  restructuring  process  and  then,  relist  this  company  on  the  stock  market.    Private   equity   funds   are   typically   organized   as   limited   liability   partnerships   –   LLP,  where   institutional   investors   make   a   capital   commitment   to   fund   investments   over                                                                                                                  2  “Valuation  ;  measuring  and  managing  the  value  of  companies”,  written  by  McKinsey  and  Company  incorporation,  July  26,  2010.       9  
  10. 10. the   duration   of   the   fund.   Of   course,   private   equity   funds   have   a   large   variety   of  investment  strategies  but  they  tend  to  be  specialized  in  venture  capital  funds  and  as  far  as  we  are  concerned,  buyout  funds.    Buyout   funds   have   typically   sought   to   leverage   their   equity   investment   with   debt,  and   are   more   concerned   with   the   ability   of   a   company   to   generate   cash   flows   (which  will  be  used  to  reimbursed  the  debt)  than  are  a  venture  capital  fund.  At  its  most  basic  level,  a  private  equity  fund  is  a  large  sum  of  money  that  is  invested  in  a  public  (more  rarely  private…)  company.  The  fund  is  managed  by  a  team  of  skilled  investment   professionals   who   rapidly   identify   investment   opportunities,   make  transactions  and  provide  management.    Structuring  a  fund  requires  a  particularly  attention  about  state  regulations,  including  securities   law   issues,   tax   problems,   liability,   or   other   issues.   Generally,   funds   solve  these   issues   through   a   limited   partnership   model,   in   which   the   investors   hold   limited  partner’s   interests   and   the   management   team   holds   an   interest   in   an   entity   that  serves  as  the  general  partner  (refer  to  the  drawing  below).  For  example,  in  the  USA,  private  equity  funds  are  typically  organized  under  “Investment  Advisers  Act”3.    More  especially,   US   based   funds   are   often   organized   as   Delaware   limited   partnerships.  Indeed,   Delaware   law   is   used   because   of   its   familiarity   to   most   practitioners   and  investors.  Private  equity  funds  formed  to  invest  outside  of  the  US  are  often  formed  as  LPs   or   LLCs   in   offshore   jurisdictions   with   favourable   tax   regimes   like   the   Cayman  Islands,  the  Channel  Islands  or  Luxembourg.The   purpose   of   the   fund  limited   partnership   is   to  eliminate   entity-­‐level   tax  and  protect  the  investors  in  the   fund   from   personal  liability   for   debts   and  obligations   of   the   fund.   As  we   have   said,   this   model   is  most   typically   implemented  through   a   limited  partnership,   but   benefits  can   be   achieved   through   a  limited   liability   company   –  LLC   –   in   jurisdictions   where  this  form  exists.    Private   equity   funds   are  managed  by  a  management  company   organized   by   the                                                                                                                  3  Investment  Advisers  Act,  1940,  amended  and  approved  January  3,  2012.     10  
  11. 11. sponsor,   which   may   act   as   the   “general   partner”   of   the   fund.   This   management  company  will  play  an  important  role  in  order  to  raise  investment  capital  and   execute  investment  transactions.  The  purpose  of  a  private  equity  fund  that  engage  in  LBO  transactions  is  to  achieve  the  most  significant  return  on  investment.    B)  Return  on  investor’s  investment.  Private   equity   funds   have   access   to   capital   for   investment   and   the   best   way   for   them  to   make   money   is   to   put   the   money   that   they   do   have   to   work,   in   the   form   of  investments.    They  look  for  a  strong  takeover  target  with  small  amounts  of  debt,  strong  cash  flow  and   assets   free   for   use   as   collateral.   The   investors   spend   lots   of   time   analysing   the  potential  returns  from  prospective  deals  and  eventually  choose  whether  to  move  on  a  company  or  not.    The   choice   of   the   target   is   so   very   important   for   any   LBO   transaction   because   the  amount  of  debt  will  be  reimbursed  by  dividends  from  the  target.      The   investor   is   so   the   “catalyst”   behind   the   transaction.   He   must   decide   how  aggressive   or   conservative   should   be   any   offer   that   is   put   forth   the   current  ownership.   To   a   certain   extent,   he   also   decides   how   much   leverage   to   use   in   the  transaction   and   more   exactly,   it’s   only   to   a   certain   extent   because   at   points   of  excessive  leverage  or  non-­‐creditworthy  deals  the  lenders  will  decline  to  award  credit.    The  investor  has  totally  discretion  over  the  multiple  of  earnings  it  is  wiling  to  assign  as  valuation  and  therefore  the  purchase  price  for  the  target  company.  It’s  up  to  the  investor   to   decide   what   is   a   reasonable   valuation   and   what   is   offer   price   for   a  company.  It’s  naturally  a  decision  that  must  take  multiple  factors  in  consideration.  Of  course,  the  investor  will  negotiate  with  the  seller  of  the  company  in  order  to  reduce  the  price  as  much  as  possible.  The   investor   is   motivated   to   ultimately   realize   the   greatest   return   possible   on   his  investment.  This  is  easier  said  than  done.  There  are  many  factors  that  can  affect  the  outcome   but   in   the   simplest   sense,   it   is   easier   to   realize   greater   returns   on   equity  capital   if   that   equity   is   a   small   number.   In   other   words,   the   greater   the   amount   of  capital  is  low  and  so,  the  greater  the  amount  of  money  borrowed  is  important,  the  greater  the  leverage  will  be  important  so  the  investor  has  to  play  as  much  as  possible  with  the  financial  leverage.    However,   the   investor   doesn’t   want   to   saddle   the   company   with   such   debt   that   he  risks  losing  his  entire  investment  because  of  a  possible  default.  So  for  this  reason,  the  investor   is   motivated   to   find   a   balance.   The   ideal   is   the   greatest   amount   of   debt  possible   that   will   not   also   sink   the   company   down   the   road,   leaving   it   able   to   pay     11  
  12. 12. down  debt,  increase  earnings  and  eventually  be  sold  at  greater  multiple  of  earnings  than  it  was  purchased  for.    The   investor   has   so   a   primary   role   in   an   LBO   but   this   role   is   equally   risky.   To   a   certain  extent,  we  can  say  that  the  fate  of  the  transaction  is  already  known  when  the  amount  of  debt  and  equity  are  determined  after  negotiations  although  unpredictable  events  may  affect  the  transaction.   II  –  The  seller  of  the  company.  A)  Different  alternatives  to  sell  a  company.    Based  upon  the  attributes  of  the  business  and  the  overall  objectives  of  the  owners  of  the   target,   there   are   a   certain   number   of   alternatives   that   might   be   a   better   fit   in  order   to   sell   a   company.   These   alternatives,   including   for   example   dividend  recapitalization  and  leveraged  buyouts,  can  be  attractive  to  shareholders  from  both  a  valuation  and  great  outcome.    Dividend   recapitalization   is   a   process   that   provides   shareholders   with   the   ability   to  take  cash  out  of  the  company  by  raising  bank  debt  to  support  a  special  dividend.  This  strategy  was  particularly  popular,  for  example  in  the  USA  in  2010,  in  anticipation  of  expected  capital  gains  tax  increases  in  2011.  Another  alternative  would  be  to  adopt  an  employee  stock  ownership  plan,  a  widely  used   method   in   the   USA.   It   involves   the   creation   of   a   retirement   benefit   plan   that  borrows   money   in   order   to   acquire   stock   in   the   company.   Company   assets   must  guarantee  the  debt  and  the  proceeds  are  also  used  to  purchase  stock  from  existing  shareholders   and   from   the   company.   The   main   advantage   of   this   method   is   tax  issues.      But  today,  if  you  are  a  business  owner  looking  to  sell  your  company,  your  potential  buyer   will   most   likely   include   private   equity   funds   as   previously   said.   An   LBO   can   also  be  accomplished  through  a  private  equity  firm.    B)  Selling  a  company  through  an  LBO  transaction.    To  gauge  the  potential  interest  level  of  private  equity  funds,  a  business  owner  should  develop  an  understanding  of  what  this  fund  look  for  in  an  acquisition  and  why.    The  seller  also  has  an  important  role  in  the  transaction.  Indeed,  the  current  owners  of  the  company  are  the  people  who  should  know  the  most  about  the  target,  both  inside  and  out.  They  understand  the  history  and  development  of  the  company  as  well  as  the  operating  environment  in  which  they  do  business.    The  seller  and  investors  should  cooperate.  The  owner  of  the  target  is  more  likely  to  provide  information  about  income,  assets,  financial,  economic  and  social  organization  of  the  target.       12  
  13. 13. The   current   owners   should   also   have   a   keen   sense   of   where   the   market   for   their  product  is  heading.  It  would  be  wrong  to  say  that  the  seller  has  a  passive  role  in  the  LBO,  he  has  a  really  interest  in  working  hand  in  hand  with  investor.    It’s   up   to   the   owners   of   the   company   to   consider   and   ultimately   accept   or   decline  offers   to   sell   their   ownership   in   the   company.   As   part   of   the   process,   the   owners   will  most  likely  try  to  negotiate  a  larger  multiple  of  earnings  into  the  purchase  price.    It  is  the  job  of  the  owners  to  test  the  upper  limits  of  what  the  purchasers  are  willing  to  pay  for  the  target  and  then,  try  to  take  that  offer  price  a  little  further.    Business   owners   will   find   all   sorts   of   justification   for   deserving   a   large   multiple   for  their  earnings;  after  all,  that  is  what  they  are  supposed  to  do…    When   a   business   owner   arrives   at   the   decision   to   sell,   there   are   few   greater  motivations   than   money.   Although,   some   business   owners   may   also   consider   such  things  as  the  identity  of  the  purchaser,  the  future  of  the  company  post-­‐sale,  and  the  likelihood   and   degree   of   cost   cutting   after   sale,   rarely   do   any   of   these   considerations  trump  monetary  pay-­‐off.  It  is  safe  to  say  that  the  primary  motivation  of  the  business  owner  is  to  get  the  greatest  valuation  and  sale  price  possible  for  the  business.  If  the  company  has  a  bright  future  en  growth  potential  is  still  relatively  high,  a  savvy  owner  will  logically  demand  a  greater  multiple  of  earnings  for  a  purchase  price  before  agreeing  to  sell.    Today,  business  sellers,  buyers  and  advisors  of  them  are  facing  many  problems  with  respect  to  bringing  a  transaction  with  a  successful  conclusion.    The  values  are  down,  financing   is   tough   even   non-­‐existent,   liquidations   are   increasing,   and   sellers   and  buyers  are  also  giving  up.  Buyers’  advisors  say  that  the  valuation  is  too  high  based  on  financing;   the   sellers’   advisors   say   the   price   is   too   low   and   the   sellers   need   in   a  certain  extent  an  all  cash  sale  to  avoid  risk.  While   the   economy   has   made   it   more   difficult   for   buyers   to   obtain   the   optimal  amount   of   financing   required   for   leveraged   buyouts,   those   buyers   can   attempt   to  bridge   this   financing   gap   by   having   sellers   provide   seller   financing,   for   example   in   the  form  of  seller  notes  or  earn  out  payments.    We  can  define  seller  notes  as  a  common  means  used  to  bridge  the  financing  gap  also  it   consists   in   asking   the   seller   of   a   business   to   provide   seller   financing   by   taking   a  portion  of  the  purchase  price  in  the  form  of  a  “note”  issued  by  the  target.  So  more  simply,   it’s   a   form   of   debt   financing   used   generally   in   small  business   acquisitions   in  which   the   seller   agrees   to   receive   a   portion   of   the   purchase   price   as   a   series   of  instalment   payments.   In   some   LBOs,   the   business   buyer   and   seller   may   agree   on  deferred   or   interest   only   payments   initially   in   order   to   reduce   the   cash   flow   pressure  on  the  buyer  during  the  business  ownership  transaction  period.     13  
  14. 14. Concerning  earn  out  payments  in  an  LBO  transaction,  it  is  a  contractual  agreement  by  the  investor  of  the  target  to  pay  to  the  seller  of  this  company  an  additional  value  or  compensation  in  the  future  depending  upon  how  the  target  performs.    There  are  a  lot  of  ways  to  calculate  and  pay  the  compensation,  but  in  general,  it  as  a  bonus  that  is  paid  based  upon  future  performance.    The  measure  used  to  calculate  an  earn  out  is  generally   based   upon   a   percentage   of   the   revenue.     An   earn   out   is   usually   used   to  close   the   value   gap   between   the   asking   price   of   the   seller   and   the   purchase   price  which  the  buyer  is  willing  to  pay.    An   earn   out   structure   can   take   on   many   forms   and   the   earn   out   amount   is   usually  paid  in  either  cash  or  equity.  For   buyers,   to   set   up   an   earn   out   clause   reduces   the   risks   of   the   purchase.   By  establishing   a   payment   plan   based   on   target   performances   in   the   future,   investors  can  protect  themselves  from  unwise  purchasing  decisions  that  have  been  made.    Sellers,  on  the  other  hand,  can  benefit  from  an  earn  out  agreement  because  they  can  earn   more   over   time   from   the   sale   if   the   clause   is   structured   correctly   and   the  companys  performance  is  great.  However,  sellers  also  run  a  risk  and  could  not  obtain  the  full  purchase  price  if  the  target  performs  poorly.  When  the  buyer  has  identified  the  target  company  and  the  seller  is  willing  to  sell,  it  is  necessary   to   associate   moneylenders.   Without   them,   a   leverage   buyout   can’t   be  realized   because   the   financial   and   so,   tax   leverage   depends   on   the   amount   of   debt  used  to  acquire  the  target.     SECTION  II  –  Lenders,  debt  investors  and  existing  creditors.  A   leveraged   buyout   is   a   type   of   takeover   where   a   substantial   proportion   of   the  acquisition   price   is   financed   by   borrowings,   using   the   target   companys   assets   to  reimburse  the  amount  of  debt.  In  other  words,  in  an  LBO  transaction,  the  debt-­‐equity  level  is  very  high.    Multiple  tranches  of  debt  are  commonly  used  to  finance  LBOs,  so  there  is  no  only  one  type   of   lender.   Lenders   are   often   classified   into   several   categories   according   to   the  priority  of  debt  reimbursement.     I  –  Banks,  the  major  lenders.    The   banks   are   without   doubt   one   of   the   major   lenders   in   every   leveraged   buyout  transaction.    Typically,  banks  extend  loans  that  are  senior  in  the  credit  pecking  order  and  secured  by  the  assets  of  the  target  that  is  to  say,  company  being  acquired,  and  sometimes,  by  the   assets   of   the   investing   company   (hereafter,   the   “Newco”).   This   fact   raises   this  following  question;  how  would  the  lenders  protect  themselves?       14  
  15. 15. The  transaction  between  a  lender  and  Newco  would  generally  involve  the  negotiation  of   a   loan   agreement   where   the   lender   would   want   various   representations   and  warranties  to  be  inserted.    In  particular,  the  lender  would  want  to  accelerate  the  repayment  of  the  loan  in  case  of   major   breaches   of   the   “entrenched   covenants”   and   the   specified   “events   of  default”.    Also,  the  lender  may  want  to  impose  restrictions  on  the  creation  of  further  charges  on   the   security,   or   the   disposal   of   the   assets,   investments   in   business   or   shares,  issuance   of   new   shares,   etc.   While   negotiating,   these   requirements   may   conflict   with  Newcos  desire  to  maintain  flexibility  as  regards  its  business  operations.    This  problem  may  be  reduced  if  banks  participate  as  syndicated  lenders  as  said  in  the  introduction  of  this  report.  Under  this  scenario,  several  banks  will  come  together  to  lend   a   portion   of   the   total   amount   of   debt.   This   reduces   consequently   the   credit  exposure   each   bank   has   to   regarding   to   the   borrower,   while   still   allowing   them   to  participate  as  a  lender.    An   investment   bank   often   arranges   the   syndication,   while   commercial   banks   makeup  a  large  number  of  the  lenders,  along  with  other  investment  banks  participating  in  the  syndication   as   lenders   in   the   deal.   Commercial   banks   have   traditionally   played   an  important  role  in  leveraged  buyout  financing,  as  provide  the  majority  of  buyout  debt,  typically  in  the  form  of  short-­‐term  and  covenant-­‐heavy  term  loans  and  revolving  lines  of  credit.    Plainly,   banks   play   an   important   role   in   takeover   finance   in   general   and   more  particularly   in   LBO   transactions.   Commercial   bank   lending   facilitates   LBO   deals.  Consequently   to   the   extent   that   they   exercise   their   authority,   banks   have   placed  themselves  in  a  position  to  control  the  borrowing  firm’s  capital.  Indeed,  the  lending  bank  can  design  a  loan  contract  to  protect  its  interests  against  substantive  changes  in  the  borrowing  firm’s  operating  and  financial  condition.    Without   diminishing   their   function   of   resource   allocation,   banks   also   contribute  importantly  to  the  borrowing  firm’s  operational  and  financial  decisions.    Along   with   the   credit   supplied   to   the   borrowing   firm   are   explicit   conditions   that  restrain  management’s  actions  regarding  the  firm’s  operations,  asset  disposition  and  executive  changes;  It’s   the   role   of   the   bank   to   evaluate   the   projected   credit   situation   of   the   company  post-­‐transaction  and  to   offer  or  decline  lending  terms  based  on  the  creditworthiness  of   the   company   under   the   proposed   capital   structure   (capital   structure   will   be  detailed  later  in  this  report).       15  
  16. 16. The  banks  are  motivated  to  assess  the  risk  of  lending  correctly  and  set  interest  rates  that  are  an  appropriate  reflection  of  that  risk.    If  a  bank  does  lend,  it  wants  to  make  sure  it  is  receiving  adequate  payment  for  the  risks  involved.     II  –  The  unsecured  lenders.  Debt   investors   are   oftentimes   the   unsecured   creditors   in   the   deal   and,   as   a   matter   of  course,  command  a  higher  fixed  rate  of  interest,  often  referred  to  as  high  yield,  which  is  compensation  for  firstly,  being  unsecured  and  secondly,  being  junior  in  the  credit  pecking  order  to  the  senior  secured  bank  debt.    Indeed,  these  creditors  find  their  place  in  the  deal  through  the  purchase  of  high  yield  bonds,  which  are  underwritten  and  arranged  by  an  investment  bank.    Unsecured  lenders  are  often  professional  fixed-­‐income  investors  that  understand  the  risks  associated  with  high-­‐yield  corporate  bonds.    As   the   senior   secured   lenders,   the   unsecured   lender’s   role   is   to   evaluate   the   credit  quality   of   the   company   post-­‐leveraged   buyout   and   determine   the   risk   of   the  company  not  being  to  pay  back  its  loan.  The  unsecured  lender  must  consider  the  fact  that  it  will  only  receive  its  money  after  the  senior  secured  lender  gets  paid.  In   the   end,   the   amount   granted   of   unsecured   debt   that   is   issued   can   make   a  significant  difference  in  the  amount  of  leverage  available  in  a  deal.    Moreover,  unsecured  creditors  are  motivated  by  the  large  interest  payments  that  are  associated   with   high-­‐yield   bonds.   Although   unsecured   loans   used   to   finance  leveraged   buyout   carry   significant   risks,   ultimately   it   is   the   large   coupon   payments  that   bring   investors   forward   to   purchase   the   securities   once   the   investment   bank  issues  the  bonds.  Once  again  the  motivation  is  a  balance  between  the  greed  and  fear  of  the  creditor,  the  same  two  things  that  run  the  entire  credit  markets.    In   return   for   the   burden   of   assuming   this   high   risk,   unsecured   lenders   typically  require   a   higher   interest   rate   often   called   “equity   kicker”,   also   known   as   equity  sweetener.   It’s   a   warrant   or   an   option   to   buy   equity,   attached   to   debt   that   is   used   to  finance  leveraged  buyouts.    The  percentage  of  ownership  can  be  as  little  as  9%  or  as  high  as  80%  of  the  target’s  shares.  The  percentage  is  higher  when  the  lender  perceives  the  greater  risk.  It’s  very  often  used  in  mezzanine  financing  where  the  lender  receives  equity  interests  from   the   borrower,   regarding   as   an   additional   financial   reward   for   according   loans.  Equity  kickers  are  generally  structured  as  conditional  rewards,  so  that  the  lender  only     16  
  17. 17. receives   its   equity   if   the   borrowers   business   meets   certain   specified   performance  goals.  Unsecured   lenders   are   entitled   to   receive   the   proceeds   of   the   sale   of   the   secured  assets  after  full  payment  has  been  made  to  the  secured  lenders  so  it  can  explain  what  unsecured   component   receive   a   higher   return   to   compensate   for   assuming   the  greater  risk  in  the  LBO  transaction.     III  –  The  risky  situation  of  existing  lenders.  This   category   of   lenders   is   made   up   of   creditors   that   issued   debt   to   the   company  before  there  was  any  talk  of  a  leveraged  buyout.  The  existing  lenders  presumably  lent  money   to   the   company   to   help   them   expand   operations   or   meet   liquidity   needs   or  both.  Most   likely,   existing   lenders   are   traditional   creditors,   such   as   a   commercial   bank  specializing  in  making  traditional  commercial  loans.    This   group   likely   has   a   relationship   with   the   company   and   has   a   reasonable  understanding  of  the  company’s  credit  situation.    The  existing  lenders  doesn’t  play  a  major  role  in  an  LBO  transaction.  Classically,  they  receive  the  loan  principal  and  any  interest  due  and  pre-­‐payment  fees  once  the  LBO  transaction  goes  through.    In  a  situation  such  as  the  pre-­‐payment  of  a  bank  loan  there  is  typically  a  pre-­‐payment  fee  between  1%  and  1,5%  that  is  agreed  at  the  initial  extending  of  the  loan.    The  fee  is  paid  to  the  lender  at  the  time  of  pre-­‐payment.  Once  a  borrower  decides  to  pre-­‐pay   a   loan,   the   existing   creditors   then   becomes   focused   on   seeing   that   its  extended  loans  and  other  monies  due  and  receivable  are  paid  back.  In  the  event  that  a  lender  is  large  enough,  it  may  be  motivated  to  seek  participation  as   one   of   the   lenders   in   the   leveraged   buyout   transaction.   This   would   present   an  opportunity  for  the  lender  to  extended  additional  loans.    But   undeniably,   the   biggest   losers   in   an   LBO   transaction   are   the   firms   existing  creditors   because   the   buyout   is   financed   primarily   with   debt   so   existing   creditors  become  creditors  of  a  much  riskier  firm.    After  listing  the  main  actors  involved  in  an  LBO  transaction,  focus  should  be  sources  of  funds  and  uses  of  them  in  the  buyout.  Indeed,  we  must  study  what  are  the  various  tranches  of  debt  which  are  the  main  part  of  financing  in  an  LBO  transaction  and  more  particularly,  how  can  investors  use  the  funds  they  have.       17  
  18. 18.     CHAPTER  II  –  SOURCES  AND  USES  OF  FUNDS.  Building   a   leveraged  buyout  is  about  organization  and  capital  structure.  The  first  step  in  building  is  preparing  the  sources  and  uses  of  funds  for  the  LBO.  In  other  words,  you  have   to   know   how   much   a   buyout   will   cost   for   the   investor   this   is   the   question   of  uses  of  funds,  but  before,  where  the  money  to  pay  for  this  might  come  from   and  this  is  the  question  of  sources  of  funds.     SECTION  I  –  Sources  of  funds.  We   need   to   figure   out   how   we   are   going   to   get   the   money.   Sources   of   funds   are  made  up  of  the  various  types  of  capital  used  to  complete  the  transaction.  One  part  of  the   price   of   an   LBO   transaction   comes   from   equity   but   this   part   is   minor.  Indeed,   the  major  part  of  the  price  comes  from  debt  in  order  to  maximize  tax  leverage  (PART  II)  and  financial  leverage.     I  –  Equity  capital.  One  part  of  funds  must  be  provided  by  the  investors.  The  common  equity/equity  capital  comes  from  a  private  equity  fund  (CHAPTER  I)  that  pools   capital   raised   from   various   sources.   These   sources   might   include   pensions,  insurance  companies,  wealthy  individuals.  The   objective   is   to   rely   on   this   equity   capital   to   build   a   Newco   that   is   large   enough   to  be   leveraged   later   with   senior   and   subordinated   debt   and   to   use   leverage   with   an  important  degree  in  order  to  realize  future  acquisitions.    The   level   of   equity   capital   provides   more   flexibility   to   the   Newco   in   making  acquisitions.  The  buyer  also  can  obtain  more  attractive  financing  in  terms  of  structure  and  pricing  because,  the  total  amount  of  equity  represents  the  sum  that  the  investors  so  generally,  private  equity  funds,  are  willing  to  put  at  risk  in  the  LBO  deal.    In   other   words,   equity   capital   represents   invested   money   that,   in   contrast   to   debt  capital,  will  be  not  repaid  to  the  investors  in  the  course  of  transaction.  It  represents  the  risk  staked  by  the  buyers.  For  the  bank,  the  equity  capital  represents  the  sum  that  could  be  seized  so,  this  amount  represents  a  guarantee  for  lenders.      With  the  equity  capital,  a  larger  pool  of  lenders  will  be  probably  available  to  provide  funding.   Lenders   know   that   all   or   an   important   amount   of   the   investor’s   funds   has  been  invested  in  the  plan  before  the  bank  lends  its  money.    What  are  different  possibilities  to  invest  equity  capital  in  the  Newco  structure?     18  
  19. 19. Equity   capital   give   legally   the   property   of   the   holding   to   investors.   This   capital  contribution   may   be   in   cash,   but   can   also   be   realized   in   the   form   of   a   transfer   of  assets.    The   seller   may   also   bring   part   of   its   securities   within   the   target   company   into   the  acquiring  holding  company.  This  method  enables  the  seller  to  remain  involved  in  the  transaction  once  the  LBO  has  been  set  up,  keeping  in  mind  that  the  value  of  the  share  contribution  will  have  to  be  assessed  by  a  statutory  registrar.  This  method  can  be  advantageous  in  a  certain  number  of  States  like  France.  Indeed,  when  the  seller  is  located  in  France,  a  transfer  of  assets  allows  him  to  differ  taxation  in  accordance  with  the  150-­‐OB  article  of  the  “CGI”4.  Although,  generally,  the  majority  of  the  equity  capital  represents  cash.  Typically,   the   common   equity   represents   25-­‐35%   of   capital   structure   but   it’s   a  question   of   financial   analysis.   Indeed,   in   every   LBO   transaction,   investors   must   see  how  returns  are  affected  with  changes  in  the  amount  of  equity  capital  that  bas  been  invested  in  this  transaction.       II  –  Tranches  of  debt.  Multiple  tranches  of  debt  are  used  to  finance  an  LBO  transaction,  and  may  including  any  of  the  following  tranches  of  capital  listed  in  descending  order  of  seniority.    Firstly,  the  Newco  can  obtain  a  revolving  credit  facility  also  called  revolver.  A  revolver  is   a   form   of   senior   bank   debt   that   we   can   compare   as   a   credit   card   and   that   is  generally  used  to  help  fund  a  companys  working  capital.    The  Newco  can  use  the  revolving  credit  up  to  the  credit  limit  when  it  needs  cash  in  the   LBO   transaction,   but   must   repay   the   amount   when   an   excess   of   cash   is   available.  What   is   very   advantageous   is   there   is   generally   no   repayment   penalty   for   using  revolver.    The   revolver   offers   Newco   a   lot   of   flexibility   according   to   its   capital   needs   and  allowing   access   to   cash   without   having   to   obtain   additional   either   debt   or   equity  financing  as  seen  before  (§  I).    Although,  there  are  two  different  costs  associated  with  revolving  credit.  On  the  one  hand,  the  interest  rate.    On  the  other  hand,  an  undrawn  commitment  fee.  The  interest  rate  that  is  charged  on  the   revolver   balance   is   usually   LIBOR,   which   must   be   added   a   premium   that   depends  on  the  credit  conditions  obtained  by  the  Newco.                                                                                                                    4  CGI  :  the  french  «  Code  général  des  impôts  »  that  contains  tax  law.     19  
  20. 20. The   undrawn   commitment   fee   is   usually   a   fixed   rate   that   is   multiplied   by   the  difference  between  the  revolvers  limit  and  any  drawn  amount.  A)  First  lien  debt.  The   senior   bank   debt   is   a   lower   cost-­‐of-­‐capital   and   more   exactly,   lower   interest   rates  than   subordinated   debt   but   there   are   typically   more   restrictive   provisions   and  limitations  than  mezzanine  debt  for  example.    Bank  debt  generally  needs  a  fully  amortization  over  a  5  to  8  year-­‐period.  Provisions  typically   restrict   the   Newco’s   flexibility   either   to   make   further   acquisitions   or   raise  additional  debt  holders.  Senior  bank  debt  also  contains  financial  maintenance  clauses  that  are  generally  secured  by  the  assets  of  the  borrower.    Senior  bank  debt  can  take  two  forms.  On  the  one  hand,  a  term  loan  A.  This  tranche  of  debt  is  generally  amortized  evenly  over  5  to  7  years.  In  other  words,  loan  tranche  A  characterised   by   a   fixed   amortisation   schedule   with   maturity   reached   after   seven  years.  On  the  other  hand,  a  term  loan  B  that  usually  involves  a  repayment  over  5  to  8  years,  with  a  large  payment  in  the  last  year.    In   other   words,   the   latter   allows   borrowers   to   defer   reimbursement   of   a   large  amount  of  the  loan  but  it’s  more  costly  for  the  Newco  than  term  loan  A.    However,  at  present,  tranche  A  debt,  amortised  over  its  maturity,  is  shrinking  while  tranche   B,   which   carry   no   periodic   capital   repayment,   is   preferred   by   banks   to  improve  the  leverage  degree.  The   interest   rate   charged   on   senior   bank   debt   is   often   a   floating   rate   that   is  approximately  equal  to  the  LIBOR  and  a  premium,  depending  on  the  credit  conditions  of  the  borrower.  If  the  borrower  has  negotiated  a  great  credit  terms,  bank  debt  may  be  repaid  early  without  penalty.    B)  Second  lien  debt.    In  a  second  lien  debt  or  second  lien  loan  transaction,  the  second  lien  lenders  hold  a  second  priority  security  interest  about  the  borrower’s  assets.    Second   lien   financing   continue   to   be   popular,   particularly   in   the   USA,   with   deal  volumes   reaching   approximately   $27.8   billions   during   2008,   but   have   also   gained   a  large  growth  in  Europe,  with  approximately  3  billions  raised  in  20075.  Second   lien   debt   is   simply,   as   this   name   suggests,   debt   which   benefits   principally  from   the   same   security   as   secured   senior   debt   as   we   have   seen   previously,   on   a  second  ranking  basis.                                                                                                                    5  According  to  18th  annual  Thomson  Reuters  LPC  loan  market  conference.       20  

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