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 Leveraged-Buyouts; Market mechanism, Tax shield and exiting of an LBO Document Transcript

  •       MARKET MECHANISM, TAXSHIELD AND EXITING OF AN LBOResearch  report  drafted  by  Guillaume  ALLEGRE  Under  the  supervision  of  Jean-­‐François  Louit,  Partner  in  Scotto  &  Associés.  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  • 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  
  •     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  
  • 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  
  • 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  
  • The  senior  lenders  (so  who  can  called  first  lien  lenders)  and  second  lien  lenders  agree  that  on  respect  of  the  security,  the  senior  lenders  will  be  fully  paid  before  the  second  lien  lenders.    The   second   lien   debt   can   have   the   form   of   a   loan   or   bonds   and   is   typically   lent   at   the  same  level  as  the  senior  debt.    Second   lien   debt   is   not   new   in   Europe   and   differs   from   mezzanine   debt   in   that   the  repayment  right  of  the  second  lien  lender  isn’t  normally  subordinated  to  those  of  the  senior  lender.    The   price   and   flexibility   are   the   two   factors   that   attract   borrowers   to   second   lien  deals.   It’s   more   expensive   than   senior   bank   debt   but   second   lien   debt   in   the   USA   and  Europe  is  significantly  less  expensive  than  mezzanine  loans  as  we’ll  see  just  after.  The   price   depends   on   risk   profile   and   more   particularly   in   Europe,   second   lien   is  generally   priced   between   400   and   700   basis   points6,   against   11.000   basis   points   or  more  for  certain  mezzanine  vehicles.  To   conclude,   the   second   lien   loan   is   situated   between   senior   debt   and   mezzanine  senior   debt.   It   offers   larger   repayment   duration   than   the   senior   debt   and   its  remuneration   is   higher.   Since   the   second-­‐lien   is   second   in   ranking   behind   the  traditional  senior  credit  facility,  its  repayment  will  be  made  in  full,  at  maturity,  once  the  first  lien  senior  debt  has  been  fully  repaid.  C)  High  yields  and  junk  bonds.  This  tranche  of  debt  is  typically  very  unsecured.  High  yield  debt  is  often  referred  to  as  “junk   bonds,”   but   this   term   is   past.   Today,   high  yield   bonds   are   a   mature   asset   can  provide  a  number  of  advantages  to  investors  who  understand  and  accept  the  risks.    Companies  with  credit  ratings  that  are  beneath  investment-­‐grade  offer  those  bonds7.  Investment   grade   companies   are   large   multinational   firms   with   massive   recurring  revenues  and  a  lot  of  cash  on  their  balance  sheets.  In  other  words,  there  is  no  chance  that  they  will  default,  or  fail  to  make  their  interest  and  principal  payments  on  time.    Companies   with   outlooks   that   are   questionable   enough   and   also,   could   default,   have  lower  credit  ratings  and  investors  demand  higher  yields  to  own  their  bonds.  High-­‐yield  debt  characteristic  is  very  high  interest  rates,  which  compensate  investors  for   their   risk   as   we   said   previously.   This   tranche   of   debt   is   often   used   to   increase  leverage  levels.    High-­‐yield  bonds  don’t  offer  any  access  to  capital.                                                                                                                    6  Basis  point;  unit  of  measure  using  to  describe  the  percentage  change  in  the  value  or  rate  of  a  financial  instrument  ;  one  basis  point  is  equivalent  to  0,01%.    7  Investment  grade;  for  example,  Microsoft  or  Apple.       21  
  • D)  Mezzanine  debt.    One   reason   why   the   second   lien   concept   is   difficult   to   settle   down   in   Europe   is   the  presence  of  a  healthy  junior  debt  market.    The  mezzanine  ranks  last  in  the  hierarchy  of  tranches  of  debt.  Private  equity  investors  and  hedge  funds8  often  finance  this  type  of  debt.    Mezzanine  financing   is  an  intermediate  step  between  equity  capital  and  debt.  It’s  a  hybrid-­‐financing   instrument   that   can   be   used   to   improve   creditworthiness,   to  optimise  tax  structures,  and  to  achieve  a  better  rating  of  the  company.    The   mezzanine   capital   that   can   be   provided   has   a   lower   ranking   than   senior   debt   but  a  higher  ranking  than  shareholders  equity.  In   the   USA,   a   company   doesn’t   grant   security   to   mezzanine   investors,   and   so   the  market   for   second   lien   debt   was   untapped   until   recent   years.   On   insolvency,   the   USA  second   lien   lenders   now   fit   into   the   debt   structure,   ranking   just   behind   senior  secured  debt,  but  just  ahead  of  the  unsecured  subordinated  mezzanine  lenders  and  high  yield  bondholders.    The  USA  senior  lenders  have  become  more  comfortable  with  the  reduced  exposure  that  has  been  offered  by  a  new  class  of  second  ranking  debt.  On   the   other   hand,   European   mezzanine   debt,   although   usually   contractually  subordinated   through   an   intercreditor   agreement,   benefits   from   second   lien   debt  over  the  assets  of  the  borrower’s  company.    European   senior   banks   often   already   have   the   reduced   exposure   offered   by   a   second  ranking   secured   debt,   but   that   debt   is   also   usually   contractually   or   structurally  subordinated.  In   other   words,   the   mezzanine   debt   is   a   hybrid   component   of   the   financing   in   an   LBO  transaction,   between   senior   debt   and   equity   capital.   It   incorporates   convertible  bonds  or  bonds  attached  to  subscription  warrants,  and  it  gives  the  bond  lenders  the  rights   to   convert   to   an   ownership   or   equity   interest   in   the   Newco   if   the   loan   is   not  paid  back  in  time  and  fully.    The   reimbursement,   generally   made   in   full   at   maturity,   is   subordinated   to   the  repayment  of  senior  debt.  It  provides  flexibility  for  setting-­‐up  and,  by  diversifying  the  financing  sources,  its  fulfils  the  needs  of  senior  lenders  and  those  of  equity  investors.    There   are   other   sources   of   funds   equally   important   like   seller   credit.   It   meets   the  concern   of   the   buyer.   Part   of   the   target   companys   price   is   materialized   through   a  loan   granted   by   the   seller.   By   getting   involved   in   this   financing   scheme,   the   seller                                                                                                                  8  It’s  an  aggressively  structure,  different  to  a  private  equity  fund,  which  managed  portfolio  of  investments  in  order  to  maximize  the  return  of  investment;         22  
  • expresses  his  confidence  in  the  success  of  the  transaction  and  so,  in  the  event  such  transaction   fails,   the   amount   of   the   granted   loan   will   not   be   repaid.   As   the   seller  grants  financing  facilities,  he  will  try  to  negotiate  a  higher  purchase  price  as  well  as  higher  interest  rates.    Regarding   the   senior   debt   lenders,   they   often   demand   that   this   loan   shall   be  subordinated  to  the  senior  debts.  The   targets   companys   cash   flow,   apart   from   cash   flow   invested   for   saving   the  activity,   may   also   be   used   in   the   LBO   deal.   There   could   be   an   extraordinary  distribution   of   dividends   to   the   purchaser.   In   other   words,   they   are   distributable  reserves   not   mentioned   within   the   deduction   part   of   the   tax   return,   which   avoids   tax  payment   on   this   dividend   return   (this   point   will   be   more   especially   detailed   in   the  PART  II  of  this  report).    Lastly,   the   company   could   sell   one   or   several   of   its   fixed   assets   to   use   them   as   a  source   of   funds,   provided   that   certain   precautions   should   be   respected.   Businesses  can  use  them  as  a  source  of  finance.  The  company  can  own  buildings  that,  although  desirably   situated,   are   not   totally   used   or   which   are   likely   to   be   located   in   areas  where   the   price   of   land   is   low.   It   will   be   worth   selling  these   assets   at   good   conditions  and   it   will   generate   a   sufficient   profit,   returned   to   the   purchaser   in   the   form   of  dividends.  After   listing   the   available   funds   for   the   investors   in   an   LBO   transaction,   we   must  consider  how  they  should  be  used.       SECTION  II  –  Uses  of  funds.  The   purchaser   must   first   establish   a   business   plan.   This   selling   tool   reveals   to  investors  and  bankers  cash  movements  over  a  period  of  approximately  five  years.  The   business   plan   must   be   explicit   and   shall   highlight   the   appropriateness   of   the   LBO  project.    The   aim   of   the   plan   is   to   convince   the   purchasers   partners   and   more   particularly   the  private  equity  sponsor  of  the  profitability  of  such  an  investment.     I  –  Structuring  an  LBO  transaction.    The  two  most  common  ways  of  structuring  an  LBO  are  through  acquisition  of  either  the   assets   of   the   target   company   or   its   stock.   After   a   target   has   been   identified,  generally   a   special   purpose   vehicle   or   a   shell   corporation   that   is   typically   called  Newco,  is  created  for  the  purpose  of  making  the  acquisition.    In   asset   acquisition,   Newco   buys   the   assets   of   the   target   company   and   secures   the  loan  (SECTION  I,  §  II)  on  these  assets.  The  target  company  may  become  a  pool  of  cash     23  
  • with   no   assets,   and   it   may   either   grant   a   liquidating   dividend   to   its   shareholders   or  become  an  investment  company.    In  an  asset  purchase,  the  current  owner  retains  ownership  of  shares  of  stock  of  the  company.  Only  assets  and  liabilities  that  are  identified  in  the  purchase  agreement  are  transferred  to  the  buyer.  All  of  the  other  assets  remain  with  the  existing  business  and  thereby   the   seller.   Asset   purchase   transactions   are   generally   more   complicated  because   ownership   of   the   assets   and   liabilities   must   be   transferred,   sometimes  through  the  filing  of  documents  with  governmental  offices.  Let’s   detail   more   precisely   the   acquisition   of   shares   of   the   target   company.   If   you  decide  as  an  investor  to  build  an  LBO  through  an  acquisition  of  shares,  the  loan  may  be  granted  either  to  Newco  or  to  the  target  company.    If   the   amount   granted   is   lent   to   the   former,   Newco   uses   the   loan   to   buy   the   stock  from   the   existing   shareholders,   and   in   the   same   time,   pledges   this   stock   with   the  secured   lenders,   or   it   may   require   the   target   company   to   issue   a   guarantee   to   the  lender,  or  it  may  cause  the  target  company  to  merge  with  it,  and  then  secure  the  loan  on  the  assets  of  the  target  company,  which  now  also  belong  to  Newco.    Alternatively,  since  mergers  take  a  long  time  to  materialise,  the  LBO  transaction  can  be  structured  to  take  place  through  a  two-­‐step  process;  a  tender  offer  followed  by  a  merger.    If  the  loan  is  given  to  the  target,  it  may  either  purchase  its  own  shares  or  may  make  a  further  loan  to  Newco  to  enable  it  to  purchase  the  shares.   II  –  Share  deal  and  purchase  agreement.    In  an  acquisition  of  shares,  there  are  three  major  uses  of  funds.  Firstly,  the  major  use  of  funds  is  the  purchase  of  the  company’s  equity.    A)  Acquisition  equity.  Investor  must  calculate  how  much  money  is  going  to  be  required  to  buy  the  equity  of  the  target.  In  order  to  obtain  this  amount,  we  have  to  multiply  the  acquisition  stock  price  by  the  number  of  shares  outstanding.    The   acquisition   stock   price   (or   current   stock   price)   is   the   last   sale   price   of   shares  prevailing  in  the  market  at  a  specific  moment.  Purchasers  typically  pay  at  least  a  20  or  40%  transaction  premium  over  the  current  stock  price.  Naturally,  the  purpose  of  the  purchaser  of  shares  is  to  buy  the  equity  at  a  price  that  is  less  than  what  the  company  will  later  be  sold  for  post  restructuring  (PART  II).    On   the   other   hand,   the   equity   seller   has   to   sell   the   stock   if   he   thinks   that   the  premium  price  is  above  what  the  stock  is  really  worth.  If  he  thinks  the  stock  is  really     24  
  • worth   more   than   what   is   being   offered   and   this   for   whatever   reason   it’s   not   being  reflected  the  market  price,  he  wouldn’t  naturally  accept  the  offer.    In   order   to   obtain   the   acquisition   stock   price,   investor   has   to   multiply   the   current  stock  price  by  the  transaction  premium  that  represents  a  percentage  and  depends  on  cases.    When  the  purchaser  has  the  acquisition  stock  price,  he  has  to  find  the  number  of  fully  diluted   shares   outstanding   in   the   target   annual   report   or   in   the   10-­‐K 9 ,   which   is  sometimes   required   by   the   SEC.   Fully   diluted   shares   outstanding   is   the   number   of  common  shares  that  would  be  outstanding  if  all  instruments  that  can  be  converted  to  common  equity  such  as  options  ere  converted.    Now,  the  buyer  knows  the  amount  of  cash  that  it  will  be  used  in  order  to  purchase  the  equity  of  the  target.    B)  Target’s  net  debt.    Another  major  use  of  funds  that  an  investor  has  to  consider  in  an  LBO  transaction  is  the  purchase  of  the  target  company’s  net  debt.    Indeed,   the   amount   of   net   debt   must   be   added   to   the   equity   purchase   price   in   order  to   obtain   an   implied   transaction   enterprise   value   –   TEV.   TEV   can   be   defined   as   the  amount  of  money  that  is  purely  required  in  order  to  realize  the  LBO  of  the  target,  but  without   taking   in   consideration   the   cost   of   doing   this   transaction   that   is   to   say  bankers’  fees,  lawyers’  fees  etc.    The  TEV  concept  is  very  important  because  it  tell  us  if  the  price  of  the  LBO  transaction  is  within  investor’s  reach  or  not,  depending  on  the  funds  he  believes  to  be  available.  In   order   to   better   understand   the   relative   value   concerning   the   LBO   transaction,  investors   and   bankers   will   look   at   the   TEV   either   as   a   multiple   of   revenue   or   of  EBITDA.  Typically,   the   calculation   of   net   debt   is   quite   simply.   The   investor   has   to   add   the  short-­‐term   debt   of   the   target,   it   long   term   debt   minus   the   cash   on   the   target’s  balance  sheet.  He  finds  all  those  information  on  the  latest  target  balance  sheet.    The   final   cost   that   an   investor   has   to   consider   in   order   to   build   his   business   plan   is  transaction   costs.   Those   costs   will   include   the   fees   that   are   paid   to   the   lawyers,  advisors,  brokers10  and  all  other  parties  that  are  involved  in  some  way  with  the  LBO  transaction.                                                                                                                    9  it’s  a  form  that  the  SEC  requires  from  publicly  traded  companies  and  sometimes,  private  companies  to  file  every  year.    10  Persons  or  firms  that  conducts  transactions  for  a  client.       25  
  • It  remains  to  know  what  are  the  main  reasons  that  may  influence  an  investor  to  buy  a  business   especially   through   an   LBO.   There   are   indeed   many   techniques   in   order   to  buy  a  company.  If  investors  choose  particularly  LBO  transactions,  it  is  maybe  to  use  the   leverage   and   more   especially,   tax   leverage   in   order   to   further   optimize   the  purchase  of  the  company.  But  after  executing  the  LBO  and  developed  the  activity  of  the   target,   investors   want   LBO   exit   and   sell   their   shares   in   order   to   realize   an  important   capital   gain.   We   will   also   examine   the   main   exit   opportunities   and  strategies  for  the  investors  in  order  to  maximize  their  gains.     PART  II  –  TAX  SHIELD  AND  STRATEGIES  FOR   EXITING  AN  LBO.  Let’s   begin   with   the   principal   leverage   in   an   LBO   transaction   namely,   tax   leverage.  Various   commercial   and   legal   factors,   not   directly   related   to   the   tax   distinction  between  debt  and  equity,  are  relevant  to  the  choice  between  debt  and  equity  for  a  corporation.    In   recent   decades,   a   very   substantial   portion   of   the   acquisition   market   has   been  driven  by  private  equity  funds,  and  more  particularly  as  LBO.    Because   cash   used   for   interest   payments   is   generally   deductible   by   the   target  enterprise,   the   capitalized   value   of   cash   flowing   to   debt   is   determined   on   a   pre-­‐tax  basis,  thereby  increasing  the  value  of  the  enterprise.    Moreover,   if   returns   from   the   investment   exceed   the   rate   paid   on   the   debt,   the  excess  accrues  to  the  equity  holders  and,  therefore,  their  return  is  increased  by  the  leverage.    Concerns  have  been  expressed  for  many  years,  with  regard  to  leveraged  buyouts  and  other   transactions,   such   as   stock   repurchases,   that   overly   lenient   interest  deductibility  rules  have  resulted  in  distortion  of  corporate  ownership  and  of  financing  decisions.   For   instance,   Germany’s   tax   laws   discourage   leveraged   buyouts   by  reducing   the   tax   shield   attractively.   We   can   observe   the   same   movement   in   France  since  the  latest  financial  law.   CHAPTER  I  –  TAX  SHIELD  IN  AN  ACQUISITION  BY  LBO.    It’s   usually   said   that   the   only   two   certainties   in   the   life   are   death   and   taxes.  Unfortunately,  LBO  transactions  don’t  escape  the  latter.  However,   motivating   forces   for   corporate   acquisitions   include   the   free   cash   flow  problem,  tax  incentives,  deregulation,  synergies  etc.   But,  of  this  list,  tax  incentive  is  the   most   frequently   discussed   motivation   for   corporate   acquisitions,   especially   in  leveraged  buyouts.       26  
  • SECTION  I  –  Tax  aspects  in  the  world.    We  must  study  the  tax  incentives  for  leveraged  buyouts  by  measuring  the  change  in  taxes   paid   by   a   firm   due   to   a   buyout.   Tax   incentives   are   numerous   and   differ  depending  on  where  the  LBO  transaction  takes  place  in  the  world.  But  nevertheless,  we  can  focus  on  the  deductibility  of  interest  generated  by  the  high  level  of  debt  used  for  the  acquisition.  This  is  the  main  incentive  tax  in  an  LBO  transaction.   I  –  Deductibility  of  interest  expenses.  The   deduction   of   loan   interest   is   an   essential   point   in   all   LBO   transaction   and   in  almost  every  country  in  the  world.  Firstly,   Switzerland   is   a   very   attractive   market   for   the   purchase   of   companies   using  high   leverage,   so   LBO   transactions.   Especially,   interest   expenses   which   are   paid   is   tax  deductible  from  the  income  and  with  a  large  degree  of  debt  financing  what  is  a  major  characteristic  for  every  LBO  transaction,  there  will  be  a  tax  reducing  effect,  which  is  called   as  tax  shield.   The   Newco   is  generally   used   in  another  country  that  Switzerland,  and  merged  with  the  target  company  in  order  to  create  a  debt  pushdown11.  But  this  scheme   is   in   principle   not   really   accepted   by   the   Swiss   tax   authorities.   Investors  should   be   careful   because   the   LBO   could   quickly   lose   any   incetive   effect   if   the   tax  authorities  invalidate  the  scheme.    In   the   UK,   an   important   tax   reform   has   significantly   increased   the   tax   costs   of  leveraged  buyouts  and  also  in  generally,  mergers  and  acquisitions.  It’s  the  Tax  Reform  Act  –  TRA  dated  1986  that  created  a  major  change  in  leveraged  buyout  tax  structures.  Tax  practitioners  now  must  carefully  consider  taxable  income  levels  about  operations  in  structuring  an  LBO.  Today,  we  can  say  that  the  UK  has  made  great  efforts  in  order  to   reform   its   corporate   tax   rules   and   make   them   competitive   for   the   UK  multinationals.     Corporates   are   indeed   entitled   to   request   an   interest   deduction   in  respect   of   acquisition   debt.    The   UK   executive   power   has   considered   whether   it  should  restrict  or  not  the  right  to  deduct  interest  expenses  but  finally,  he  has  always  decided  against  any  this  restriction.     There  are  of  course  a  certain  number  of  specific  anti-­‐avoidance   rules   that   restrict   interest   deduction   but   the   general   principle,  however,  is  that  acquisition  debt  is  totally  deductible  for  tax  purposes,  whatever  the  acquisition   is   unlikely   ever   to   generate   any   UK   taxable   incomes.  These   rules   are   very   useful   for   highly   leveraged   acquisitions   and   so   in   LBO  transactions.   In   some   jurisdictions   in   European   Union   like   France   as   we   will   see   after,  a   general   interest   restriction   has   been   introduced,   with   an   excessive   interest   being  denied   if   the   total   interest   deduction   exceeds   a   certain   percentage   of   taxable  incomes.                                                                                                                      11  A  debt  push  down  consists  in  the  creation  of  an  acquisition  structure  in  order  to  shift  debt  to  a  subsidiary  company  and  realize  a  tax  benefit.       27  
  • What  is  the  situation  in  the  USA?  An  LBO  purchaser  may  be  able  to  deduct  interest  against   its   taxable   income,   whereas   dividends   on   stock   are   non-­‐deductible.   Interest  paid   during   the   year   by   the  company   is   in   principle  allowed   as   a   tax   deduction   during  this  taxable  year  subject  to  a  certain  number  of  exceptions.    In   Belgium,   companies   can   deduct   all   length   business   expenses   when   calculating  taxable   income.   Interest   is   generally   deductible   up   to   a   reasonable   amount   given   the  risk   associated   with   the   loan   that   has   been   lent.   Where   a   Belgian   financial   institution  has   made   the   loan,   interest   expenses   are   automatically   deductible.   But   when   a  company   pays   interest   to   a   beneficial   owner   that   is   a   tax   exempt   company   or   a  company  for  which  interest  income  is  subject  to  a  tax  regime  more  interesting  than  in  Belgium,   the   debt   is   called   “tainted.”   Consequently,   the   interest   payment   rests   tax  deductible  but  only  if  the  company  proves  that  the  debt  relates  to  real  transactions  and  that  the  conditions  of  the  loan  are  normal.    In   Germany,   the   government   introduced   fixe   years   ago   the   “Interest   barrier  (Zinsschranke   in   German),   which   was   viewed   as   a   new   thin-­‐capitalization-­‐rule.   It  marked   the   deepest   cuts   in   modern   German   tax   history   and   we   could   assume   that  this   reform   has   been   motivated   by   the   crisis.   The   German   interest   barrier   also  massively   restricts   the   deductibility   of   interest   expenses   (as   well   intra-­‐group   debt  financing   as   bank   loans)   for   German   corporate   income   tax.   Introducing   today   the  unique   concept   in   the   world   of   the   interest   barrier   with   the   German   business   tax  reform   2008,   the   law   limits   the   tax   deduction   of   interest   expenses   that   the   Newco  could  pay  to  the  bank  in  an  LBO  transaction.  According  to  the  interest  barrier  rule,  a  German  Newco  could  only  deduct  interest  expenses  of  up  to  30%  of  taxable  income  before   interest   expenses,   taxes,   depreciation   and   amortization   (called   EBITDA)   per  fiscal   year.   The   amount   of   interest   expenses   must   be   understood   as   a   net   amount.  Consequently,   the   interest   barrier   has   a   very   bad   influence   on   investments   in  Germany,   particularly   in   LBO   transactions   because   the   tax   leverage   has   lost   its  principal   interests,   although   it   rests   others.   Although,   companies   and   lawyers   have  found   some   means   in   order   to   optimize   and   reduce   German   tax   perspective.   Intra-­‐group   cross-­‐border   debt   financing   is   maybe   the   most   interesting   instrument   of  international  tax  planning  for  companies  and  groups  in  order  to  reduce  considerably  their  ETR12.  In  a  German  tax  scheme,  many  parameters  must  be  studied  in  order  to  benefit  effectively  from  the  cross-­‐border  tax  differential  by  shifting  profits  from  high-­‐taxed   German   corporations   to   a   foreign   country   with   a   low   tax   rate   with   an   intra-­‐group  debt  financing.  One  of  those  parameters  is  the  fact  that  German  CFC  taxation  (Controlled   Foreign   Company   law)   doesn’t   apply   or   if   not,   negative   tax   effects   of  German  CFC-­‐Taxation  can  be  minimized  enough.  German  CFC  taxation  is  defined  as  an  anti-­‐avoidance  rule  that  has  been  enacted  in  order  to  avoid  the  utilization  of  the  cross-­‐border   tax   differential.   The   interest   income   produced   by   a   foreign   low   taxed  corporation   or   permanent   establishment   is   attributed   to   the   German   parent                                                                                                                  12  Effective  tax  rate  is  the  average  rate  at  which  the  taxpayer  is  taxed.       28  
  • company   and   will   be   taxed   on   the  current   basis.   Double   taxation  can   be  avoided  by  a  tax  credit  for  taxes  of  the  foreign  establishment  paid  in  its  country.    The   application   of   the   interest   barrier   extremely   depends   on   the   legal   structure   of  the  German  financed  entity.  In  the  case  of  a  German  fiscal  group  the  interest  barrier  is   only   applicable   at   the   level   of   the   parent   company.   Interest   expenses   are   tax  deductible   up   to   the   amount   of   the   interest   earned   per   business   without   limits.  So  consequently,   the   interest   barrier   is   not   applicable   in   the   case   of   intra   fiscal   group  debt  financing.  The  scheme  shows  us  an  example  of  a  cross-­‐border  tax  differential.             II  –  Tax  optimisation  in  France.        The  leverage  used  for  LBO  financing  has  also  continued  to  rise  in  Germany  over  the  past  few  years,  following  the  international  trend.  The  clearly  growing  importance  of  LBOs  in  Germany  is  being  reflected  in  their  growing  share  of  the  total  German  market  for   mergers   and   acquisitions.   In   the   second   half   of   2010,   the   volume   of   LBOs  surpassed  the  amount  of  non-­‐LBOs  for  the  first  time.  Another   country,   Ireland,   has   recently   developed   a   great   reputation   for   the  establishment   of   both   European   Union   and   more   generally,   international   holding  companies   because   this   country   also   offers   a   favourable   tax   regime   for   holding  companies,   particularly   for   interest   expenses.   In   general,   interest   paid   by   an   Irish  holding   company   is   not   deductible   for   Irish   tax.   However,   where   an   Irish   holding  company  borrows  funds  in  order  to  acquire  shares  or  assets,  interest  expenses  may  qualify  for  relief.    To  conclude,  we  can  say  few  words  about  Luxembourg.  Luxembourg  tax  law  permits  the   deduction   of   normal   operating   expenses   in   calculating   taxable   income.  Deductible   items   include   for   example   interest   paid   to   third   parties   as   well   banks   as  another  company,  which  has  lent  the  loan.  Luxembourg  is  a  really  attractive  country     29  
  • for   multinational   cash   pooling.   Cash   pooling   is   a   method   that   allows   equalizing   the   accounts   of   subsidiaries,   saving   costs   due   from   financial   market   imperfections.  The  efficiency  of  a   cash   pooling   is   really   impacted   for  example  by  withholding  taxes   on  interest  payments  and  limited   deductibility  of  interest  expenses.   However,   anti-­‐avoidance   rules   restricting   tax   planning   opportunities,   as   well   as   stamp   duties   and   registration   taxes.   Here   is   an   example   of   a   cash   pooling  scheme.    Inefficiency   of   cash   pooling   may   arise   if   the   deductibility   of   interest   expenses   paid   by  the  pool-­‐leader  to  pool-­‐members  were  restricted  for  income  tax  purposes,  whereas  the  corresponding  income  realized  by  the  pool-­‐members  would  be  taxable  for  the  full  amount.   The   limited   deductibility   of   interest   expenses   may   be   due   to   numerous  reasons  as  thin  capitalization  rules,  interest  barrier  rules  in  Germany  as  we  have  just  seen   before,   CFC   legislation   and   anti-­‐avoidance   rules.   Unlike   some   other   European  countries,   Luxembourg   hasn’t   enacted   interest   barrier   rules,   local   anti-­‐avoidance  rules   or   a   CFC   legislation.     Interest   expenses   charged   on   a   Luxembourg   pool-­‐leader  should  also  be  deductible  for  income  tax  purposes.      Moreover,  Luxembourg  is  a  member  of  the  European  Union  so  CFC  legislation  or  anti-­‐avoidance  rules  existing  in  a  European  country  as  Germany  should  not  be  applicable  to   interest   payments   made   by   pool-­‐members   located   in   those   countries,   to   the  extent  the  Luxembourg  pool-­‐leader  has  sufficient  “substance”  in  Luxembourg.   II  –  Parameters  existing  in  France  in  order  to  reduce  taxes.  Also  in  France,  the  debt  interest  expenses  are  tax  deductible,  even  if  the  Finance  Act  for   2013   has   profoundly   changed   the   tax   treatment   of   those   expenses.  However,  other  mechanisms  have  a  tax  decisive  impact  in  an  LBO  transaction  and  are  necessary  in  order  to  optimize  the  tax  cost  of  this  operation.  The   integration   tax   regime13  is   one   of   those   tax   incentives.   Under   an   optional   tax  consolidation   regime,   a   French   company   can   include   the   income   of   its   French  affiliates   companies   of   which   it   controls   at   least   95%   of   the   capital   in   its   taxable  income.  If  the  parent  company  controls  this  minimum  percentage,  this  company  pays  the  corporation  tax  for  all  the  affiliates  companies  in  the  group.  Moreover  and  since  2008,  groups  in  which  the  parent  company  controls  at  least  95%  of  a  French  affiliate                                                                                                                  13  Article  223A  of  French  Code  Général  des  Impôts.     30  
  • company   through   one   or   several   companies   that   are   based   in   the   European   Union  can  also  choose  this  regime.  This  second  possibility  is  the  consequence  of  a  decision  of  the  European  Court  of  Justice  in  2008,  “Papillon”14.    In  this  decision,  the  Court  sanctioned  the  fact  that  the  French  legislation  allowed  to  build   a   group   tax   if   the   parent   company   which   was   resident   in   France   held  subsidiaries   and   sub-­‐subsidiaries   which   were   also   resident   in   this   State,   but   by  contrast,  was  unavailable  for  a  parent  company  if  its  sub-­‐subsidiaries  were  controlled  through  a  subsidiary  which  was  resident  in  another  European  State.  France  adapted  his  legislation  in  order  to  conform  to  this  European  rule.  The   French   law   doesn’t   set   out   the   manner   in   which   the   tax   paid   by   the   parent  company  should  be  split  out  between  the  companies.  This  is  also  set  out  from  a  tax  group  agreement  signed  at  the  moment  the  group  is  formed.In   an   acquisition   financed   in   majority   by   debt   through   a   holding   company,   so   in   an  LBO   transaction,   the   regime   of   French   integration   tax   provides   a   significant  advantage   than   the   parent-­‐subsidiary   regime   because   by   virtue   of   the   former,   the  Newco   can   charge   interests   expenses   on   the   taxable   results   of   the   whole   group.  However,   as   we   will   see   just   after   (SECTION   II),   this   tax   incentive   effect   has   been  considerably  reduced  by  an  amendement  in  2005,  and  more  recently  by  the  Financial  Law  for  2013.    Another   French   mecanism   is   very   important   in   LBO   transactions,   it’s   the   parent-­‐subsidiary   regime.   Indeed,   the   integration   tax   regime   allows   to   deduct   a   part   of  interest  expenses  generated  by  the  debt,  but  it’s  not  sufficient.    The   French   parent-­‐subsidiary   regime   is   available   when   several   specific   conditions  regarding   the   shareholding   interest,   the   holding   period,   and   the   shares   and   their  origin  are  met.  Those  conditions15  have  been  modified  by  the  Financial  law  for  2005.    The  first  condition  is  that  the  parent  company  has  to  keep  the  shares  of  subsidiaries  for  at  least  a  two-­‐year  period.  If  the  parent  company  doesn’t  meet  this  condition,  the  benefit   of   the   regime   would   be   lost.   The   beneficiary   company   would   pay   the  corresponding  corporate  income  tax  assessed  on  the  full  amount  of  dividends  (with  a    late  payment  interest  of  0.40%  per  month)  within  the  three-­‐month  period  following  the  sale  of  shares.  The   option   for   the   parent-­‐subsidiary   regime   is   available   when   the   parent   company  controls   at   least   5%   of   the   share   capital   and   5%   of   the   voting   rights   of   the   subsidiary.  It’   also   a   double   condition,   and   the   only   detention   of   the   capital   or   of   the   voting  rights  is  not  sufficient  to  opt  for  this  regime.                                                                                                                  14  ECJ,  Case  C-­‐418/07,  November  2008.  15  Articles  145  and  216  of  French  Code  Général  des  Impôts.       31  
  • When   those   conditions   are   met,   what   are   consequences?   The   French   parent-­‐subsidiary   regime   offers   a   tax   exemption   regime   and   more   precisely,   limits   the  taxable   basis   of   the   dividends   at   the   level   of   the  beneficiary   company   to   a   5%   service  charge 16 ,   with   the   service   charge   being   neutralized   —   not   taxed   —   when   the  companies  are  part  of  the  same  French  tax  group.  As  we  will  see  just  after  (SECTION  II),  this  regime  has  been  recently  modified,  as  well  as  consolidation  tax  regime;     SECTION  II  –  Limitation  of  tax  leverage:  example  in  France,  The   Netherlands.    The  general  principle  in  the  UK  is  that  acquisition  debt  is  entirely  deductible  for  tax  purposes.   By   way   of   contrast,   Germany   (with   the   interest   barrier),   France,   the  Netherlands   and   other   States   are   seeking   to   restrict   tax   deductions   for   acquisition  debt.   I  –  Example  in  France.    Both  the  consolidation  and  parent-­‐subsidiary  regime  have  been  modified  in  order  to  restrict  incentives  tax  effects.  A)  The  “Charasse  amendment”  followed  by  the  “Carrez  amendment”.    In   France,   the   deduction   of   interest   expenses   must   comply   with   general   principles  that  govern  the  right  to  deduct  business  expenses.  The  general  rule  is  that  business  expenses  are  tax  deductible;  firstly  if  they  are  paid  in  the  corporate  interest,  secondly  are  actually  incurred  and  properly  documented,  and  thirdly,  reduce  the  net  worth  of  the  company.    Concerning   interest   expenses,   the   deduction   is   also   authorized   as   soon   as   the  relevant  loan  is  extended  for  the  business  purpose  of  the  borrowing  company  and  if  the   borrower   can   prove   in   its   books,   the   existence   of   the   loan   and   of   the   interest  expenses.      But   additional   restrictions,   specific   to   the   deduction   of   interest   expenses,   apply   for  corporate  income  tax  purposes.    At  first,  if  interests  are  paid  to  shareholders  and  related  companies,  the  deduction  is  limited   to   interest   paid   at   a   rate   not   exceeding   the   annual   average   rate   of   interest  charged  by  financial  institutions17.    Second,  if  interests  are  only  paid  to  a  related  company18,  the  deduction  is  denied  in  regard   to   any   portion   of   the   interest   that   does   not   comply   with   a   three-­‐stage  leverage  test  (thin-­‐capitalization  rule).                                                                                                                    16  This  service  charge  is  called  in  French  “réintégration  d’une  quotepart  pour  frais  et  charges”.  17  In  French,  this  is  the  «  taux  effectif  moyen  ».       32  
  • Third,   within   the   framework   of   a   group   benefiting   from   a   consolidation   tax   regime,  the  deduction  of  interest  related  to  the  purchase  of  a  new  company  is  limited  if  this  company   was   acquired   from   a   shareholder   that   controls   the   group.   This   is   the  “Charasse  Amendment”  and  it  concerns  directly  LBO  transactions.  1  –  Charasse  amendment.  Indeed,   in   an   LBO   transaction   shares   acquisition   of   the   target   to   be   included   in   the  tax   group   from   a   related   party   may   be   subject   to   the   Charasse   amendment  limitation19.  This  rule  provides  the  fact  that,  when  shares  of  the  target  that  becomes  a  member  of  the  tax  group  (created  specially  for  the  LBO  transaction)  are  purchased  from   shareholders   who   directly   or   indirectly   control   the   group,   or   from   non-­‐group  companies   that   are   controlled   by   non-­‐group   parents,   a   part   of   interest   expenses  incurred  by  the  tax  group  will  be  non  deductible  from  the  group  profits  during  a  15  year  period.  In  order  to  calculate  the  amount  that  has  to  be  reintegrated,  you  have  to  multiply   annual   interest   expenses   of   the   tax   group   by   the   purchases   prices   of   the  target   shares   and   divide   the   result   by   the   average   amount   of   the   group’s   debt   during  the  tax  year.  However,  this  Charasse  amendment  doesn’t  apply  in  three  cases.  Firstly,  if  the  target  shares  are  acquired  in  exchange  for  newly  issued  shares  that  is  to  say,  a  capital  increase  equal  to  the  value  of  the  shares  that  has  been  acquired.  Secondly,  if  the   target   shares   are   acquired   from   members   of   the   tax   group.   Thirdly,   if   target  shares   are   acquired   by   related   companies   from   unrelated   companies   with   in   the  order  to  transfer  the  target  shares  shortly  afterwards  to  a  member  of  the  French  tax  group.  This  rule  applies  to  a  stock  acquisition  even  if  the  acquisition  wasn’t  financed  by  a  loan  granted  by  a  bank.    However,  some  attenuations  of  this  restrictive  law  have  been  adopted  since  2006.  On  the   one   hand,   the   concept   of   “control”   has   been   précised.   the   Administrative  Supreme   Court   indicates20  that,   for   the   aplication   of   the   amendment   Charasse,   the  concept   of   control   should   be   appreciated   at   the   time   of   the   sale   of   shares   and   not  before.  Judges  have  invalidated  a  French  administrative  doctrine  which  provided  that  control   has   to   be   appreciated   during   the   12   months   preceding   the   acquisition   of  target  shares.  In   this   same   decision,   the   Court   precised   that   the   notion   of   “control”   must   be  restricted   to   situations   of   detention   of   more   than   40%   share   capital   against   33%  previously.   In   addition   to   this,   the   reintegration   must   be   stopped   when   the   holding  company  is  no  longer  controlled  by  persons  who  control  it  at  the  time  of  acquisition  of  the  target.                                                                                                                                                                                                                                                                                                                                                                                      18  Article  39  .12  of  the  French  Code  Général  des  Impôts.  19  Article  223B  of  the  French  Code  Général  des  Impôts.  20  Administrative  Supreme  Court,  July  13,  2011,  n°312285       33  
  • On  the  other  hand,  a  second  decision  allowed  to  reduced  the  Charasse  amendment  effects 21 .   Indeed,   the   Administrative   Supreme   Court   rendered   a   decision   which  states,   for   the   first   time,   that   LBO   transactions   are   not   purely   artificial   for   tax  purposes  and,  thus,  consistent  with  the  general  anti-­‐avoidance  rule.  In  this  case,  the  shares   of   a   company   providing   IT   services   (the   target)   were   divided   between   two  shareholders.   The   target   had   a   lot   of   cash   in   reserve,   which   were   converted   into  equity   shortly   before   the   shares   in   that   company   were   sold   to   a   holding   company.  The   shareholders   established   the   Newco   for   the   specific   purpose   of   acquiring   the  target.   Just   after   the   acquisition,   the   target   distributed   a   significant   amount   of  dividends   to   its   new   shareholder.   The   acquisition   made   by   the   Newco   was   principally  financed   by   dividend   distribution,   and   by   debt.   The   LBO   lasted   over   a   year,   and  eventually   enabled   the   holding   vehicle   to   reimburse   the   acquisition   price   of   the  target   to   its   shareholders,   and   retain   its   accounts   some   cash.   After   a   tax   control   of  the   target,   the   French   tax   authorities   took   the   position   that   the   LBO   transaction  constituted   an   artificial   arrangement   that   permitted   the   two   shareholders   to   avoid,  for   individual   income   tax   purposes,   the   progressive   rates   applicable   to   dividends.  Consequently,  the  shareholders  were  liable  to  tax  on  the  capital  gains  derived  from  the   disposal   of   the   shares   and   subject   to   a   lower   flat   rate   of   16%.   Therefore,   the  French   tax   authorities   applied   the   anti   avoidance   rule   (GAAR)   and   imposed   on   the  shareholders   a   fine   equal   to   80%   of   the   avoided   tax.   The   Court   ruled   in   favour   of   the  shareholders,   and   held   that   the   LBO   structure   described   above   was   not   purely  artificial.  2  –  Carrez  amendment.  Until   2011,   interest   on   loans   exposed   in   order   to   acquire   a   participation   in   another  company   was   tax   deductible   in   France   even   where   dividends   issued   from   those  shares   were   exempt   under   the   French   participation   exemption   regime.   This  derogation   deemed   to   represent   non-­‐deductible   expenses   under   the   participation  exemption  regime.    But   in   order   to   follow   other   interest   expenses   restrictions   recently   adopted,   the  “Carrez   Amendment”   adopted   in   the   Finance   Amendment   Law   for   2011   limits   the  deduction  of  interest  regarding  to  acquisitions  of  participation  shares.    The   rule   targets   leveraged   acquisitions   where   the   French   Newco   is   only   the   formal  legal   owner   of   the   participation   shares,   whereas   another   company   situated   abroad  exercises  effective  control  and  management  of  the  shares.    In  this  situation,  the  deductibility  of  a  percentage  of  the  acquisition  related  interest  expenses  is  denied  and  added  back  to  the  company’s  tax  base.    Surprisingly,   the   aim   of   this   reintegration   mechanism   is   not   clear.   Leveraged  acquisitions   that   are   controlled   and   managed   from   France,   even   where   the   French                                                                                                                  21  Administrative  Supreme  Court,  January  27,  2011,  n°320313,  «  Bourdon  ».     34  
  • Newco  is  also  a  formal  legal  owner  interposed  between  the  target  company  and  the  real  buyer,  may  benefit  of  a  safeguard  clause.  This  recapture  mechanism  is  aimed  at  preventing   interest   deductions   in   situations   where   the   participation   shares   are  effectively   managed   from   abroad.   We   can   take   the   example   of   a   US   company   using   a  French   Newco   as   a   Special   Purpose   Acquisition   Vehicle   (SPV)   to   purchase   an  operating  target  company  situated  in  Germany.    The   Carrez   Amendment   bans   interest   expenses   deduction   for   participations   acquired  by  a  French  company  if  this  company  can’t  demonstrate  two  cumulative  conditions.  First,  decisions  relating  to  these  participations  are  effectively  made  by  the  acquiring  French  company,  or  by  a  company  that  is  established  in  France  and  that  directly  or  indirectly   has   the   control   of   the   acquiring   company   and   where   control   or   influence   is  exercised  over  the  target  company,  the  acquiring  company  effectively  exercises  this  control  or  influence.    B)  Parent-­‐subsidiary  regime:  a  new  French  tax  on  dividend  distributions.  Indeed,   a   new   tax   has   just   been   created   since   2012   on   dividend   distributions.   It’s  levied   at   the   level   of   the   distributing   company   also   in   an   LBO   transaction,   of   the  target   that   distributes   dividends   to   the   Newco   in   order   to   reimburse   the   debt  borrowed.  The  target  must  be  subject  to  French  corporate  income  tax.  The  tax  on  dividends  is  not  deductible  from  the  taxable  income  of  the  target  company.  The   3%   rate   applies   to   the   amount   of   the   dividends   that   are   really   distributed.   The  tax  also  targets  incomes  which  are  realized  in  France  by  foreign  companies  through  permanent   establishments,   and   which   are   deemed   to   be   distributed   to   a   non  resident  shareholder,  where  such  incomes  aren’t  reinvested  in  the  French  company.  The  tax  is  applicable  to  distributions  made  from  August  17,  2012.  The   bill   of   the   Amended   Finance   Law   initially   provided   for   an   exemption   regarding  distributions   made   to   corporate   shareholders   likely   to   benefit   from   the   parent-­‐subsidiary   regime   that   we   has   just   studied   before.   But   this   exemption   has   been  eliminated.    Since   January   1st   2013,   a   new   limitation   of   interest   expenses   deductibility   exists   in  France.   In   the   Financial   Law   for   2013   the   Parliament   has   limited   the   deduction   of   net  interest  expenses  for  companies.  Those  companies  will  be  allowed  to  deduct  85%  of  the  total  amount  of  deductible  interest  paid  in  2012  and  2013,  and  75%  of  the  total  amount  of  deductible  interest  paid  as  from  2014.    In  order  to  apply  this  new  measure,  all  loans  will  be  taken  into  account,  whatever  the  quality  of  lender  (it  could  be  a  related  or  an  unrelated  undertaking  company,  French  or  foreign),  and  concerning  the  allocation  of  granted  funds  (it  could  be  used  either  for  acquisition  of  capital  assets,  or  financing  of  activity).     35  
  • The   amount   of   net   financial   expenses   will   be   calculated   by   the   difference   between  the   financing   amount   granted   to   the   company   and   the   income   received   by   this  company  in  consideration  for  financing  granted  by  it.  If   the   company   is   a   member   of   a   consolidation   tax   group,   this   measure   will   not  applied  to  companies  that  are  members  of  the  same  tax  group,  with  the  exception  of  financial   charges   relating   to   operations   realised   with   companies   outside   the   group.  The  net  financial  expense  must  be  defined  at  the  tax  consolidated  groups  level  and  not  at  the  level  of  each  company  in  the  group.   II  –  The  Netherlands.  Interest  expenses  are  generally  deductible  from  basis  for  Dutch  corporate  income  tax  purposes.   This   also   applies   to   interest   relating   to   a   participation   to   which   the  participation   exemption   applies,   irrespective   of   whether   the   shareholding   is   in   a  resident  or  non-­‐resident  company.  But   the   Netherlands,   as   the   other   members   of   the   European   Union,   recently  restricted  the  regime  of  interest  expenses.    In  the  Bosal  case22,  the  European  Court  of  Justice  affirmed  that  the  interdiction  of  the  deductibility   of   the   interest   expenses   suffered   by   the   Dutch   corporation   in  connection  to  foreign  participation  was  in  contradiction  to  the  right  by  virtue  of  the  European   Treaty   to   establish   a   company   under   the   European   law.   The   decision  decreed  that  interest  expenses  related  to  debts  incurred  in  order  to  finance  a  foreign  subsidiary  are  deductible  at  the  level  of  Dutch  entity.    Regarding   this   decision,   the   government   has   just   after   adopted   a   law   in   order   to  restrict  the  tax  deduction  of  interest  expenses.    The  new  law  that  has  been  enacted  in  June  2012  contains  a  principle  that  limits  the  deduction  of  excessive  interest  which  are  paid  by  a  Dutch  corporate  company  related  to  interest  expenses  that  are  incurred  with  debts  financed  to  generate  income  that  is  exempt  under  the  Dutch  participation  exemption.    Under   the   new   law,   the   notion   of   “excessive   interest”   is   defined   as   the   amount   of  interest   and   costs   paid   by   a   Dutch   corporate   company   for   debt,   this   amount   being  multiplied   by   its   average   amount   of   participation   debt   and   divided   by   its   average  amount  of  total  debt.    The   participation   debt   is   considered   as   present   if   the   cost   price   of   a   company’s  participation   exceeds   its   equity   for   tax   purposes.   The   participation   debt   can   exceed  neither   the   total   amount   of   debt   nor   the   total   cost   price   of   the   participations.   The  participation   debt   is   also   lowered   with   the   debt   that   is   subject   to   other   interest  deduction  limitations.                                                                                                                    22  European  Court  of  Justice,  September  18,  2003,  Bosal  Holding,  case  C-­‐168/01.     36  
  • Interest  expenses  on  the  acquisition  debt  also  are  deductible  up  to  the  amount  of  the  acquirer’s  own  profit  before  the  deduction  of  the  acquisition  interest  expenses  (own  profit).   If   the   acquisition   interest   exceeds   the   own   profit   and   the   excess   amount   is  less   than   one   million   euros,   then   the   interest   deduction   will   not   be   limited   on   the  basis  of  the  new  rule.    Moreover,   if   there   is   no   excess   acquisition   interest,   the   interest   will   also   remain  deductible   in   full.   We   should   also   mention   the   fact   that   all   acquisition   interest   that   is  non  deductible  in  any  year  will  be  reported  to  the  following  year,  where  it  will  again  be  assessed  to  see  if  it  falls  under  the  interest  deduction  limitation.    There  is  another  tax  issue  to  study  more  precisely,  the  capital  gains  eventualluy  made  by  investors  through  the  LBO  transaction.  But  this  aspect  will  be  studied  at  the  last  chapter  of  this  research  report  that  concerns  with  differents  strategies  for  exiting  an  LBO  deal.     CHAPTER  II  –  EXIT  ROUTES  IN  LBO  TRANSACTIONS.  A  leveraged  buyout  is  the  acquisition  financed  primarily  with  debt  by  a  small  group  of  equity   investors   of   a   public   or   private   company.   The   equity   holders   service   the   heavy  interest  and  principal  payments  of  debt  with  cash  from  operations  and/or  asset  sales.  The   shareholders   generally   hope   to   reverse   the   LBO   within   three   to   seven   years  through  a  public  offering  or  company  sale.   SECTION  I  –  Exit  planning  considerations.    When  a  private  equity  firm  decides  to  invest  in  an  LBO  transaction,  the  fund  has  to  invest  in  portfolio  companies  and  at  the  end  of  a  certain  period,  has  to  take  profits  and  also,   recovering   its  initial  investment.   There   are   mainly   two   different   strategies  for   exiting   an   LBO   transaction,   the   initial   public   offering   (IPO)   and   the   sale   of   the  portfolio  company  another  party,  another  investor.   I  –  Initial  public  offering;  “Reverse  LBO”.  When   a   fund   exits   its   investment   through   an   IPO,   it   does   so   through   an   offering   of  shares  to  the  public  of  either:  the  portfolio  company  or  the  parent  holding  company  that   wholly   owns   the   portfolio   company   and   through   which   the   fund   made   its  investment  and  owns  equity.    An   IPO   is   a   financial   transaction   conducted   by   a   company   and   its   various   counsels  (lawyer,   banks   etc.)   that   allows   the   listing   of   shares   of   this   company   on   a   stock  market.    In  increasing  numbers  and  at  ever  shrinking  spans  of  time,  companies  that  have  gone  private  through  leveraged  buyouts  are  again  going  public.     37  
  • A   leveraged   buyout   involves   the   merger   of   a   public   company   with   a   private   one,  financed   primarily   with   borrowed   funds,   with   the   public   companys   assets   as  collateral  and  the  process  in  which  a  company  that  has  gone  private  through  an  LBO  and   then   sells   shares   to   the   public   has   been  called   a   reverse   leveraged   buyout.   It   is   a  process  that  produces  enormous  profits  for  investors  in  the  original  buyout  and  helps  the  company  selling  the  shares  reduce  onerous  debt.  A  lot  of  studies  were  conducted  to  examine  the  long  term  stock  price  performance  of  firms  that  undergo  a  reverse  leveraged  buyout.    A   reverse   LBO   occurs   when   either   a   publicly   traded   firm   or   a   division   within   one  converts   to   private   ownership   by   means   of   an   LBO   and   subsequently   goes   public.  When   the   performance   returns   of   firms   that   had   a   reverse   LBO   are   compared   with  those   of   a   portfolio   of   comparable   companies,   reverse   LBO   firms   outperform   the  others.   That   reveals   the   fact   that   takeover   premiums   may   certainly   cause   these  positive  returns  after  a  reverse  LBO.    Reverse  leveraged  buyouts  represent  also  a  special  class  of  initial  public  offering.  In  contrast   to   original   IPOs,   reverse  LBOs   refer   to   the   reentry   into   the   equity   markets   of  once  publicly  traded  firms  or  subsidiaries  of  publicly  traded  firms.  These  firms  were  previously   taken   private   in   a   leveraged   buyout   and,   after   a   period   of   restructuring,  seek  to  obtain  the  same  benefits  as  original  IPOs.    During   the   restructuring   period,   LBO   firms   sell   off   unwanted   assets,   renegotiate  contracts   and   reduce   debt   levels.   Whereas   original   IPOs   involve   firms   during   the  growth   phase   of   the   firm   life   cycle,   reverse   LBOs   involve   firms   that   have   recently  reduced  the  scale  of  their  operations.    Although  both  are  classified  as  initial  public  offerings,  original  IPO  firms  and  reverse  LBO   firms   are   fundamentally   different   with   respect   to   the   level   of   information  available   to   investors   and   the   stage   of   the   firm   life   cycle.   It   is   hypothesized   that  differences  in  the  characteristics  of  original  IPOs  and  reverse  LBOs  lead  to  differences  in  the  level  of  underpricing  in  early  trading  and  the  factors  affecting  early  returns.  Once  IPO  is  realized,  sponsor  typically  can’t  liquidate  fully  the  fund’s  investment  in  a  portfolio   company   in   the   company’s   IPO.   To   complete   a   full   exit   after   the   IPO,   a   fund  can  sell  shares  in  unregistered  sales.    Making  a  reverse  LBO  can  present  several  advantages.   Firstly,  the  IPO  allows  to  the  investor  a  future  liquidity.  Second,  the  private  equity  firm  which  invested  in  the  LBO  transaction   generally   prefers   an   IPO   because   it   results   in   a   higher   valuation   for  portfolio  company’s  equity  than  other  possible  exits  as  sale  to  a  third  party.    But   reverse   LBO   has   some   disadvantageous.   The   main   disadvantage   is   that   the  private   equity   firm   doesn’t   fully   liquidate   its   investment   through   the   portfolio  company’s  equity.  Indeed,  the  private  equity  fund’s  investment,  with  the  shares  the     38  
  • company  sells  in  the  IPO,  is  generally  too  large  to  be  sold  into  the  market  at  one  time  at  the  desirable  price.     II  –  Alternative  ways  for  exiting  an  LBO  .  “The   credit   quality   of   many   LBOs   is   threat   from   private   equity   investors   propensity   to  take   out   dividends   early   in   the   life   of   such   transactions”,   says   a   report   published   in  2010  by  Standard  &  Poors  Ratings  Services.    Indeed,   private   equity   funds   generally   envisage   an   exit   from   their   investments   within  a  three  to  four  years  period.  Failure  to  show  an  exit  way  at  that  point  may  reflect  a  possible  decline  in  the  enterprise  value  of  the  company.    Private   equity   sponsors   typically   use   one   of   three   routes   to   exit   all   or   part   of   their  equity  investment.  Firstly  and  as  we  have  just  said,  an  initial  public  offering.  Secondly,  a   secondary   and   why   not,   a   tertiary   LBO   which   is   a   highly   leveraged   acquisition   by  another   private   equity   firm.   Thirdly,   a   trade   sale   that   is   to   say   an   acquisition   by  another  operating  company  in  the  same  industry.  IPOs   and   secondary   LBOs   can   share   a   common   point   in   that   there   are   expected   to   be  significant   unrealized   equity   gains   due   to   favourable   regulatory   or   market   trends   at  the  point  of  sale.  These  gains  should  be  visible  and  attractive  enough  to  an  investor  with  limited  or  no  involvement  in  the  industry.    Trade   sales   may   be,   but   not   necessarily,   more   successful   than   either   an   IPO   or   a  secondary   buyout   because   business   synergies   may   be   available   to   the   trade   buyer  that  are  not  available  to  the  general  investor.  As  a  result,  the  trade  buyer  should  be  able  to  generate  higher  returns  on  the  same  price  paid  for  the  LBO  company.  In  secondary  and  tertiary  buyouts,  the  LBO  fund  sells  the  company  to  other  financial  investors.   Such   transactions   usually   lead   to   a   renewed   rise   in   the   leverage   effects.  Exits  of  this  kind  have  recently  been  occurring  at  shorter  and  shorter  intervals.  In  this  connection,   it   seems   justified   to   ask   if   a   secondary   buyouts   really   lead   to   further  improvements  in  the  operational  ability  or  the  efficiency  of  the  capital  structure   or  if  there  is  only  a  significant  increase  in  risk  through  the  increased  use  of  debt  to  finance  the  company.    However,   secondary   buyouts   are   important   for   individual   LBO   funds   because   these  funds  have  been  created  to  exist  only  over  a  given  life  span  and  therefore  have  to  sell  their  shares  after  no  more  than  a  few  years.  For   example   in   France,   the   company   “LBO   France”   has   acquired   building   materials  company   “Materis”   in   a   secondary   buyout   transaction.   The   transaction   provides   an  exit   for   Advent   International,   The   Carlyle   Group   and   CVC   Capital   Partners,   generating  a  return  of  over  two  times  the  money  invested…  LBO  France,  managed  by  LBO  France     39  
  • Gestion,   now   owns   86%   of   Materis   and   Lafarge   and   management   each   retain   a   7%  stake.  Another   strategie   for   exiting   an   LBO   is   the   dividend   recap.   Since   2006,   some  leveraged   buyout   firms   have   rushed   to   embrace   recapitalizations   in   order   to  monetize   quickly   their   investments.   Classically,   buyout   firms   put   together   dividend-­‐paying  recaps  three  to  five  years  after  the  original  LBO  and  after  the  buyout  firms  had  proven   the   company’s   ability   to   deliver   strong   earnings,   cash   flow   and   revenues   in  good   times   and   bad.   LBO   firms   are   also   recapitalizing   deals   they   negotiated   only  months  earlier  or  using  the  recaps  as  a  way  to  pull  out  the  whole  of  their  equity  in  an  old  deal  that  has  gone  stale.     SECTION  II  –  Capital  gain,  carried  interest  and  tax  aspects.  The   process   of   an   LBO   transaction   is   simple.   The   Newco,   in   order   to   reimburse   its  debt   and   interest   payments,   has   to   improve   its   profitability.   The   Newco   increases  generally   its   value,   and   after   few   years,   investors   so   private   equity   firms,   sell   their  participation   in   order   to   obtain   a   significant   capital   gain.   That’s   like   it   as   general  partners  can  hope  capital  gain  and  enrich  their  limited  partners.  Last   year,   secondary   buyout,   which   is   a   possibility   for   exiting   an   LBO,   was   a   more  common  exit  for  private  equity  investors  than  sale  of  businesses  back  to  the  public  by  an  IPO.  This  fact  is  surprising  because  we  know  that  the  goal  of  any  LBO  is  to  extract  the  maximum  value  and  streamline  the  company.    Also,  if  a  second  group  of  private  equity  firms  step  in  to  do  another  LBO  transaction  of  a  target  that  has  been  through  the  process  once,  that  likely  means  either  that  the  first  group  has  failed  or  that  the  second  group  has  made  a  faulty  analysis.  Then,   there   is   the   rather   interesting   way   in   which   the   industry   has   structured  compensation,  enabling  it  to  claim  that  its  employees  arent  just  earning  salaries  but  rather  capturing  long  term  capital  gains  called  "carried  interest".     I  –  Concept  of  carried  interest.  Carried   interest   can   be   defined   as   the   right   that   entitles   the   general   partner   of   a  private  equity  firm  to  a  share  of  the  fund’s  profits.    Generally   in   a   private   equity   fund,   the   general   partner   is   a   partnership   and   is  controlled   by   investment   managers   and   contributes   1   to   5%   of   the   fund’s   initial  capital.   The   general   partner   must   engage   to   manage   the   fund’s   assets.   The   general  partner  obtains  an  annual  fee  of  2%  of  the  fund’s  assets  and  a  "carried  interest"  of  20%  of  the  fund’s  profits  that  exceed  a  certain  "hurdle"  rate  of  return.    The   individual   partners   of   the   general   partner,   not   the   general   partner   itself,   are  taxed  on  these  payments.       40  
  • Carried   interests   conflate   generally   three   tax   problems.   Firstly,   the   classification   of  income  as  capital  gains  or  ordinary  income.  Secondly,  the  determination  of  partners  income   at   the   partnership,   or   entity,   level,   and   thirdly,   the   dependence   of   the   tax  system  on  realizable  events.    Whether   carried   interests   produce   ordinary   income   or   capital   gains   has   attracted   the  most   controversy,   particularly   in   the   USA   and   in   France   the   last   year.   Logically,   the  profit   from   the   sale   of   assets   must   be   defined   as   the   essence   of   a   capital   gain,   and  carried  interests  do  give  general  partners  a  right  to  future  capital  gains  generated  by  the  sale  of  partnership  assets.    The   profit   from   an   asset   sale   must   be   also   thought   to   belong   to   the   owner   of   the  asset,  who  pays  the  applicable  capital  gains  tax.    But  general  partners  pay  effectively  the  capital  gain  tax  rate  on  their  carried  interest  income,  even  though  they  don’t  own  the  assets  whose  sale  generated  the  income.    By   contrast,   the   limited   partners   have   a   "capital   interest,"   which   gives   them   the  shared   and   sole   right   to   the   liquidation   value   of   the   partnership.   Indeed,   limited  partners  hope  to  realize  a  capital  gain  on  their  initial  private  equity  investment,  but  risk   losing   this   capital.   General   partners   so   the   private   equity   firms,   risk   only   their  “time”  and  effort…  Carried   interest   constitutes   approximately   one-­‐third   of   the   payments   that   private  equity   general   partners   obtain,   and   the   management   fee   the   remainder.   Under  current   law,   the   management   fee   is   taxed   like   a   simple   salary   income,   with   a   top  income  tax  rate  of  45%  in  France,  whereas  the  carried  interest  is  currently  taxed  as  investment  profit,  also  with  a  lower  tax  rate.    In  particular,  any  portion  of  the  carried  interest  that  represents  qualified  dividends  or  long  term  capital  gains  of  the  fund  is  taxed  at  a  top  rate  of  20%  plus  a  3.8%  surtax.  Many   commentators   believe   it   would   be   fairer   and   more   efficient   for   carried   interest  to  be  taxed  like  wage  and  salary  income,  like  the  current  French  Government.     II  –  Comparison  between  the  USA  and  in  France.    In   the   US,   legislators   are   currently   debating   whether   carried   interest   qualifies   as  capital  gains,  or  should  be  taxed  as  ordinary  income  instead.    Frances   Parliament   decided   four   or   five   years   ago   that   carried   interest   qualified   as  capital  gains,  and  recent  clarifications  from  the  last  government  indicate  that  carrys  tax  status  is  not  in  danger.    But  today  some  analysts  and  lawyers  explain  that  the  French  view  carried  interest  as  being  "at  risk",  while  the  US  seems  to  see  carry  more  and  more  as  a  fee  for  services  rendered.     41  
  • Before  the  new  legislation,  the  carried  interest  of  a  private  equity  fund  could  receive  a   capital   gain   tax   treatment   if   the   fund   managers   fulfill   two   main   conditions:   they  should   receive   a   normal   income,   a   salary,   and   they   should   also   invest   a   certain  amount   in   the   fund,   which   wasnt   clearly   determined   by   the   tax   administration.  Those  were  the  only  rules  that  were  applied.  But  things  have  changed  since  the  Financial  law  for  200923.    With   the   new   legislation,   several   new   rules   have   been   enacted.   One   is   that   the  amount   the   manager   must   invest   in   the   fund   has   been   more   clearly   determined.   The  amount   is   now   1%   of   the   total   commitments   of   the   fund   for   a   carried  interest  with  a  rate   of   2%,   except   in   the   cases   of   venture   capital   funds   that   invest   in   innovative  companies  or  in  European  “PME”.    The   capital   gain   tax   treatment   of   carried   interest   is   the   result   of   the   risk   taken   by   the  managers  of  the  funds.  The   last   year,   there   has   been   a   bad   time   for   French   private   equity   funds.   Most  obviously,   it   has   found   itself   in   the   firing   line   of   hefty   tax   increases,   wanted   by   the  new   socialist   government   and   President   François   Hollande.   These   include   a   special  75%  tax  for  people  earning  more  than  €  1  million  per  year.  The  government  has,  to  the  relief  of  buyout  firms,  softened  its  stance  on  the  taxation  of   carried   interest,   after   initially   saying   it   would   be   classified   as   income   and,  therefore,  potentially  attracting  the  75%  rate.  Instead,   carried   interest   will   always   benefit   from   capital   gains   tax,   meaning   owners  will   receive   a   20%   tax   exemption   on   shares   held   between   two   and   four   years,  increasing  to  40%  for  assets  held  for  more  than  six  years.  About   the   taxation   regime   abroad,   the   Belgian   tax   ruling   service   has   recently  concluded  that  carried  interests  paid  to  managers  of  a  private  equity  fund  were  liable  to  tax  as  ordinary  income  that  is  to  say  in  Belgium,  53,5%.    To   conclude,   it   has   been   estimated   that   there   are   between   1,500   to   2,000   French  companies  under  leveraged  buyout  financing  in  2011,  of  which  some  25%  have  not  been  able  to  respect  one  or  more  of  their  financial  covenants  to  lenders.  The  breach  of   financial   covenants   by   a   company   under   LBO   is   often   the   first   warning   sign   to  lenders  that  all  is  not  well.    This  may  indicate  a  temporary  problem  resulting  from  a  downturn  in  current  market  conditions   or,   when   linked   to   an   immediate   or   pending   liquidity   problem,   a   more  serious  structural  problem  requiring  a  restructuring  of  the  capital  and  debt  financing  structure  of  the  company  and  its  subsidiaries.                                                                                                                  23  Article  150-­‐0-­‐A  II,  8°)  of  the  French  Code  Général  des  Impôts.       42