Going private — transformation of a public corporation into a privately held firm Leverage buyout (LBO) — purchase of a company by a small group of investors using a high percentage of debt financing Investors are outside financial group or managers or executives of company Management buyout (MBO) — leveraged buyout performed mainly by managers or executives of the company

2. Introduction
• Going private — transformation of a public
corporation into a privately held firm
• Leverage buyout (LBO) — purchase of a
company by a small group of investors
using a high percentage of debt financing
– Investors are outside financial group or
managers or executives of company
– Management buyout (MBO) — leveraged
buyout performed mainly by managers or
executives of the company

3. – Results in significant increase of equity share
ownership by managers
– Turnaround in performance is usually
associated with formation of LBO
– Typical LBO operation
• Financial buyer purchases company using high
level of debt financing
• Financial buyer replaces top management
• New management makes operating
improvements
• Financial buyer makes public offering of improved
company at higher price than originally purchased

4. • Management buyouts (MBOs)
– Investor group dominated by incumbent
management
– Segment acquired from parent company
• LBO transaction may be reversed with
future public offering
– Aim is to increase profitability of company
and thereby increase market value of firm
– Buyout group seeks to harvest gain within
three- to five-year period

5. • Elements of a typical LBO operation
– First stage — raise cash required for buyout
and devise management incentive systems
• Financing
– About 10% of cash is put up by investor group headed
by company's top managers and/or buyout specialist
– About 50-60% of required cash through secured bank
loans
– Rest of cash by issuing senior and junior subordinated
debt
• Private placement with pension funds, insurance
companies, venture capital firms
• Public offerings of "high-yield" notes or bonds (junk
bonds)

6. • Management incentives
– Managers receive stock price-based incentive
compensation in form of stock options or warrants
– Incentive compensation plans based on measures
such as operating performance
– Second stage — organizing sponsor group
takes company private
• Stock-purchase — buys all outstanding shares of
company
• Asset-purchase — purchases all assets of
company and forms new privately held
corporation
• New owners sell off parts of acquired firm to
reduce debt

7. – Third stage — management strives to
increase profits and cash flows
• Cut operating costs
• Cut spending in research and development
• Cut new plants and equipment as long as
provisions for capital expenditures are adequate
and satisfy lenders
• Increase revenues by changing marketing
strategies

8. – Fourth stage — reverse LBOs
• Investor group may take improved company
public again through public equity offering
(secondary initial public offering - SIPO)
• Create liquidity for existing stockholders
• Muscarella and Vetsuypens (1990)
– 72 reverse LBOs in 1976-1987
– 86% of firms use offering proceeds to lower company's
leverage
– Equity participants realized median annualized rate of
return of 268.4% on equity investment by time of SIPO
– Median length of time between LBO and SIPO was 29
months

9. – Other target characteristics
• Track record of capable management
• Strong market position within industry to enable
it to withstand economic fluctuations and
competition
• Highly liquid balance sheet
– Little debt, either short or long term
– Large unencumbered asset base — for collateral
– High proportion of tangible assets with fair market
value above net book value

10. – Leverage factors
• Increase return on equity (ROE) and cash flows
to retire debt
• Attractions for lenders
– Interest rates only 3-5 points above prime rate
– Company and collateral characteristics
• Large amounts of cash/cash equivalents
• Undervalued assets (hidden equity)
• Could liquidate some subsidiaries to raise funds
– High prospective rates of return on equity especially for
lenders such as venture capitalists and insurance
companies with equity participation
– Confidence in management group spearheading LBO

11. – Management factors
• Record of capability
• Betting reputation and personal wealth on
success of LBO
• Highly motivated by potential large personal
gains from stock ownership
– Sources of MBO targets
• Divestitures of divisions by public companies
• Private companies with low growth records
• Public corporations selling at low P/E multiples
representing large discounts from book values

12. • Sources of gains in LBOs
– Tax benefits — can enhance already viable
transaction
• Specific tax benefits
– Interest tax shelter from high leverage
– Asset step-up provides higher asset value for
depreciation expenses; especially accelerated
depreciation on assets involving little recapture — more
difficult under Tax Reform Act of 1986
– Tax advantages of using ESOP as LBO vehicle
– Most of premium paid is financed from tax savings
– New companies may operate tax-free up to six years
(LBO often sold at this point anyway when debt/equity
ratio declines from 10 times to 1 or under)

13. – Management incentives and agency cost
effects
• Argument for: Increased ownership stake
provides increased incentives for improved
performance
– Profitable investments that require disproportionate
effort of managers may only be undertaken if
managers are given disproportionate share of profits
– Concentrated ownership aligns managers and
shareholders' interest, reducing agency costs
– Debt from LBO commits cash flows to debt payment,
reducing agency costs of free cash flows
– Debt puts pressure on managers to improve firm
performance to avoid bankruptcy

14. • Arguments against:
– Management already held large stake before buyout
– Internal and external controls are sufficient to align
managers' interests to shareholders

15. – Wealth transfer effects
• Payment of premiums in LBO transactions may
represent wealth transfer to shareholders from
other stakeholders
• Wealth transfer from existing bondholders and
preferred stockholders
– Reduction in value of firm's outstanding bonds and
preferred stock due to
• Large increase in debt
• Bond covenants may not protect existing
bondholders in event of control changes and debt
issue
• In bankruptcy proceedings, "absolute priority rule"
for senior security may not be strictly followed

16. • Wealth transfer from current employees to new
investors
– Management turnover in buyout firms lower than in
average firm; sometimes new management team is
brought in after LBO
– Number of employees grows more slowly in LBO firm
than others in same industry and sometimes even
decreases — may result from postbuyout divestitures
and more efficient use of labor

17. • Tax benefits in LBO constitute subsidy from
public and loss of revenue to government
– Net effect of LBO on government tax revenues may be
positive
• Shareholders pay capital gains taxes on sale of
their stock in LBO tender offer
• LBO investor group pays capital gains taxes when
firm goes public at a later date
• Improved profitability — firms pay more corporate
taxes

18. – Asymmetric information and underpricing
• Managers or investor groups have more
information on value of firm than public
shareholders
• Large premium in buyout proposal signals that
future operating income will be larger than
previously expected or firm is less risky than
previously perceived
• Investor group believes new company worth more
than purchase price — prebuyout shareholders
receive less than adequately informed
shareholders

19. – Other efficiency considerations
• More efficient decision process as private firm
– No need to justify new programs with detailed studies
and reports to board of directors, more speedy actions
can be taken
– Public firms have to publish reports that can disclose
valuable information to competitors
• Stockholders' servicing costs and other related
expenses do not appear to be a major factor in
going private
• Alternatively, perhaps LBOs performed well
because of favorable stock market/economic
conditions