Financing patterns of European Buy-Outs

Diplomarbeit von Sascha Kaumann

Introduction:

The 1980’s saw the creation of a new form of corporate takeover: Leveraged Buy-Outs. Extensively discussed, they led to a widespread public debate on corporate governance in the US that culminated in a 1989 congressional hearing on the possible implications of leveraged Buy-Outs for the economy.

The public picture was clear: The ‘Barbarians at the Gate’ travelled in pin-striped suits knocking on executives’ doors while asking for their seat in the corporate boardroom. Actions such as, paying for acquisitions with borrowed money, cutting jobs, stealing tax money from the state through increased leverage and selling the firms after a couple of years for a huge profit, all contributed to the image of LBO financiers as corporate raiders. Not only within the public spectre, but moreover, economic literature seriously criticised the one-off gains and zero-sum sources of value associated with leveraged Buy-Outs. Summers labels the private benefit of LBO shareholders as being achieved at the expense of other stakeholder groups, misevaluations and future growth opportunities.

Despite this, advocates of this new form of organisation were to be found. Not only did investors searching for higher returns in a low interest environment, welcome the advent of the LBO asset class, but moreover literature began to develop awareness of the benefits of those transactions. The solution to acute incentive problems found in public corporations, which this new form of takeover was able to offer led Jensen to remark: ‘The last share of publicly traded common stock will be sold in 2003’.

Knowledge of this new acquisition technique quickly began to reach Europe and by 1989 the total value of Buy-Out transactions undertaken reached €bn 6.5 in the old continent, a 70% year on year increase from 1981. After a fall in Buy-Out activity in the late 1990’s transactions have recently increased with prominent examples in 2003 including the €bn 1.05 takeover of BertelsmannSpringer, the science and business media publishing unit of Bertelsmann, by UK financial sponsors Cinven and Candover and the €bn 5.7 takeover of Seat PagineGialle by a consortium of BC Partners, CVC Capital Partners, Investitori Associati, and Permira, Europe’s biggest Buy-Out in 2003.

Of particular interest to both the academic and financial communities, is the aspect of their financing structure. Why are LBOs financed with so much debt? How are the complicated financing structures justified? In the end, what value will be created for the equity investor? These are just some questions that will be touched upon within this research.

The first chapter should give us a first glance of the Buy-Out landscape and the structure of this document by providing:

- A definition of Buy-Outs in general and our research subject in detail.

- A justification of the relevance of the Buy-Out sector to an equity investor.

- Guidance on the focus of our research within the Buy-Out process.

- An introduction to the methodology and structure employed in this research.

Table of Contents:

	TABLE OF CONTENTS	I
	LIST OF ACRONYMS	III
	LIST OF OBJECTS	VI
1.	INTRODUCTION	1
1.1	DEFINITION OF BUY-OUTS	2
1.2	RELEVANCE OF BUY-OUTS	4
1.3	RESEARCH FOCUS	6
1.4	METHODOLOGY & STRUCTURE	6
2.	THE QUEST FOR A THEORY ON OPTIMAL CAPITAL STRUCTURE	8
2.1	TRADITIONALISTS	8
2.1.1	Assumptions made by traditionalists	9
2.1.2	Irrelevance hypothesis	10
2.2.	MODERNISTS	12
2.2.1	Tax hypothesis	12
2.2.1.1	Corporate taxes	13
2.2.1.2	Corporate and personal taxes	13
2.2.2	Risky debt hypothesis	16
2.2.3	Costly contracting hypothesis	18
2.2.3.1	Assumptions made in Agency Theory	18
2.2.3.2	Definition of contracting parties	21
2.2.3.3	Agency conflicts and costs	22
2.2.3.4	Implications for shareholders and empirical evidence from leveraged Buy-Outs	29
2.3	AN INTEGRATED MODEL OF CAPITAL STRUCTURE	31
2.3.1	The case of pure debt and equity	32
2.3.2	The case of hybrid financing instruments	33
3.	FINANCING PATTERNS OF EUROPEAN BUY-OUTS	37
3.1	DETERMINANTS OF CAPITAL STRUCTURE CHOICE	37
3.1.1	Asset characteristics	38
3.1.2	Liability characteristics	39
3.1.2.1	Senior debt	40
3.1.2.2	Mezzanine	45
3.1.2.3	High Yield	47
3.1.2.4	Preferred equity	49
3.1.2.5	Ordinary equity	50
3.1.2.6	Summary	51
3.1.3	Availability of funds	52
3.1.4	Summary	54
3.2	EVIDENCE FROM EUROPEAN BUY-OUT CAPITALISATION	54
4.	THE CAPITALISATION PROCESS AND OTHER SOURCES OF VALUE	58
5.	SUMMARY AND OUTLOOK	61
6.	REFERENCES	63
7.	APPENDIX	77
7.1	ADDITIONAL SOURCES OF INFORMATION	77
7.2	LEVERAGE EFFECT	77
7.3	DERIVATION OF THE MILLER MODEL	78
7.4	FINANCIAL MODEL FOR CAPITALISATION ANALYSIS	79

Text Sample:

Chapter 3.1.2.1, Senior debt:

The most debt like element in an LBO capitalisation is senior debt. It is provided by banks and financial institutions in the form of term loans. To cover a wide spectrum of risk and return trade-offs, senior loans are available in three different tranches. Tranche A is the most secured tranche with B&C senior loans ranking lower in a company’s capital structure.

The financial terms of the different tranches are distinguished by interest rate, repayment mode and maturity. Typically, senior debt is provided at a floating cash rate with a mark-up over LIBOR increasing in maturity and security. Repayment terms also vary with amortising repayment preferred by A loan investors and bullet repayment preferred by B&C loan investors. Maturity of senior debt is relatively short compared to hybrid instruments. Normally, no call premium is imposed on shareholders in the case of repayment before maturity. Senior debt loans are essentially privately placed bonds that enjoy the advantages of lower distribution cost and avoidance of public registration cost. Banks and Financial institutions are the main players in senior debt provision.

After this short wrap-up of general terms we will now see how senior debt can alter asset induced firm problems through its contractual feature.

Tax hypothesis:

The tax effect of senior debt is threefold: Interest payments are tax deductible, assets financed with senior debt are depreciable, and placement costs can be amortised over the life of the issue. Therefore, contractual prerequisites exist to realise the full value creation potential of debt and non-debt tax shields. Latest empirical evidence seems to support these findings. Senior debt consequently is an efficient means to lower a company’s tax burden.

Risky debt hypothesis:

Interest charged is essentially a function of the loans’ security features. We can broadly distinguish between asset based and cash flow based lending. In an asset based lending scheme, the company’s assets will serve as collateral, whereas the company’s projected future cash flow will serve as collateral in a cash flow based lending scheme. Asset based lending schemes are less risky as lenders have direct access to the company’s assets whose value is less subject to volatility than a company’s cash flow. Senior A loans are provided through an asset based lending scheme, whereas Senior B&C loans are provided through a cash flow lending scheme.

To further reduce their exposure to single transactions, senior debt investors can pass default risk on to other banks. This technique, known as syndication, is quite common with over 60% of senior Buy-Out related debt being syndicated. The global coordinator of the bond issue originates the transaction and then passes on part of the default risk to other banks for a fee.

The limited number of counterparties in senior debt loans results in easier renegotiation in the case of default which can substantially decrease direct and indirect costs associated with financial distress.

Another means of risk reduction can be found in the comparatively short maturity of senior debt loans. Merton and later Ho and Singer demonstrate that a reduction in the time to maturity of debt outstanding will reduce the elasticity of the value of the bonds with respect to the value of the firm, i.e. reduce the risk of these bonds.

The floating rate interest payments of senior loans are a major risk driver in Buy-Out transactions. Due to the high leverage, companies have huge exposure to interest rate shifts. However, instruments exist to limit that risk, e.g. swap contracts, 40% of Buy-Out debt in Europe remains un-hedged.

We conclude that costs of financial distress do exist, but modern contractual specifications in senior debt loans allow for a significant reduction of those costs for banks. These lowered costs of financial distress should result in lower prices for senior loans and consequently benefit shareholders.

Costly contracting hypothesis:

Agency costs of debt are being imposed on shareholders due to the existence of a discretionary freedom of action, induced by asymmetric information, which could be exploited to the detriment of bondholders, in the case of misaligned incentives. We will now examine the conditions being present in senior debt contracts that foster Agency costs.

As far as the informational aspect of senior debt is concerned, we find that documentation, both legal and marketing, are private documents. The private nature of these documents lowers the cost of information transfer, because managers can be sure that no sensitive information will be leaked to the market and information has to be provided on an informal basis. Banks seem to have a cost advantage in information production and transmittel. As with every good, lower price means higher consumption, thus implying that private debt holders will be better informed than public ones. Another important source of information is board seat representation. This superior information lets banks perform monitoring efforts more efficiently and thus reduces Agency costs of debt.

On the incentive structure side we find a very debt focussed mindset. No warrants are being used in senior debt thus drawing a strict line between debt- and equityholders. To make up for the shortcomings of this divergence of incentives, covenants are used quite heavily.

Strong covenant protection is important for bondholders, as they might otherwise be subject to wealth expropriation by corporate decisions. In an LBO situation, however, the specific shareholder structure implies disincentives for bondholder wealth appropriation. Being the main holders of ordinary share capital, financial sponsors are repeated players in the debt markets with their reputation as good borrowers at stake. Hence, they are rather interested in doing good business with bondholders on a repeated basis then reaching one-off gains through bondholder wealth appropriation.

We conclude that tight informational control fosters an active monitoring of shareholders by bondholders, thus lowering Agency costs of debt. The impact of incentive structures on Agency costs of debt is twofold: The traditional Agency problems of debt are existent, but are ameliorated through Buy-Out specific ownership and contractual structures.

Agency costs of equity are being imposed on shareholders by managers that make inefficient use of free cash flow, either through over-investing or consuming of perquisites, or by under-leveraging the firm.

In this context, debt is an efficient means to fight the free cash flow problem, because interest payments reduce free cash flow available on manager’s discretion, thus curbing inefficient use of cash reserves. Additionally, debt gives shareholders the right to force the company into bankruptcy and thus pay out excess cash. As Glassman and Steward put it: ‘Equity is soft, debt hard. Equity is forgiving, debt insistent. Equity is a pillow, debt a sword’.

Monitoring activities, either through informal information exchange or contractual covenants, help to fight both, the free cash flow and the under-leverage problem.

We conclude that senior debt is an efficient means to fight Agency costs of equity.

Mezzanine:

Mezzanine is a hybrid instrument that shares characteristics of both, debt and equity. Its subordination (equity like) is compensated by higher interest payments (debt like).

Mezzanine facilities are usually provided for long-term financing (10 years), are repaid at maturity and charge both cash and non-cash interests. Floating cash interest is paid, as this allows banks to better match assets and liabilities in their balance sheet. Non-cash interest is a specific feature of mezzanine facilities. Interest is paid by issuing additional bonds, thus not straining a company’s cash flow. However, the interest and principal have to be paid all-in-once at maturity, the liquidity problem can be ameliorated by granting several mezzanine facilities with different maturity dates. If shareholders whish to pay back the principal amount of the mezzanine facility pre-maturely, they have to bear a call premium to make up for the foregone subsequent interest payments of bondholders. As placement agents are private institutions, the placement costs are comparatively low.

Tax hypothesis:

Mezzanine enjoys the same tax deductibility measures as senior debt and thus constitutes an instrument to reach the full value creation potential of corporate tax shields.

Risky debt hypothesis:

Mezzanine’s secondary ranking in the case of bankruptcy does impose higher costs of financial distress on the company with recovery rates far below those of senior debt. Mezzanine loans are facing mounted interest rate risk, as they are provided on a floating rate basis. Like in the case of senior debt, syndication and a concentrated counterparty structure are able to ameliorate the mounted costs of financial distress. Shareholders indirectly have to bear those costs of financial distress through higher interest payments.

Costly contracting hypothesis:

As for the Agency costs of debt, we see the same private character of information as experienced with senior debt loans. This should help reduce information asymmetries significantly.

Mezzanine holders are interested in the securitisation of their interest and principal payments and might thus collide with shareholder interests. However, the nature of mezzanine instruments offers two contractual characteristics to align shareholder and bondholder interests. First, through the ‘stick” of strong covenant protection, secondly, through the ‘carrot’ of equity participation. Equity participation is typically achieved through the issuance of warrants giving the mezzanine-holder the right to purchase a company’s shares at maturity for a specified price. As this right is valuable, interest payments for the shareholders are reduced. With this technique, bondholders have strong incentives to maximise equity value yielding additional profits to them.

We can conclude that Agency costs of debt seem to be minimised by powerful information exchange and incentive alignment.

As far as Agency costs of equity are concerned, mezzanine facilities enjoy the same effects as senior debt loans by disciplining management through increased monitoring and pressure to meet interest payments.