Department of Management Sciences, National University of Modern

Languages

Assignment
Submitted by:
Shahraz Mushadi
Roll NO: 31466
Subject: M&A
Submitted to: Sir Rao Akmal
Class: MBA (3.5)5th Evening
Date: 12-12-2020
Chap #08
Topics in going-private transactions
Summary
Private equity firms have played a major role in the takeover market during the past
quarter of a century. Particularly in the mid-2000s, these firms have been able to attract
large amounts of capital and have very aggressively pursued mergers and acquisitions
(M&As). Their ability to raise capital has greatly increased in recent years. We will see
that at times, rather than competing with each other, many private equity firms have
decided to become partners in deals. This has greatly enhanced the size of transactions
they can pursue.
PRIVATE EQUITY MARKET
The private equity market is a collection of funds that have raised capital by soliciting
investments from various large investors where the funds will be invested in equity
positions in companies. When these investments acquire 100% of the outstanding equity
of a public company, we have a going-private transaction. When the equity is acquired
through the use of some of the investment capital of the private equity fund but mainly
borrowed funds, we tend to call such a deal a leveraged buyout (LBO). The fact that such
deals are very common investments for private equity funds has led some to call these
funds LBO funds. However, these firms can certainly use more equity and less debt. The
value of using more debt, however, is that the added leverage can amplify positive returns
from the deal. Private equity funds may make other investments such as providing
venture capital to nascent businesses. Funds established for this purpose are sometimes
called venture capital funds. Private equity funds seek out investments that are
undervalued. These could be whole companies that are not trading at values
commensurate with what the fund managers think is possible. They could also be
divisions of companies that want to sell the units due to a change in strategy or a need
for cash. In general, private equity fund managers raise capital from a variety of
institutional investors. They typically charge their investors ‘‘2 and 20.’’ This refers to 2%
of invested capital and 20% of profits. The 20% of profits is referred to as ‘‘carried
interest.’’
Seller versus Private Equity Fund Valuations and Negotiations
When private equity firms believe that a target has been poorly managed, there may be
a greater gap between the value that the private equity firm believes it can readily achieve
through the installation of a new management team and the enactment of certain
necessary changes in company operations, and the current value of the target based on
its unadjusted future cash flows. This gap may provide the basis for some flexibility in
negotiations and allow for an agreed-on price. However, when the target has been
reasonably well-managed and both are aware of the risk-adjusted present value of the
company’s cash flows, there is less room to provide the seller with the full value of the
company while allowing private equity buyers an opportunity to generate a good return
on their investment. While they are certainly not immune from making valuation mistakes,
private equity buyers tend to be careful not to overpay, as their gains mainly come from
the difference between their purchase price and an eventual resale price plus any monies
extracted from the company prior to that resale.
Partial Equity Investment by a Private Equity Firm: An Example
In November 2008, Los Angeles–based private equity firm Leonard Green Partners
announced that it bought a 17% stake in Whole Foods Market for $425 million. This deal
came at a time when the takeover business, and private equity in particular, was
depressed due to the subprime crisis and the drastically reduced access to credit. In prior
years’ complete takeovers were the norm. However, when credit markets sharply
tightened, private equity firms had to look at smaller and less than 100% equity
investments. The needs of Leonard Green Partners matched those of Whole Foods.
When the economy was booming in the 2000s, the stock of Whole Foods took off. The
company used M&A to expand by acquiring competitor Wild Oats. When the economy
slowed, Whole Foods had second thoughts about its expansion and even the acquisition
of Wild Oats. As the market turned down and competition with traditional grocery stores
heated up, the stock of Whole Foods fell. Whole Foods needed a cash infusion and this
created an opportunity for Leonard Green Partners. When the economy and Whole Stock
began to recover in 2010, Green Equity Investors, an affiliate of Leonard Green Partners,
sold 4.5 million shares of Whole Foods for $152.million. Based upon the early returns,
this deal is shaping up well for Leonard Green Partners. As we know, not all private equity
investments turn out well.
Total Acquisition by a Private Equity Firm: An Example
As noted, private equity funds seek to find undervalued assets, improve them, and sell
them for a higher price. Wilbur Ross, through his private equity firm, Wilbur Ross & Co.
LLC, has made this practice a highly skilled art. In the early 2000s, he focused on the
troubled steel industry and bought the once-giant LTV Corp. (see case study in Chapter
3 on the conglomerate LTV) and then bought Acme Steel Co., Bethlehem Steel Corp.
(another former steel giant), and Weirton Steel Corp. He combined these companies into
one steel firm, called International Steel Group (ISG), based in Richfield, Ohio. He then
sold the entity to a company that became Mittal Steel. Mittal itself was formed through the
acquisition of LNM Holdings by its Netherlands-based sister company, Ispat International
NV, for $13.3 billion. This entity then acquired ISG for $4.5 billion, thereby creating the
world’s largest steel company. Ross’s firm has invested $343 million and was reported to
have achieved a sevenfold return for investors.
M&A Opportunities After Private Equity Cash-Out
As noted, private equity firms seek to find undervalued opportunities, take corrective
actions to improve the market value of the enterprise, and then sell the company. Often
the sale is done through an initial public offering (IPO). One might think that after the sale
the target is appropriately valued and no further near-term acquisition opportunities exist
for the sold company. While normally that is the case, there are numerous examples of
companies that are acquired relatively soon after a private equity–inspired IPO. Some
have been critical of certain private equity buyers that do no more than merely ‘‘flip’’
companies. Such flippers try to buy at an attractive price, engage in some cosmetic
changes to buttress the financial results, and then sell at a higher price without adding
any meaningful value to the company. Shareholders in companies that are targets of such
offers sometimes have encouraged their boards to reject them based on the belief that
their own management can take the same actions as these private equity buyers likely
would.
Leading Private Equity Firms
A private equity firm may raise capital to build several different funds. Based on investors’
participation in the fund, they will receive a proportion of the return that the fund enjoyed
less the management fees for running the fund.
Private Equity Fund Partnerships and ‘‘Club Deals’’
Private equity funds may acquire stock in a target company individually or they may
combine with other private equity firms to acquire a target. These types of deals are
sometimes referred to as club deals. The combinations enable them to spread out the
risk. This may be necessary as many funds require that no more than a certain
percentage, such as 10%, of a fund’s assets may be invested in any particular investment.
For 100% acquisition, a $10 billion fund, a large private equity firm by any standards,
would then be limited to acquisitions no larger than $1 billion if it chose not to utilize debt
to complete the transactions. Private equity firms have become so involved in takeovers
that they find themselves forming competing groups or partnerships and bidding against
each other for takeover targets. Some have argued that the club deals tend to lower the
pool of potential demanders for target companies thereby lowering the prices that targets
receive in the market. This was the finding of a study by Officer, Ozbas and Sensoy.4
They found that target shareholders receive 10% less of pre-bid value and 40% lower
premiums!
Sales to Other Private Equity Buyers
Another change that has taken place in the private equity business is the willingness of
private equity firms to buy companies from other private equity firms. Each private equity
buyer may bring specialized expertise to the target company. The company is then
passed on to a second private equity buyer as it pursues its growth.
• Dividend Recapitalizations
Private equity firms generate returns from their portfolio companies in more ways than
just cashing out the investment when it is sold. In recent years we are seeing private
equity firms engaging in ‘‘dividend recapitalizations.’’ This is when private equity firms
 have companies they have acquired take on more debt, such as through issuing
bonds and using the proceeds to pay a dividend to the fund investors.
• Management and Termination Fees
In addition to such dividend recapitalizations, private equity firms sometimes also
charge their captive companies management fees in the range of 1 to 2%. The private
equity firms may charge management fees even if they really are not active in
managing the target—which has its own independent management team anyway.
These fees are supposed to offset the overhead at the private equity firm, but it is also
a source of return for these firms. Such firms may also charge the companies fees for
having one of their representatives sit on its board. They also may charge a
termination fee when the company is sold. Not all private equity firms charge such
fees and the arrangements vary by firm.
• Private Equity Business Model
While some of the leading names in finance work in this industry and often earn incredibly
lucrative compensation, the business model is a relatively simple one.
1. The first step in the process for private equity buyers is to have contacts with
investors and sales skills that will enable them to convince institutional investors
to invest a portion of their capital into one of their private equity funds.
2. The next step is to find undervalued targets.
3. The next step in the process is to secure ample low-cost debt.
4. The next step in the process is to conduct this business in a good economy with a
rising market.
Characteristics of Private Equity Returns
private equity returns do not outperform the market. This was confirmed by Kaplan and
Scholar, who examined the LBO fund and venture capital fund returns of private equity
firms. They found that gross of fees, both LBO and venture capital fund returns, exceeded
the S&P 500. However, when fees were also considered, the superior performance of
these funds disappeared.
One characteristic of investment performance that has attracted much attention over the
years has been the persistence of returns of mutual fund managers. This refers to the
likelihood that above-average returns in one period are associated with above-average
returns in later periods. Mutual fund managers have not been able to demonstrate much
persistence. However, Kaplan and Scholar do find persistence in performance for general
managers of one fund and others that they establish. Kaplan and Scholar also examined
capital flows into private equity funds. As expected, fund flows are positively related to
fund performance—both on the fund and industry level. However, they found that higher
industry performance seems to enable more funds to be formed, but many of the funds
do not perform as well in the future.
Board Interlocks and Likelihood of Targets
to Receive Private Equity Bids
Using a sample of all US publicity traded companies over the years 2000-2007, Stuart
and Yim found that when a company had directors which had previous positive
experience in receiving private equity bids while at other companies, such firms were
more 42% likely to receive offers from private equity firms.11 When the directors has
negative experiences with private equity in the past, what they termed the “PE Interlock
Effect” largely disappeared. They concluded that board members and the social networks
they bring to the board influences which companies become takeover targets.
JUNK BONDS’ FINANCING OF TAKEOVERS
Junk bonds, also called high-yield bonds, are debt securities that have ratings below
investment grade. The junk bond market is another financing source that can be used to
finance takeovers—especially leveraged takeovers.
History of the Junk Bond Market
Contrary to what some believe, junk bonds are not a recent innovation. They went by the
term low-grade bonds for decades. In the 1930s and 1940s, they were called ‘‘Fallen
Angels.’’ In the 1960s, some of the lower-grade debt that was issued to help finance
conglomerate acquisitions was referred to as ‘‘Chinese Paper.’’ In the 1920s and 1930s,
approximately 17% of all new corporate bond offerings were low-grade high-yield bonds.
The ranks of the high-yield bonds swelled during the 1930s as the Great Depression took
its toll on many of America’s companies. In 1928, 13% of all outstanding corporate bonds
were low-grade bonds; in 1940, this percentage had risen to 42%. By the 1940s, the low-
grade bond market started to decline as old issues were retired or the issuing corporations
entered into some form of bankruptcy. The declining popularity of the low-grade bond
market made new issues difficult to market. Between 1944 and 1965, high-yield bonds
accounted for only 6.5% of total corporate bond issues. This percentage declined even
further as the 1970s began; by the beginning of the decade only 4% of all corporate bonds
were low-grade bonds. The high-yield/low-grade market began to change in the late
1970s. Lehman Brothers, an investment bank that was itself acquired in the 1980s by
Shearson, underwrote a series of new issues of high-yield corporate debt. By 1982, junk
bond issuance had grown to $2 billion per year. Just three years later, in 1985, this total
had risen to $14.1 billion and then jumped to $31.9 billion in the following year. This was
the highest level the market reached in the fourth merger wave. It maintained similar
levels until it collapsed in the second half of 1989. After falling to $1.4 billion in 1990, the
market rebounded in 1992 and rose to new heights in the first half of the 1990s. Although
the market thrived in the 1990s, it took a different form from being a major source of
merger and LBO financing, which accounted for its growth in the fourth merger wave.
Why the Junk Bond Market Grew?
The junk bond market experienced dramatic and rapid growth in the 1980s, although in
the 1990s this growth would seem modest. The growth that occurred in the fourth wave
was very different from that which occurred later in the 1990s. The fourth wave growth
occurred for several reasons. Some of these factors are:
• Privately placed bonds.
• Development of market makers.
• Changing risk perceptions.
• Deregulation.
• Merger demand.
Historical Role of Drexel Burnham Lambert
Drexel Burnham Lambert was one of the first investment banks to underwrite new-issue
junk bonds and was unique in its efforts to promote the junk bond market as an attractive
investment alternative. These efforts were spearheaded by the former manager of
Drexel’s Beverly Hills office, Michael Milken. Drexel’s unique role as a market maker
became most apparent in 1986, when bondholders accused Morgan Stanley of failing to
make a market for the junk bonds of People Express, which it had previously under-
written. When the price of the bonds fell significantly, Morgan Stanley was reported to
have done little to support them. Morgan Stanley’s reported passive stance contrasts
strongly with Drexel’s aggressive market making in the 1980s. As a result of its
involvement in the junk bond market, Drexel progressed from a second-tier investment
banking firm to a major first-tier firm. The firm’s dominance in the junk bond field during
the 1980s made Drexel second only to Salomon Brothers as an underwriting firm Drexel
made a market for the junk bonds it had underwritten by cultivating a number of buyers
who could be depended on to purchase a new offering of junk bonds. The network of
buyers for new issues often consisted of previous issuers whose junk bonds were under
written by Drexel Burnham Lambert. Drexel and Michael Milken used this network to
guarantee a demand for new issues of junk bonds. This guarantee often came in the form
of a commitment letter indicating that the buyer would buy a specific amount of a given
issue of junk bonds when they were issued. The commitment fees that the investor might
receive were usually less than 1% (i.e., three-quarters of 1%) of the total capital
committed. In riskier deals, however, it ranged as high as 2%. Drexel commanded a
dominant 57% of the total market share of new public issues of junk bonds in 1983 and
40 to 50% from 1984 through the beginning of 1987, when its market share began to
steadily decline. This was mainly the result of the energetic efforts of other large
investment banks—especially Goldman Sachs, Merrill Lynch, First Boston, and Morgan
Stanley—to capture part of the lucrative junk bond market. They increased their junk bond
resources by expanding their trading, research, and sales staffs. The investment
apparently paid off; by the late 1980s each of these banks had captured a significant part
of the new public issue junk bond market. Drexel’s dominant role in the junk bond market
appeared to loosen in 1989 after Milken’s indictment. Some firms, hesitant to do business
with Drexel, turned to other underwriters. Drexel’s end came ingloriously with its Chapter
11 filing in February 1990.
Investment Bankers and Highly Confident Letters
As the size and complexity of the financing packages associated with the deals of the
fourth merger wave increased, the need to demonstrate an ability to raise the requisite
capital became more important, particularly for bidders who were significantly smaller
than their targets. This process was facilitated by the use of a Highly Confident Letter, in
which the bidder’s investment bank states that, based on market conditions and its
analysis of the deal, it is highly confident that it can raise the necessary capital to complete
the deal. This letter is often attached to tender offer filing documents.
Investment Banks and Liquidity of Junk Bond Investments
As noted previously, investment banks, led by the trailblazing role of Drexel Burnham
Lambert in the 1980s, served as a market maker for junk bonds. In doing so, they became
buyers when holders wanted to sell and sellers when investors wanted to buy. This gave
the market liquidity it otherwise would not have had. The enhanced liquidity lowered the
risk of these investments and made them more marketable.
Another way in which investment banks enhanced the liquidity of these investments was
to work with troubled issuers when they appeared to be in danger of defaulting. One
version of such securities is PIK, or payment-in-kind securities. These bonds do not make
cash payments for an initial period, which might range from three to ten years.
Junk Bond Refinancing and Bridge Loans
When companies do a cash acquisition, they need the up-front capital to pay the target
company shareholders for their shares. They may plan on using high-yield bonds to
finance the deal, but the seller might not want to exchange its share for the high-yield
bonds the buyer would issue. What the buyer then does is enlist the services of its
investment banker, who raises the short-term financing the buyer needs. This financing
usually comes in the form of a bridge loan, which can in turn come from various sources.
Bridge loans are even more necessary in European buyouts than they are in the United
States.
Collapse of the Junk Bond Market in the Late 1980s
In spite of its rapid growth in the mid-1980s, the junk bond market collapsed at the end of
that decade. Certain major events rocked the junk bond market in the 1980s. They
include:
❖ LTV Bankruptcy
The resiliency of the junk bond market was called into question in 1986, when the LTV
Corporation defaulted on the high-yield bonds it had issued. The LTV bankruptcy was
the largest corporate bankruptcy at that time and represented 56% of the total debt
defaulting in 1986.
❖ Financing Failures of 1989
In the first half of 1989, $20-billion worth of junk bonds was offered, compared with
$9.2 billion for the same period in 1988. Issuers had to offer higher and higher rates
to attract investors to buy the risky securities. Campeau Corporation’s offering of junk-
 bonds in 1988, led by the investment bank First Boston Corporation, was poorly
received, even though it provided 16% coupon payments on 12-year bonds and
17.75% coupons on 16-year bonds. In October 1988, First Boston had to withdraw a
$1.15 billion junk-bond offering as investor demand for the debt-laden concern’s
securities failed to materialize. The investment bank responded with a $750-million
offering that provided higher yields. However, demand was very weak. This downturn
was a contributing factor in the unravelling of the financing for the buyout of United
Airlines in October 1989.
❖ Default of Integrated Resources
Integrated Resources, a company built on junk bonds and the most prominent buyer
of junk bonds among insurance companies, defaulted in June 1989 and filed for
bankruptcy in early 1990.
❖ Bankruptcy of Drexel Burnham Lambert
The immediate cause of Drexel’s Chapter 11 bankruptcy filing was a liquidity crisis
resulting from the firm’s inability to pay short-term loans and commercial paper
financing that came due. Drexel had been the issuer of more than $700 million in
commercial paper. When the commercial paper market contracted in 1989, Drexel
was forced to pay off more than $575 million, which could not be refinanced through
the issues of new commercial paper. Closing the commercial paper market effectively
wiped out Drexel’s liquidity. With the prior collapse of the junk bond market, Drexel
could not seek long-term financing as a substitute. The firm had no recourse but to file
for Chapter 11 protection.
❖ Banking Regulation
The savings and loan difficulties of this period led to a regulatory backlash against
those institutions that invested heavily in junk bonds. When the Financial Institutions
Reform, Recovery, and Enforcement Act was passed in 1989, banks were forced to
mark their junk bond holdings to market values. Many were forced to sell off their junk
bond investments into a market in which demand was weak and supply was
increasing. This further weakened the junk bond market.
Fate of the Big Junk Bond Issuers
As of the end of the 1990s, we have the opportunity to consider the fate of the major junk
bond issuers of the fourth merger wave. According to a study conducted by KDP
Investment Advisors, of the 25 largest issuers of junk bond debt between the years 1985
and 1989 and that each had issued a minimum of $1 million in junk bond debt, almost
half had defaulted. Sixteen of these 25 companies were acquired. Clearly many of them
took on too much debt to withstand the economic downturn that followed at the end of the
decade.
Role of Junk Bond Research in the Growth of the
Market in the Fourth Wave
Various studies on junk bonds have been performed that seem to indicate these securities
are not as risky as some investors perceive, and may provide returns in excess of the risk
they have. One such study was done by W. Braddock Hickman’s National Bureau of
Economic Research, which was published in 1958.21 One of Hickman’s main conclusions
was that noninvestment-grade bonds showed higher returns than investment-grade
bonds, even after taking into account default losses. The time period of his study was
from 1900 to 1943. These results were challenged by Fraine, who pointed out that factors
such as interest rate fluctuations may have biased Hickman’s results. A study by Altman
and Namacher seemed to provide evidence that the default rates of low-rated firms were
much lower than was believed.23 The Altman and Namacher study showed that the
average default rate for junk bonds was 2.1%, which was not significantly higher than the
default rate on investment-grade securities, which was almost 0%. The Altman and
Namacher study revealed that as the time of default approaches, the rating declines. They
observed that 13 of 130 (10%) were rated as investment-grade one year before default,
whereas only 4 out of 130 (3%) received such a rating six months before default.24 This
implies that the bond rating can be used as a reliable indicator of the likelihood of default.
A study by Asquith, Mullins, and Wolff considered the aging effect of junk bonds. He and
his core searchers followed the junk bonds that were issued in 1977 and 1978 until 1986.
In doing so, they offset the impact of the rapidly growing junk bond market that affected
the Altman and Namacher results. The Asquith study also considered the adverse impact
that the call-in of bonds had.
❖ Junk Bond Defaults and Aging
The Asquith study also measured the relationship between defaults and aging. As noted,
it showed that default rates were low in the early years after the issuance of a junk bond.
The Asquith study raises serious questions regarding the riskiness of junk bonds. It
contradicts the Altman and Namacher findings, which downplay the riskiness of junk
bonds. However, later research by Altman supports the aging factor.
❖ Other Junk Bond Research
Wigmore exposed further problems in the junk bond market of the 1980s that went beyond
those identified by Asquith. Although the Asquith study pointed out the risk effects of junk
bond aging, calls, and exchanges, it did not consider changes in the quality of bonds that
were being issued as the junk bond market grew.
Wigmore examined a database of 694 publicly underwritten junk bonds issued between
1980 and 1988 (excluding financial institution issues). He measured the quality of the
issues by considering ratios such as interest coverage, debt/net tangible assets, and cash
flow as a percentage of debt. He found that earnings before interest and taxes (EBIT)
coverage of interest charges fell from 1.99 in 1980 to 0.71 in 1988. Debt as a percentage
of net tangible assets presented a similar picture of deterioration. This ratio rose from
60% in 1980 to 202% in 1988. Cash flow as a percentage of debt fell from 17% in 1980
to 3% in 1988. Wigmore’s financial ratios show that the quality of junk bonds issued during
the 1980s deteriorated steadily.
❖ Junk Bond Recovery Rates
Researchers define recovery as the price of the bond relative to its issue value either at
the time of default or at the end of the reorganization period. Altman and Namacher found
an average recovery rate of $41.70 per $100 face value on 700 defaulting bonds from
1978 to 1995.29 Altman and Kishore, in measuring the recovery rate on 696 defaulted
bonds from 1971 to 1995, showed that this recovery rate varied by seniority with senior
secured debt averaging 58% of face value, whereas less senior securities averaged lower
values. They also showed significant variation across industry categories. The highest
recovery occurred in the public utility sector (70%), whereas other sectors were
considerably below that rate. Conclusion of the Junk Bond Default Research. The
conclusion is that junk bond default rates clearly may be adversely affected by poor
economic conditions and declines in this market, but over longer periods the default rates
are generally low.

Changing Role of Junk Bond Financing in

Takeovers and Corporate Finance
The growth of the junk bond market in the 1980s added a highly combustible fuel to the
fires of the fourth merger wave. Junk bond financing was particularly important for bidders
that lacked the internal capital and access to traditional financing sources such as bank
loans.
The use of junk bond financing to finance acquisitions grew dramatically in 1988, and
dramatically collapsed in the years that followed. The collapse of the junk bond market in
the late 1980s contributed to the end of the fourth merger wave. There were other major
factors, such as the slowdown of the economy along with the overall decline of the stock
market. As the junk bond market recovered in the 1990s its growth began to ‘‘pick up
steam.’’ In fact, between 1997 and 2008 the high-yield bond market grew at an impressive
17% per year.
Financing for M&A is still one of the main uses of high-yield bond financing. However,
other uses, such as refinancing, project finance and other general corporate purposes
are also important.
Yields on Junk Bonds
The spread between investment grade-bonds, those with an S&P rating BBB or better,
and high-yield bonds, who’s with a rating of BB or worse is highly variable. It varies as a
function of the credit quality and rating of the specific borrowers as well as on market
conditions.
Leveraged Loan Market
Leveraged loans are loans to speculative grade borrowers. These are usually borrowers
who already have a significant amount of debt or who are now taking on a high amount
of debt relative to equity capital. These loans are usually syndicated loans that are loans
with a single set of terms but that have multiple lenders with each supply part of the overall
debt capital. One major difference between the leveraged loan market that now exists
compared with the past is that there are now more sources of lending, such as hedge
funds. These funds provide financing for loans such as second lien debt.
o Impact of Leveraged Loans on Junk Bond Indenture Contracts
Leveraged loans have moved into competition against junk bonds. In an effort to make
junk bonds more competitive, financing providers have tried to adapt the indenture
contracts of junk bonds to make them more appealing to bond buyers.
o Impact of Sarbanes-Oxley on the Competitiveness of Junk Bond Financing
Junk bonds are publicly issued securities. This means that issuers are then bound by
the provisions of the Sarbanes-Oxley Act (this act is discussed in Chapter 12). This
adds a layer of reporting and accounting requirements that are not normally present
with leveraged loans. Therefore, this law has given leveraged loans another
advantage over junk bonds.
o Default, Recovery, and Loss Rates: Leveraged Loans versus Junk Bonds
Both junk bonds and leveraged loans have comparable default rates. However, the
recovery rate is much greater for leveraged loans. As expected, the loss rate for
leveraged loans is then much lower. This lower risk profile makes it easier for
borrowers to raise debt capital through leveraged loans. It also enables them to get
lower rates than what they would with junk bonds.
o Expansion of Banks Originating Leveraged Loans
Commercial banks have discovered that by syndicating leveraged loans to buyers of
debt, such as hedge funds, they can quickly take the debt off their balance sheet while
originating the loans and generating good income from this service. In the early 2000s,
in the United States only a few large commercial banks accounted for the bulk of the
leveraged loan business. Dealmakers in the mid-2000s noticed that they could not
always count on a positive reception from the high-yield bond market, whereas the
response was often more favorable in the leveraged loan market. In 1999, regulations
that previously limited the ability of banks to underwrite securities were relaxed. This
allowed commercial banks to enter underwriting markets such as the junk bond
business.
STAPLED FINANCING
Another more recent trend in the M&A market is the use by buyers of stapled financing.
When a buyer is considering a purchase of a target, one element of uncertainty is the
financing that will be needed to complete the deal. Such uncertainty could cause a buyer
to pass on a given transaction. Stapled financing became popular during and right after
the 2001 recession that followed the downturn in securities markets. Stapled financing
can help facilitate an auction, which tends to result in greater sale prices. By making the
financing easier, a potentially greater number of buyers may pursue a given deal. For this
reason, it may be advantageous for sellers to utilize the services of investment bankers
and advisors that also have a strong financing capability. The terms of the stapled
financing package may not always be the best for the buyer. The investment banks
offering the stapled financing are making the deal easier to finance and seek a fee for this
service. However, shrewd buyers, such as private equity firms who normally have good
access to other financing providers, can ‘‘shop the loan’’ to other banks so that they
assure themselves they are getting the best terms. As with other areas of M&A, stapled
financing is not without its potential conflicts. While having a stapled financing
commitment in place can greatly reduce the financing-related uncertainties for both
buyers and sellers, it is not fool proof.
Covenant-Lite Loans
During the booming private equity takeover period of 2004-07, covenant-lite loans
became increasingly popular. These are loans which lacked the normal restrictive
covenants which gave lenders a greater ability to restrict the actions of the borrower –
especially if the performance of the borrowers worsened. Typical covenants could include
various financial ratios that have to be maintained so as to limited total indebtedness or
provide for greater cash flows to service debt.
SECURITIZATION AND M&A FINANCING
Securitization has long been used by corporations and financial institutions to enhance
the financing needs of companies. Private equity firms have developed operating
company securitizations as an important financing source for deals. They take specific
assets and income streams associated with those assets and direct the income to a
financial vehicle that they create. This vehicle then issues asset-backed securities (ABSs)
collateralized by this anticipated income. The securitization could be for a collection of
assets of a firm or it could be for a whole company (called whole company securitization).
The securitization can be used for M&A financing as well as for recapitalization.
The securitization vehicles are typically structured so that the vehicle is separate from the
parent company. This lowers the risk of the securities that are issued since they could
theoretically be valuable and of high quality even when the issuer is in default. The
structure of the deal must be such that the issuer cannot tap into the revenue stream from
the dedicated assets as it desires.
Securitizations for deals are easier to do when there is a defined income stream that is
readily separable from the overall business of the company.
Origins of ABSs for M&As
While this financing vehicle became quite popular in the mid-2000s, it can trace its origins
back to the end of the fourth merger wave. In 1989, Michael Milken and Drexel Burnham
Lambert assisted a buyout fund, Reliance Capital, which had taken the company private
in 1984 and then public in 1988.37 In 1989, Drexel helped Days Inn raise $167 million in
investment-grade debt by using the franchise fees that Days Inn derived from agreements
with its different franchisees. These franchise revenues were directed to a special-
purpose entity that issued the securities. This early use of these securitizations did not
turn out well, as the franchise revenues were not clearly separated from the operating
company, which later fell into bankruptcy. However, by the 2000s, other users pursued
securitization, such as Triac did with the Arby’s food chain. The securities offering was
backed by the royalties of the thousands of restaurants that used the Arby’s name.
Securitization and the Subprime Crisis
While the securitization business boomed in the mid-2000s, its growth came to a stunting
halt when the subprime crisis occurred. At that time the market lost its appetite for creative
securitizations and such securities became markedly difficult to sell. While the market has
rebounded somewhat, buyers are much more selective and try to make sure they are
comfortable with how they are going to be repaid. Transactions that are based on opaque
structures are very difficult to market.