Chapter 13: FINANCING THE DEAL

Private Equity, Hedge Funds, and Other Sources of Financing

Answers to End of Chapter Discussion Questions

13.1 What are the primary ways in which a leveraged buyuot is financed?

Answer: In a leveraged buyout, borrowed funds are used to pay for most of the
purchase price. Historically, as much as 90% or more of the purchase price was
financed with debt; however, more recently, financial sponsor equity contributions are
averaging closer to 25% to 30% of the purchase price. Typically, the tangible assets of
the firm to be acquired are used as collateral for the loans. The liquid assets are often
used as collateral for obtaining bank financing. Such assets commonly include
receivables and inventory. The firm’s fixed assets are commonly used to secure a
portion of long-term senior financing. Subordinated debt, either unrated on low-rated
debt, is used to raise the balance of the purchase price. This debt is often referred to
as junk bond financing. The transactions were normally characterized by complex
capital structures consisting of senior bank debt secured by the target’s assets,
subordinated unsecured debt, preferred stock, and common equity. Secured debt
often comprised about 60% of the total purchase price with unsecured debt or junk
financing accounting for about 20 –25%.

13.2 How do loan and security covenants affect the way in which a leveraged buyout is
managed? Note the
differences between positive and negative covenants.

Answer: Security provisions and protective covenants in loan documents are intended
to ensure that the interest and principal of outstanding loans will be repaid in a timely
fashion. The number and complexity of security provisions depends on the size of the
firm. Loans to small firms tend to be secured more often than term loans to large firms.
Typical security features include the assignment of payments due under a specific
contract to the lender, an assignment of a portion of the receivables or inventories,
and a pledge of marketable securities held by the borrower. Other features include a
mortgage on property, plant, and equipment held by the borrower and the assignment
of the cash surrender value of a life insurance policy held by the borrower on key
executives. An affirmative covenant is a portion of a loan agreement that specifies the
actions the borrowing firm agrees to take during the term of the loan. These typically
include furnishing periodic financial statements to the lender, carrying sufficient
insurance to cover insurable business risks, maintaining a minimum amount of net
working capital, and retention of key management personnel acceptable to the lending
institution. Such covenants restrict the actions of the borrower. They include limiting
the amount of dividends that can be paid, the level of salaries and bonuses that may
be given to the borrower’s employees, the total amount of indebtedness that can be
assumed by the borrower, and investments in plant and equipment and acquisitions.
The borrower may also be required to obtain the lender’s approval before certain
assets can be sold. LBO management tends to have much less flexibility in decision
making if the covenants are highly restrictive.

13.3 Describe common strategies LBO firms use to exit their investment. Discuss the
circumstances under which
some methods are preferred to others.

Answer: Comprising about 13 percent of total transactions since 1970s, initial public offerings (i.e., IPOs)
have declined in importance as an exit strategy. At 39 percent of all exits, the most common ways of exiting
buyouts is through a sale to a strategic buyer; the second most common method at 24 percent is a sale to

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 another buyout firm. Selling to a strategic buyer usually results in the best price as the buyer may be able to
generate significant synergies by combining the firm with its existing business. If the original buyout firm’s
investment fund is coming to an end, the firm may be able to sell the LBO to another buyout firm that is
looking for new investment opportunities. This option is best used when the LBO’s management is still
enthusiastic about growing the firm rather than cashing out. Consequently, the LBO may be attractive to
another buyout firm. An IPO is often less attractive due to the massive amount of public disclosure
required, the substantial commitment of management time, the difficulty in timing the market, and the
potential for incorrectly valuing the IPO. The original investors also can cash out while management
remains in charge of the business through a leveraged recapitalization. This strategy may be employed once
the firm has paid down its original debt level. The firm may borrow additional monies to repurchase stock
from other shareholders, leaving the firm with a more conventional capital structure

13.4 While most LBOs are predicated on improving operating performance through a combination of aggressive
cost cutting and revenue growth, hospital chain HCA laid out an unconventional approach which relied
heavily on revenue growth in its effort to take the firm private. On July 24, 2006, management again
announced that it would "go private" in a deal valued at $33 billion including the assumption of $11.7
billion in existing debt. Would you consider a hospital chain a good or bad candidate for an LBO? Be
specific.

Answer: Answer: Hospitals generally represent bad candidates. Hospital cash flow is heavily dependent on
government reimbursement rates which are likely to be declining in the future as the U.S. government
deficit balloons. Furthermore, hospital staffing levels are likely to increasingly subject to regulation thereby
limiting the opportunity for cost cutting. Hospitals also will be subject to increased capital spending to meet
new government standards, with the government being unable or unwilling to finance such spending on
behalf of the hospitals. The combination of these factors is likely to constrain cash flow growth.

13.5 In a move reminiscent of the blockbuster buyouts of the late 1980s, seven private investment firms acquired
100 percent of the outstanding stock of SunGard Data Systems Inc. (SunGard) in late 2005. SunGard is a
financial software firm known for providing application and transaction software services and creating
backup data systems in the event of disaster. The company‘s software manages 70 percent of the
transactions made on the Nasdaq stock exchange, but its biggest business is creating backup data systems in
case a client’s main systems are disabled by a natural disaster, blackout, or terrorist attack. Its large client
base for disaster recovery and back-up systems provides a substantial and predictable cash flow.
Furthermore, the firm had substantial amounts of largely unencumbered current assets. The deal left
SunGard with a nearly 5 to 1 debt to equity ratio. Why do you believe lenders might have been willing to
finance such a highly leveraged transaction?

Answer: The firm had substantial market share in a stable industry, disaster recovery and back-up systems,
that provides a substantial and predictable cash flow. The firm also had substantial unencumbered current
assets which could be used for collateral for short-term financing.

13.6 In an effort to take the firm private, Cox Enterprises announced on August 3, 2004 a proposal to buy the
remaining 38% of Cox Communications’ shares that they did not currently own for $32 per share. Cox
Enterprises stated that the increasingly competitive cable industry environment makes investment in the
cable industry best done through a private company structure. Why would the firm believe that increasing
future levels of investment would be best done as a private company?

Answer: Substantial levels of investment would result in increasing levels of depreciation and amortization
expense, which would erode the firm’s earnings per share and penalize the firm’s share price in the short-run
if it were a public company. Investors tend to track quarterly changes in EPS and punish firms which miss
forecasts or show year over year declines.

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13.7 Following Cox Enterprises’ announcement on August 3, 2004 of its intent to buy the remaining 38% of Cox
Communications’ shares that they did not currently own, the Cox Communications Board of Directors
formed a special committee of independent directors to consider the proposal. Why?

Answer: Special board committees consisting of outside directors often are set up when company insiders
are involved in taking the company private. This arrangement is intended to eliminate any appearance of
potential conflicts of interests.

13.8 Qwest Communications agreed to sell its slow but steadily growing yellow pages business, QwestDex, to a
consortium led by the Carlyle Group and Welsh, Carson, Anderson and Stowe for $7.1 billion in late 2002.
Why do you believe the private equity groups found the yellow pages business attractive? Explain the
following statement: “A business with high growth potential may not be a good candidate for an LBO.”

Answer: QwestDex was considered an attractive candidate because of its steadily growing, highly
predictable cash flow, strong management team, and the willingness of management to continue with the
business. The growth in the business is likely to mirror population growth in the region covered by the
business.

A high growth business is often not considered a good LBO candidate, because it will generally have high
reinvestment requirements in terms of working capital, R&D spending, and new plant and equipment. The
high reinvestment rate could inhibit the ability to pay down debt incurred to take the business private.

13.9 Describe the potential benefits and costs of LBOs to stakeholders including
shareholders, employers, lenders, customers, and communities in which the firm
undergoing the buyout may have operations. Do you believe that on average LBOs
provide a net benefit or cost to society? Explain your answer.

Answer: Target shareholders prior to the buyout clearly benefit greatly from efforts to take the company
private. However, in addition to the potential transfer of wealth from bondholders to stockholders, some
critics of LBOs argue that a wealth transfer also takes place in LBO transactions when LBO management is
able to negotiate wage and benefit concessions from current employee unions. LBOs are under greater
pressure to seek such concessions than other types of buyouts, because they need to meet huge debt service
requirements. Empirical studies suggest that employment in firms that undergo a leveraged buyout does
grow more slowly than for other firms in the same industry, at least for the first few years immediately
following the buyout. This appears to result from the more efficient use of labor and the sale of non-strategic
assets following the LBO. However, employment growth at these firms then begins to grow at about the
same pace as other firms in the industry

The tax benefits associated with LBOs represent a subsidy of the premium paid to the shareholders of the
firm subject to the buyout. However, this subsidy is offset by the taxes paid by the shareholders when they
sell their stock. If the LBO firm is actually made stronger because of the transaction, taxes paid may
actually be higher than they would have been if the transaction had not occurred. Furthermore, the eventual
sale of the LBO either to a strategic buyer or in a secondary public offering will also generate additional
taxes. It often is difficult to determine if LBOs offer a net benefit or cost to society because of so-called
“selection bias,” i.e., LBOs that are eventually taken public or sold to strategic buyers are generally those
that have succeeded in improving cash flow substantially. Consequently, studies of these firms tend to show
increases in employment, R&D spending, and taxes paid due to their increased profitability, thereby
potentially biasing upward the results.

13.10 Sony’s long-term vision has been to create synergy between its consumer electronics products business and
its music, movies, and games. On September 14, 2004, a consortium, consisting of Sony Corp of America,
Providence Equity Partners, Texas Pacific Group, and DLJ Merchant Banking Partners, agreed to acquire
MGM for $4.8 billion, consisting of $2.85 billion in cash and the assumption of $2 billion in debt. The cash
portion of the purchase price consisted of about $1.8 billion in debt and $1 billion in equity capital. Of the
equity capital, Providence contributed $450 million, Sony and Texas Pacific Group $300 million, and DLJ

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 Merchant Banking $250 million. In what way do you believe that Sony’s objectives might differ from those
of the private equity investors making up the remainder of the consortium? How might such differences
affect the management of MGM? Identify possible short-term and long-term effects.

Answer: Sony wanted to gain access to the film library to help provide content for the growth in its play
station and games product lines. However, private equity investors often want to cash out in 5-7 years or
less. This may have created short-term management disagreements as Sony may have wanted to reinvest in
the business in the form of building brand identification, new movie content, and new distribution channels.
In the long-run, MGM would have to either sell to another strategic investor or engage in a secondary public
offering to allow the private equity investors to cash out.

Solutions to Chapter Case Study Questions

Abbott Labs Suffers Credit Downgrade in Wake of Takeover of St. Jude's Medical

Discussion Questions and Answers:

1. What is the form of payment and form of acquisition used in this transaction? Speculate as to why they
were these chosen?

Answer: The form of payment was a combination of cash and stock. Abbott could not easily finance an
entirely cash transaction so some portion of the payment was offered in stock. From St. Jude's shareholders
viewpoint, receiving cash enables them to pay taxes on any tax liability they may have and the Abbott
shares enable them to participate in any future share appreciation. The form of acquisition is a purchase of
stock. That was used because all rights and intellectual property transfer with the shares to Abbott ensuring
that Abbott would have rights to such valuable property in this knowledge based business.

2. What are positive (or affirmation) and negative covenants? How can such covenants affect Abbott's future
investment decisions? Be specific.

Answer: Loan covenants are commitments made by borrowers to lenders. They can take many forms and
often are expressed as maximum debt to equity or debt to total capital ratios. They can also affect the
amount and timing of dividends paid and capital outlays as well as minimum working capital levels and
retention of key employees. Once broken, the lender can demand immediate repayment of outstanding
loans, although often lenders allow for a grace period during which the borrower can remedy the breach.
Positive or affirmative covenants require a borrower to undertake certain actions such as providing audited
financial performance reports in accordance with GAAP, compliance with the law, and maintaining a
specific credit rating. Negative covenants are those that prohibit borrowers from doing certain things.
Common examples include limitations on the amount of new borrowing that can be undertaken and that the
borrower must not violate a minimum interest coverage ratio. Covenants can limit the ability of Abbott to
pursue what it believes are attractive future investment opportunities by prohibiting additional borrowing to
finance new spending.

3. The deal is taxable to St. Jude shareholders to the extent that they realize a gain. The reason is that the
reverse triangular merger structure used in this instance does not qualify as a tax free merger. Why?

Answer: For the reverse triangular merger to be tax free, at least 80% of the payment to St. Jude
shareholders must consist of Abbott stock. In fact, about 42% of the payment is in Abbott stock; and, as
such, the deal does not qualify as tax free.

4. What is a bridge loan? What does it mean that they were unsecured? The terms of these bridge loans were
to automatically terminate no later than July 27, 2017, at which point Abbott was to have its permanent
long-term financing in place. What is "permanent financing?" Explain your answer.

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 Answer: Bridge loans are short duration loans granted to bridge the gap between when funds are needed but
not available. They are granted until the borrower is able to secure longer-term or permanent financing or
withdraws from the loan facility. The loans are usually no longer than one year and usually backed by
collateral such as inventory, receivables or real estate for smaller firms. Abbott's size, the amount of
business it had done with its lenders, and reputation enabled them to negotiate unsecured (lacking collateral)
bridge loans. Permanent financing refers to the debt issued to replace bridge loans and other forms of short term
financing and are usually long-term in nature. This financing is undertaken to avoid having to refinance debt
at potentially higher interest rates.

5. The merger is characterized as a reverse triangular merger. Speculate as to why this structure may have
been chosen? Explain your answer.

Answer: The reverse triangular merger may have been chosen as it eliminates the need for parent firm
shareholder approval, because the parent is the sole shareholder in the merger sub. Since the target firm
survives, the target can retain any nonassignable franchise, lease, or other contract rights. By not dissolving
the target, the acquirer avoids accelerating 1 the repayment of loans outstanding.

6. Abbott could have directly merged with St. Jude. Why was a wholly-owned merger sub created by Abbott to
own St. Jude's assets and liabilities instead? Explain your answer.

Answer: By holding St. Jude as a wholly owned subsidiary, Abbott is limiting its exposure to any significant
liabilities such as the failure of one of the firm's medical devices. The dollar cost any such liabilities are
limited to the extent of Abbott's investment in St. Jude.

Examination Questions and Answers

True/False Questions: Answer true or false to the following questions:

1. Leveraged buyout firms use the unencumbered assets and operating cash flow of the target firm to finance
the transaction. True or False
Answer: True

2. Accounts receivable represent an undesirable form of collateral from the lender’s point of view because they
are often illiquid. True or False
Answer: False

3. Because of their high liquidity, lenders often lend up to 100% of the book value of accounts receivable
pledged as collateral in leveraged buyouts. True or False
Answer: False

4. A negative loan covenant is a portion of a loan agreement that specifies the actions the borrowing firm
agrees to take during the term of the loan. True or False
Answer: False

5. Loan agreements commonly have cross-default provisions allowing a lender to collect its loan immediately
if the borrower is in default on a loan to another lender. True or False
Answer: True

6. Junk bonds are high-yield bonds either rated by the credit-rating agencies as below investment grade or not
rated at all. True or False
Answer: True

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Loan agreements often require the repayment of loans if a change of control of the borrower takes place.

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7. According to fraudulent conveyance laws, if a new company is found by the court to have been inadequately
capitalized to remain viable, the lender could be stripped of its secured position in the assets of the company
or its claims on the assets could be made subordinate to those of the general creditors. True or False
Answer: True

8. Typical LBO targets are in mature industries such as manufacturing, retailing, textiles, food processing,
apparel, and soft drinks. True or False
Answer: True

9. High growth firms with high reinvestment requirements often make attractive LBO targets. True or False
Answer: False

10. Premiums paid to LBO target firm shareholders often exceed 40%. True or False
Answer: True

11. The high premiums paid to LBO target shareholders reflect the tax benefits associated with the high
leverage of such transactions and the improved operating efficiency following the completion of the buyout
resulting from management incentive plans and the discipline imposed by the need to repay debt. True or
False
Answer: True

12. Investors in highly leveraged transactions who are primarily focused on relatively short-to-intermediate term
financial returns are often called financial buyers. True or False
Answer: True

13. When a public company is subject to a leveraged buyout, it is said to be “going private.” True or False
Answer: True

14. A leveraged buyout initiated by a firm’s management is called a management buyout. True or False
Answer: True

15. Financial buyers usually hold onto their investments for at least 15-20 years. True or False
Answer: False

16. Investors in LBOs are frequently referred to as financial buyers, because they are primarily focused on
relatively short-to-intermediate-term financial returns. True or False
Answer: True

17. LBO capital structures are often very complex, consisting of bank debt, subordinated unsecured debt,
preferred stock, and common equity. True or False
Answer: True

18. LBO investors seldom sell assets to repay debt used to acquire the firm. True or False
Answer: False

19. LBO investors often use public offerings of the firm’s stock or sell the firm to a strategic buyer in order to
exit the business. True or False
Answer: True

20. LBO investors will often use the target firm’s cash in excess of normal working capital requirements to
finance the transaction. True or False
Answer: True

21. Asset based lending does not require the borrower to pledge assets as collateral underlying the loans. True
or False
Answer: False

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22. The loan agreement stipulates the terms and conditions under which the lender will loan the borrower funds.
True or False
Answer: True

23. A single asset is often used to collateralize loans from different lenders in LBO transactions. True or False
Answer: False

24. Asset based lenders will usually lend up to 100% if the book value of the LBO target’s receivables. True or
False
Answer: False

25. Cash flow lenders view the borrower’s future cash flow generation capability as the primary means of
recovering a loan, while largely ignoring the assets of the LBO target. True or False
Answer: False

26. Junk bonds have invariably proved to be a reliable source of low-cost financing in LBO transactions during
the last 30 years. True or False
Answer: False

27. Fraudulent conveyance laws are intended to prevent shareholders, secured creditors, and others from
benefiting at the expense of unsecured creditors. True or False
Answer: True

28. To avoid being subject to fraudulent conveyance laws, a properly structured LBO should have a balance
sheet that clearly indicates solvency at the time of closing. True or False
Answer: True

29. The risk associated with overpaying is magnified for leveraged buyout transactions. True or False
Answer: True

30. Under-performing operating units of large companies are often excellent candidates for LBOs. True or
False
Answer: True

31. Junk bonds are always high risk. True or False

Answer: False

32. Firms with redundant assets and predictable cash flow are often good candidates for leveraged buyouts.
True or False
Answer: True

33. Common exit strategies for LBOs include sale to a strategic buyer, an IPO, a leveraged recapitalization, or a
sale to another buyout firm. True or False
Answer:
True

34. Divisions of larger companies are generally poor candidates for successful leveraged buyouts. True or False
Answer: False

35. Financial buyers usually plan to hold onto acquired firms longer than strategic buyers. True or False
Answer: False

36. Borrowers often seek revolving lines of credit that they can draw upon on a daily basis to run their business.
True or False
Answer: True

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37. A term loan usually has a maturity of less than one year. True or False
Answer: False

38. The loan agreement stipulates the terms and conditions under which the lender will loan the firm funds.
True or False
Answer: True

39. An affirmative covenant is a portion of a loan agreement that specifies the actions the borrowing firm cannot
take during the term of the loan. True or False
Answer: False

40. Borrowers often prefer term loans because they do not have to be concerned that these loans will have to be
renewed. True or False
Answer: True

41. LBOs can be of an entire company or divisions of a company . True or False

Answer: True

42. When a public company is subject to an LBO, it is said to be going private, because more than 50% of the
equity of the firm has been purchased by a small group of investors and is no longer publicly traded. True
or False
Answer: False

43. The LBO that is initiated by the target firm’s incumbent management is called a management buyout. True
or False
Answer: True

44. LBO firms seldom purchase a firm to use as a platform to undertake other leveraged buyouts in the same
industry. True or False
Answer: False

45. A common technique used during the 1990s was to wait for favorable periods in the stock market to sell a
portion of the LBO’s equity to the public. The proceeds of the issue would be used to repay debt, thereby
reducing the LBO’s financial risk. True or False
Answer: True

46. LBO investors have become much more actively involved in managing target firms in recent years than they
have in the past. True or False
Answer: True

47. There is some evidence that the Sarbanes-Oxley Act of 2002 has also been a factor in some firms going
private as a result of the onerous reporting requirements of the bill. True or False
Answer: True

48. The growth in LBO activity is not simply a U.S. phenomenon. Western Europe has seen a veritable
explosion in private equity investors taking companies private, reflecting ongoing liberalization in the
European Union as well as cheap financing and industry consolidation. True or False
Answer: True

49. The promissory note commits the borrower to repay the loan, only if the assets when liquidated fully cover
the unpaid balance. True or False
Answer: False

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50. If the borrower defaults on the loan or otherwise fails to honor the terms of the agreement, the lender can
seize and sell the collateral to recover the value of the loan only if the borrower agrees that it is unlikely that
the loan will be repaid. True or False
Answer: False

51. Because term loans are negotiated privately between the borrower and the lender, they are much more
expensive than the costs associated with floating a public debt or stock issue. True or False
Answer: False

52. Limitations the lender imposes on the borrower on the amount of dividends that can be paid, the level of
salaries and bonuses that may be given to the borrower’s employees, the total amount of indebtedness that
can be assumed by the borrower, and investments in plant and equipment and acquisitions are called
affirmative covenants. True or False
Answer: False

53. Secured debt often is referred to as mezzanine financing. True or False

Answer: False

54. Bridge financing is usually expected to be replaced within two years after the closing date of the LBO
transaction. True or False
Answer: False

55. Debt issues not secured by specific assets are called debentures. True or False
Answer: True

56. An indenture is a contract between the firm that issues the long-term debt securities and the lenders. True or
False
Answer: True

57. Preferred stock often is issued in LBO transactions, because it provides investors a fixed income security,
which has a claim that is junior to common stock in the event of liquidation. True or False
Answer: False

58. The acquirer often is asked for a commitment letter from a lender, which commits the lender to providing
financing for the transaction. True or False
Answer: True

59. If the LBO is structured as a direct merger in which the seller receives cash for stock, the lender will make
the loan to the buyer once the appropriate security agreements are in place and the target’s stock has been
pledged against the loan. The target then is merged into the acquiring company, which is the surviving
corporation. True or False
Answer: True

60. LBOs may be consummated by establishing a new subsidiary that merges with the target. This may be done
to avoid any negative impact that the new company might have on existing customer or creditor
relationships. True or False
Answer: True

61. Management buyouts without a financial equity contributor are relatively rare. True or False
Answer: True

62. LBO exit strategies involving selling to a strategic buyer usually result in the best price as the buyer may be
able to generate significant synergies by combining the firm with its existing business. True or False
Answer: True

63. LBOs normally involve public companies going private. True or False

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 Answer: False

64. Most highly leveraged transactions consist of acquisitions of private rather public firms. True or False
Answer: True

65. Private equity investments are normally focused on the manufacturing industry. True or False
Answer: False

Multiple Choice Questions: Circle only one of the alternatives for each of the following questions:

1. Which of the following is generally not true about leveraged buyouts?

a. Borrowed funds are used to pay for all or most of the purchase price, perhaps as much as 90%
b. Tangible assets of the target firm are often used as collateral for loans.
c. Bank loans are often secured by the target firm’s intangible assets
d. Secured debt is often referred to as junk bond financing.
e. C and D only
Answer: C

2. Asset based lending is commonly used to finance leveraged buyouts. Which of the following is not true
about such financing?
a. The borrower generally pledges tangible assets as collateral.
b. Lenders look at the target firm’s assets as their primary protection.
c. Bank loans are secured frequently by receivables and inventory.
d. Loans maturing in more than one year are often referred to as term loans.
e. The target firm’s most liquid assets generally secure longer-term loans.
Answer: E

3. Security provisions and protective covenants are included in loan documents to increase the likelihood that
the interest and principal of outstanding loans will be repaid in a timely fashion. Which of the following is
not true about security provisions and protective covenants?
a. Security features include the assignment of payments due under a specific contract to the lender.
b. Negative covenants include limits on the amount of dividends that might be paid
c. Limitations on the amount of working capital that the borrower can maintain.
d. Periodically, financial statements must be sent to lenders.
e. Automatic loan repayment acceleration if the borrower is in default on any loans outstanding
Answer: C

4. Which of the following is not true about junk bonds?

a. Junk bonds are either unrated or rated below investment grade by the credit rating agencies
b. Typically yield about 1-2 percentage points below yields on U.S. Treasury debt of comparable
maturities.
c. Junk bonds are commonly used source of “permanent” financing in LBO transactions
d. During recessions, junk bond default rates often exceed 10%
e. Junk bond default risk on non-investment grade bonds tends to increase the longer the elapsed time
since the original issue date of the bonds
Answer: B

5. Which of the following characteristics of a firm would limit the firm’s attractiveness as a potential LBO
candidate?
a. Substantial tangible assets
b. High reinvestment requirements
c. High R&D requirements
d. B and C
e. All of the above
Answer: D

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6. Premiums paid to LBO firm shareholders average
a. 20%
b. 70%
c. 5%
d. Less than typical mergers
e. More than typical mergers
Answer: E

7. Factors that are most likely to contribute to the magnitude of premiums paid to LBO target firm
shareholders are
a. Tax benefits
b. Improved operating efficiency
c. Improved decision making
d. A, B, and C
e. A and C only
Answer: D

8. Which of the following is not true about attractive LBO candidates?

a. Most assets tend to be encumbered
b. Have low leverage
c. Have predictable cash flow
d. Have assets that are not critical to the ongoing operation of the firm
e. Are in mature, moderately growing industries
Answer: A

9. Which of the following is generally not considered a characteristic of a financial buyer?

a. Focus on short-to-intermediate returns
b. Concentrate on actions that enhance the ability of target firm’s ability to generate cash flow to
satisfy debt service requirements
c. Intend to own the business for very long periods of time
d. Manage the business to maximize return to equity investors
e. All of the above
Answer: C

10. Which of the following are commonly used sources of funding for leveraged buyouts?
a. Secured debt
b. Unsecured debt
c. Preferred stock
d. Seller financing
e. All of the above
Answer: E

11. Fraudulent conveyance is best described by which of the following situations:

a. A new company spun off by its parent to the parent’s shareholders that enters bankruptcy is found
to have been substantially undercapitalized when created
b. An acquiring company pays too high a price for a target firm
c. A company takes on too much debt
d. A leveraged buyout is taken public when its operating cash flows are increasing
e. None of the above
Answer: A

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12. LBO investors must be very careful not to overpay for a target firm because
a. Major competitors tend to become more aggressive when a firm takes on large amounts of debt
b. High leverage increases the break-even point of the firm
c. Projected cash flows are often subject to significant error limiting the ability of the firm to repay its
debt
d. A and B only
e. A, B, and C
Answer: E

13. LBOs often exhibit very high financial returns during the years following their creation. Which of the
following best describes why this might occur?
a. LBOs invariably improve the firm’s operating efficiency
b. LBOs tend to increase investment in plant and equipment
c. The only LBOs that are taken public are those that have been the most successful
d. LBOs experience improved decision making during the post-buyout period
e. None of the above
Answer: C

14. Which of the following is not typically true of LBOs?

a. Managers are generally also owners
b. Most employees are given the opportunity to participate in profit sharing plans
c. The focus tends to be on improving operational efficiency though cost cutting and improving
productivity
d. R&D budgets following the creation of the LBO are always increased significantly
e. All of the above
Answer: D

15. Which of the following tends to be true of LBOs

a. LBOs rely heavily on management incentives to improve operating performance
b. The premium paid to target firm shareholders often exceeds 40%
c. Tax benefits are predictable and are built into the purchase price premium
d. The cost of equity is likely to change as the LBO repays debt
e. All of the above
Answer: E

16. An investor group acquired all of the publicly traded shares of a firm. Once acquired, such shares would no
longer trade publicly. Which of the following terms best describes this situation?
a. Merger
b. Going private transaction
c. Consolidation
d. Tender offer
e. Joint venture
Answer: B

12
17. The management team of a privately held firm found a lender who would lend them 90 percent of the
purchase price of the firm if they pledged the firm’s assets as well as their personal assets as collateral for
the loan. This purchase would best be described by which of the following terms?
a. Merger
b. Leveraged buyout
c. Joint venture
d. Tender offer
e. Consolidation
Answer: B

Case Study Short Essay Examination Questions

The Legacy of Leverage, Bad Assumptions and Poor Timing:

The Largest LBO in U.S. History Goes Bankrupt
________________________________________________________________________________
Key Points:
 Leverage offers the prospect of outsized financial returns for investors
 However, excessively leveraged firms often have little margin for error
 If key assumptions underlying the deal are unrealistic, the only alternative may be bankruptcy
 Chapter 11 reorganization can be protracted
______________________________________________________________________________

Energy Future Holdings Corporation emerged from bankruptcy in late 2016 bringing to a close a deal based on
excessive optimism, poor timing and unrealistic assumptions. What follows is a discussion of why the LBO seemed
attractive, the deal’s complex legal and financial structure, factors that ultimately pushed the firm into bankruptcy,
and how the firm was ultimately reorganized.

Amid great fanfare, a consortium of storied investor groups along with highly sophisticated lenders took Texas
based electric utility holding company TXU private on October 7, 2007. Immediately following closing, TXU Corp
was renamed Energy Future Holdings (EFH). EFH consisted on two subsidiaries: Oncor, a business that sells
electricity in wholesale markets to other utilities and big businesses, and Texas Competitive Electric Holdings
(TCEH), which holds TXU’s public utility operating assets and liabilities. The latter firm is the one that ultimately
filed for bankruptcy.

Valued at $48 billion, the leverage buyout consisted of $40 billion in debt and $8 million in equity provided by
the private equity consortium, subsequently referred to as the financial sponsor. The deal was fueled by record low
borrowing rates and the belief that natural gas prices which had been trending lower would turn around, dramatically
improving EFH’s profit and cash flow. While things looked rosy at the closing, the underpinnings of what was to be
the nation’s largest bankruptcy of a nonfinancial firm already were underway.

The U.S went into recession in December 2007 and did not emerge until June 2009 according to the National
Bureau of Economic Research, the widely recognized organization that defines such things. The recession reduced
the demand for electricity and forced natural gas prices lower. While the recession clearly exacerbated the situation,
much of the damage done to EFH was self-inflicted by the complex financial engineering used to finance the deal
and by the byzantine legal structure created to limit investors’ exposure to potential liabilities. These factors made it
increasingly difficult for the firm to meet its scheduled debt service payments and ultimately to reorganize in
bankruptcy.

Since the 2007 closing, equity investors who put $8 billion into the deal have seen their positions wiped out and
bond holders have experienced large losses. By early 2014, those who bought the firm’s $40 billion in debt saw its
market value plunge to as low as 20 to 30 cents on the dollar. The firm struggled for years to remain afloat,
renegotiating the terms of its loans with creditors. However, the $20 billion loan repayment due in 2014 proved the

13
downfall of the firm. Unable to meet its commitments and with lenders running out of patience, the firm sought the
protection of Chapter 11 of the U.S. Bankruptcy Court in late spring of 2014.

Chapter 11 gives the debtor the exclusive right to formulate a reorganization plan which if acceptable to the court
and lenders enables the firm to emerge from bankruptcy. The firm has one year to submit a plan for emerging from
bankruptcy to the court and can get a six month extension if permitted by the court. At the end of this time, so-called
creditor committees representing secured and unsecured debt and equity groups can submit their own plans. Such
plans can range from the debtors swapping what they are owed for an equity stake in the business to forgiveness of
much of the debt (or at least repayment on more lenient terms) to outright liquidation of the firm with the proceeds
used to pay its obligations.

How could investors with sterling reputations and sophisticated lenders make such a big mistake? Simply saying
it was due to greed would be overly simplistic. The investors and lenders participating in this deal were at some level
victims of their own earlier success. Private equity firms seek unusually high returns on the equity they put into
projects by borrowing as much as they feel can be managed. And given Federal Reserve policies that pushed interest
rates to historical lows, LBO financial sponsors were encouraged to take on much more debt than would have been
considered prudent had interest rates been higher. Investors and lenders were piling into LBO deals in 2007 in a
search for higher financial returns. The prior successes of the LBO sponsors lent credibility to the deals they put
together. The conditions were ripe for the addictive effects of over-optimism and cheap money to create a mega deal
whose success was dependent on literally everything going according to plan.

A private equity consortium consisting of Kohlberg Kravis Roberts & Co, Texas Pacific Group, and Goldman
Sachs (the financial sponsor group) considered TXU an attractive investment because it was the biggest utility in the
fast growing Texas electricity market and the only one in the state that had not been broken up as a result of the
state’s deregulation of its electricity market. The key assumption underlying the deal was that natural gas prices
would go up in line with the global price of oil as they had done for years. Electricity rates in Texas were pegged by
regulators to natural gas prices, but since TXU generated most of its electricity with less-expensive coal and uranium
for nuclear plants, it stood to profit from higher electricity rates. Instead natural gas prices plunged as hydraulic
fracturing of shale rock unleashed a glut in the U.S., pushing down natural gas prices and in turn electricity rates.

Wall Street banks were similarly enamored with the proposed deal to take TXU private. They were competing in
2007 to make loans to buyout firms on easier terms, with the banks also investing their own funds in the deal. The
allure to the banks was the prospect of dividing up as much as $1.1 billion in fees for originating the loans,
repackaging such loans into pools called collateralized loan obligations, and reselling them to long-term investors
such as pension funds and insurance companies. In doing so, the loans would be removed from the banks’ balance
sheets, eliminating potential losses that could arise if the deal soured at a later date. Furthermore, the deal appeared
to be attractive as an investment opportunity as some banks put up $500 million of their own cash for a stake in the
TXU.

Despite the sophistication of the sponsor group and lenders in this deal success was to be elusive. In fact, hubris
seems to have clouded what previously had been sound economic reasoning. No one seems to have taken into
account the potential for a recession and a further decline in natural gas prices. Both of these factors were beyond the
control of those involved in the deal and both occurred to doom the deal.

The financial sponsor group created a shell corporation referred to as Merger Sub Parent and its wholly-owned
subsidiary Merger Sub. TXU was merged into Merger Sub, with Merger Sub surviving. Each outstanding share of
TXU common stock was converted into the right to receive $69.25 in cash. Total cash required for the purchase was
provided by the financial sponsor group and lenders (Creditor Group) to the Merger Sub. See Figure 13.3.

14
 Merger Sub
Parent TXU
(Sponsor
Group)

Merger Sub
. Stock Cash

Lenders
(Creditor Merger Sub Cash TXU Public
Group) Cash Shareholders

TXU Stock
Figure 13.3 Forward Triangular Cash Merger

Subsequent to closing, Merger Sub was reorganized into a new holding company, controlled by the
Financial Sponsor Group and renamed Energy Future Holdings (EFH). EFH consisted of two subsidiaries: a
regulated business, Oncor, and an unregulated business, Texas Competitive Electric Holdings (TCEH). All TXU
non-Sponsor Group related debt incurred to finance the transaction is held by EFH. See Figure 13.4.

Energy Future Holdings –

EFH (Formerly Merger
Sub)

Oncor Texas Competitive

Electric Holdings-TCEH

Figure 13.4 Post Merger Organization

The firm faced an untenable financial position by 2014. Absent a turnaround in natural gas prices, EFH had to
find a way to substantially reduce the burden of the pending 2014 $20 billion loan payment with its lenders through a
debt for equity swap, more favorable terms on existing debt, or by pursuing Chapter 11 bankruptcy. In December
2012 in an effort to extend debt maturities to buy time for a turnaround and to reduce interest expense, EFH
exchanged $1.15 billion of new payment-in-kind notes (interest is paid with more debt) for existing notes with a face
value of $1.6 billion. However, despite this limited debt restructuring, the firm was still in violation of loan
covenants on existing debt. 2
EFH’s ability to reduce its leverage was further weakened as the private equity sponsors siphoned off $560
million in advisory and monitoring fees since the buyout’s inception in late 2007. With no-where to turn and the $20
billion loan payment looming, EFH had run out of options. On April 29, 2014, EFH entered into Chapter 11
bankruptcy. Its initial reorganization plan was to hand control of the firm’s operations to its lenders. Creditors

2
Loan covenants limit EFH’s and its subsidiaries’ ability to incur additional indebtedness or issue preferred stock;
pay dividends on, repurchase or make distributions of capital stock or make other restricted payments; make
investments; sell or transfer assets; consolidate, merge, sell or dispose of all or substantially all its assets; and repay,
repurchase or modify debt. A breach of any of these covenants could result in an event of default.

15
objected to various aspects of the plan. A sticking point with creditors was how to value the unregulated subsidiary
for tax purposes. Under the terms of the proposed deal, the lenders would forgive debt for ownership of the
unregulated subsidiary (TCEH) through a debt for equity swap with bondholders and a subsequent tax free spin off to
avoid a huge tax bill for EFH. EFH bondholders owed $1.7 billion were set to take control of the regulated Oncor
unit.
The bankruptcy court judge extended the company’s exclusive right to solicit acceptances to its reorganization
plan on October 29, 2014 to December 29, 2015. The extension represents the maximum exclusivity extension
available under the U.S. Bankruptcy Code, which limits plan filing exclusivity to the debtor to 18 months and vote
solicitation to 20 months. During this period no other creditor or investor can develop its own reorganization plan for
EFH and solicit others to vote for their plan. Arguing that EFH’s plan had no creditor support, the committee
representing unsecured creditors of EFH, Texas Competitive Electric Holdings (TCEH), as well as TCEH first lien
holders, objected to no avail to the length of the firm’s exclusivity extension. They argued for much shorter
extensions ranging from two weeks to two months.

In an effort to gain support for its reorganization plan, EFH called off the bankruptcy auction of its 80% stake in
Oncor on June 26, 2015 and proceeded to promote the spin-off of Oncor in a tax free transaction. EFH would leave
$805 million in cash to pay TCEH secured creditors. The bankruptcy court judge approved the firm's reorganization
plan on December 3, 2015. The tax free spin off of Oncor was completed on October 4, 2016 paving the way for
emergence from Chapter 11, almost two and one-half years after the firm had sought court protection.

What can be learned from this investment debacle? Investors often are seduced by the potential for eye-popping
financial returns made possible by the use of leverage: other people’s money. However, it is easy to overlook the
dark side of leverage. If everything doesn’t go according to plan, as is often the case, the inability to satisfy debt
service requirements can force the firm into default and subsequent bankruptcy. The financial sponsor group and the
lenders involved in taking TXU private were well aware of this potential outcome but were confident that history
would repeat itself: natural gas prices would rise significantly, which as we know did not happen. Also, the
exceedingly low cost of borrowing made possible by the Federal Reserve coaxed borrowers to take on more debt than
would have been prudent at higher rates of interest. All these factors combined to set the stage for the largest
bankruptcy of a nonfinancial firm in U.S. history.

Discussion Questions and Answers:

1. This chapter identifies a number of ways in which LBOs can create value for their investors. The
financial sponsor group was relying on which of the sources of value creation identified in this chapter.
Be specific. In your opinion, were the financial sponsors placing too great a bet on factors that were
beyond their control? Explain your answer.

Answer: For public firms, LBOs create value by reducing underperformance related to agency conflicts
between management and shareholders; for private firms, LBOs improve access to capital. For both
public and private firms, LBOs create value by temporarily shielding the firm from taxes, reducing
debt, improving operating performance, and timing properly the sale of the business. In the case of the
TXU LBO, investors seem to focus on the use of complex financial engineering to create a highly
leveraged firm which under the right circumstances offered spectacular returns. Little seems to have
been done to improve the firm’s performance. In focusing on boosting financial returns through
leverage, the financial sponsor group seemed to focus primarily on those factors over which they had
little control. That is, they bet on natural gas prices rising sharply to boost EFH’s profitability and cash
flow and that in turn would enable them to exit the business in a few years via an IPO or selling to
strategic investors. The proceeds would have been used to pay off existing debt with the remainder
returned to shareholders. They also felt confident the economy would continue to grow enabling them
to exit the business during a rising stock market. The deal was structured to have a $20 billion balloon
payment in early 2014 on the assumption that they could exit the business long before the balloon
payment had to be made. The reliance of factors largely beyond their control made this deal more
dependent on luck than skill.

16
 2. How does the postclosing holding company structure protect the interests of the financial sponsor group
and the utility’s customers but potentially jeopardize creditor interests in the event of bankruptcy?

Answer: A holding company structure was used for two reasons: (1) to limit the risks to the financial
and creditor groups to potential liabilities and (2) to satisfy the requirement by Texas public utility
regulators to insulate the public utility from the additional debt service requirements created by the debt
incurred to finance the LBO. The structure effectively concentrates debt in EFH and TH, while
separating the cash producing assets in other legal entities (i.e., Oncor and Texas Competitive Electric
Holdings). Consequently, EFH and TH could be put into Chapter 11 if need be, while limiting creditor
access to Oncor’s and Texas Competitive Electric Holdings’ assets.

The use of a subsidiary merger to transfer ownership from the TXU public shareholders to the
Sponsor Group was undertaken to avoid any negative impact on any existing relationships that the
Sponsor Group had with creditors. For example, the existence of cross-default clauses could trigger
demands by multiple lenders for immediate repayment of loans if a single loan went into default.
Furthermore, if any parent assets were used as collateral to assist the subsidiary in financing the
transaction both the parent and the subsidiary could be viewed as having a security interest or implied
guarantee in the debt. As such, they could be held jointly and severally liable in the event of default. To
avoid this possibility, the parent made a capital or cash contribution to the subsidiary rather than
provide collateral or a loan guarantee. Furthermore, any parent loans to the subsidiary would have
added to its leverage.

Moreover, by isolating the liabilities within the subsidiaries of their respective parents, an individual
subsidiary can be taken through bankruptcy in the event of financial distress without endangering other
operations owned by the parent. Finally, the Texas utility regulators wanted to separate the TXU’s
public utility operations from the obligation to pay the interest and principal on the additional debt that
was incurred by the Sponsor Group and the Creditor Group as a condition of receiving regulatory
approval and required that this debt be carried on TH’s and EFH’s balance sheets. As such, servicing
this debt would come from cash flows generated by the holding companies from dividends they receive
from their operating subsidiaries. While unsecured intercompany loans also represent another means of
transferring cash between the subsidiary and the parent, the parent would be liable for the repayment of
such loans in the event of the subsidiary entering bankruptcy. In doing so, the regulators were
attempting to protect the interests of TXU customers and other stakeholders.

3. What was the purpose of the pre-closing covenants and closing conditions as described in the merger
agreement?

Answer: The purpose of the covenants is to ensure that the target firm will operate its business between
the signing of the agreement and closing in a manner acceptable to the buyer. Also, it gives the buyer a
limited amount of control over actions the seller may wish to take that the buyer views as inappropriate.
Closing conditions give the buyer and seller an opportunity to exit the agreement of purchase and sale if
certain events considered critical to the viability of the transaction do not occur.

4. Loan covenants exist to protect the lender. How might such covenants inhibit the EFH from meeting its
2014 $20 billion obligations?

Answer: The loan covenants limit EFH’s ability to issue new equity, preferred stock, or to take on new
debt without the permission of the lender. Moreover, efforts to sell assets to raise funds to repay loans
are made more complicated if such assets already serve as collateral for existing loans outstanding.

INFORMATICA GOES PRIVATE TO IMPLEMENT

AN AGGRESSIVE SPENDING PROGRAM

Key Points

17
  Firms hoping to spur growth through new capital investments and takeovers often find it difficult to do so as
a public firm due to investor impatience
 One option is to take the firm private
 LBOs undertaken following the 2008 recession have tended to be more conservatively financed than those
prior to 2008
_____________________________________________________________________________________
The realization of sustained earnings growth often requires a sizable initial investment. Investments in software and
other intellectual property must be expensed according to Generally Accepted Accounting Principles resulting in an
immediate reduction in earnings. While certain types of investments can be capitalized and depreciated or amortized
over their useful lives, such spending can depress near term earnings. Similarly, acquisitions made to jump start
growth often have a short-term negative impact on earnings as firms write off acquisition related expenses and incur
substantial post acquisition integration costs.

Firms with successful track records in achieving revenue and earnings growth goals such as Facebook, Google,
and [Link] often are able to convince investors to be patient following a major investment. However, firms
with poor track records can get hammered by investors immediately following the announcement of an aggressive
investment program. What options are available for such firms?

One alternative is to take the firm private by consolidating ownership among a few investors patient enough to
allow the firm to realize promised returns. This public to private leveraged buyout (LBO) requires an investor group
or financial sponsor (sometimes involving a firm’s management) using a combination of equity and borrowed funds
to acquire publicly held shares. 3 This is exactly what data integrator Informatica did. On August 6, 2015, the firm’s
shares were removed from the NASDAQ, retiring the INFA ticker symbol, following the completion of its
acquisition by private equity investors Permira and Canada Pension Plan Investment Board. The newly private firm
also has several strategic investors: Microsoft and Salesforce Ventures, the investment arm of [Link]. The
LBO was the biggest of 2015. Public investors received $48.75 per share held.

Informatica, once a high flying stock, offers enterprise wide data integration and management software enabling
firms to analyze masses of data stored in offsite servers often referred to as the “cloud.” Data integration is the use of
technical and business processes to combine data from disparate sources into useful information. The firm claims to
have more than 5800 enterprise wide customers.

In 1999, the firm displayed a meteoric price to earnings ratio common among internet firms during the dotcom
bubble enabling the firm to reach a multibillion dollar valuation. However, the firm’s valuation collapsed when the
speculative bubble burst in 2000. It would be years before the firm would again be able to reach its pre-2000
valuation.

Like competitor Tibco, Informatica had seen its revenue growth slow due to market maturation after seeing its
stock soar and then crater. Both firms have since seen their valuations grow to multibillion dollar levels, but it has
taken years to get back to where they were before the dotcom debacle. Tibco was taken private in December 2014 for
$4.3 billion.

In explaining why the firm went private, Informatica announced its intention to “grow into a multi-billion dollar
leader in all things data.” As a private company, with a long view measured in years, not quarters, the firm reasoned
that it will have more flexibility and more time to implement a transformative business model based in part on a
string of strategic acquisitions.

Informatica had undertaken an auction process to sell itself in early 2015 attracting a range of bidders including
Silver Lake Partners and Hellman & Friedman. The sale was marred by litigation initiated by shareholders alleging
improprieties during the sale process. The rationale for including Microsoft and Salesforce Ventures was their prior
partnership relationships with Informatica. Informatica has been working with [Link] for years and utilizes
Microsoft’s cloud services.

3
While public to private LBOs get the most publicity because of their size and visibility, most LBOs involve the
leveraging of private firms. The reasons for this are discussed in detail later in this chapter.

18
 Under private ownership, Informatica will continue to focus on its main product areas, including cloud services,
data security and “big data” analysis. But the company, with the support of its new backers, will also search for
potential takeover targets as part of an effort to be a consolidator in the fragmented data integration industry. The
new owners will be able to provide financing for future takeovers.

Financing for the Informatica LBO consisted of $650,000,000 of 7.125% senior notes due in 2023. The notes are,
fully and unconditionally guaranteed, joint and severally, on a senior unsecured basis by each of the Company’s
subsidiaries and parent entities. The firm also entered into new credit facilities (lending arrangements) with a
syndicate (group) of financial institutions led by Bank of America, N.A. The new credit facilities consisted of a
$1,710 million dollar term or multiyear loan and a €250 million euro term loan, each maturing August 6, 2022, and a
$150.0 million revolving facility (short term line of credit) that matures August 6, 2020. The revolving loan facility
is intended to satisfy short term financing requirements for the firm. The lenders have first priority on the proceeds of
any liquidation of the firm in the event it defaults on its loans. Unlike extraordinarily highly leveraged LBOs of the
2004 to 2007 period, the Informatica capitalization is comparatively conservative with debt comprising about one-
half of total capital (debt plus equity).

Berkshire Hathaway and 3G Buy American Food Icon Heinz

______________________________________________________________________________

Case Study Objectives: To illustrate

 Form of payment, form of acquisition, acquisition vehicle, and post-closing organizations and

 How complex leveraged buyout structures are organized and financed.

______________________________________________________________________________
In a departure from its traditional deal making strategy, Berkshire Hathaway (Berkshire), the giant conglomerate run
by Warren Buffett, announced on February 14, 2013 that it would buy food giant H.J. Heinz (Heinz) for $23 billion
or $72.50 per share in cash. Including assumed debt, the deal is valued at $28 billion. Traditionally, Berkshire had
shown a preference for buying entire firms with established brands and then allowing then allowing them to operate
as they had been. Investors greeted the news enthusiastically boosting Heinz’s stock price by nearly 20% to the offer
price and Berkshire’s class A common stock price by nearly one percent to $148,691 a share.

Unlike prior transactions, Berkshire teamed with 3G Capital Management (3G), a Brazilian-backed investment
firm that owns a majority stake in Burger King, a company whose business is complementary to Heinz, and interests
in other food and beverage companies. Heinz’s headquarters will remain in Pittsburgh, its home for more than 120
years. The major attraction to Berkshire is the extremely well known Heinz brand and the opportunity to use Heinz
as a platform for making additional acquisitions in the global food industry. Berkshire is adding another widely
recognized brand to his portfolio which already contains Dairy Queen and Fruit of the Loom. The strong Heinz brand
gives it the ability to raise prices.

The deal is intended to assist Heinz in growing globally. By taking the firm private, Heinz will have greater
flexibility in decision making not having to worry about quarterly earnings. Currently, about two thirds of the firm’s
total annual revenue comes from outside the U.S. Heinz earned $923 million on sales of $11.65 billion in fiscal 2013.

At 20 times 2013 current earnings, the deal seems a bit pricey when compared to price to earnings ratios for
comparable firms (See Table 13.4). The risks to the deal are significant. Heinz will have well over $10 billion
in debt, compared to $5 billion now. Before the deal, Moody’s Investors Service rated Heinz just two
notches beyond junk. If future operating performance falters, the firm could be subject to a credit rating
downgrade. The need to pay a 9% preferred stock dividend will also erode cash flow. 3G will have
operational responsibility for Heinz. Heinz may be used as a platform for making other acquisitions.

Table 13.4 Food Company Peer Group

19
Company Recent price 52 Week 2013 Est. P/E Dividend Market Value Family Stake
change Yield ($B)
Campbell $38.72 21.6% 15.2 3.0% $12 Yes
Soup
General Mills 44.31 11.9 16.5 3 28 No
Heinz 72.50 40.2 20.5 2.8 23 No
Hershey 80.89 33.7 22.2 2.1 18 Yes
Hormel 35.91 24 18.4 1.9 9 Yes
Foods
Kellogg 59.58 12.7 15.5 3.0 21 Yes
Kraft Foods 47.16 4.5** 17.8 4.2 28 No
Mondelez 26.57 6.1 16.9 2.0 47 No
Source: Thomson Reuters **since 9/17/12 spinoff

Risk to existing bondholders is that one day they own an investment grade firm with a modest amount of debt and
the next day they own a highly leveraged firm facing a potential downgrade to junk bond status. On the
announcement date, prices of existing Heinz triple B rated bonds fell by over two cents on the dollar, while the cost
to ensure such debt (credit default swaps) soared by over 25% to a new high.

The structure of the deal is described in Figure 13.3. H.J. Heinz Company, a Pennsylvania Corporation, entered
into a definitive merger agreement with Hawk Acquisition Holding Corporation (Parent), a Delaware corporation,
and Hawk Acquisition Sub (Merger Sub), Inc., a Pennsylvania corporation and wholly owned subsidiary of Parent.
The agreement called for Merger Sub to merge with Heinz, with Heinz surviving as a wholly owned subsidiary of
Parent.
Berkshire and 3G acquired one-half of the common stock of Parent for $4.12 billion each, with Berkshire also
purchasing $8 billion in 9% preferred stock issued by Parent, bringing the total cash injection to $18.24 billion. The
preferred stock has an $8 billion liquidation preference (i.e., assurance that holders are paid before common
shareholders), pays and accrues a 9% dividend, and is redeemable at the request of the Parent or Berkshire under
certain circumstances. The use of preferred stock has been a hallmark of Berkshire deals and has often included
warrants to buy common stock.
Parent used the $18.24 billion cash injection from Berkshire and 3G (i.e., $14.12 from Berkshire + $4.12 from
3G) to acquire the common shares of Merger Sub. J.P. Morgan and Wells Fargo provided $14.1 billion of new debt
financing to Merger Sub. The debt financing consisted of $8.5 billion in dollar-denominated senior secured term
loans, $2.0 billion of Euro/British Pounds senior secured term loans, a $1.5 billion senior secured revolving loan
facility, and a $2.1 billion second lien bridge loan facility. Total sources of funds equal $32.34 billion, consisting of
$18.24 in equity plus $14.1 billion in debt financing.

The deal does not contain a go shop provision, which allows the target to seek other bids once they have reached
agreement with the initial bidder in exchange for a termination fee to be paid to the initial bidder if the target chooses
to sell to another firm. Go shop provisions may be used since they provide a target’s board with the assurance that it
got the best deal; for firms incorporated in Delaware, the go shop provision helps target argue that they satisfied the
so-called Revlon Duties, which require a board to get the highest price reasonably available for the firm. While
Heinz did not have such a go shop provision, if another bidder buys Heinz, it will have to pay a termination fee of
$750 million, plus $25 million in expenses. If Berkshire and 3G cannot close the deal they must pay Heinz $1.4
billion before they can walk away.

3G Capital Berkshire Hathaway

Management

$4.12 Billion Parent $14.12 Billion

Common in Parent and
Stock Hawk Acquisition Preferred Stock
Holding Corporation & Warrants
H.J. Heinz Company
(Parent)

20
 $18.24
Hawk Merger Sub
Hawk Billion
Merges with Heinz
Merger Sub Equity
with Heinz Surviving
Stock Contribution

J.P. Morgan & Hawk Merger Heinz Common Heinz Shareholders

Wells Fargo $14.1 Subsidiary Stock
(Lenders) Billion (Merger Sub)

$8.24 Billion

Figure 13.3 Berkshire, 3G, and H.J. Heinz Deal Structure

Heinz may not have negotiated a go shop provision which is common in firms seeking to protect their
shareholder interests because it is incorporated in Pennsylvania. Pennsylvania corporate law is intended to give
complete latitude to boards in deciding whether to accept or reject takeover offers because it does not have to
consider shareholders’ interests as the dominant determinant of the appropriateness of the deal (unlike Delaware).
Instead, the directors can base their decision on interest of employees, suppliers, customers and creditors and
communities. This may explain why Berkshire and 3G have agreed to have Heinz’s headquarters remain in
Pittsburgh, keep the firm’s name, and preserve the firm’s charitable commitments. Firms incorporated in Delaware
may be subject to greater pressure to negotiate go shop arrangements because Delaware corporate law requires the
target’s board to get the highest price for its shareholders.

Discussion Questions:

1. Identify the form of payment, form of acquisition, acquisition vehicle, and post-closing organization?
Speculate why each may have been used.

Answer: The form of payment was cash, due to its attractiveness to Heinz’s public shareholders. The use of
cash is common in these types of deals. The form of acquisition was the purchase of common stock from
public shareholders, effectively converting Heinz from a public to a private firm. The purchase of stock also
ensured that the acquirer would own all valuable intellectual property owned by Heinz such as product
brand names which are not recorded on the balance sheet. The acquisition vehicle is the Hawk Acquisition
Corporation and the post-closing organization is a holding company structure in which Heinz is a wholly
owned subsidiary of Hawk Acquisition Corporation (Parent). The post-closing holding company structure
helps insulate the Parent shareholders from Heinz liabilities and also serves as a platform for additional
related acquisitions.

2. How was ownership transferred in this deal? Speculate as to why this structure may have been used?

Answer: The deal structure involved a reverse triangular merger in which Heinz was merged into a wholly
owned subsidiary of Parent, with Heinz surviving. This preserves the Heinz brand name and results in a
holding company structure insulating 3G and Berkshire from Heinz liabilities in the event of bankruptcy.
The use of a subsidiary merger to transfer ownership from the Heinz’s public shareholders to the Parent may
also have been undertaken to avoid any negative impact on any existing relationships that the Parent and
Heinz had with their with creditors. For example, the existence of acceleration and cross-default clauses
could trigger demands by multiple lenders for immediate repayment of loans if a single loan went into
default. Furthermore, if any Parent assets were used as collateral to assist the subsidiary in financing the
transaction, both the parent and the subsidiary could be viewed as having a security interest or implied
guarantee in the debt. As such, they could be held jointly and severally liable in the event of default. To
avoid this possibility, Parent made a capital or cash contribution to the subsidiary rather than provide

21
 collateral or a loan guarantee. Furthermore, any parent loans to the subsidiary would have added to its
leverage.

3. Describe the motivation for Berkshire and 3G to buy Heinz.

Answer: Berkshire saw the business as undervalued, and it fit with the firm’s tendency to invest in firms
with widely recognizable brand names. 3G has experience in managing food and beverage businesses and
adds value by helping to manage Heinz.

4. How will the investors be able to recover the 20% purchase price premium?

Answer: 3G has excellent business connections in Brazil which may enable Heinz to improve its market
share in that country and other Latin American countries. Both 3G and Berkshire can provide additional
capital to fund further expansion in emerging markets.

5. Do you believe that Heinz is a good candidate for a leveraged buyout? Explain your answer.

Answer: Yes. In the food manufacturing business for 120 years with a widely recognizable brand, the firm
has a substantial and defensible market share in the United States. Moreover, given the nature of its basic
food product, its sales tend not to be cyclical. Moreover, industry growth tends to be modest in the mature
segments in which the firm competes. The need for substantial future capital expenditures is likely to be
limited or at least discretionary if the firm chooses to expand internationally. Overall, the firm’s operating
cash flow can be expected to remain relatively predictable, increasing its ability to pay off its outstanding
debt.

6. What do you believe was the purpose of the $1.5 billion senior secured revolving loan facility, and the $2.1
billion second lien bridge loan facility as part of the deal financing package?

Answer: The revolving loan facility is commonly a part of financing such transactions as it provides a
source of financing of short-term working capital requirements and is especially important in meeting
unanticipated cash needs. The bridge loan facility was intended to provide funds to pay cash to Heinz
shareholders at closing and to give the firm time to raise so-called permanent or long-term financing.

7. Why do you believe Berkshire Hathaway wanted to receive preferred rather than common stock in exchange
for its investing $8 billion? Be specific.

Answer: The preferred stock has a $8 billion liquidation preference (i.e., assurance that holders are paid
before common shareholders in the event of liquidation), pays and accrues a 9% dividend (a rate well above
prevailing interest rates at the time), and is redeemable at the request of the Parent or Berkshire under
certain circumstances. The latter factor gives Berkshire management substantial flexibility over the timing
of when to cash out of Heinz. Preferred stock also is attractive to corporations because of its preferential
treatment to common shares if the issuing firm is liquidated and the favorable tax treatment (i.e., dividend
received deduction) of preferred dividends paid to corporate investors. Up to 70% of preferred dividends
received are tax deductible if a firm owns less than 20% of another company; 80% if the company owns
more than 20% but less than 80% of the company paying the dividend; and up to 100% if it owns more than
80% of the dividend-paying firm. The purpose of this tax treatment is to soften the impact of potential
“triple taxation.” Triple taxation occurs because the company paying the dividend does so with after-tax
money and the receiving company is subject to income tax on the dividends. Therefore, if the company that
receives the dividends decides to pay out its shareholders, the money will have been taxed three times.

INSIDE M&A: VERIZON FINANCES ITS $130 BILLION BUYOUT OF

VODAFONE’S STAKE IN VERIZON WIRELESS

Key Points

22
  The timing of buyouts is influenced heavily by equity and credit market conditions.
 To close deals, interim or “bridge financing” often is required and replaced with longer-term or “permanent
financing.”
 How deals are financed can impact a firm’s investment strategy long after the deal is completed.
_____________________________________________________________________________________
In a deal that has been in the making for almost a decade, Verizon Communications agreed to buy British-based
wireless carrier Vodafone’s 45% ownership stake in the Verizon Wireless joint venture corporation for $130 billion.
Formed in 2000, the joint venture serves more than 100 million customers in the United States.
Announced on September 2, 2013, the deal marked the crowning event in the careers of Vittorio Colao and
Lowell McAdam, the chief executives of Vodafone and Verizon, respectively. The agreement succeeded in
rebuilding relations between the two firms that had long been strained by clashes about the size of the dividend paid
by the JV, matters of strategy, and who would eventually achieve full ownership.
While Verizon sees growth in the U.S. wireless market it is due more to the potential growth in the car or home
security markets. While smartphone and cellphone growth may have plateaued, the growth in tablet computers is not
likely to drive demand for wireless communication since 90% of tablets sold connect only to Wi-Fi rather than
cellular wireless networks. For Vodafone, the deal leaves the British firm flush with cash to repay debt, reinvest in its
operations, and to buy competitors in Europe and in emerging markets.
The total consideration (purchase price) of $130 billion, consisted of $58.9 billion of cash, $60.2 billion of
common stock issued directly to Vodafone shareholders, $5 billion of notes to Vodafone, the sale of a minority stake
in Omnitel to Vodafone for $3.5 billion, and other net consideration of $2.4 billion (consisting of specific assets
transferred between Verizon and Vodafone). The price paid is equal to Verizon’s market value, enormous by most
metrics. The Verizon buyout of Vodafone was the third-largest corporate acquisition after Vodafone’s $203 billion
(enterprise value) takeover of German cell phone operator Mannesmann in 2000 and the $182 billion (enterprise
value) merger of AOL and Time Warner in 2001.
The timing of the deal reflects the near record low interest rate environment and the strength of Verizon’s own
stock. A higher Verizon share price meant that it would have to issue fewer new shares limiting the potentially
dilutive impact on the firm’s current shareholders. Another major issue was making sure the debt markets could
absorb the sheer amount of new Verizon debt without sending interest rates spiraling upward. The huge increase in
Verizon’s leverage was sure to catch the eye of credit rating agencies charged with evaluating the likelihood that
borrowers could repay their debt on a timely basis. While Verizon’s rating was reduced, it was only one notch from
what it had been to “investment grade,” rating agency jargon for ok for investors to buy.
Verizon hired two banks, JPMorgan Chase and Morgan Stanley, to raise $61 billion in debt to finance the cash
portion of the deal. The $61 billion raised exceeded the cash portion of the total consideration by $2.1 billion to leave
Verizon with a positive yearend cash balance. As lead banks, the two banks joined in a “syndicate” with Bank of
America and Barclays to provide short term financing to “bridge” the gap between the payment of the purchase price
and the time required to raise long-term financing. The $61 billion bridge loan was to be eventually replaced by a
$49 billion bond offering and $12 billion in bank term loans.
The record books were shattered when Verizon sold $49 billion in investment grade debt in a single day without
roiling the bond markets. The bond markets absorbed the huge debt issue because of the relative attractiveness of the
yields offered by Verizon. The debt offering included 10-year bonds that yielded 5.3% and 30-year bonds yielding
6.55%. These yields compared to the average BBB-rated industrial bond of 4.16% at the time and BBB bonds for
telecommunications companies averaging 4.34%.
The addition of a massive new debt load on Verizon's books may tie the company's hands in making major
investments for some time as its priority during the next several years will be reducing its leverage as quickly as
possible. It is likely to limit the firm’s ability to finance additional deals at least in the short-run and maybe longer if
the U.S. wireless market slows and smaller rivals compete more aggressively on price, as these factors erode the
firm’s cash flow.

Hollywood’s Biggest Independent Studios Combine in a Leveraged Buyout

23
Key Points

LBOs allow buyouts using relatively little cash and often rely heavily on the target firm’s assets to finance the
transaction.
Private equity investors often “cash out” of their investments by selling to a strategic buyer.
______________________________________________________________________________

The Lionsgate-Summit tie-up represented the culmination of more than four years of intermittent discussions
between the two firms. The number of studios making and releasing movies has been shrinking amid falling DVD
sales and continued efforts to transition to digital distribution. As the largest independent studios in Hollywood, both
firms saw their cash flow whipsawed as one blockbuster hit would be followed by a series of failures. Film and TV
program libraries offered the only source of cash flow stability due to the recurring fees paid by those licensing the
rights to use this proprietary content.

Lionsgate first approached Summit about a buyout in 2008 in an effort to bolster its film and TV library.
However, it was not until early 2012 that the two sides could reach agreement. The time was ripe because Summit’s
investors were looking for a way to cash in on the success of the firm’s Twilight movies series. Consisting of four
films, this series had grossed $2.5 billion worldwide. On February 2, 2012, Lionsgate announced that it had reached
an agreement to acquire Summit Entertainment by paying Summit shareholders $412.5 million in cash and stock for
all of their outstanding shares and assumed debt of $506.3 million. According to the merger agreement, Lionsgate
would provide administrative, production, and distribution services to Summit for a 10% servicing fee. Layoffs are
expected at both firms as they merge redundant departments in their film operations, such as marketing, production,
and distribution. The acquisition provides a windfall to Summit’s investors, including eBay cofounder Jeff Skoll’s
film company Media and private equity fund Traverse Management. These investors had previously received a $200
million dividend as part of a recapitalization in early 2011 and gained handsomely from the sale to Lionsgate.

Lionsgate is a diversified film and television production and distribution company, with a film library of 13,000
titles. The firm’s major distribution channels include home entertainment and prepackaged media (DVDs); digital
distribution (on-demand TV) and pay TV (premium network programming). Summit, also a producer and distributor
of film and TV content, has a less consistent track record in realizing successful releases, with the Twilight
“franchise” its primary success. However, Summit does have strong international licensing operations, with
arrangements in the United States, Canada, Germany, France, Scandinavia, Spain, and Australia. The acquisition also
strengthens Lionsgate’s position as a leading content supplier and, controlling the Twilight and Hunger Games
franchises, positions Lionsgate as a market leader for young adult audiences. The combination also results in cost and
revenue synergies, more diversified cash flow streams, and greater access to international distribution channels.

Figure 13.3 illustrates the subsidiary structure for completing the buyout of Summit Entertainment LLC. As is
typical of such transactions, Lionsgate created a merger subsidiary (Merger Sub) and funded the subsidiary with its
equity contribution of $100 million in cash and $69 million in Lionsgate stock, receiving 100% of the subsidiary’s
stock in exchange. Merger Sub was further capitalized by a bank term loan of $500 million. Following a tender offer
to Summit’s shareholders by Merger Sub, Merger Sub was merged into Summit Entertainment, with Summit
surviving as a wholly owned subsidiary of Lionsgate in a reverse triangular merger. At closing, $284.4 million of
Summit’s excess cash was used to finance the total cost of the deal.
$284.4
Million in
Lionsgate Excess Summit
Entertainment Summit Entertainment
Cash

$100 Million in
Cash & $69
Merger Million in Merger Sub Merges
Sub Stock Lionsgate With Summit
Shares

$500 Million
Loan
24
 Lender Merger Sub Summit
Summit
Shareholders
Shares
Merger Sub Loan Cash & Lionsgate
Guarantee Shares
Figure 13.3
Lionsgate-Summit Legal and Financing Structure.
Table 13.4 summarizes the sources of financing for the buyout and shows how these funds were used to pay for
the deal. Lionsgate financed the total cost of the deal of $953.4 million (consisting of $412.5 million for Summit
stock + the pretransaction term loan of $506.3 million + $34.6 million in transaction-related fees and expenses) as
follows: $100 million in cash from Lionsgate and $69 million in Lionsgate stock + $284.4 million of the $310
million in cash on Summit’s balance sheet at closing + a new $500 million term loan. Summit’s $506.3 million term
loan B was refinanced with the new term loan for $500 million as part of the transaction. The new term loan is an
obligation of and is secured by the assets of Summit and its subsidiaries. It also is secured by a loan guarantee
provided by Merger Sub, created by Lionsgate to consummate the transaction. The guarantee is secured by the equity
in Summit held by Merger Sub. Lionsgate anticipates paying off the term loan well in advance of its 2016 maturity
date out of future cash flows from new movie releases. Summit’s pretransaction net debt was $196.3 million
(pretransaction term loan of $506.3 less total cash on the balance sheet of $310 million). Postclosing net debt
increased to $474.4 million (postclosing term loan of $500 million less $25.6 million in total cash of the balance
sheet).

Table 13.4
Lionsgate-Summit Transaction Overview
 Sources of Funds ($ Millions)  Uses of Funds ($ Millions)
Lionsgate Cash Consideration1 100.0 Seller Consideration 412.5
Lionsgate Stock Consideration 2 69.0 Repay Term Loan 506.3
Summit Cash on Balance Sheet 284.4 Fees and expenses 34.6
New Term Loan 500.0
Total 953.4 953.4
1
Includes $55 million of Lionsgate cash and $45 million of convertible bond proceeds.
2
Includes $20 million of stock consideration to be issued to Summit sellers 60 days after closing.
Summit Pro Forma Capitalization
 As of 12/30/11  Pro Forma
$ Millions Adjustment ($ Millions) $ Millions
Cash3 310 (284.4) 25.6

Revolver ($200 million) — — NA4

Prior Term Loan B Due 9/2016 506.3 (506.3) 0.0
New Term Loan B Due 9/2016 0.0 500.0 500.0
Total Debt 506.3 (6.3) 500.0
Contributed Equity5 169.0
3
Total cash balance prior to the transaction announcement. $284 million is excess Summit cash used by Lionsgate
to finance a portion of the deal. The remaining $25.6 million is cash needed to meet working capital requirements.
4
Revolver commitments terminated for the acquisition.
5
Consists of $100 million in cash from Lionsgate and $69 million in Lionsgate stock.
Source: Lionsgate 8K filing with the Securities and Exchange Commission on 2/1/2012.

Table 13.5 presents the key features of the new term loan B facility. Note how Summit’s assets are used as
collateral to secure the loan. In addition, the lender has first priority on the proceeds from certain types of
transactions, giving them priority access to such funds. Cash distributions are not possible until the loan is almost
paid off, and even then the size of such distributions is limited. Finally, loan covenants require Summit to maintain a
comparatively liquid position during the term of the loan.

25
 Table 13.5
Initial Terms and Conditions of the New Term Loan B Facility
 Item  Comment
Borrower Summit Entertainment LLC (Lionsgate subsidiary)
Guarantor Merger Sub
Security First priority security interest in tangible and intangible assets
Pledge of equity interests of Summit and guarantor
Assignments of all trademarks and copyrights
Direct assignment of all proceeds payable to borrowers or any guarantor under all existing
license and distribution agreements
Facilities $500 million senior secured term loan B
Ratings B1/B+
Maturity September 2016
Mandatory $13.75 million, paid quarterly
Amortization
Pricing To be determined
Incremental None
Facility
Optional Up to one year at the discretion of the borrower
Prepayments
Mandatory 100% of proceeds from asset sales
Prepayments 100% of insurance proceeds
50% of excess cash flow as defined in purchase agreement
Excess over mandatory maximum cash balance allowance
Permitted No distributions before loan facility is 75% amortized
Distributions Only distributions of up to $25 million allowed once loan is 75% amortized
Financial Fixed charge coverage ratio of 1.25 to 1
Maintenance Minimum liquidity ratio of at least 1.1 to 1
Covenants

Discussion Questions

1. What about Lionsgate’s acquisition of Summit indicates that this transaction should be characterized as a
leveraged buyout? How does Lionsgate use Summit’s assets to help finance the deal? Be specific.

Answer: LBOs are characterized by a substantial increase in a firm’s post-LBO debt-to-equity ratio (a
common measure of leverage), usually as a result of the substantial increase in borrowing to purchase stock
held by its pre-buyout private or public shareholders. However, in some instances, a firm’s leverage
increases even though there is no significant increase in borrowing. This may result from the way in which
the target firm’s assets are used to finance the buyout. For example, the investor group or firm initiating the
takeover may use the target’s excess cash balances or sell certain target assets using the proceeds to buy out
current shareholders. If the amount of the target’s debt outstanding remains unchanged, the target firm’s
debt-to-equity ratio will rise due to the decline in the firm’s equity (i.e., assets decline relative to liabilities
shrinking the firm’s equity).

In Lionsgate’s buyout of Summit, Lionsgate assumed responsibility for $506.3 million in Summit debt and
contributed only $100 million in cash and $69 million in stock, using $284.4 million of the $310 million on
Summit’s balance sheet to pay most of the total cost of the deal. Consequently, Summit’s pre-transaction net
debt was $196.3 million (pre-transaction term loan of $506.3 less total cash on the balance sheet of $310
million). Post-closing net debt increased to $474.4 million (post-closing term loan of $500 million less $25.6
million in total cash of the balance sheet). As measured by net debt the combined Lionsgate-Summit firms
became much more levered following the completion of the transaction.

Therefore, the deal should be considered an LBO since Summit’s net debt increases by about 240% from
$196.3 million pre-transaction to $474.4 million post-transaction. Lionsgate used $284.4 million in Summit

26
 excess cash to help finance the deal and used Summit’s tangible and intangible assets (trademarks) as
security for the $500 million term loan.
.
2. How are $34.6 million in fees and expenses associated with the transaction paid for? Be specific.

Answer: The fees and other acquisition-related expenses are routinely paid for in LBOs through borrowing
such that the acquisition-related expenses are amortized over the life of the loan.

3. Speculate as to why Lionsgate refinanced as part of the transaction the existing Summit Term Loan B due in
2016 that had been borrowed in the early 2000s.

Answer: Interest rates in the early 2000s were considerably higher than in 2012 making refinancing sensible.

4. Do you believe that Summit is a good candidate for a leveraged buyout? Explain your answer.

Answer: Probably not. The cash flows of the two firms are highly erratic, dependent largely on the
fickleness of the public in accepting films and TV programming. Furthermore, new films often can require
multi-million dollar expenditures. However, the film libraries do provide some degree of earnings’ stability
and the content can be used as collateral to support new borrowing.

5. Why is Summit Entertainment organized as a limited liability company?

Answer: An LLC limits the investor/member liability to the extent of their investment. In addition, LLCs
for tax purposes are pass-through organizations such that they must pay out 100% of their profits to
members who are taxed at their ordinary tax rates.

6. Why did Lionsgate make an equity contribution in the form of cash and stock to the Merger Sub rather than
making the cash portion of the contributed capital in the form of a loan?

Answer: The financial sponsor or parent firm, in this case Lionsgate, makes an equity contribution so as not
to excessive leverage the Merger Sub and make it more difficult for the Merger Sub to borrow from banks
and other lenders.

TXU Goes Private in the Largest Private Equity Transaction in History—The Dark Side of Leverage

Key Points

The 2007/2008 financial crisis left many LBOs excessively leveraged.

As structured, the TXU buyout (now Energy Future Holdings) left no margin for error.
Excessive leverage severely limits the firm’s future financial options.
_____________________________________________________________________________

Before the buyout, TXU, a Dallas-based energy giant, was a highly profitable utility. Historically low interest rates
and an overly optimistic outlook for natural gas prices set the stage for the largest private equity deal in history. The
2007 buyout of TXU was valued at $48 billion and, at the time, appeared to offer such promise that several of Wall
Street’s largest lenders –—including the likes of Lehman Brothers and Citigroup—invested, along with such storied
names in private equity as KKR, TPG, and Goldman Sachs. However, the price of gas plummeted, eroding TXU’s
cash flow. Since the deal closed in October 2007, investors who bought $40 billion of TXU’s debt have experienced
losses as high as 70% to 80% of their value. The other $8 billion used to finance the deal came from the private
equity investors, banks, and large institutional investors. They, too, have suffered huge losses. Having met its
obligations to date, the firm faces a $20 billion debt repayment coming due in 2014.

Wall Street banks were competing in 2007 to make loans to buyout firms on easier terms, with the banks also
investing their own funds in the deal. The allure to the banks was the prospect of dividing up as much as $1.1 billion
in fees for originating the loans, repackaging such loans into pools called collateralized loan obligations, and

27
reselling them to long-term investors such as pension funds and insurance companies. In doing so, the loans would be
removed from the banks’ balance sheets, eliminating potential losses that could arise if the deal soured at a later date.
Furthermore, the deal appeared to be attractive as an investment opportunity because some banks put up $500 million
of their own cash for a stake in TXU.

The financial sponsor group, consisting of Kohlberg Kravis Roberts & Co, Texas Pacific Group, and Goldman
Sachs, created a shell corporation, referred to as Merger Sub Parent, and its wholly owned subsidiary Merger Sub.
TXU was merged into Merger Sub, with Merger Sub surviving. Each outstanding share of TXU common stock was
converted into the right to receive $69.25 in cash. Total cash required for the purchase was provided by the financial
sponsor group and lenders (Creditor Group) to Merger Sub. Regulatory authorities required that the debt associated
with the transaction be held at the level of the Merger Sub Parent holding company so as not to leverage the utility
further.

Subsequent to closing, the new company was reorganized into independent businesses under a new holding
company, controlled by the Sponsor Group, called Texas Holdings (TH). Merger Sub (which owns TXU) was
renamed Energy Future Holdings. TH’s direct subsidiaries are EFH and Oncor (an energy distribution business
formerly held by TXU). EFH’s primary direct subsidiary is Texas Competitive Electric Holdings, which holds TXU’s
public utility operating assets and liabilities. All TXU non-Sponsor Group–related debt incurred to finance the
transaction is held by EFH, while any debt incurred by the Sponsor Group is shown on the TH balance sheet. This
legal structure allows for the concentration of debt in TH and EFH, separate from the cash-generating assets held by
Oncor and Texas Competitive Electric Holdings.

Loan covenants limit EFH’s and its subsidiaries’ ability to issue new debt or preferred stock; pay dividends on,
repurchase, or make distributions of capital stock or make other restricted payments; make investments; sell or
transfer assets; consolidate, merge, sell, or dispose of all or substantially all its assets; and repay, repurchase, or
modify debt. A breach of any of these covenants could result in default. Table 13.6 illustrates selected covenants in
which certain ratios must be maintained either above or below stipulated thresholds. Note that EFH was in violation
of certain covenants when you compare actual December 31, 2009 (the last year for which public information is
available), ratios with required threshold levels.

Table 13.6
EFH Holdings Debt Covenants
 December 31,  Threshold Level as
2009 of December 31, 2009
Maintenance Covenant
TCEH Secured Facilities: Ratio of Secured debt to 4.76–1.00 Must not exceed 7.25–1.00
adjusted EBITDA
Debt Incurrence Covenants
EFH Corp Senior Notes:
EFH Corp fixed charge coverage ratio 1.2–1.0 At least 2.0–1.0
TCEH fixed charge coverage ratio 1.5–1.0 At least 2.0–1.0
EFH Corp 9.75% Notes:
EFH Corp fixed charge coverage ratio 1.2–1.0 At least 2.0–1.0
TCEH fixed charge coverage ratio 1.5–1.0 At least 2.0–1.0
TCEH Senior Notes:
TCEH fixed charge coverage ratio 1.5–1.0 At least 2.0–1.0
TCEH Senior Secured Facilities:
TCEH fixed charge coverage ratio 1.5–1.0 At least 2.0–1.0
Restricted Payments/Limitations on Investments
Covenants
EFH Corp Senior Notes
General restrictions
EFH Corp fixed charge coverage ratio 1.4–1.0 At least 2.0–1.0
General restrictions
EFH Fixed Charge coverage ratio 1.2–1.0 At least 2.0–1.0

28
 EFH Corp leverage ratio 9.4–1.0 ≤7.0–1.0
EFH Corp 9.75% Notes
General restrictions
EFH Corp fixed charge coverage ratio 1.4–1.0 At least 2.0–1.0
General restrictions
EFH Corp fixed charge coverage ratio 1.2–1.0 At least 2.0–1.0
EFH Corp leverage ratio 9.4–1.0 ≤7.0–1.0
TCEH Senior Notes
TCEH fixed charge coverage ratio 1.5–1.0 At least 2.0–1.0

Things clearly have not turned out as expected. The firm faces an almost-untenable capital structure. The firm’s
debt traded at between 20 and 30 cents on the dollar throughout most of 2012. The $8 billion equity invested in the
deal has been virtually wiped out on paper. Absent a turnaround in natural gas prices, EFH is left with seeking a way
to reduce substantially the burden of the pending 2014 $20 billion loan payment with its lenders through a debt-for-
equity swap or more favorable terms on existing debt or by pursuing Chapter 11 bankruptcy. EFH has posted eight
consecutive quarterly losses. In December 2012, in an effort to extend debt maturities to buy time for a turnaround
and to reduce interest expense, EFH exchanged $1.15 billion of new payment-in-kind notes (interest is paid with
more debt) for existing notes with a face value of $1.6 billion. By any measure, this transaction illustrates the dark
side of leverage.

Discussion Questions

1. How does the postclosing holding company structure protect the interests of the financial sponsor group
and the utility’s customers but potentially jeopardize creditor interests in the event of bankruptcy?

Answer: A holding company structure was used for two reasons: (1) to limit the risks to the financial
and creditor groups to potential liabilities and (2) to satisfy the requirement by Texas public utility
regulators to insulate the public utility from the additional debt service requirements created by the debt
incurred to finance the LBO. The structure effectively concentrates debt in EFH and TH, while
separating the cash producing assets in other legal entities (i.e., Oncor and Texas Competitive Electric
Holdings). Consequently, EFH and TH could be put into Chapter 11 if need be, while limiting creditor
access to Oncor’s and Texas Competitive Electric Holdings’ assets.

The use of a subsidiary merger to transfer ownership from the TXU public shareholders to the Sponsor
Group was undertaken to avoid any negative impact on any existing relationships that the Sponsor
Group had with creditors. For example, the existence of cross-default clauses could trigger demands by
multiple lenders for immediate repayment of loans if a single loan went into default. Furthermore, if
any parent assets were used as collateral to assist the subsidiary in financing the transaction both the
parent and the subsidiary could be viewed as having a security interest or implied guarantee in the debt.
As such, they could be held jointly and severally liable in the event of default. To avoid this possibility,
the parent made a capital or cash contribution to the subsidiary rather than provide collateral or a loan
guarantee. Furthermore, any parent loans to the subsidiary would have added to its leverage.

Moreover, by isolating the liabilities within the subsidiaries of their respective parents, an individual
subsidiary can be taken through bankruptcy in the event of financial distress without endangering other
operations owned by the parent. Finally, the Texas utility regulators wanted to separate the TXU’s
public utility operations from the obligation to pay the interest and principal on the additional debt that
was incurred by the Sponsor Group and the Creditor Group as a condition of receiving regulatory
approval and required that this debt be carried on TH’s and EFH’s balance sheets. As such, servicing
this debt would come from cash flows generated by the holding companies from dividends they receive
from their operating subsidiaries. While unsecured intercompany loans also represent another means of
transferring cash between the subsidiary and the parent, the parent would be liable for the repayment of
such loans in the event of the subsidiary entering bankruptcy. In doing so, the regulators were
attempting to protect the interests of TXU customers and other stakeholders.

29
 2. What was the purpose of the pre-closing covenants and closing conditions as described in the merger
agreement?

Answer: The purpose of the covenants is to ensure that the target firm will operate its business between
the signing of the agreement and closing in a manner acceptable to the buyer. Also, it gives the buyer a
limited amount of control over actions the seller may wish to take that the buyer views as inappropriate.
Closing conditions give the buyer and seller an opportunity to exit the agreement of purchase and sale if
certain events considered critical to the viability of the transaction do not occur.

3. Loan covenants exist to protect the lender. How might such covenants inhibit the EFH from meeting its
2014 $20 billion obligations?

Answer: The loan covenants limit EFH’s ability to issue new equity, preferred stock, or to take on new
debt without the permission of the lender. Moreover, efforts to sell assets to raise funds to repay loans
are made more complicated if such assets already serve as collateral for existing loans outstanding.

4. As CEO of EFH, would you recommend to the board of directors as an appropriate strategy for paying
the $20 billion in debt that is maturing in 2014?

Answer: The principal owners private equity buyout firms Kohlberg Kravis Roberts & Co (KKR) and
Texas Pacific Group (TPG), two of the nation’s leading private equity firms, and global investment
bank Goldman Sachs (Goldman) face additional decisions as the 2014 refinancing inches closer. The
options range from swapping debt for equity, the sale of “non-core” assets, or have KKR, TPG and
Goldman put in more of their own money into the mix.

5. The substantial writedown of the net acquired assets in 2008 suggests that the purchase price paid for
TXU was too high. How might this impact KKR, TPG, and Goldman’s ability to earn financial returns
expected by their investors on the TXU acquisition? How might this writedown impact EFH’s ability
meet the $20 billion debt maturing in 2014?

Answer: The purchase price paid for TXU was clearly too high. Private equity investors were caught up
in the euphoria of 2007 when interest rates were exceptionally low and banks were aggressively
competing for lending opportunities. While the $8 billion writedown of net acquired assets in 2008 was
substantial, it is unclear if additional asset revaluations may be necessary. As a charge in earnings,
future writedowns will limit reported financial returns. The presence of substantial writedowns also
calls into question the true value of EFH’s assets that could be used as collateral. Consequently, efforts
to “rollover” the debt in 2014 may be expensive if lenders question the value of the underlying
collateral.

Lessons from Pep Boys’ Aborted Attempt to Go Private

Key Points

LBOs in recent years have involved financial sponsors’ providing a larger portion of the purchase price in cash than
in the past.
Financial sponsors focus increasingly on targets in which they have previous or related experience.
Deals that would have been completed in the early 2000s are more likely to be terminated or subject to renegotiation
than in the past.
_____________________________________________________________________________________

It ain’t over till it’s over” quipped former New York Yankees’ catcher Yogi Berra, famous for his malapropisms. The
oft-quoted comment was once again proven true in Pep Boys’ unsuccessful attempt to go private in 2012. On May
30, 2012, after nearly two years of discussions between Pep Boys and several interested parties, the firm announced

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that a buyout agreement with the Gores Group (Gores), valued at approximately $1 billion (including assumed debt),
had collapsed, a victim of Pep Boys’ declining operating performance. The firm’s shares fell 20% on the news to
$8.89 per share, well below its level following the all-cash $15-a-share deal with Gores announced in January 2012.
The terms of the transaction also included a termination fee if either party failed to complete the deal by July 27,
2012. The failed transaction illustrates the characteristics and potential pitfalls common to contemporary LBOs.

Pep Boys, a U.S. auto parts and repair business, operates more than 7,000 service bays in over 700 locations in 35
states and Puerto Rico. With its share price lagging the overall stock market in recent years, the firm’s board of
directors explored a range of options for boosting the firm’s value and ultimately decided to put the firm up for sale.
Gores was attracted initially by what appeared to be a low purchase price, stable cash flow, and the firm’s real estate
holdings (many of the firm’s store sites are owned by the firm). Such assets could be used as collateral underlying
loans to finance a portion of the purchase price. Furthermore, Gores has experience in retailing, having several
retailers among their portfolio of companies, including J. Mendel and Mexx.

The transaction reflected a structure common for deals of this type. Pep Boys had entered into a merger agreement
with Auto Acquisitions Group (the Parent), a shell corporation funded by cash provided by Gores as the financial
sponsor, and the Parent’s wholly owned subsidiary (Merger Sub). The Parent would contribute cash to Merger Sub,
with Merger Sub borrowing the remainder from several lenders. Merger Sub would subsequently buy Pep Boys’
outstanding shares and merge with the firm. Pep Boys would survive as a wholly owned subsidiary of the Parent. The
purpose of this reverse triangular merger was to preserve the Pep Boys’ brand name and facilitate the transfer of
supplier and customer contracts. The Parent also was to have been organized as a holding company to afford
investors some degree of protection from Pep Boys’ liabilities. The purchase price was to have been financed by an
equity contribution of $489 million from limited partnerships managed by Gores and the balance by loans provided
by Barclays Bank PLC, Credit Suisse AG, and Wells Fargo Bank.

Upon learning that the Pep Boys’ reported earnings for the first quarter of 2012 would be well below expectations,
Gores attempted to renegotiate the terms of the deal, arguing that Pep Boys had breached the deal’s agreements.
With Pep Boys unwilling to accept a lower valuation, Gores exercised its right to terminate the deal by paying the
$50 million breakup fee and agreed to reimburse Pep Boys for other costs it had incurred related to the deal. Pep
Boys said the firm will use the proceeds of the breakup fee to refinance a portion of its outstanding debt.

"Grave Dancer" Takes Tribune Corporation Private in an Ill-Fated Transaction

At the closing in late December 2007, well-known real estate investor Sam Zell described the takeover of the
Tribune Company as "the transaction from hell." His comments were prescient in that what had appeared to be a
cleverly crafted, albeit highly leveraged, deal from a tax standpoint was unable to withstand the credit malaise of
2008. The end came swiftly when the 161-year-old Tribune filed for bankruptcy on December 8, 2008.

On April 2, 2007, the Tribune Corporation announced that the firm's publicly traded shares would be acquired in a
multistage transaction valued at $8.2 billion. Tribune owned at that time 9 newspapers, 23 television stations, a 25%
stake in Comcast's SportsNet Chicago, and the Chicago Cubs baseball team. Publishing accounts for 75% of the
firm's total $5.5 billion annual revenue, with the remainder coming from broadcasting and entertainment. Advertising
and circulation revenue had fallen by 9% at the firm's three largest newspapers (Los Angeles Times, Chicago Tribune,
and Newsday in New York) between 2004 and 2006. Despite aggressive efforts to cut costs, Tribune's stock had
fallen more than 30% since 2005.

The transaction was implemented in a two-stage transaction, in which Sam Zell acquired a controlling 51%
interest in the first stage followed by a backend merger in the second stage in which the remaining outstanding
Tribune shares were acquired. In the first stage, Tribune initiated a cash tender offer for 126 million shares (51% of
total shares) for $34 per share, totaling $4.2 billion. The tender was financed using $250 million of the $315 million
provided by Sam Zell in the form of subordinated debt, plus additional borrowing to cover the balance. Stage 2 was
triggered when the deal received regulatory approval. During this stage, an employee stock ownership plan (ESOP)
bought the rest of the shares at $34 a share (totaling about $4 billion), with Zell providing the remaining $65 million
of his pledge. Most of the ESOP's 121 million shares purchased were financed by debt guaranteed by the firm on
behalf of the ESOP. At that point, the ESOP held all of the remaining stock outstanding valued at about $4 billion. In

31
exchange for his commitment of funds, Mr. Zell received a 15-year warrant to acquire 40% of the common stock
(newly issued) at a price set at $500 million.

Following closing in December 2007, all company contributions to employee pension plans were funneled into the
ESOP in the form of Tribune stock. Over time, the ESOP would hold all the stock. Furthermore, Tribune was
converted from a C corporation to a Subchapter S corporation, allowing the firm to avoid corporate income taxes.
However, it would have to pay taxes on gains resulting from the sale of assets held less than ten years after the
conversion from a C to an S corporation (Figure 1).

Stage 1
$3.85 Billion
Lenders Tribune
126 Million Shares
Zell
$.25 billion $4.2 Billion
Stage 2 126 Million Shares Tribune
$.065 Billion & Loan Guarantee Shareholders
Lenders ESOP $4.05

Zell 121 Million Shares

$4 Billion

Figure 13.1
Tribune deal structure.

The purchase of Tribune's stock was financed almost entirely with debt, with Zell's equity contribution amounting
to less than 4% of the purchase price. The transaction resulted in Tribune being burdened with $13 billion in debt
(including the approximate $5 billion currently owed by Tribune). At this level, the firm's debt was ten times
EBITDA, more than two and a half times that of the average media company. Annual interest and principal
repayments reached $800 million (almost three times their preacquisition level), about 62% of the firm's previous
EBITDA cash flow of $1.3 billion. While the ESOP owned the company, it was not be liable for the debt guaranteed
by Tribune.

The conversion of Tribune into a Subchapter S corporation eliminated the firm's current annual tax liability of
$348 million. Such entities pay no corporate income tax but must pay all profit directly to shareholders, who then
pay taxes on these distributions. Since the ESOP was the sole shareholder, Tribune was expected to be largely tax
exempt, since ESOPs are not taxed.

In an effort to reduce the firm's debt burden, the Tribune Company announced in early 2008 the formation of a
partnership in which Cablevision Systems Corporation would own 97% of Newsday for $650 million, with Tribune
owning the remaining 3%. However, Tribune was unable to sell the Chicago Cubs (which had been expected to fetch
as much as $1 billion) and the minority interest in SportsNet Chicago to help reduce the debt amid the 2008 credit
crisis. The worsening of the recession, accelerated by the decline in newspaper and TV advertising revenue, as well
as newspaper circulation, thereby eroded the firm's ability to meet its debt obligations.

By filing for Chapter 11 bankruptcy protection, the Tribune Company sought a reprieve from its creditors while it
attempted to restructure its business. Although the extent of the losses to employees, creditors, and other stakeholders
is difficult to determine, some things are clear. Any pension funds set aside prior to the closing remain with the
employees, but it is likely that equity contributions made to the ESOP on behalf of the employees since the closing
would be lost. The employees would become general creditors of Tribune. As a holder of subordinated debt, Mr. Zell
had priority over the employees if the firm was liquidated and the proceeds distributed to the creditors.

Those benefitting from the deal included Tribune's public shareholders, including the Chandler family, which
owed 12% of Tribune as a result of its prior sale of the Times Mirror to Tribune, and Dennis FitzSimons, the firm's

32
former CEO, who received $17.7 million in severance and $23.8 million for his holdings of Tribune shares. Citigroup
and Merrill Lynch received $35.8 million and $37 million, respectively, in advisory fees. Morgan Stanley received
$7.5 million for writing a fairness opinion letter. Finally, Valuation Research Corporation received $1 million for
providing a solvency opinion indicating that Tribune could satisfy its loan covenants.

What appeared to be one of the most complex deals of 2007, designed to reap huge tax advantages, soon became a
victim of the downward-spiraling economy, the credit crunch, and its own leverage. A lawsuit filed in late 2008 on
behalf of Tribune employees contended that the transaction was flawed from the outset and intended to benefit Sam
Zell and his advisors and Tribune’s board. Even if the employees win, they will simply have to stand in line with
other Tribune creditors awaiting the resolution of the bankruptcy court proceedings.

Discussion Questions:

1. What is the acquisition vehicle, post-closing organization, form of payment, form of acquisition, and tax
strategy described in this case study?

Answer: The ESOP is the acquisition vehicle and the subchapter S corporation is the post-closing
organization. Cash is the form of payment and the form of acquisition is stock. The tax strategy is to
minimize/eliminate taxes to be paid by either the Tribune or its shareholders. This will increase cash flow
available to satisfy interest and principal repayments.

2. Describe the firm’s strategy to finance the transaction?

Answer: The transaction will be financed primarily by debt. The firm’s free cash flow will be improved by
$348 million in annual tax savings to help pay for the increased interest and principal repayments.
Furthermore, asset sales will be undertaken to reduce total outstanding debt. Presumably additional efforts to
reduce costs and improve revenue will also be undertaken.

3. Is this transaction best characterized as a merger, acquisition, leveraged buyout, or spin-off? Explain your
answer.

Answer: A leveraged buyout, since the Tribune is being taken private in a transaction financed almost
entirely by debt.

4. Is this transaction taxable or non-taxable to Tribune’s public shareholders? To its post-transaction

shareholders? Explain your answer.

Answer: The transaction is taxable since public shareholders receive cash for their stock. This results in an
immediate tax liability for those experiencing capital gains as a result of the transaction. After the
transaction is completed, Tribune shares are held by the ESOP, which is non-taxable.

5. Comment on the fairness of this transaction to the various stakeholders involved. How would you apportion
the responsibility for the eventual bankruptcy of Tribune among Sam Zell and his advisors, the Tribune
board, and the largely unforeseen collapse of the credit markets in late 2008? Be specific.

Answer: The transaction was clearly highly leveraged by most measures. It was financed almost entirely
with debt, with Zell’s equity contribution amounting to less than 4 percent of the purchase price. The
transaction resulted in the Tribune being burdened with $13 billion in debt (including the approximate $5
billion currently owed by Tribune). At this level, the firm’s debt was 10 times EBITDA, more than 2.5
times that of the average media company. Annual interest and principal repayments reached $800 million
(almost three times their pre-acquisition level), about 62 percent of the firm’s previous EBITDA cash flow
of $1.3 billion. The business plan assumed the sale of such properties as the Chicago Cubs on a timely basis
in order to refinance a portion of the outstanding debt. The rapid tightening of the credit markets during the
second half of 2008 made this impossible. While the National Bureau of Economic Research, often regarded
as the arbiter of when the U.S. economy is in recession, declared in November 2008 that the economy had
been in recession since December 2007, there was no real consensus as to the state of the economy even as

33
 late as August 2008. For Sam Zell and his advisors to be held culpable requires proving they had reasonable
fore-knowledge of the impending economic downturn and credit crisis when the deal was first announced in
April 2007.

Financing LBOs--The SunGard Transaction

With their cash hoards accumulating at an unprecedented rate, there was little that buyout firms could do but to
invest in larger firms. Consequently, the average size of LBO transactions grew significantly during 2005. In a
move reminiscent of the blockbuster buyouts of the late 1980s, seven private investment firms acquired 100 percent
of the outstanding stock of SunGard Data Systems Inc. (SunGard) in late 2005. SunGard is a financial software firm
known for providing application and transaction software services and creating backup data systems in the event of
disaster. The company‘s software manages 70 percent of the transactions made on the Nasdaq stock exchange, but
its biggest business is creating backup data systems in case a client’s main systems are disabled by a natural disaster,
blackout, or terrorist attack. Its large client base for disaster recovery and back-up systems provides a substantial and
predictable cash flow.

SunGard’s new owners include Silver lake Partners, Bain Capital LLC, The Blackstone Group L.P., Goldman
Sachs Capital Partners, Kohlberg Kravis Roberts & Co., Providence Equity Partners Inc. and Texas Pacific Group.
Buyout firms in 2005 tended to band together to spread the risk of a deal this size and to reduce the likelihood of a
bidding war. Indeed, with SunGard, there was only one bidder, the investor group consisting of these seven firms.

The software side of SunGard is believed to have significant growth potential, while the disaster-recovery side
provides a large stable cash flow. Unlike many LBOs, the deal was announced as being all about growth of the
financial services software side of the business. The deal is structured as a merger, since SunGard would be merged
into a shell corporation created by the investor group for acquiring SunGard. Going private, allows SunGard to invest
heavily in software without being punished by investors, since such investments are expensed and reduce reported
earnings per share. Going private also allows the firm to eliminate the burdensome reporting requirements of being a
public company.

The buyout represented potentially a significant source of fee income for the investor group. In addition to the 2
percent management fees buyout firms collect from investors in the funds they manage, they receive substantial fee
income from each investment they make on behalf of their funds. For example, the buyout firms receive a 1 percent
deal completion fee, which is more than $100 million in the SunGard transaction. Buyout firms also receive fees
paid for by the target firm that is “going private” for arranging financing. Moreover, there are also fees for
conducting due diligence and for monitoring the ongoing performance of the firm taken private. Finally, when the
buyout firms exit their investments in the target firm via a sale to a strategic buyer or a secondary IPO, they receive
20 percent (i.e., so-called carry fee) of any profits.

Under the terms of the agreement, SunGard shareholders received $36 per share, a 14 percent premium over the
SunGard closing price as of the announcement date of March 28, 2005, and 40 percent more than when the news first
leaked about the deal a week earlier. From the SunGard shareholders’ perspective, the deal is valued at $11.4 billion
dollars consisting of $10.9 billion for outstanding shares and “in-the-money” options (i.e., options whose exercise
price is less than the firm’s market price per share) plus $500 million in debt on the balance sheet.

The seven equity investors provided $3.5 billion in capital with the remainder of the purchase price financed by
commitments from a lending consortium consisting of Citigroup, J.P. Morgan Chase & Co., and Deutsche Bank. The
purpose of the loans is to finance the merger, repay or refinance SunGard’s existing debt, provide ongoing working
capital, and pay fees and expenses incurred in connection with the merger. The total funds necessary to complete the
merger and related fees and expenses is approximately $11.3 billion, consisting of approximately $10.9 billion to pay
SunGard’s stockholders and about $400.7 million to pay fees and expenses related to the merger and the financing
arrangements. Note that the fees that are to be financed comprise almost 4 percent of the purchase price. Ongoing
working capital needs and capital expenditures required obtaining commitments from lenders well in excess of $11.3
billion.

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 The merger financing consists of several tiers of debt and “credit facilities.” Credit facilities are arrangements for
extending credit. The senior secured debt and senior subordinated debt are intended to provide “permanent” or long-
term financing. Senior debt covenants included restrictions on new borrowing, investments, sales of assets, mergers
and consolidations, prepayments of subordinated indebtedness, capital expenditures, liens and dividends and other
distributions, as well as a minimum interest coverage ratio and a maximum total leverage ratio.

If the offering of notes is not completed on or prior to the closing, the banks providing the financing have
committed to provide up to $3 billion in loans under a senior subordinated bridge credit facility. The bridge loans
are intended as a form of temporary financing to satisfy immediate cash requirements until permanent financing can
be arranged. A special purpose SunGard subsidiary will purchase receivables from SunGard, with the purchases
financed through the sale of the receivables to the lending consortium. The lenders subsequently finance the purchase
of the receivables by issuing commercial paper, which is repaid as the receivables are collected. The special purpose
subsidiary is not shown on the SunGard balance sheet. Based on the value of receivables at closing, the subsidiary
could provide up to $500 million. The obligation of the lending consortium to buy the receivables will expire on the
sixth anniversary of the closing of the merger.

The following table provides SunGard’s post-merger proforma capital structure. Note that the proforma capital
structure is portrayed as if SunGard uses 100 percent of bank lending commitments. Also, note that individual LBO
investors may invest monies from more than one fund they manage. This may be due to the perceived attractiveness
of the opportunity or the limited availability of money in any single fund. Of the $9 billion in debt financing, bank
loans constitute 56 percent and subordinated or mezzanine debt comprises represents 44 percent.

SunGard Proforma Capital Structure

Pre-Merger Existing SunGard Debt Outstanding $Millions

Senior Notes (3.75% due in 2009) 250,000,000
Senior Notes (4.785 due in 2014) 250,000,000
Total Existing Debt Outstanding 500,000,000
Debt Portion of Merger Financing
Senior Secured Notes (≤ $5 billion) 5,000,000,000
$1 billion revolving credit facility with
6 year term
$4 billion term loan maturing in 7-1/2 years
Senior Subordinated Notes (≤$3 billion) 3,000,000,000
Payment-in-Kind Senior Notes (≤$.5 billion) 500,000,000
Receivables Credit Facility (≤$.5 billion) 500,000,000
Total Merger Financing (as if fully utilized) 9,000,000,000
Equity Portion of Merger Financing
Equity Investor Commitment ($Millions)
Silver Lake Partners II, LP1 540,000,000
Bain Capital Fund VIII, LP 540,000,000
Blackstone Capital Partners IV, L.P. 270,000,000
Blackstone Communications Partners I, L.P. 270,000,000
GS Capital Partners 2000, L.P. 250,000,000
GS Capital Partners 2000 V, L.P. 250,000,000
KKR Millennium Fund, L.P. 540,000,000
Providence Equity Partners V, L.P. 300,000,000
TPG Partners IV, L.P. 540,000,000
Total Equity Portion of Merger Financing 3,500,000,000
Total Debt and Equity 13,000,000,000
1
The roman numeral II refers to the fund providing the equity capital managed by the
partnership.

Case Study Discussion Questions:

35
 1. SunGard is a software company with relatively few tangible assets. Yet, the ratio of debt to equity of almost
5 to 1. Why do you think lenders would be willing to engage in such a highly leveraged transaction for a
firm of this type?

Answer: Lenders are confident that the loans can be repaid because of the predictable cash flow associated
with SunGard’s disaster-recovery business.

2. Under what circumstances would SunGard refinance the existing $500 million in outstanding senior debt
after the merger? Be specific.

Answer: If interest rates decline below those currently paid on the existing debt, it would make sense to
refinance the higher cost current debt.

3. In what ways is this transaction similar to and different from those that were common in the 1980s? Be
specific.

Answer: In the 1980s, few hi-tech companies were taken private due to their lack of tangible assets and high
reinvestment requirements. Also, LBOs usually paid off debt through asset sales and cost cutting rather than
through accelerating revenue growth. LBO funds rarely collaborated with other investors. The capital
structures in the 1990s usually have more equity and use less exotic financing such as PIK notes.

4. Why are payment-in-kind securities (e.g., debt or preferred stock) particularly well suited for financing
LBOs? Under what circumstances might they be most attractive to lenders or investors?

Answer: Such securities conserve cash. They are likely to be most attractive to investors or lenders
when the LBO target generates large and predictable cash flow.

5. Explain how the way in which the LBO is financed affects the way it is operated and the timing of when
equity investors choose to exit the business. Be specific.

Answer: The greater the leverage and non-PIK debt the greater the need to manage the business for cash and
the lower the reinvestment in new product development, advertising, capacity additions, etc. The average
maturity date of the debt will determine when the LBO resumes paying taxes. At that point, equity investors
will often consider selling to a strategic buyer or a secondary IPO if public market conditions are favorable.

HCA'S LBO REPRESENTS A HIGH-RISK BET ON GROWTH

While most LBOs are predicated on improving operating performance through a combination of aggressive cost
cutting and revenue growth, HCA laid out an unconventional approach in its effort to take the firm private. On July
24, 2006, management again announced that it would "go private" in a deal valued at $33 billion including the
assumption of $11.7 billion in existing debt.

The approximate $21.3 billion purchase price for HCA's stock was financed by a combination of $12.8 billion in
senior secured term loans of varying maturities and an estimated $8.5 billion in cash provided by Bain Capital,
Merrill Lynch Global Private Equity, and Kohlberg Kravis Roberts & Company. HCA also would take out a $4
billion revolving credit line to satisfy immediate working capital requirements. The firm publicly announced a
strategy of improving performance through growth rather than through cost cutting. HCA's network of 182 hospitals
and 94 surgery centers is expected to benefit from an aging U.S. population and the resulting increase in health-care
spending. The deal also seems to be partly contingent on the government assuming a larger share of health-care costs
in the future. Finally, with many nonprofit hospitals faltering financially, HCA may be able to acquire them
inexpensively.

While the longer-term trends in the health-care industry are unmistakable, shorter-term developments appear
troublesome, including sluggish hospital admissions, more uninsured patients, and higher bad debt expenses.
Moreover, with Medicare and Medicaid financially insolvent, it is unclear if future increases in government health-
care spending would be sufficient to enable HCA investors to achieve their expected financial returns. With the

36
highest operating profit margins in the industry, it is uncertain if HCA's cash flows could be significantly improved
by cost cutting, if the revenue growth assumptions fail to materialize. HCA's management and equity investors have
put themselves in a position in which they seem to have relatively little influence over the factors that directly affect
the firm's future cash flows.

Discussion Questions:

1. Does a hospital or hospital system represent a good or bad LBO candidate? Explain your answer.

Answer: Hospitals generally represent bad candidates. Hospital cash flow is heavily dependent on
government reimbursement rates which are likely to be declining in the future as the U.S. government
deficit balloons. Furthermore, hospital staffing levels are likely to increasingly subject to regulation
thereby limiting the opportunity for cost cutting. Hospitals also will be subject to increased capital
spending to meet new government standards, with the government being unable or unwilling to finance
such spending on behalf of the hospitals. The combination of these factors is likely to constrain cash
flow growth.

2. Having pledged not to engage in aggressive cost cutting, how do you think HCA and its financial
sponsor group planned on paying off the loans?

Answer: The financial sponsor group is assuming that increased government spending in view of the
growing demands of an aging population will result in increased total spending, even though
reimbursement per patient may decline. Furthermore, HCA is betting on being able to acquire other
hospitals and to improve their operating performance by applying the firm’s standardized operating
practices.
Case Study. Sony Buys MGM

Sony’s long-term vision has been to create synergy between its consumer electronics products and music, movies,
and games. Sony, which bought Columbia Pictures in 1989 for $3.4 billion, had wanted to control Metro-Goldwyn-
Mayer’s film library for years, but it did not want to pay the estimated $5 billion it would take to acquire it. On
September 14, 2004, a consortium, consisting of Sony Corp of America, Providence Equity Partners, Texas Pacific
Group, and DLJ Merchant Banking Partners, agreed to acquire MGM for $4.8 billion, consisting of $2.85 billion in
cash and the assumption of $2 billion in debt. The cash portion of the purchase price consisted of about $1.8 billion
in debt and $1 billion in equity capital. Of the equity capital, Providence contributed $450 million, Sony and Texas
Pacific Group $300 million, and DLJ Merchant Banking $250 million.

The combination of Sony and MGM will create the world’s largest film library of about 7,600 titles, with MGM
contributing about 54 percent of the combined libraries. Sony will control MGM and Comcast will distribute the
films over cable TV. Sony will shut down MGM’s film making operations and move all operations to Sony. Kirk
Kerkorian, who holds a 74 percent stake in MGM, will make $2 billion because of the transaction. The private
equity partners could cash out within three-to-five years, with the consortium undertaking an initial public offering or
sale to a strategic investor. Major risks include the ability of the consortium partners to maintain harmonious
relations and the problematic growth potential of the DVD market.

Sony and MGM negotiations had proven to be highly contentious for almost five months when media giant Time
Warner Inc. emerged to attempt to satisfy Kerkorian’s $5 billion asking price. The offer was made in stock on the
assumption that Kerkorian would want a tax-free transaction. MGM’s negotiations with Time Warner stalled around
the actual value of Time Warner stock, with Kerkorian leery about Time Warner’s future growth potential. Time
Warner changed its bid in late August to an all cash offer, albeit somewhat lower than the Sony consortium bid, but it
was more certain. Sony still did not have all of its financing in place. Time Warner had a “handshake agreement”
with MGM by Labor Day for $11 per share, about $.25 less than Sony’s.

37
 The Sony consortium huddled throughout the Labor Day weekend to put in place the financing for a bid of $12
per share. What often takes months to work out in most leveraged buyouts was hammered out in three days of
marathon sessions at law firm Davis Polk & Wardwell. In addition to getting final agreement on financing
arrangements including loan guarantees from J.P. Morgan Chase & Company, Sony was able to reach agreement
with Comcast to feature MGM movies in new cable and video-on-demand TV channels. This distribution
mechanism meant additional revenue for Sony, making it possible to increase the bid to $12 per share. Sony also
offered to make a $150 non-refundable cash payment to MGM. As a testament to the adage that timing is everything,
the revised Sony bid was faxed to MGM just before the beginning of a board meeting to approve the Time Warner
offer.

Discussion Questions:

1. Do you believe that MGM is an attractive LBO candidate? Why? Why not?

Answer: MGM made an attractive LBO candidate because of its ownership of a large film library, which
offered the potential of an annuity revenue stream from the movie rentals and growth in the DVD market.
The potential for significant cost savings was also great following the combination of the MGM movie film
making studios with Sony’s previously acquired Columbia Pictures operations.

2. In what way do you believe that Sony’s objectives might differ from those of the private equity investors
making up the remainder of the consortium? How might such differences affect the management of MGM?
Identify possible short-term and long-term effects.

Answer: Sony wanted to gain access to the film library to help provide content for the growth in its play
station and games product lines. However, the private equity investors were more likely to want to cash out
in 3-5 years or less. This may have created short-term management disagreements as Sony may have wanted
to reinvest in the business in the form of building brand identification, new movie content, and new
distribution channels. In the long-run, MGM would have to either sell to another strategic investor or
engage in a secondary public offering to allow the private equity investors to cash out.

3. How did Time Warner’s entry into the bidding affect pace of the negotiations and the relative bargaining
power of MGM, Time Warner, and the Sony consortium?

Answer: The bargaining was contentious and stalled for 5 months until Time Warner converted the bilateral
discussions into an auction. Consequently, bargaining leverage shifted to MGM and the Sony led
consortium was forced to put together a deal in a fraction of the time (a weekend) normally required to get
financing. It is often the case that the bulk of the progress on negotiations takes place when all parties feel
pressure to complete the deal.

4. What do you believe were the major factors persuading the MGM board to accept the Revised Sony bid? In
your judgment, do these factors make sense? Explain your answer.

Answer: MGM’s board and Kirk Kerkorian, MGM’s largest shareholder, were uncertain about the future
value of Time Warner’s stock. Sony’s bid looked more attractive because it was $12 per share vs. Time
Warner’s $11, it was in cash, and J.P. Morgan Chase bank had provided loan guarantees to ensure the cash
would be available.

RJR NABISCO GOES PRIVATE—

KEY SHAREHOLDER AND PUBLIC POLICY ISSUES

Background

The largest LBO in history is as well known for its theatrics as it is for its substantial improvement in shareholder
value. In October 1988, H. Ross Johnson, then CEO of RJR Nabisco, proposed an MBO of the firm at $75 per share.
His failure to inform the RJR board before publicly announcing his plans alienated many of the directors. Analysts
outside the company placed the breakup value of RJR Nabisco at more than $100 per share—almost twice its then

38
current share price. Johnson’s bid immediately was countered by a bid by the well-known LBO firm, Kohlberg,
Kravis, and Roberts (KKR), to buy the firm for $90 per share (Wasserstein, 1998). The firm’s board immediately was
faced with the dilemma of whether to accept the KKR offer or to consider some other form of restructuring of the
company. The board appointed a committee of outside directors to assess the bid to minimize the appearance of a
potential conflict of interest in having current board members, who were also part of the buyout proposal from
management, vote on which bid to select.

The bidding war soon escalated with additional bids coming from Forstmann Little and First Boston, although the
latter’s bid never really was taken very seriously. Forstmann Little later dropped out of the bidding as the purchase
price rose. Although the firm’s investment bankers valued both the bids by Johnson and KKR at about the same
level, the board ultimately accepted the KKR bid. The winning bid was set at almost $25 billion—the largest
transaction on record at that time and the largest LBO in history. Banks provided about three-fourths of the $20
billion that was borrowed to complete the transaction. The remaining debt was supplied by junk bond financing. The
RJR shareholders were the real winners, because the final purchase price constituted a more than 100% return from
the $56 per share price that existed just before the initial bid by RJR management.

Aggressive pricing actions by such competitors as Phillip Morris threatened to erode RJR Nabisco’s ability to
service its debt. Complex securities such as “increasing rate notes,” whose coupon rates had to be periodically reset
to ensure that these notes would trade at face value, ultimately forced the credit rating agencies to downgrade the
RJR Nabisco debt. As market interest rates climbed, RJR Nabisco did not appear to have sufficient cash to
accommodate the additional interest expense on the increasing return notes. To avoid default, KKR recapitalized the
company by investing additional equity capital and divesting more than $5 billion worth of businesses in 1990 to
help reduce its crushing debt load. In 1991, RJR went public by issuing more than $1 billion in new common stock,
which placed about one-fourth of the firm’s common stock in public hands.

When KKR eventually fully liquidated its position in RJR Nabisco in 1995, it did so for a far smaller profit than
expected. KKR earned a profit of about $60 million on an equity investment of $3.1 billion. KKR had not done well
for the outside investors who had financed more than 90% of the total equity investment in KKR. However, KKR
fared much better than investors had in its LBO funds by earning more than $500 million in transaction fees, advisor
fees, management fees, and directors’ fees. The publicity surrounding the transaction did not cease with the closing
of the transaction. Dissident bondholders filed suits alleging that the payment of such a large premium for the
company represented a “confiscation” of bondholder wealth by shareholders.

Potential Conflicts of Interest

In any MBO, management is confronted by a potential conflict of interest. Their fiduciary responsibility to the
shareholders is to take actions to maximize shareholder value; yet in the RJR Nabisco case, the management bid
appeared to be well below what was in the best interests of shareholders. Several proposals have been made to
minimize the potential for conflict of interest in the case of an MBO, including that directors, who are part of an
MBO effort, not be allowed to participate in voting on bids, that fairness opinions be solicited from independent
financial advisors, and that a firm receiving an MBO proposal be required to hold an auction for the firm.

The most contentious discussion immediately following the closing of the RJR Nabisco buyout centered on the
alleged transfer of wealth from bond and preferred stockholders to common stockholders when a premium was paid
for the shares held by RJR Nabisco common stockholders. It often is argued that at least some part of the premium is
offset by a reduction in the value of the firm’s outstanding bonds and preferred stock because of the substantial
increase in leverage that takes place in LBOs.

Winners and Losers

RJR Nabisco shareholders before the buyout clearly benefited greatly from efforts to take the company private.
However, in addition to the potential transfer of wealth from bondholders to stockholders, some critics of LBOs
argue that a wealth transfer also takes place in LBO transactions when LBO management is able to negotiate wage
and benefit concessions from current employee unions. LBOs are under greater pressure to seek such concessions
than other types of buyouts because they need to meet huge debt service requirements.

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Discussion Questions:

1. In your opinion, was the buyout proposal presented by Ross Johnson’s management
group in the best interests of the shareholders? Why? / Why not?

Answer: No. The management group proposed to buy the firm for $75 per share.
Immediately, outside analysts placed a break-up value of the firm of at least $100 per
share. The firm was finally sold for more than $120 per share. The initial low bid by
the MBO group probably reflected their knowledge of internal information about the
value of the firm rather than ignorance of its true value.

2. What were the RJR Nabisco board’s fiduciary responsibilities to the shareholders? How
well did they satisfy these responsibilities? What could/should they have done
differently?

Answer: The board’s fiduciary responsibilities were to maximize shareholder value.

The board’s actions resulted in RJR shareholders receiving more than twice what the
value of their shares were on the day the MBO group announce its initial bid.
Conceivably, shareholder value could have been increased had existing RJR
management decided to break-up the firm immediately, pay off existing liabilities, and
use the remaining proceeds to buy back the firm’s outstanding shares.

3. Why might the RJR Nabisco board have accepted the KKR bid over the Johnson bid?

Answer: The board may have accepted the KKR bid, because they did not believe that
Johnson could finance his higher bid or simply because they resented the way in which
he developed his buyout proposal without the direct knowledge of the RJR board.

4. How might bondholders and preferred stockholders have been hurt in the RJR Nabisco
leveraged buyout?

Answer: One of the most contentious discussions immediately following the closing of
the RJR Nabisco buyout centered on the alleged transfer of wealth from bond and
preferred stockholders to common stockholders when a premium was paid for the
shares held by RJR Nabisco common stockholders. It is often argued that at least some
part of the premium is offset by a reduction in the value of the firm’s outstanding
bonds and preferred stock because of the substantial increase in leverage that takes
place in LBOs. However, empirical studies of the change in the value of a firm’s
outstanding debt at the time of a leveraged buyout announcement provide mixed
results. In a lawsuit against RJR Nabisco, it was alleged but never proven that its $5
billion in bonds outstanding at the time of the announcement lost more than 20% of
their value.

5. Describe the potential benefits and costs of LBOs to shareholders, employers, lenders,
customers, and communities in which the firm undergoing the buyout may have
operations. Do you believe that on average LBOs provide a net benefit or cost to
society? Explain your answer.

Answer: RJR Nabisco shareholders prior to the buyout clearly benefited greatly from efforts to take the
company private. However, in addition to the potential transfer of wealth from bondholders to stockholders,
some critics of LBOs argue that a wealth transfer also takes place in LBO transactions when LBO
management is able to negotiate wage and benefit concessions from current employee unions. LBOs are
under greater pressure to seek such concessions than other types of buyouts, because they need to meet huge
debt service requirements. Empirical studies suggest that employment in firms that undergo a leveraged
buyout does grow more slowly than for other firms in the same industry. However, this appears to result

40
 from the more efficient use of labor and the sale of non-strategic assets following the LBO. The tax benefits
associated with LBOs represent a subsidy of the premium paid to the shareholders of the firm subject to the
buyout. However, this subsidy is offset by the taxes paid by the shareholders when they sell their stock. If
the LBO firm is actually made stronger because of the transaction, taxes paid may actually be higher than
they would have been if the transaction had not occurred. Furthermore, the eventual sale of the LBO either
to a strategic buyer or in a secondary public offering will also generate additional taxes. It is difficult to
determine if LBOs offer a net benefit or cost to society because of so-called “selection bias,” i.e., LBOs that
are eventually taken public or sold to strategic buyers are generally those that have succeeded in improving
cash flow substantially. Consequently, studies of these firms tend to show increases in employment, R&D
spending, and taxes paid due to their increased profitability.

Case Study. Private Equity Firms Acquire Yellow Pages Business

Qwest Communications agreed to sell its yellow pages business, QwestDex, to a consortium led by the Carlyle Group
and Welsh, Carson, Anderson and Stowe for $7.1 billion. In a two stage transaction, Qwest sold the eastern half of
the yellow pages business for $2.75 billion in late 2002. This portion of the business included directories in Colorado,
Iowa, Minnesota, Nebraska, New Mexico, South Dakota, and North Dakota. The remainder of the business, Arizona,
Idaho, Montana, Oregon, Utah, Washington, and Wyoming, was sold for $4.35 billion in late 2003. Caryle and
Welsh Carson each put in $775 million in equity (about 21 percent of the total purchase price).

Qwest was in a precarious financial position at the time of the negotiation. The telecom was trying to avoid
bankruptcy and needed the first stage financing to meet impending debt repayments due in late 2002. Qwest is a local
phone company in 14 western states and one of the nation’s largest long-distance carriers. It had amassed $26.5
billion in debt following a series of acquisitions during the 1990s.

The Carlyle Group has invested globally, mainly in defense and aerospace businesses, but it has also invested in
companies in real estate, health care, bottling, and information technology. Welsh Carson focuses primarily on the
communications and health care industries. While the yellow pages business is quite different from their normal
areas of investment, both firms were attracted by its steady cash flow. Such cash flow could be used to trim debt over
time and generate a solid return. The business’ existing management team will continue to run the operation under
the new ownership. Financing for the deal will come from J.P. Morgan Chase, Bank of America, Lehman Brothers,
Wachovia Securities, and Deutsche Bank. The investment groups agreed to a two stage transaction to facilitate
borrowing the large amounts required and to reduce the amount of equity each buyout firm had to invest. By staging
the purchase, the lenders could see how well the operations acquired during the first stage could manage their debt
load.

The new company will be the exclusive directory publisher for Qwest yellow page needs at the local level and
will provide all of Qwest’s publishing requirements under a fifty year contract. Under the arrangement, Qwest will
continue to provide certain services to its former yellow pages unit, such as billing and information technology,
under a variety of commercial services and transitional services agreements (Qwest: 2002).

Discussion Questions:

1. Why was QwestDex considered an attractive LBO candidate? Do you think it has significant growth potential?
Explain the following statement: “A business with high growth potential may not be a good candidate for an
LBO.

QwestDex was considered an attractive candidate because of its steadily growing, highly predictable cash flow,
strong management team, and the willingness of management to continue with the business. The growth in the
business is likely to mirror population growth in the region covered by the business.

A high growth business is often not considered a good LBO candidate, because it will generally have high
reinvestment requirements in terms of working capital, R&D spending, and new plant and equipment. The high
reinvestment rate will inhibit the ability to pay down debt incurred to take the business private.

41
2. Why did the buyout firms want a 50-year contract to be the exclusive provider of publishing services to Qwest
Communications?

The buyout firms wanted a long-term, exclusive contract to ensure a predictable, multi-year revenue stream.

3. Why would the buyout firms want Qwest to continue to provide such services as billing and information
technology support? How might such services be priced?

The buyers wanted to ensure a flawless transition of payroll, IT, and other administrative support services when
the business changed owners in order to avoid disrupting the business and angering employees. If Qwest were
willing to price these services at the same level as what third party vendors would charge, the buyers would have
ample incentive to pursue this option.

4. Why would it take five very large financial institutions to finance the transactions?

The $7.1 billion transaction was large by conventional LBO standards. By borrowing from a consortium of
banks, the buyout firms may have been able to get better terms, as the risk of lending was spread across five
lenders.

5. Why was the equity contribution of the buyout firms as a percentage of the total capital requirements so much
higher than amounts contributed during the 1980s?

The equity contribution amounted to about one-fifth of the total purchase price, two-to-three times the average
of the 1980s. The higher equity contribution was necessary because of the poor track record of many of the
deals put together during the 1980s.

Cox Enterprises Offers to Take Cox Communications Private

In an effort to take the firm private, Cox Enterprises announced on August 3, 2004 a proposal to buy the remaining
38% of Cox Communications’ shares that they did not currently own for $32 per share. Cox Communications is the
third largest provider of cable television, telecommunications, and wireless services in the U.S, serving more than 6.2
million customers. Historically, the firm’s cash flow has been steady and substantial.

The deal is valued at $7.9 billion and represented a 16% premium to Cox Communication’s share price at that
time. Cox Communications would become a subsidiary of Cox Enterprises and would continue to operate as an
autonomous business. In response to the proposal, the Cox Communications Board of Directors formed a special
committee of independent directors to consider the proposal. Citigroup Global Markets and Lehman Brothers Inc.
have committed $10 billion to the deal. Cox Enterprises would use $7.9 billion for the tender offer, with the
remaining $2.1 billion used for refinancing existing debt and to satisfy working capital requirements.

Cable service firms have faced intensified competitive pressures from satellite service providers DirecTV Group
and EchoStar communications. Moreover, telephone companies continue to attack cable’s high-speed Internet service
by cutting prices on high-speed Internet service over phone lines. Cable firms have responded by offering a broader
range of advanced services like video-on-demand and phone service. Since 2000, the cable industry has invested
more than $80 billion to upgrade their systems to provide such services, causing profitability to deteriorate and
frustrating investors. In response, cable company stock prices have fallen. Cox Enterprises stated that the
increasingly competitive cable industry environment makes investment in the cable industry best done through a
private company structure.

Discussion Questions::

1. Why did the board feel that it was appropriate to set up special committee of independent board directors?

42
 Answer: Special board committees consisting of outside directors often are set up when company insiders
are involved in taking the company private. This arrangement is intended to eliminate any appearance of
potential conflicts of interests.

2. Why does Cox Enterprises believe that the investment needed for growing its cable business is best done
through a private company structure?
Answer: Substantial levels of investment would result in increasing levels of depreciation and amortization
expense, which would erode the firm’s earnings per share and penalize the firm’s share price in the short-run
if it were a public company. Investors tend to track quarterly changes in EPS and punish firms which miss
forecasts or show year over year declines.

Financing Challenges in the Home Depot Supply Transaction

Buyout firms Bain Capital, Carlyle Group, and Clayton, Dubilier & Rice (CD&R) bid $10.3 billion in June 2007 to
buy Home Depot Inc.’s HD Supply business. HD Supply represented a collection of small suppliers of construction
products. Home Depot had announced earlier in the year that it planned to use the proceeds of the sale to pay for a
portion of a $22.5 billion stock buyback.

Three banks, Lehman Brothers, JPMorgan Chase, and Merril Lynch agreed to provide the firms with a $4 billion
loan. The repayment of the loans was predicated on the ability of the buyout firms to improve significantly HD
Supply’s current cash flow. Such loans are normally made with the presumption that they can be sold to investors,
with the banks collecting fees from both the borrower and investor groups. However, by July, concern about the
credit quality of subprime mortgages spread to the broader debt market and raised questions about the potential for
default of loans made to finance highly leveraged transactions. The concern was particularly great for so-called
“covenant-lite” loans for which the repayment terms were very lenient.

Fearing they would not be able to resell such loans to investors, the three banks involved in financing the HD
Supply transaction wanted more financial protection. Additional protection, they reasoned, would make such loans
more marketable to investors. They used the upheaval in the credit markets as a pretext for reopening negotiations on
their previous financing commitments. Home Depot was willing to lower the selling price thereby reducing the
amount of financing required by the buyout firms and was willing to guarantee payment in the event of default by the
buyout firms. While Bain, Carlyle, and CD&R were willing to increase their cash investment and pay higher fees to
the banks, they were unwilling to alter the original terms of the loans. Eventually the banks agreed to provide
financing consisting of a $1 billion “covenant-lite” loan and a $1.3 billion “payment-in-kind” loan. Home Depot
agreed to assume the loan payments on the $1 billion loan if the investor firms were to default and to lower the
selling price to $8.5 billion for 87.5 percent of HD Supply, with Home Depot retaining the remaining 12.5 percent.

By the end of August, Home Depot had succeeded in raising the cash needed to help pay for its share repurchase,
and the banks had reduced their original commitment of $4 billion in loans to $2.3 billion. While they had agreed to
put more money into the transaction, the buyout firms had been successful in limiting the number of new restrictive
covenants.

Case Study Discussion Questions:

1. Based on the information given it the case, determine the amount of the price reduction Home Depot
accepted for HD Supply and the amount of cash the three buyout firms put into the transaction?

Answer: The price reduction amounted to $600 million (i.e., $10.3 -$8.5/(1.00-.125) = $10.3 – 9.7 =$.6).
The amount of cash invested in the transaction by the buyout firms totaled $6.2 billion ($8.5 -$2.3).

2. Why did banks lower their lending standards in financing LBOs in 2006 and early 2007? How did the lax
standards contribute to their inability to sell the loans to investors? How did the inability to sell the loans
once made curtail their future lending?

43
 Answer: Banks were willing to lower lending standards in order to generate fee income in what was a highly
competitive lending market for LBO business. However, the lax standards made investors to whom banks
had traditionally sold such loans to question the ability of borrowers to repay. Banks that were unable to sell
the loans had to eventually write down the value of the questionable loans to their market value reducing
bank equity and their ability to make loans without violating regulatory requirements.

Cerberus Capital Management Acquires Chrysler Corporation

According to the terms of the transaction, Cerberus would own 80.1 percent of Chrysler's auto manufacturing and
financial services businesses in exchange for $7.4 billion in cash. Daimler would continue to own 19.9 percent of the
new business, Chrysler Holdings LLC. Of the $7.4 billion, Daimler would receive $1.35 billion while the remaining
$6.05 billion would be invested in Chrysler (i.e., $5.0 billion is to be invested in the auto manufacturing operation
and $1.05 billion in the finance unit). Daimler also agreed to pay to Cerberus $1.6 billion to cover Chrysler's long-
term debt and cumulative operating losses during the four months between the signing of the merger agreement and
the actual closing. In acquiring Chrysler, Cerberus assumed responsibility for an estimated $18 billion in unfunded
retiree pension and medical benefits. Daimler also agreed to loan Chrysler Holdings LLC $405 million.

The transaction is atypical of those involving private equity investors, which usually take public firms private,
expecting to later sell them for a profit. The private equity firm pays for the acquisition by borrowing against the
firm's assets or cash flow. However, the estimated size of Chrysler's retiree health-care liabilities and the uncertainty
of future cash flows make borrowing impractical. Therefore, Cerberus agreed to invest its own funds in the business
to keep it running while it restructured the business.

By going private, Cerberus would be able to focus on the long-term without the disruption of meeting quarterly
earnings reports. Cerberus was counting on paring retiree health-care liabilities through aggressive negotiations with
the United Auto Workers (UAW). Cerberus sought a deal similar to what the UAW accepted from Goodyear Tire
and Rubber Company in late 2006. Under this agreement, the management of $1.2 billion in health-care liabilities
was transferred to a fund managed by the UAW, with Goodyear contributing $1 billion in cash and Goodyear stock.
By transferring responsibility for these liabilities to the UAW, Chrysler believed that it would be able to cut in half
the $30 dollar per hour labor cost advantage enjoyed by Toyota. Cerberus also expected to benefit from melding
Chrysler's financial unit with Cerberus's 51 percent ownership stake in GMAC, GM's former auto financing business.
By consolidating the two businesses, Cerberus hoped to slash cost by eliminating duplicate jobs, combining
overlapping operations such as data centers and field offices, and increasing the number of loans generated by
combining back-office operations.

However, the 2008 credit market meltdown, severe recession, and subsequent free fall in auto sales threatened the
financial viability of Chrysler, despite an infusion of U.S. government capital, and it’s leasing operations as well as
GMAC. GMAC applied for commercial banking status to be able to borrow directly from the U.S. Federal Reserve.
In late 2008, the U.S. Treasury purchased $6 billion in GMAC preferred stock to provide additional capital to the
financially ailing firm. To avoid being classified as a bank holding company under direct government supervision,
Cerberus reduced its ownership in 2009 to 14.9 percent of voting stock and 33 percent of total equity by distributing
equity stakes to its coinvestors in GMAC. By surrendering its controlling interest in GMAC, it is less likely that
Cerberus would be able to realize anticipated cost savings by combining the GMAC and Chrysler Financial
operations. In early 2009, Chrysler entered into negotiations with Italian auto maker Fiat to gain access to the firm's
technology in exchange for a 20 percent stake in Chrysler.

Discussion Questions and Answers:

1. What were the motivations for this deal from Cerberus’ perspective? From Daimler’s perspective?

Answer: Daimler had demonstrated an inability to realize the originally projected synergies and believed
that the risks of continued ownership outweighed potential future profits. Moreover, relations with the UAW
were such that they were unlikely to get significant relief from the bone-crushing retiree liabilities. In
contrast, by taking the firm private, CCM can take the actions necessary to restore long-term profitability.
These actions may necessitate incurring significant short-term expenses such as employee severance

44
 expenses and a potential UAW strike which may not have been tenable due to pressure from investors if the
firm had remained public. CCM will also save the financial reporting expenses incurred by public firms.
Finally, private equity investors may be viewed by the UAW as better equipped to turnaround Chrysler and,
as such, be willing to make concessions it would not have made to Daimler if it believes that more jobs can
be saved.

2. What are the risks to this deal’s eventual success? Be specific.

Answer: The risks include the assumption that the UAW will make significant concessions on retiree
medical liabilities and that the assumed synergies between Chrysler Financial and GMAC can be realized in
a timely fashion. Other risks include continued growth in the transportation markets served by Chrysler
worldwide and continued stability in the credit markets.

3. Cite examples of economies of scale and scope?

Answer: Economies of scope refer to the use of a single operation to support multiple activities. For
example, combining HR and accounting departments to support both the Chrysler Financial and GMAC
operations result in savings due to the elimination of duplicate positions. Economies of scale represent the
better utilization of such functions as back office operations, data centers and field offices such that more
loans can be processed at the same or a lower overall level of fixed expense due to increased productivity.

4. Cerberus and Daimler will own 80.1% and 19.9% of Chrysler Holdings LLC, respectively. Why do you
think the two parties agreed to this distribution of ownership?

Answer: CCM will be able to consolidate the Chrysler operations with its GMAC operations for tax
purposes such that losses generated by Chrysler in the near term can be used to offset profits generated by
GMAC. Daimler wanted to retain a minority ownership positions to benefit from any upside future growth
potential and to retain access to Chrysler R&D and possible joint marketing alliances in the U.S. and
elsewhere.

5. Which of the leading explanations of why deals sometimes fail to meet expectations best explains why the
combination of Daimler and Chrysler failed? Explain your answer.

Answer: Daimler’s failed attempt to operate Chrysler profitably reflected overpaying for the Chrysler
business, slow integration, and a failed business plan.

6. The new company, Chrysler Holdings, is a limited liability company. Why do you think CCM chose this
legal structure over a more conventional corporate structure?

Answer: The principal reason is that the LLC avoids double taxation associated with the conventional
corporate structure.

Pacific Investors Acquires California Kool in a Leveraged Buyout

Pacific Investors (PI) is a small private equity limited partnership with $3 billion under management. The objective
of the fund is to give investors at least a 30-percent annual average return on their investment by judiciously
investing these funds in highly leveraged transactions. PI has been able to realize such returns over the last decade
because of its focus on investing in industries that have slow but predictable growth in cash flow, modest capital
investment requirements, and relatively low levels of research and development spending. In the past, PI made
several lucrative investments in the contract packaging industry, which provides packaging for beverage companies
that produce various types of noncarbonated and carbonated beverages. Because of its commitments to its investors,
PI likes to liquidate its investments within four to six years of the initial investment through a secondary public
offering or sale to a strategic investor.
Following its past success in the industry, PI currently is negotiating with California Kool (CK), a privately
owned contract beverage packaging company with the technology required to package many types of noncarbonated

45
drinks. CK's 2003 revenue and net income are $190.4 million and $5.9 million, respectively. With a reputation for
effective management, CK is a medium-sized contract packaging company that owns its own plant and equipment
and has a history of continually increasing cash flow. The company also has significant unused excess capacity,
suggesting that production levels can be increased without substantial new capital spending.
The owners of CK are demanding a purchase price of $70 million. This is denoted on the balance sheet (see Table
13-15 at the end of the case) as a negative entry in additional paid-in capital. This price represents a multiple of 11.8
times 2003's net income, almost twice the multiple for comparable publicly traded companies. Despite the "rich"
multiple, PI believes that it can finance the transaction through an equity investment of $25 million and $47 million
in debt. The equity investment consists of $3 million in common stock, with PI's investors and CK's management
each contributing $1.5 million. Debt consists of a $12 million revolving loan to meet immediate working capital
requirements, $20 million in senior bank debt secured by CK's fixed assets, and $15 million in a subordinated loan
from a pension fund. The total cost of acquiring CK is $72 million, $70 million paid to the owners of CK and $2
million in legal and accounting fees.
As indicated on Table 13-15, the change in total liabilities plus shareholders' equity (i.e., total sources of funds or
cash inflows) must equal the change in total assets (i.e., total uses of funds or cash outflows). Therefore, as shown in
the adjustments column, total liabilities increase by $47 million in total borrowings and shareholders' equity declines
by $45 million (i.e., $25 million in preferred and common equity provided by investors less $70 million paid to CK
owners). The excess of sources over uses of $2 million is used to finance legal and accounting fees incurred in
closing the transaction. Consequently, total assets increase by $2 million and total liabilities plus shareholders' equity
increase by $2 million between the pre- and postclosing balance sheets as shown in the adjustments [Link] 1
Delta;Total assets = ΔTotal liabilities + ΔShareholders' equity: $2 million = $47 million –$45 million =
$2 million.
Revenue for CK is projected to grow at 4.5 percent annually through the foreseeable future. Operating expenses
and sales, general, and administrative expenses as a percent of sales are expected to decline during the first three
years of operation due to aggressive cost cutting and the introduction of new management and engineering processes.
Similarly, improved working capital management results in significant declines in working capital as a percent of
sales during the first year of operation. Gross fixed assets as percent of sales is held constant at its 2003 level during
the forecast period, reflecting reinvestment requirements to support the projected increase in net revenue. Equity cash
flow adjusted to include cash generated in excess of normal operating requirements (i.e., denoted by the change in
investments available for sale) is expected to reach $8.5 million annually by 2010. Using the cost of capital method,
the cost of equity declines in line with the reduction in the firm's beta as the debt is repaid from 26 percent in 2004 to
16.5 percent in 2010. In contrast, the adjusted present value method employs a constant unlevered COE of 17
percent.
The deal would appear to make sense from the standpoint of PI, since the projected average annual internal rates
of return (IRRs) for investors exceed PI's minimum desired 30 percent rate of return in all scenarios considered
between 2007 and 2009 (see Table 13-13). This is the period during which investors would like to "cash out." The
rates of return scenarios are calculated assuming the business can be sold at different multiples of adjusted equity
cash flow in the year in which the business is assumed to be sold. Consequently, IRRs are calculated using the cash
outflow (initial equity investment in the business) in the first year offset by any positive equity cash flow from
operations generated in the first year, equity cash flows for each subsequent year, and the sum of equity cash flow in
the year in which the business is sold or taken public plus the estimated sale value (e.g., eight times equity cash flow)
in that year. Adjusted equity cash flow includes free cash flow generated from operations and the increase in
"investments available for sale." Such investments represent cash generated in excess of normal operating
requirements; and as such, this cash is available to LBO investors.
The actual point at which CK would either be taken public, sold to a strategic investor, or sold to another LBO
fund depends on stock market conditions, CK's leverage relative to similar firms in the industry, and cash flow
performance as compared to the plan. Discounted cash flow analysis also suggests that PI should do the deal, since
the total present value of adjusted equity cash flow of $57.2 million using the CC method is more than twice the
magnitude of the initial equity investment. At $56 million, the APV method results in a slightly lower estimate of
total present value. See Tables 13-14,13-15, and 13-16 for the income, balance-sheet, and cash-flow statements,
respectively, associated with this transaction. Exhibits 13-1 and 13-2 illustrate the calculation of present value of the
transaction based on the cost of capital and the adjusted present value methods, respectively. Note the actual Excel

46
spreadsheets and formulas used to create these financial tables are available on the CD-ROM accompanying this
book in a worksheet, Excel-Based Leveraged Buyout Valuation and Structuring Model.
Discussion Questions

1. What criteria did Pacific Investors (PI) use to select California Kool (CK) as a target for an LBO? Why
were these criteria employed?

Answer: PI has been able to realize attractive financial returns over the last decade because of their
focus on investing in industries that have slow but predictable growth in cash flow, modest capital
investment requirements, and relatively low levels of research and development spending. The criteria
were selected because they would enable PI to get adequate bank financing based on the relative
certainty of the cash flows.

2. Describe how PI financed the purchase price. Speculate as why each source of financing was selected?
How did CK pay for feels incurred in closing the transaction?

Answer: PI financed the purchase price through a modest $3 million equity contribution, one-half of
which was provided by PI investors and the remainder by CK management, $22 million in preferred
stock, and $47 million in debt. The debt consists of a $12 million revolving bank loan, $20 million in
senior bank loans, and $15 million in subordinated debt. The composition of the equity was skewed
toward preferred stock which has a higher priority in liquidation than common equity. The revolving
loan was to be used to satisfy working capital requirements. The senor bank debt was secured by the
firm’s assets and represented a cheaper source for financing than the longer-term subordinated debt. The
$1.5 million equity contribution was to help defray the initial cash investment and to motivate
management by making them owners. CK paid for the $2 million in legal and accounting fees incurred
in closing the transaction by borrowing the money as part of the initial financing of the transaction.

3. What are the advantages and disadvantages of using enterprise cash flow in valuing CK? In what might
EBITDA been a superior (inferior) measure of cash flow for valuing CK?

Answer: Enterprise value includes cash from operating and investing activities but excludes cash from
financing activities. The use this measure requires that the analyst estimate depreciation expense,
changes in working capital, and capital expenditures. Consequently, it requires that the analyst project
these variables based on a set of plausible assumptions. EBITDA would have been simpler to calculate
as it ignores working capital requirements and assumes implicitly that future capital expenditures equal
depreciation. Errors can be introduced using enterprise cash flow because of the difficulty in forecasting
its constituent parts. However, the analyst is at a minimum forced to understand the underlying
competitive dynamics of business to devise a set of suitable assumptions. In contrast, errors using
EBITDA result from omission by ignoring working capital and the likelihood that capital requirements
beyond a year to two will exceed depreciation which is based on the historical value of fixed assets.

4. Compare and contrast the Cost of Capital Method and the Adjusted Present Value Method of valuation.

Answer: From Exhibits 13-1 and 13-2 we see that the APV method provides an estimate of total present
value that is about 7 percent higher than the Cost of Capital Method (CCM). The APV method is
computationally simpler to estimate. However, it requires that the analyst estimate the additional
expense associated with financial distress. The two valuations would have been even closer had an
estimate of the present value of potential financial distress been deducted in the APV estimate of
present value.

47
48
Table 13-11: California Kool Model Output Summary
Sources (Cash Inflows) and Uses (Cash Outflows) of Funds:
Pro Forma Capital Structure
Amount($ Interest Uses of Funds Amount Form of Debt and Market % of Total
Sources of Funds: ) Rate (%) ($) Equity Value Capital
Cash From Balance Sheet $0.0 0.0% Cash to $70.0 Revolving Loan $12.0 16.7%
Owners
New Revolving Loan $12.0 9.0% Seller’s Equity $0.0 Senior Debt $20.0 27.8%
New Senior Debt $20.0 9.0% Seller’s Note $0.0 Subordinated Debt $15.0 20.8%
New Subordinated Debt $15.0 12.0% Excess Cash $0.0 Total Debt $47.0 65.3%
New Preferred Stock (PIK) $22.0 12.0% Paid to $70.0 Preferred Equity $22.0 30.6%
Owners
New Common Stock $3.0 0.0% Debt $0.0 Common Equity $3.0 4.2%
Repayment
Buyer $2.0 Total Equity $25.0 34.7%
Expenses
Total Sources $72.0 Total Uses $72.0 Total Capital $72.0
Ownership Distribution ($) % Distribution Fully Diluted Ownership
Equity Investment: Distribution
Common Preferred Tota Common Preferre Common Warrants Pre- Perform. Fully Dil.
l d Option Options Ownership
Ownershi
p
Equity Investor 1.5 22.0 23.5 50.0% 100.0% 50.0% 0.0% 50.0% 0.0% 50.0%
Management 1.5 0.0 1.5 50.0% 0.0% 50.0% 0.0% 50.0% 0.0% 50.0%
Total Equity Investment $3.0 $22.0 $25. 100.0% 100.0% 100.0% 0.0% 100.0% 0.0% 100.0%
0

Internal Rates of Return: Total Investor Return (%) Equity Investor Investment Management Investment Gain ($)
Gain ($)
2007 2008 2009 2007 2008 2009 2007 2008 2009
Multiple of Adjusted Equity Cash Flow1
8 x Terminal Yr. CF 0.42 0.35 0.33 $66.6 $78.9 $96.0 $4.3 $5.0 $6.1
9 x Terminal Yr. CF 0.46 0.39 0.35 $73.8 $86.6 $104.5 $4.7 $5.5 $6.7
10 x Terminal Yr. CF 0.51 0.42 0.37 $81.0 $94.2 $113.0 $5.2 $6.0 $7.2
Financial Projections and Analysis: 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Net Sales $177.6 $183.5 $190.4 $197.1 $205.0 $214.2 $223.8 $233.9 $244.4 $255.4
Annual Growth Rate 4.2% 3.3% 3.8% 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
EBIT as % of Net Revenue 5.5% 1.3% 5.1% 8.5% 9.5% 10.2% 11.2% 11.4% 11.4% 11.4%
Adjusted Enterprise Cash Flow2 $4.2 $0.2 $0.1 $9.5 $9.6 $10.8 $13.0 $13.4 $14.2 $14.9
Adjusted Equity Cash Flow $4.2 $0.2 $0.1 $0.3 $0.2 $1.8 $7.4 $7.7 $8.1 $8.5
Total Debt Outstanding 0 0 $47.0 $39.5 $31.5 $23.8 $19.2 $14.3 $8.8 $2.7
Total Debt/Adjusted Enterprise Cash 0.0 0.0 NA 4.1 3.3 2.2 1.5 1.1 0.6 0.2
Flow
EBIT/Interest Expense 0 0 0 3.6 4.9 6.6 10.1 13.3 18.6 30.9
PV of Adjusted Equity Cash Flow @ $57.2
26%
PV of 2004-10 Adj. Equity CF/Terminal 28.1%
Val
1
Net Income + Depreciation & Amortization - Gross Capital Spending - Chg. In Working Capital - Principal Repayments – Change Investments
Available
for Sale (I.e., Increases in such investments are a negative cash flow entry, but represent cash in excess of normal operating needs.)
2
EBIT(1-t) + Depreciation & Amortization - Gross Capital Spending - Chg. in Working Capital - Chg. In Investments Available for Sale

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 Table 13-12. California Kool Income Statement and Forecast Assumptions
Historical Period Projections: Twelve Months Ending December 31,
Income Statement Assumptions: 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Net Sales Growth 0.042 0.033 0.038 0.035 0.040 0.045 0.045 0.045 0.045 0.045
(%)
Cost of Sales as % of Sales 0.805 0.814 0.780 0.765 0.758 0.755 0.750 0.750 0.750 0.750
SG&A as % of Sales 0.133 0.144 0.142 0.135 0.130 0.125 0.120 0.120 0.120 0.120
Effective Tax Rate (%) 0.400 0.400 0.400 0.400 0.400 0.400 0.400 0.400 0.400 0.400
Income Statement:
Net Sales $177.6 $183.5 $190.4 $197.1 $205.0 $214.2 $223.8 $233.9 $244.4 $255.4
Cost of Sales 143.0 149.3 148.5 150.8 155.4 161.7 167.9 175.4 183.3 191.6
Gross Profit 34.6 34.1 41.9 46.3 49.6 52.5 56.0 58.5 61.1 63.9
Depreciation 1.3 5.4 5.1 2.4 2.9 3.4 3.5 3.7 3.8 4.0
Amortization of Financing Fees 0.5 0.5 0.5 0.5
Total Depreciation & 1.3 5.4 5.1 2.9 3.4 3.9 4.0 3.7 3.8 4.0
Amortization
SG&A 23.6 26.4 27.0 26.6 26.6 26.8 26.9 28.1 29.3 30.7
Management Fee 0.1 0.1 0.1 0.1 0.1 0.1 0.1
Operating Income (EBIT) 9.7 2.3 9.7 16.7 19.5 21.7 25.0 26.6 27.8 29.1
(Interest Income) 0.1 0.1 0.1 0.0 0.1 0.1 0.1 0.1 0.1 0.1
New Revolver Interest Expense 1.0 0.7 0.4 0.0 0.0 0.0 0.0
New Senior Debt Interest 1.8 1.6 1.4 1.2 0.9 0.6 0.3
Expense
Subordinated Debt Interest 1.8 1.7 1.5 1.3 1.1 0.9 0.6
Expense
Total Interest Expense 0 0 0 4.6 4.0 3.3 2.5 2.0 1.5 0.9
Earnings Before Taxes 9.8 2.4 9.8 12.1 15.6 18.5 22.6 24.7 26.4 28.3
Taxes @40% 3.9 0.9 3.9 4.8 6.2 7.4 9.0 9.9 10.6 11.3
Net Income $5.9 $1.4 $5.9 $7.3 $9.4 $11.1 $13.6 $14.8 $15.9 $17.0
PIK Preferred Dividend 2.6 3.0 3.3 3.7 4.2 4.7 5.2
Net Income to Common $5.9 $1.4 $5.9 $4.6 $6.4 $7.8 $9.9 $10.7 $11.2 $11.7

52
 Table 13-13. California Kool Balance Sheet and Forecast Assumptions
Historical Period Adjust. Closing Projections: Twelve Months Ended December,
2001 2002 2003 2003 2004 2005 2006 2007 2008 2009 2010
Balance Sheet Assumptions:
Cash & Marketable Securities 0.02 0.02 0.02 0.0 0.02 0.02 0.02 0.02 0.02 0.02 0.02 0.02
(%Sales)
Accounts Receivable (%Sales) 0.161 0.158 0.167 0.0 0.167 0.155 0.155 0.155 0.155 0.155 0.155 0.155
Other Current Assets (%Sales) 0.054 0.057 0.063 0.0 0.063 0.055 0.055 0.055 0.055 0.055 0.055 0.055
Gross Prop., Plant & Equip. 0.473 0.5 0.52 0.0 0.52 0.52 0.52 0.52 0.52 0.52 0.52 0.52
(%Sales)
Accumulated Depreciation 0.7 0.7 0.7 0.0 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7
(%GP&E)
Accounts Payable (%Sales) 0.08 0.083 0.084 0.0 0.084 0.078 0.078 0.078 0.078 0.078 0.078 0.078
Other Current Liabilities (%Sales) 0.074 0.079 0.076 0.0 0.076 0.07 0.07 0.07 0.07 0.07 0.07 0.07
Assets: ($Millions)
Current Assets
Cash and Marketable Securities 3.6 3.7 3.8 0.0 3.8 4.1 4.3 4.5 4.7 4.9 5.1 5.1
Accounts Receivable 28.6 29.0 31.8 0.0 31.8 30.6 31.8 33.2 34.7 36.3 37.9 39.6
Other Current Assets 9.6 10.5 12.0 0.0 12.0 10.8 11.3 11.8 12.3 12.9 13.4 14.0
Total Current Assets 41.7 43.1 47.6 0.0 47.6 45.5 47.3 49.5 51.7 54.0 56.4 58.8
Investments Available for Sale 0.0 0.0 0.0 0.0 0.0 8.9 16.3 24.2 32.7
Gross Property, Plant & Equipment 84.0 91.7 99.0 0.0 99.0 102.5 106.6 111.4 116.4 121.6 127.1 132.8
Less: Accumulated Depreciation 58.8 64.2 69.3 0.0 69.3 71.7 74.6 78.0 81.5 85.1 89.0 93.0
Net Property, Plant & Equipment 25.2 27.5 29.7 0.0 29.7 30.7 32.0 33.4 34.9 36.5 38.1 39.8
Transaction Fees and Expenses 0.0 0.0 0.0 2.0 2.0 1.5 1.0 0.5 0.0 0.0 0.0 0.0
Purchase price in excess of book 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
value
Total Assets 66.9 70.6 77.3 2.0 79.3 77.7 80.3 83.4 95.5 106.8 118.8 131.3
Liabilities & Shareholders' Equity ($Millions)
Current Liabilities:
Accounts Payable 14.2 15.2 16.0 0.0 16.0 15.4 16.0 16.7 17.5 18.2 19.1 19.9
Other Current Liabilities 13.1 14.5 14.5 0.0 14.5 13.8 14.3 15.0 15.7 16.4 17.1 17.9
Total Current Liabilities 27.4 29.7 30.5 0.0 30.5 29.2 30.3 31.7 33.1 34.6 36.2 37.8
Long-Term Debt:
Revolving Loan 12.0 12.0 7.9 3.7 0.0 0.0 0.0 0.0 0.0
Senior Debt 20.0 20.0 17.8 15.5 12.9 10.1 7.0 3.7 0.0
53
 Subordinated Debt 15.0 15.0 13.8 12.4 10.9 9.2 7.2 5.1 2.7
Total Long-Term Debt 0.0 0.0 0.0 47.0 39.5 31.5 23.8 19.2 14.3 8.8 2.7
Shareholders' Equity
Preferred Stock (PIK) 22.0 22.0 24.6 27.6 30.9 34.6 38.8 43.4 48.6
Common Stock 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0
Additional Paid in Capital (70.0) (70.0) (70.0) (70.0) (70.0) (70.0) (70.0) (70.0) (70.0)
Retained Earnings 39.5 40.9 46.8 0.0 46.8 51.4 57.8 65.7 75.5 86.2 97.4 109.1
Total Shareholders' Equity 39.5 40.9 46.8 1.8 9.1 18.4 29.6 43.1 58.0 73.8 90.8
Total Liabilities & Shareholders' 66.9 70.6 77.3 2.0 79.3 77.7 80.3 85.0 95.5 106.8 118.8 131.3
Equity

54
 Table 13-14: California Kool Cash Flow Statement and Analysis
Historical Data Projections: Twelve Months Ended December 31,
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
GAAP Cash Flow ($Millions)
Cash Flow from Operating Activities:
Net Income Available to Common Equity 5.9 1.4 5.9 4.6 6.4 7.8 9.9 10.7 11.2 11.7
Adjustments to Reconcile Net Income to Net Cash Flow
Depreciation 1.3 5.4 5.1 2.4 2.9 3.4 3.5 3.7 3.8 4.0
Amortization of Financing Fees 0.0 0.0 0.0 0.5 0.5 0.5 0.5 0.0 0.0 0.0
PIK Preferred Dividends 0.0 0.0 0.0 2.6 3.0 3.3 3.7 4.2 4.7 5.2
Net Change in Working Capital 0.0 1.1 (3.6) 1.1 (0.5) (0.6) (0.6) (0.6) (0.7) (0.7)
Net Cash Flow from Operations 7.2 5.7 14.6 11.3 12.2 14.4 17.0 17.9 19.0 20.3
Cash Flow from Investing Activities:
(Increase) Decrease in Investments Available for 0.0 0.0 0.0 (8.9) (7.4) (7.9) (8.5)
Sale.
(Increase) Decrease in Gross Property, Plant & (3.5) (4.1) (4.8) (5.0) (5.2) (5.5) (5.7)
Equipment
Net Cash Used in Investments 0.0 0.0 0.0 (3.5) (4.1) (4.8) (13.9) (12.7) (13.3) (14.2)
Cash Flows from Financing Activities:
Net Debt (Repayment) or Issuance 0.0 0.0 0.0 (7.5) (8.0) (7.8) (4.5) (5.0) (5.5) (6.1)
Net Cash (Used in) Provided by Financing 0.0 0.0 0.0 (7.5) (8.0) (7.8) (4.5) (5.0) (5.5) (6.1)
Activities
Net Increase (Decrease) in Cash & Marketable Securities 0.3 0.2 1.8 (1.5) 0.2 0.2 0.0
Beginning Balances--Cash & Marketable Securities 3.8 4.1 4.3 6.1 4.7 4.9 5.1
Ending Balances--Cash & Marketable Securities 4.1 4.3 6.1 4.7 4.9 5.1 5.1
Valuation Cash Flow ($Millions)
Net Income to Available to Common Equity 5.9 1.4 5.9 4.6 6.4 7.8 9.9 10.7 11.2 11.7
After-Tax Net Interest Expense (Income) 0 0 0 1.7 1.4 1.2 1.0 0.8 0.6 0.4
Depreciation 1.3 5.4 5.1 2.4 2.9 3.4 3.5 3.7 3.8 4.0
Amortization of Financing Fees 0 0 0 0.5 0.5 0.5 0.5 0 0 0
PIK Preferred Dividend 0 0 0 2.6 3.0 3.3 3.7 4.2 4.7 5.2
Net Cash Flow Before Working Capital 7.2 6.8 11.0 11.9 14.2 16.1 18.6 19.3 20.3 21.3
Net Change in Working Capital 0.0 1.1 (3.6) 1.1 (0.5) (0.6) (0.6) (0.6) (0.7) (0.7)
Net Cash Flow Before Gross Property, Plant & Equip. 7.2 7.9 7.4 13.0 13.7 15.6 18.0 18.7 19.6 20.7
Spending
(Increase) Decrease in Invest Available for Sale 0.0 0.0 0.0 (8.9) (7.4) (7.9) (8.5)
 (Increase) Decrease in Gross Property, Plant & Equipment (3.0) (7.7) (7.3) (3.5) (4.1) (4.8) (5.0) (5.2) (5.5) (5.7)
Enterprise Cash Flow 4.2 0.2 0.1 9.5 9.6 10.8 4.1 6.0 6.3 6.5
After-Tax Net Interest Expense (Income) 0.0 0.0 0.0 1.7 1.4 1.2 1.0 0.8 0.6 0.4
Net Debt (Repayments) or Issuance 0.0 0.0 0.0 (7.5) (8.0) (7.8) (4.5) (5.0) (5.5) (6.0)
Equity Cash Flow 4.2 0.2 0.1 0.3 0.2 1.8 (1.5) 0.2 0.2 0.0
Dividends on Common Stock 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Net Stock (Repurchase) or Issuance 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Net Increase (Decrease) in Cash Balance 4.2 0.2 0.1 0.3 0.2 1.8 (1.5) 0.2 0.2 0.0
Beginning Balances--Cash & Marketable Securities 3.6 3.8 3.9 4.2 4.4 6.2 4.8 5.0 5.2
Ending Balances--Cash & Marketable Securities 3.6 3.8 3.9 4.2 4.4 6.2 4.8 5.0 5.2 5.2
Adjusted Equity Cash Flow 4.2 0.2 0.1 0.3 0.2 1.8 7.4 7.7 8.1 8.5

56