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October, 2007

 Business Newsletter-Leveraged Buyouts (LBOs)

In our June 2007 Business Newsletter (http://www.4CaliforniaLaw.com/news0607.
html) we discussed some of the intricacies of venture capital financing and how
this financing technique has led literally to an explosion of deals in certain
industries, e.g. technology.  This month’s Business Newsletter will focus on
another “darling” finance technique, often used to acquire businesses in a
synergetic mode.  Though not generally regarded as similar, venture capital deals
and leveraged buyouts are, in fact, related techniques.  The former uses stock as
its linking pin, while the latter uses assets; both measure success by the income
generating capability of the newly constituted target business.


In general, a LBO is an acquisition of a business primarily with borrowed funds. The
funds are expected to be repaid out of cash generated from the operation of the
business or the sale of its assets. While many ''leveraged buyouts'' are ''management
buyouts'' (leveraged buyouts in which managers acquire a significant portion or all of
the equity of the business of which they have been employees), a number of LBOs
are initiated by hostile bidders and others to acquire public companies in
transactions not initiated or wanted by management. In these situations,
management is sometimes offered a relatively small portion of the equity on favorable
terms.  That said LBOs are more often than not purchases of businesses by lenders
who in effect ''resell'' the business to managers and other equity investors with debt
being repaid over time from income or assets sales of the target business. Thus, the
business can be viewed as buying itself for management and other equity investors.  
Put another way, it is a way of taking control of a company (or a division thereof) with
little or no cash outlay, using the company's own assets as collateral to fund the

The following graphic shows a typical LBO structure: W

It is well established finance principle that the return on investment of an acquisition
using “borrowed” funds has a greater return than if an investor uses his or her own
money.  This is the basis for margin trading and many other financial management
techniques.  Moreover, the use of “borrowed” money lowers the risk inherent to the
investor.  In the arena of business acquisitions and mergers, the use of LBOs has
proved the point once again.  Some historic examples of successful LBOs may
illuminate the point. In 1982, the company Gibson Greeting Cards was acquired by a
financial group headed by Wesray Capital. The purchase price of the buyout was
US$80 million. The financial group itself put in only US$1 million, borrowing the rest
in junk bonds. Upon acquisition, the group turned Gibson into a privately held
corporation. A year and a half later, in the midst of a bull market, the group took
Gibson public. The total value of the company at this point was US$220 million. One
of the principle architects of the LBO, William Simon, who had initially invested
US$330,000, received US$66 million from the final transaction.  Another shining
example of the successful track record of LBOs is that of Reginald Lewis and Beatrice
Foods. Lewis bought Beatrice International Foods from Beatrice Companies for $985
million in the 1980s.  He subsequently renamed the division TLC Beatrice
International; specializing in snack food, beverages, and grocery store condiments.  At
the time, it was the largest black-owned and black-managed business in the U.S. The
deal was partly financed through Mike Milken, the junk bond maverick from the
investment banking firm of Drexel Burnham Lambert.  Milken was later made famous
for his federal conviction for security law violations in the junk bond market. However,
when TLC Beatrice reported revenue of $1.8 billion in 1987, it became the first black-
owned company to have more than $1 billion in annual sales.


From a LBO borrower or organizer’s perspective, there are 5 rudimentary steps which
precede the LBO:

•       Research the target company and/or division to be acquired. Make sure
       underlying assets are adequate to secure the necessary debt/investment and
       that projected cash flow is sufficient to repay the debt/investment.

•       Access whether the target’s management is strong and will continue with the
       company after the buyout and/or whether they are necessary to the overall
       success of the deal. This may be critical if the company will have to operate at its
       optimum to repay the debt/investment incurred during the buyout and still make a

•       Consider hiring a professional liaison to act as “go-between” in negotiations
       with management, shareholders, potential investors and board members.

•       Coalesce a LBO team of investment bankers, financial managers, accountants
       and attorneys to assist in the planning and structuring of the deal.

•        Acquire a controlling interest in the target company or division. Obtain the
       majority of funds using the company's assets as collateral and, if necessary,
       solicit the company's management team and outside investors for the remainder
       of the cash necessary to complete the purchase.

From the lender/investor’s perspective, there are three basic approaches to LBOs
(two broad  based and one hybrid):

Cash Flow Buyouts

In the ''cash flow'' approach, lenders perform credit analyses and structure loans
primarily on the basis of the projected cash flow of the “target,” which will ultimately
repay the loan. A cash flow lender is not as concerned about its position in the
eventuality of liquidation and sale of the “target’s” assets, since it considers the
probability of that outcome as relatively low. Generally, commercial banks are more
likely than commercial credit corporations to consider the cash flow approach. The
amount of the lender's fee often precipitates this interest as a bank lender may often
seek a large fee if it will make a cash-flow based loan to conduct an analysis
justifying the loan (and the related fee) where other banks' analyses would not justify
a cash flow loan. Because a cash flow loan entails greater risk in the event of default,
fees charged tend to reflect the higher perceived risk. Lending banks inevitably try to
spread the credit risk of leveraged loans to others by selling participations in the loan.

Asset-Based Buyouts

The ''asset-based'' approach involves secured lenders who look first and foremost to
the liquidation value of the borrower's assets for repayment of the loan if it cannot be
repaid from the cash flow of the operation. Secured lenders analyze specific assets of
the borrower, such as inventory, receivables and machinery and equipment and
assign a loan value for each category of asset, based on a percentage of a specified
valuation. For example, a typical secured lender might lend 75% of the balance sheet
value of certain receivables, 50% of the balance sheet value of certain inventories and
50% of the liquidation value of machinery and equipment; usually as determined by
appraisers acceptable to lenders. No matter how acceptable the cash flow
projections look, without asset valuations indicating an ability to repay the loan, an
asset-based lender will not proceed.

Hybrid Buyouts

Obviously then, many lenders are not ''pure'' secured lenders and therefore will look to
justifying a transaction on either cash flow or assets, or a combination of the two, and
are willing to be somewhat flexible in their lending practices, particularly, as indicated
above, where they feel able to obtain fees they believe will represent compensation
for the risks involved.  Even though the lender oerceives of a transaction as ''cash
flow'' based, it is quite common to seek a security interest in the borrower's assets to
protect a lending position as much as possible in the event the credit decision turns
out to be wrong or future events generate unforeseen problems, cash shortfalls or
liabilities which could become liens on the borrower's assets enabling the lien holder
to be paid ahead of unsecured lenders.


An “earnout” is a derivation of the “cash flow” approach.  In an earnout, the buyer
(borrower) may come up with a substantial portion of the acquisition or purchase
price of the “target” company or division.  The remaining balance of the acquisition
price is then paid to the seller(s) from and is contingent upon the future sales or
profitability of the “target” company or division by use of an earnout formula.  Earnouts
are illustrative because some of the common problems associated with them are
also germane to LBOs.  We’ll discuss a few for purposes of clarity.  

Most acquisition agreements contain “representations,” “warranties” and
“indemnifications.”  These legal assurances by both parties act as safeguards
against non-disclosure by either party, but particularly the seller.  Using the earnout
approach allows the buyer to offset any claims associated with misrepresentation,
warranties or indemnification against any future obligations tied to agreed upon future
earnout payments to the seller.  A collateral issue that is common to both LBOs and
the earnout variety is that of control of the “new” business.  The “target” is often
“managed” through a newly formed subsidiary of the buyer; thus, enabling it to
segregate income, expenses and other aspects of the “new” business.   Obviously,
the “new” business is not “new” at all.  It is simply the “target” company or division of a
“target” company that will now become the buyer’s company or part thereof.  One of
the common aspects of mergers and acquisitions (or M&As) is that “targets” are often
chosen because they are attractive to the buyer’s existing businesses or expertise.  In
such cases, the mandates of the lenders or the buyer itself may dictate that the “target’
s” management either play a subservient or supporting role to new management in
an effort to maximize “earnout” profitability.  In addition to the earnout formula, the
earnout period may also be important as seller-managers may wish to sacrafice
longer term goals in order to accomplish the short term goal of meeting the earnout
formula “benchmarks,” e.g. sacraficing long term R&D and marketing efforts, as well
as needed capital improvements, for the short term goal measuring the benchmark.
Moreover, the ability of management to make significant changes in the operations of
the “target” in the post-closing period during which the earnout formula is applied, can
have a dispositive impact on the outcome of the deal.      

Benchmarks are typically revenue, net income (with or without modifications), cash
flow or equity based.  The buyer will generally pay the seller a stated amount if the
benchmark is satisfied or a percentage of the excess of the measurement basis over
the benchmark amount.  Measurements may be cumulative or periodic.  Payment of
earnout formula amounts may also be subordinated to lender payments as
mandated by lenders.  Benchmarks are usually established for a 2 to 5 year period
following the closing date of the buyout transaction.  The time period may run
concurrent with other subsidiary or ancillary agreements, e.g. employment
agreements, customer contracts, covenants not to compete, etc.  Further, provision
must be made for the possibility that certain events will make the earnout completion
impractical or impossible and thus require a buyout of the earnout.  

Another key aspect of earnouts that may become significant in LBOs is the method of
accounting used to calculate formula amounts.  Although GAAP or Generally Accepted
Accounting Principles may dictate standardize results of operations, revenue, income,
etc., it may not be the method best suited for the earnout formula employed in the
deal.  Certain items, e.g. inventory valuation methods, the treatment of leases,
extraordinary or nonrecurring items of income or expense, depreciation, or allocations
of general and administrative (overhead) expenses may all dictate the use of a
method of accounting other than GAAP, or at least a modification of GAAP.


There are a myriad of legal, accounting, tax and business aspects to LBOs, in their
many forms and varieties.  Just a few have been discussed in this newsletter.  
Others, e.g. “poison pills” and security law issues have been omitted for the sake of
brevity.  It is nevertheless, instructive to note that attempting a LBO, or any significant
acquisition or merger, without capable legal counsel should never be contemplated.  
The many financial accounting, tax, legal, securities law and business implications
are many and necessitate professional advice and assistance.  Further reading on
the many things that can go wrong in a LBO transaction, resulting in the dismantling
of a “target” can be found in the following case:  Horizon Holdings, LLC v. Genmar
Holdings, Inc. (10th Cir 2004) 387 F3d 1188.