M&A: Brazos & Comark LBO Case Study

Source: Harvard Business School Publishing, February 2004, Ref journal No. 9-202-090

Introduction:

• Brazos equity fund --> US middle market Leverage Buyout group (LBO).
• LBO firms made money by buying established companies, fixing them or selling off various portions of assets, and eventually selling the enterprise itself. Usually these transactions were funded by significant amount of debt. As long as the company could carry the debt, selling the healthy parts or improving performance would generate cash to yield. When the company was sold, the bank loan would be repaid and the excess went to the partners in the fund.
• Even when a buyout firm found a good target, obtaining a necessary leverage to complete the deal was a challenge. Generally two types of leverage were used:
• Senior Debt:
• provided by financial institutions such as insurance companies and commercial bank.
• Saving and loans scandal (early 1990s) inspired government to tighten regulations on senior debt, created a significant degree of risk aversion among lenders.
• Another contraints: the consolidation of the banking market.
• Subordinated Debt --> consist of high-yield (junk) bonds, issued in the name of the acquired company, or privately placed debt (unsecured debt with an equity conversion feature)
• Increasingly, buyout funds were moving away from the mega-buyout into new strategies, which included investing in less-efficient small-company segment, establishing investment focus, developing operating expertise, diversifying geographically, and into broader areas of private equity, such as venture capital and mezzanine financing:
• a hybrid of debt and equity financing that is typically used to finance the expansion of existing companies.
• gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back.
• it is treated like equity on a company's balance sheet and may make it easier to obtain standard bank financing

Brazos

• Brazos targeted firms with enterprise value between $25 million and $250 million, solid management teams and well-defined niches.
• Most deals were relationship driven, local and offer real value. Need to be able to grow the company's cash flow organically and efficiently.
• Developed a strategic relationship with Maverick Capital, a large fund that traded large-cap public equities, used it network and public market relationship to help Brazos research industries, conduct diligence and source deals.
• How Brazos-LBO add value?
• Differentiation through the Generation Transfer Transaction (GTT). 
• Partnership with the family and the management team.
• GTT is tax efficient, provides liquidity,  and continued operating control for the owner along with a flexible capital structure to accomodate future growth.
• Owner would reinvest a sum to maintain 50.1% of the common stock of the new company.
• Managers achieved liquidity and retaining significant equity ownership.
• Transaction was an exchange of securities, thus cash would not be taxed until the new shares were liquidated. 
• Brazos would buy 49.9% of the common stock and a block of preferred shares with attached warrants for the purchase of common stock. Also, arrange the senior debt financing for the balance of the purchase price.
• Ensured the family could still control the firm as long as it met certain performance targets, if the performance not achieved, Brazos would own more of the firm and receives greater purchase price when it was sold.
• Brazos as a minority had protections, such as significant board representation, supermajority right to block major changes, and in the case of severe under-performance, they had the right to take control of the board.

 The Comark Deal

• CoMark, a speciality manufacturer of commercial modular buildings. As of September 2001, CoMark's revenues were $35 million with an adjusted EBITDA of $10.6 million. CoMark sold to 3 major segments: government agencies (73%), education (22%) and private entities (5%).
• Brazos interested to CoMark deal, because 
• Comark has solid cash flow, good management, and a well-defined niche in building modular structures.
• Comark is family based company and Brazos had experienced before in dealing with this type of business as they could leverage the operational efficiency and successfully deal with the family issues.
• Diverse market segments and end-users, a good company in a good industry and was selling to the government effectively. 
• Operating performance:
• growing business.
• government procurement provides stability.
• high margin (custom-designed) products.
• there seems to be a customer concentration issues, but this is where Brazos sees undervaluation.
• Asset structure :
• Mainly cash, inventory and physical assets.
• Cash Holding:
• Cash rich relative to size.
• Capital structure :
• zero debt.
• banks do not understand the company.
• comparable firm (Modtech): debt/asset = 21%
• Government issues/management incentives:
• good management, improving sales force
• management incentives will decline after the transaction.
• but this can be structured using earn outs.
• Ownership structure:
• Family business
• No hold out problem, as the deal is subject to negotiation only
• easy to set up contingent payment
• easy to set up seller financing
• Other issues about the company :
• mixing up of personal and company expenses
• mixing up of capital expenditure and operating expenses
• poor record keeping
• a night mare for any due diligence team.
• Price:
• CoMark's founders wanted $40 million.
• But, the fund offered $38 million in cash at closing, with a deferred $2 million payment for each of the next 2 years if CoMark hit its 2002 and 2003 EBITDA projections. 
• Financing:
• CoMark's founders agrees to contribute through the provision of seller financing and reinvestment of capital into the company. Managers encouraged to reinvest $4 million of the purchase price in the form of equity (27% of firm's equity).
• Provide 10 year 8% subordinated seller note, which gave Brazos a leverage to meet its return threshold and keep the founders involved, not only motivated by the earn-outs and substantial equity stakes, but they would also receive the seller note.
• Seller note is more preferable rather than a mezzanine note, because of: 
• mezzanine players sought return of 20%, which decrease Brazos return.
• Going to mezzanine market, added a complexity to the deal.
• Difficulty in financing environment.
• Brazos could attracted bank interests, because: big loan ($16 million senior term loan, at a rate of LIBOR plus 425 basis point, or 6.25%) --> higher than 10 year Treasury Bond (4.65%)
• "bank book" for potential lenders --> investment memorandum.
• Structure:
• Stock Purchase:
• LBO purchase a portion of equity (73%)
• No dissolution/liquidation of firms
• Buyers assume all kinds of existing liabilities.
• Sellers can automatically retain some ownership stakes (27% in this case). They can delay paying capital gain tax on this portion.
• Asset purchase:
• Purchase (and liquidation) of firm's assets.
• Often involves the repayment of debt, and contracting of new debt.
• Owners get 100% of residual value after debt repayment.
• If they want to hold on to some equity stakes, they have to reinvest (purchase) equity of new firm.
• Immediate capital tax gain to owners/sellers.
• But assets sales create a goodwill amount, which can be depreciated and result in a tax shield for the firm.
• may help avoid unwanted liabilities.