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.

M&A: Restructuring and Leveraged Transactions

Definition:

• Wikipedia: (http://en.wikipedia.org/wiki/Restructuring)
• "Restructuring is the corporate management term for the act of reorganizing the legal, ownership, operational, or other structures of a company for the purpose of making it more profitable, or better organised for its present needs. Other reasons for restructuring include a change of ownership or ownership structure, demerger, or a response to a crisis or major change in the business such as bankruptcy, repositioning, or buyout. Restructuring may also be described as corporate restructuring, debt restructuring and financial restructuring."
• Investopedia: (http://www.investopedia.com/terms/r/restructuring.asp)
• "A significant modification made to the debt, operations or structure of a company. This type of corporate action is usually made when there are significant problems in a company, which are causing some form of financial harm and putting the overall business in jeopardy. The hope is that through restructuring, a company can eliminate financial harm and improve the business."

Major restructuring transaction:

• Asset restructuring --> asset sales, merging division, adding division
• Ownership restructuring --> changing the ownership structure of either parent or division
• Liabilities restructuring --> changing the debt/equity ratio
• Rationale: to create value by reversing the negative consequences of:
• conglomeration/corporate diversification.
• value destroying M&A or over-investment --> hubris mgt, agency issues.
• sub-optimal capital structure --> has not borrow enough or not capture optimal benefits of debt.
• financial distress --> too much debt/equity ratio.

Benefits and costs of corporate diversification

• Benefits of conglomeration (non-core business and unrelated divisions):
• More synergy by sharing a common headquarter.
• Create internal capital markets (could trade each others and makes profit)
• Tax advantages (tax-loss acquisitions, interest tax shield, basis step-up)
• Avoid dependence on one product line and greater stability of profits since if one division experience losses, other may create profits.
• Costs of conglomeration:
• Lack of diverse capabilities, lack of focus, duplication and wastes.
• Cross-subsidisation and inter-division politics.
• Symptomatic of over-investment or free cash flow problems.
• Twin-agency problems: difficulties in monitoring divisional managers --> lack of information to capture division/individual performance.
• Opportunity costs of potentially greater synergies if the assets are deployed elsewhere.
• Do the costs outweigh the benefits?
• Contra: 
• reduces value by 13-15%
• often forced to sell units to return to a more manageable structure.
• performance decline - segment/whole company.
• Pro:
• divestiture announcement usually increase shareholders wealth, greater than zero.
• divestiture announcement have a negative effect on competitors share price.
• larger divestment --> larger price increase
• Divestment of unrelated non-core business --> larger price increase
• asset sold --> larger price increase.

Ownership Restructuring:

• Divestiture (by auction or negotiated sale): 
• a sale of a subsidiary, division or product line to a 3rd party, generally in a private transaction.
• Raising cash to strengthen seller's financial conditions.
• Assets are revalued to reflect expected CF under buyer mgt.
• Subject to taxable capital gain/losses --> tax liability can be huge.
• Control benefits: better use of assets --> assets are undervalued, target not efficiently using them or may be in financial distress situations.
• Equity Carve Out: 
• initial public offering (IPO) of stock in a wholly owned subsidiary.
• New public shareholders own control of subsidiary.
• parent firm typically retains a controlling interest in the carved out subsidiary (median 80%).
• means of raising funds (cash) in the capital market
• after carve-out, subsidiary has its own board of directors.
• tax free spin-off --> differ tax paid (no cash involvement)
• Corporate Spin-Off:
• Distribution of shares in a subsidiary to existing shareholders of parent firms as a (non-cash) dividend --> usually pro rata (not change ownership structure)
• No cash inflows to parent firms.
• creates publicly held stock in subsidiary and reduces or eliminates parent ownership in subsidiary.
• established an independent board of directors and grant decision making authority to subsidiary management.
• Divest asset - on a tax efficient basis (subsidiary shares distributed to shareholders are not taxed)

Rationale for Leveraged Buyout (LBOs) and Leverage Recapitalisations

• Major leveraged transactions:
• Debt-to-equity and equity-to-debt swaps --> involve major debt-holders and shareholders and not public investors.
• Leverages acquisition: --> target become a private firm
• Leverage Buyout (LBO) --> control transferred to an LBO fund or syndicate. 
• An acquisition where the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt.
• LBOs have become very attractive as they usually represent a win-win situation --> the financial sponsor can increase the returns on his equity by employing the leverage; banks can make substantially higher margins due to higher interest chargeable.
• The management of the target is usually retained and often takes an equity interest in new company.
• Management Buyout (MBO) --> control transferred to existing management.
• the incumbent management team acquires a sizeable portion of the shares of the company.
• Face a conflict of interest, being interested in a low purchase price personally while at the same time being employed by the owners who obviously have an interest in a high purchase price.
• To minimize conflict of interest: Owner (offer a deal fee if certain price threshold is reached); Financial sponsor (offer compensation of lost deal fee); or earn-outs scheme (purchase price being contingent on reaching certain future profitabilities).
• Leverage recapitalisation: --> self tender; target remains a public firm
• Large scale buyback funded by debt issue
• Control concentrated in the hands of existing management.
• Target remain a public firm.
• LBO Source of value:
• Not significantly from: losses employees, tax savings, market inefficiency.
• But, restructuring benefits come from:
• Breakup values can be realised.
• Corporate governance is improved.
• Change of corporate governance, allow manager to have better incentives.
• better compensation structure and management are kept on their toes through threat of bankruptcy, reduced free cash flow.
• Profile of ideal LBO Target:
• Asset structure: more assets, so it can be sold to pay debt.
• Capital structure: low debt --> reduce financial distress.
• Operating performance: strong performance --> less value creation to repay debt
• Cash holdings: large amount of cash to pay debt.
• Management incentives: less incentives and use available cash to pay debt.
• Ownership structure: concentrated --> easier to negotiate and to control major shareholders.