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Leverage Buy Out — Transcript

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0:21Welcome, welcome to banking and finance
0:24laws course. We are discussing different
0:28kinds of finance. This is the third
0:30week. This is the 13th session. In this
0:34session, we will discuss about leverage
0:36buyout.
0:39Now, in the different kinds of finance,
0:42we have already discussed about
0:44different kinds of debt financing in the
0:46previous classes. More specifically, we
0:49have understood all the different kinds
0:52of financing and the law relating to
0:54pledge gender hypothecation and high
0:56purchase also. And in this particular
0:59class we will discuss about leverage
1:01buyout. What is a leverage buyout?
1:03Companies or firms use leverage buyout
1:07to acquire another company in a way take
1:09loan to buy another company. Simply put
1:12now funds for acquiring the new firm are
1:15mainly financed as debt but very limited
1:19equity is used. Now debt will be repaid
1:22mainly out of the cash flows of the
1:24acquired company. So private equity
1:28firms provide the needed funds.
1:30Sometimes there could be others
1:32financial institutions which may also
1:34provide but usually private equity firms
1:36provide this kind of finance. Now for a
1:39person who is investing into this
1:41leverage buyout. His main investment
1:45thinking would be how do I get back my
1:47money or what is the exit option that is
1:50available to me when I make this
1:52investment. How do I take my investment
1:54back? whether I will take it as shares
1:57or whether I will get my return back or
1:59whether the debt will get converted into
2:01equity. So these are multiple options
2:04that are available to the investors who
2:06have invested in the debt in a way of
2:09leverage buyout. Usually this is just
2:12one of the examples of how a leverage
2:14buyout can happen. It is not necessary
2:17that this is the only process in which a
2:20leverage buyout is executed. There are
2:22other forms as well but this is the most
2:24popular form of leverage buyout. Now an
2:27acquiring company will set up an other
2:30special purpose vehicle. It could be
2:32another company where they put some
2:35fully owned subsidiary model and they
2:37might give some equity investment into
2:39that new SPV and they will take now
2:43limited this leverage that is debt
2:46amount to buy the new company. So they
2:49charge a target company. It could be new
2:51company or it could be a company which
2:53is operating in a way the target company
2:55which will be new for acquisition in the
2:58context of leverage buyout. So a
3:01particular company will buy another
3:03company with the model of SPV by taking
3:08leverage finance and purchase the other
3:11company as simple as that. But this is
3:14very complex procedure in a way. Now how
3:17does it happen is the acquiring company
3:19floats an SPV. It is usually floated in
3:23the form of a fully owned subsidiary of
3:25the company which is intending to
3:27acquire and it will make some amount of
3:30minimum equity investment as capital.
3:33Now why an SPV is usually used? Because
3:36a company if that acquisition goes wrong
3:39the main company will not get affected
3:42and the liability is limited to the
3:44special purpose vehicle that is this SPV
3:48is acquiring the other company that is
3:50how legally it will be. So the legal
3:52implication or in a way the loss or
3:55profit of this acquisition may not
3:57directly affect the business of the
3:59acquiring company in the very first
4:01instant. This is the advantage of
4:03setting up a special purpose vehicle.
4:06what we call it as multi-purpose use
4:08this word is now so SPV is a kind of a
4:11company only set up by the acquiring
4:14company to purchase the target company
4:18if we want to put it in a normal terms
4:22now this particular SPV will leverage
4:24this equity to raise huge amount of debt
4:27so when the SPV is set up the equity
4:30will be financed and then total amount
4:33will be raised by way of debt usually
4:36And this debt and equity is used. So the
4:39investment that this company which has
4:41set up the SPV in the form of equity
4:43that finance and the leveraged money
4:46that is the debt amount that is raised
4:48both this amount will be used to buy the
4:50target company. Now how is the debt paid
4:53off? Then the debt is usually paid off
4:56by the company's cash flow. So the
4:59companies can take the cash the amount
5:01the new company will generate that
5:03amount will be used to pay the debt.
5:06This looks very simple but usually when
5:10you want to give loan the company will
5:12look into a financial institution. If a
5:14company is asking them to finance a
5:17leverage acquisition they will look into
5:20your potential ability to purchase that
5:22company and operate that company and why
5:25this purchase is happening. what are the
5:27benefits? Will I get my money back? All
5:30this will be very very carefully
5:31considered because it involves very high
5:34risk. But there are abundant leverage
5:36buyout uh happening in the markets and
5:40there are many many case studies
5:41available in the net. People who are
5:44interested to study about leverage
5:46buyout can study abundant examples are
5:49available. I have taken one example to
5:52explain a leverage buyout in the more
5:55meaningful way for the purpose of
5:58explanation of leverage buyout. So I
6:01have taken the example of Tata Tetley
6:03case study. In 1962 Tata entered into T
6:08business. Tata as you know is a very
6:10prominent company in India doing
6:12business in multiple fields. Now they
6:15entered into tea business and their main
6:18packaging operation is in Bangalore and
6:20tea plantations were in Monat. That is
6:23how they started in 1962 the tea
6:26business. Now it wanted to expand its
6:29business and it want to acquire more tea
6:32plantations and it reach to the abroad
6:36markets also not just to India but other
6:38countries markets also. So it expanded
6:41from 1962 to 2000. It has expanded many
6:44fold. Many other tea plantations were
6:47acquired. They went out to the other
6:49countries also and they were selling the
6:52tea in other countries also not just in
6:54India. In 2000 in the year 2000 Tat
6:58acquired the UK brand Tetley. Now UK
7:02brand tetling is a major tea company
7:04there and the acquisition cost is about
7:07271
7:09million pounds. So this is what the Tata
7:12company has to pay them to acquire that
7:15company totally. Now Tetley by then was
7:18a globally renowned tea brand and this
7:21acquisition was made using leverage
7:23buyout and it became very successful. I
7:26will show you how this has happened and
7:29what are the convergence benefits. Now
7:32Tetley at that time had huge presence
7:34globally in 35 countries. Tetly tea was
7:38abundantly used. So they had market in
7:41other countries extensively and Tata had
7:45very many specialtity products also like
7:48they had besides regular tea they had
7:51herbal tea, organic tea, green tea like
7:53that. So they had other specialtity
7:55products which can be marketed and Tata
7:59has developed huge expertise in
8:01marketing and more specifically in tea
8:04marketing also. They have developed
8:06extensive expertise which can be used
8:08for the benefit. Then Tetley is also the
8:12second largest tea brand globally. So
8:14they are already having huge business.
8:17Now Tetley could enter into Indian
8:19premium market. Now collectively Tata
8:22and Tetly together they could reach to
8:24multiple countries and multiple
8:26products. So when Tata buy Tetley it can
8:29do multiple business.
8:32Now how did Tata finance this whole
8:35acquisition? Now they have entered into
8:37agreement. The amount is fixed. 271
8:40million pound is what Tata company has
8:43to pay Tly to acquire this. But for this
8:46they have 235 million of debt and £70
8:50million equity is what they have to
8:53finance. Now if we calculate 23570
8:57is more than 300. So they are buying it
9:00for 271 million but they need some more
9:03money for their legal charges and
9:06operating costs. So they are totally
9:08they are thinking that this can go on
9:11when we raise more than so around 305
9:14million pound is what they are looking
9:16at together costs expenses operating
9:20cost plus acquisition costs. So together
9:22it is coming to that and Tata provided
9:2570 million. So 70 million pound
9:29investment Tata is making into this. So
9:32and 235 million pound is what debt they
9:35wanted. Now how is the debt financed?
9:39How did they get the loan from? Now they
9:41used techly assets as a security and
9:45they also obtained a loan from abroad
9:48not from Indian markets but from uh UK.
9:51The re Europe the reason is also simple
9:54more specifically UK only. Now the
9:57reason is also very simple because there
10:00the rate of interest was far less
10:02compared to India and Tattly assets were
10:04situated there. So because of that
10:07reason they have obtained a loan from
10:09that company from the those financial
10:11institution and debt was financed for
10:14acquisition working capital and for
10:16costs and the security for the loan were
10:19tetly assets. Now what happened the Tata
10:23company's profits and tly company
10:25profits they started repaying the debt
10:28very periodically. So they started
10:31paying interest and the loan very
10:33systematically without any failure.
10:37So what happened now? Did it result in
10:40success or did it result in failure? Now
10:43if we were to imagine 300 million pound
10:46means what? If we convert it into Indian
10:49rupees, it is 3 lakh cr Indian rupees.
10:53So it is a very big finance deal. Now in
10:572000 they did this acquisition. In 2005
11:01what Tata did was they refinanced their
11:04entire debt. So refinanced means they
11:08restructured their debt and took more
11:10loan or something like that or they took
11:13the loan in a very different institution
11:15something like that. We call it
11:17refinancing the debt. Now their entire
11:19debt outstanding was 184 million. They
11:23originally took 235 million but today in
11:272005 it's stood at 184 million. That
11:30means they went on paying interest for
11:33that 235 million and also paid some
11:36amount of principal amount also they
11:39have repaid. So their debt on that day
11:41in 2005 was only outstanding debt was
11:45184 million and the rate of interest
11:48charged on that was 2.95%
11:51rate of interest was charged but that
11:54loan entirely they took it and
11:57restructured their debt and took it to
11:59other financial institution or any same
12:02institution with a new loan form because
12:04rate of interest keep changing over
12:06period of time and debt servicing
12:09history will make them more creditw
12:11worthy. So they get loan at lesser rate
12:13of interest. So the rate of interest
12:16they got was 1.4%.
12:18So there is huge difference in the loan
12:21interest rate from 2.95% to 1.4%. And
12:26also they repaid some more loan. So 24
12:30million they paid up front when they
12:32went for refinancing. So the total loan
12:35they took was only 160 million. So from
12:38235 million loan they came down to 160
12:42million and that too at the 1.4% rate of
12:45interest. So what happened with this uh
12:49when we call what happened with this uh
12:52refinancing was their debt to equity
12:55ratio has abnormally come down. The
12:57original debt to equity ratio was 3 is
13:00to1 at that time 235 million was the
13:03debt and 70 million was equity. So it is
13:07somewhere equal to 3 is to1 ratio. But
13:10today their debt is only 160 million out
13:14of 300 million. So their investment
13:17equity investment has grown. So it has
13:20come to somewhere around 1.6 is to 1.1
13:24uh sorry 1 so 1.6 is to1 in 2005. So in
13:29a way their debt to equity ratio has
13:31come down. So they have debt and equity
13:34has become slightly their difference has
13:37come down a lot and this refinancing was
13:41provided to them because they had strong
13:43cash flows and they were repaying the
13:46debt very systematically. Their
13:48creditworthiness has grown a lot. So
13:51they need not go for high-risk lenders.
13:54So people when they were initially
13:55giving they were giving huge loan so
13:58they were very scared. Now they were
13:59paying very promptly and the interest
14:01rates also fluctuating floating rates of
14:05interest. So depending on all of those
14:07advantages, Tata had made advantage of
14:10those all of that and took this uh
14:13refinancing step and this made it Tat
14:17could completely merge Tata Tetley in
14:212005. So Tat and Tatly were merged. So
14:24in a way the new name that came by was
14:27Tata Tetley in 2005
14:30and after this merger what happened was
14:33they captured the tea markets globally
14:36and abundant today uh 53% of the global
14:41packaged tea business is with Tata
14:44Teeti. So in a way they emerged as a
14:47major market player in the tea business
14:50and they other competitors like
14:52Hindustan liver and others their share
14:55in the tea market has drastically
14:58reduced. So in a way they emerged as the
15:01most successful tea business market in
15:05the world. Now this is the published
15:09results of the uh from this Tata Tly
15:13story. Now I have taken these are below
15:17quoted are the references from which I
15:19have taken this case study. Abundant
15:22case studies are available in the Google
15:25about multimedia purchase about Gibson
15:29greeting cards purchase. So there are
15:32many many leverage buyout deals that
15:34happen day in and day out. And these
15:36kind of deals can emerge successful.
15:39they can emerge as failure also because
15:42the debt equity ratio determines and
15:44also after the merger the business must
15:47grow. When will the business grow when
15:50the convergence benefits are higher?
15:52Suppose a software company is in
15:54distress. Another major software company
15:57like Vipro or uh say Infosys purchases
16:01the software company in distress they
16:04will have clients which can categorize
16:07to these kind of product development and
16:10make it a business venture. So it
16:12depends on who is acquiring the firm. So
16:16because Tartar T already had market in
16:19the T business market and Tartar T knows
16:23marketing and they know the tea business
16:25very well. They understand tea business,
16:28they know marketing, they have presence
16:30globally, they know global tea business
16:32markets. So this understanding helps
16:35them to make the merger a successful
16:38story. Not just the financing decision
16:41but of course fin without financing
16:43support Tata could not have acquired
16:46this totality company only because this
16:50kind this amount of financing would be
16:52very very tough even for a major
16:54companies like Tata because three lakh
16:57cr rupees is no small amount and
16:59anything going wrong would mean a
17:01disaster for the company or for the
17:04financial institution which is giving
17:06that kind of loan. So in leverage
17:08buyouts the kind of decisions that the
17:11companies make and the financial
17:13institution providing that leverage make
17:16is very very crucial
17:19and the most important decision in this
17:22kind of financing would be looking at
17:25the debt to equity ratio. When the debt
17:27in equity ratios are far higher whatever
17:31profits that you make will only go into
17:34the repayment of interest. then the
17:36companies can never flourish and they
17:38can never repay the loans. So in a way
17:41the financial institution and the
17:43companies have to look at what is the
17:46expected cash flow and how can they
17:48repay this debt and what is the amount
17:51of debt and equity ratios. So this debt
17:54and equity ratio is often considered the
17:57major testing factor to determine the
18:00success in the leverage buyouts. Not in
18:03just leverage buyouts in any business
18:05entity when they are doing good business
18:08also. If their debts are mounting and
18:11the interests are mounting, the whatever
18:14profits they generate from the company
18:16will only go to only service the
18:18interest, then their debts will always
18:21be hanging on the company and they will
18:23never be able to show the profits to
18:25their shareholders or the company can
18:28never emerge successful. So debt equity
18:31ratios must be dependent on the cash
18:33flow of the company and the amount of
18:36cash flows should determine the rate or
18:38the percentage of interest visav the
18:42equity investment in a company at that
18:44given point of time otherwise it cannot
18:47emerge successful. Just because Tatas
18:50emerged as successful does not mean that
18:53all leverage buyouts can emerge
18:55successful. There are abundant examples
18:57of failed leverage buyouts also
19:00available in the
19:02in the market which can be studied
19:04through case study examples. But what we
19:07need to understand in a leverage buyout
19:09is the financing companies have to look
19:12at the acquiring company's prior
19:15knowledge of the acquiring company the
19:19acquisition company
19:21business. So Tat has knowledge of the
19:25business. So that made it more easy to
19:28market it. That is one. Second, what is
19:31the debt equity ratio? Tatas have
19:33invested 70 million pounds their own
19:36equity investment in the SPV. So in a
19:39way they have a huge interest in the
19:41success of this merger. So the financial
19:44institution giving the debt knows very
19:46well that the acquiring company also has
19:49put in lot of finance into this and want
19:52believes that this merger is going to
19:55help them. So in a way that gives a clue
19:58and the servicing the debt very properly
20:01and they have also given huge collateral
20:04all tetly assets were given as
20:07collateral for this loan because the
20:09financial institution cannot believe
20:11that the T business they will come up to
20:1353% and they will repay is one
20:16hypothetical situation. What if it goes
20:19wrong? Huge amount of debt financing is
20:22done. So they also need some collateral,
20:24some guarantee, some property as
20:27security to them. If something goes
20:28wrong, something they can recover by
20:30sale of the assets at least. So all of
20:33these considerations will determine
20:36similarly the Tata's expertise in
20:38marketing, the Tata's expertise in
20:41global marketing helped this leverage
20:44deal turn into a successful leverage
20:47buyout. But not as I said it has to be
20:50very carefully weighed pros and cons
20:52will determine
20:54suppose there is a movement against tea.
20:57Suppose people think tea taking will
21:00help have adverse health impacts and
21:02suppose people stopped drinking teas. So
21:05no matter how successful business person
21:07you are and how successful marketing you
21:10are if the people believe that the
21:12health impacts are adverse and they stop
21:14taking you can't grow. So not just the
21:17financial prudence and business prudence
21:19will determine success of a leverage
21:21buyout at any given point of time. There
21:24is also some risks that are not what we
21:28call asymmetric or in a way they they
21:30cannot be only determined on the
21:33company's business strategies and the
21:35business deals. Some external factors
21:37also may determine the success or
21:40failure of the leverage buyouts deals.
21:43There was a greeting card business
21:45leverage buyout deal. The company was
21:47doing very successful but people stopped
21:50using the printed greeting cards in the
21:53later days and only they were doing the
21:55uh virtual digital card model. So the
21:58business could fail. So these kind of
22:01multiple reasons could affect the
22:04success or failure of an acquired
22:06company's business. But a financer has
22:10to definitely look at the unforeseeable
22:13financial risk as well as foreseeable
22:16financial risk. That is exactly where
22:18the collateral which will come into the
22:20picture for the financial institutions
22:23rescue in terms of financing them. So
22:26leverage buyouts are very popular ways
22:28of companies acquiring other companies
22:31by taking debt as the major amount for
22:35acquiring that particular company and
22:37debt servicing and repayment of debt
22:40cannot be undermined by the company's
22:42acquiring because huge amount of cash
22:45flows are required to service that debt
22:47and LBO can be considered generally
22:50successful when debt equity ratios are
22:52not very higher. This is only a studies
22:55that have been suggested. There is no
22:58hard and fast rule that if debt equity
23:00ratio is very less it will be
23:01successful. When debt equity ratio is
23:04very high it will be failure. There is
23:06no hard and fast rule like that. There
23:08are LBOs where debt equity ratio is very
23:11high but still they could be successful.
23:13There are LBOS where equity ratio is
23:16very less but they could not emerge
23:18successful because of other factors. So
23:20multiple factors will determine the
23:23success or failure of a leverage buyout
23:25and the financer has to and the acquirer
23:28has to very carefully consider the
23:30financial risks as well as business
23:32risks as well as unforeseeable risks. So
23:36these are some of the things that we
23:38need to consider when leverage buyouts
23:40are proposed. We will discuss further
23:43about debt equity ratios, finance
23:45structures and debt financing in the
23:48next class. And we will conclude this
23:51class with this. Thank you.

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