Investment banking (ii) - LBO (cont'd)

Background

In the previous post on LBO, we already set the background on the LBO. In this chapter, we explore:

- how to calculate the amount of equity injection needed;
- how to calculate the pro-forma ownership of the Sponsor, original shareholder, etc.

Assumptions

For this hypothetical LBO analysis, we make the following assumptions:

- The Target's share is trading at HKD 10.00 per share, and the Target has 100mn shares outstanding;

- The Target's founder is 55% ownership in the company, and the rest is public float;

- The Sponsor is acquiring the Target at a 20% premium, ie. the Sponsor is willing to pay HKD 12.00 per share to acquire the Target;

- The Target's founder will rollover its ownership stake, ie. the Target's founder will not sell his/her to the Sponsor; 

- The Bank will extend a HKD 250mn term loan facility to fund the transaction (typically the Bank will run a debt-sizing analysis to determine the amount of debt financing it can extend; I can cover this topic in a separate chapter)

Here the analysis begins ......

After all these assumptions, we can start to do some analysis:

1. Equity from Sponsor

One of the first, important steps of the LBO analysis is to figure out how much equity is needed from the Sponsor to buyout the Target.

In this hypothesis case, the Target's founder, who has 55% ownership, is rolling over his ownership stake. As a result, the Sponsor only needs to buyout the remaining 45% shares, which are owned by the public. 

Buying this 45% ownership would need HKD 10.00* (1+20%) * 100mn *45% = HKD 540mn, where

- 20% represents the acquisition premium;

- 100mn represents the number of shares outstanding;

- 45% represents the public float

Don't forget that the Bank is lending HKD 250mn to fund the transaction, so the equity required from the Sponsor is HKD 540mn - HKD 250mn = HKD 290mn

2. Pro-forma ownership

Before the LBO ...

Ownership % of the Sponsor = 0%
Ownership % of the Target's founder = 55% (from the assumption)
Ownership % of the public = 45%

After the LBO

Equity contribution from the Sponsor = HKD 290mn

Equity contribution from the Target's founder = HKD 10.00 * (1+20%) * 55% = HKD 660mn

Total equity contribution from all participants = HKD 290mn + HKD 660mn = HKD 950mn

Ownership % of the Sponsor = 290/950 = 31%

Ownership % of the Target's founder = 660/950 = 69%

Ownership % of the public = 0%

Note how the ownership percentage changes before and after the LBO transaction. In this hypothetical case, all parties get what they want. 

First, we can see that the deal is value accretive to the Target' founder -- his ownership stake of the Target increases from 55% to 69%;
Second, we can see that the Sponsor puts down HKD 290mn and gets a 31% ownership in the Target;
Finally, the public shareholder is also compensated through receiving a share premium of 20% (see the assumption) paid by the Sponsor.

More to come ....

Now, we have gone through topics such as equity contribution and the pro-forma ownership, we can go through more advanced topics such as calculating internal rate of return ("IRR") in future chapters. Watch out this space.

Again, please post any comments / questions you may have. The whole idea of writing this series is for those of us interested in finance to interact and learn about this topic.

Investment banking (i) - LBO

LBO (Leveraged Buyout) may sound like a fancy term in the finance circle. This series attempts to breakdown LBO, showing what an LBO is, how it works, and why it is so attractive.

Chapter I: what is an LBO

In simple words, LBO refers to the action of a sponsor (usually a private equity fund) buying a target company, using a large amount of debt financing.

Here let me set the background for a hypothetical LBO - we will use this background in future chapters to illustrate how an LBO works and how does it add value to the key players in an LBO.

- Sponsor ABC ("Sponsor"): Also called the "Buyer" / "Acquirer" - typically a private equity fund
- Target XYZ ("Target"): The company which is being bought, ie. the company that is targeted by the Sponsor
- Lender 123 ("Bank"): Typically a bank, lending to the Sponsor, such that the Sponsor can fund the buying of the Target with debt.

Please watch out for future chapters for breaking down an LBO. Please also feel free to post any questions you may have. 

Book review (i) - "What They Don't Teach You at Harvard Business School"

I found people skills can sometimes be very important in different business situations. Hence, I have been reading books on this topic. 

"What They Don't" is a very good book that teaches some "street-smart" and practical business skills. I will share some learnings from this book in a series of blog posts:

Reading people

- A person's true nature, true self, cannot change with situations. Most business situations provide all sorts of evidences that allows you to see beneath the surface. The better you know someone, the more you can predict how he / she is like to respond in any business situation.

- Listen and observe aggressively.

- Business is a constant process of keeping your own guard up, while encouraging others to lower theirs. Usually, the less formal the situation or venue, the more likely people will be o let their guards down. Formal business situations, highly structured meetings, etc on the other hand are likely to be less revealing.

- Be prudent: the idea of using what you have learned about people is not tell them how insecure you think they are or to point out all the things you think they maybe doing wrong. If you let them know what you know, you will blow any chance of using the insights effectively.

- Be detached: if you force yourself to take a step back from any business situations, you powers of observations increases. 

Creating impressions

- In any new business situation there is a kind of mutual sizing up that goes on between the players. Whoever is better equipped to control the impressions being formed will walk away accomplishing the most.

- Be aware of all the subtle opportunities you have everyday for impressing positively, as well as all the "not so subtle" ways to impress negatively. If you can take advantage of all the little opportunities to create an overall, ongoing image of competence, effectiveness, maturity and fair-minded toughness - the image of the kind of people other want to do business with - people will forgive all sorts of "out-of-character" behavior in you.  

- Make a notable gesture: business gestures are acts made on behalf or at the request of someone for the purpose of obligating that person in some ways. However, the more a favor is perceived as "owing you one", the less effective it will be. 
- Business gestures fall into two categories: 

1) gestures that are easily overlooked, ignored, or misinterpreted - this type of favor either go unnoticed or actively work against you, you don't want to make this kind of gesture; 

2) gestures that are appreciated in the long term. Examples include: 

i) acting as a middleman;
ii) doing something for the kids;

iii) let people off the hook - ie. "let them change their minds". It can be tempting to say "but you promised......". However, if you can listen to why someone wants to change his / her mind and consider the overall relationship, it maybe in your interest to let him / her off; 

iv) flatter legitimately;

v) make friends - you don't have to become best friends with everyone, but call them up occasionally, find out how they are doing;

vi) make mentors - "mentorism" means seeking advice / direction from someone you respect and trust. Pretty soon, the line between giving you advice and doing you a favor totally disappear;

vii) be discreet.