The Art of the LBO

November 2004

Agenda
I. II. III. IV. An Overview of Leveraged Buyouts The Building Blocks Putting It All Together How It Happens in Reality

I. An Overview of Leveraged Buyouts

What Are LBOs?

What Is an LBO?
A L everaged BuyOut is the acquisition of an entire Company or division n Buyer (the Sponsor) raises debt and equity to acquire Target Borrows majority of purchase price Contributes proportionately small equity investment

n Buyer grows Company, improves performance Relies on Companys free cash flow and asset sales to repay debt Potentially makes add-on acquisitions Later sells or IPOs all or a portion of the Company to exit investment

What Is An LBO?
Typical Leveraged Buyout Structure

Current Owners

Purchase Price

Equity Investment

Acquiror (LBO Firm)

High Yield Bondholders Bonds

NewCo (Merged Into Target)

Bank Loan

Banks

Target

More Common Than You Think

Some prominent LBOs:

Company Sponsor Size

Silver Lake TPG, Bain & GS

$2.0bn $1.6bn

Madison Dearborn Partners $1.5bn KKR THLee Bain Blackstone $1.5bn $1.1bn $1.0bn $700mm
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Value of LBO Activity: 1997-2003

Global Announced Volume ($ Billions) 100 $81 80 60 40 20 0 1997 1998 1999 2000 2001 2002 2003 $39 $43 $60 $86 $85 $86

Source: GS F&P, Securities Data Co., Buyouts, Thompson Financial Securities Data

LBO Analysis An Important Banker Tool

n M&A valuation Complements other valuation techniques n Acquisition financing LBO Corporate acquisition Staple-on financing n Dividend recapitalization n Straight debt financings n Complex merger plan analysis Cash flow impact vs. EPS

II. The Building Blocks

How Are LBOs Financed?

The Building Blocks

Types of Acquisition Financing

Bank Debt (Senior)

~ 45%

High Yield Debt (Subordinated) Private Equity

~ 25%

~ 30% 100%
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How Are LBOs Financed?

Hypothetical Example
Cum. Multiple of LTM EBITDA

($ in millions)

12/31/2003

% of Capitalization

Revolving Credit Facility - 6 Years Tranche A Senior Term Loan - 6 Years Tranche B Senior Term Loan - 8 Years Total Senior Secured Debt Senior Subordinated Notes due 2014 Total Debt Management Rollover Equity Sponsor Cash Equity Total Equity Total Capitalization LTM EBITDA = $120.0 million.

$ 0.0 150.0 200.0 350.0 200.0 550.0 50.0 200.0 250.0 $800.0 31.3% 100.0% 6.7x 68.8% 4.6x 43.8% 2.9x

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Comparing the Building Blocks

How the Pieces Differ
Ranking in Capital Structure Cost Structure of Coupon or Dividend Maturity and Amortization Callability and Prepayment Fees to Underwriters Ratings Covenants and Legal Restrictions Marketing and the Capital-Raising Process Investor Base
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Private Equity
Terminology
n Most junior money in the capital structure n Typically no dividends n Voting control at all times n Co-investing with other sponsors n Raised in the alternative investment market Portion from Sponsor put your money where your mouth is Pension funds, endowments, investment portfolios, investment banks, commercial banks, fund of funds Represents 5% to 10% of investors portfolios n Net IRRs to LPs are generally 15-25%

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Size of the Private Equity Market

US Fund Raising Activity
80 $63.3 60 ($ Billions) $55.4

40 $23.2 20 $11.6 $18.4

$34.5

$34.6

$36.9 $24.0 $17.0 $9.9

0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 YTD

Source: Buyouts Magazine

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Average LBO Equity Contribution

45% 40.6%40.0% 40 35 Average Equity Contribution to LBOs (%) 31.6% 30 25 20.7% 20 22.0%25.2% 26.2% 23.7% 22.9% 30.0% 37.8% 35.7% 39.4%

16% 14 12 Historical Single B Default Rates (%)

10 8 6

15 9.7% 10 7.0% 5 0

13.4% 4 2 0 1987 1988 1989 19901991(a)1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

(a) No data for 1991 Source: Portfolio Management Data and Standard & Poors

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...But Equity Alone Is Not Enough

Using Leverage to Turbo-Charge Returns
Average Debt Multiples of Highly Leveraged Loans (a) 1987 Second Quarter 2004 10 9 8 7 6 5 4 3 2 1 0 1987 1988 1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 YTD Total Debt/EBITDA 8.8x

7.2x 6.7x 5.8x 5.7x 5.3x 5.0x 5.2x 5.3x 5.2x 5.3x 4.5x 4.0x 3.7x 3.8x 4.0x 4.5x

(a) Criteria: Pre-1996: L+250 and higher; 1996 to date: L+225 and higher; Media and Telecom loans excluded; there were too few details in 1991 to form a meaningful sample. Source: Portfolio Management Data.

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How Are LBOs Financed?

Hypothetical Example
Cum. Multiple of LTM EBITDA

($ in millions)

12/31/2003

% of Capitalization

Revolving Credit Facility - 6 Years Tranche A Senior Term Loan - 6 Years Tranche B Senior Term Loan - 8 Years Total Senior Secured Debt Senior Subordinated Notes due 2014 Total Debt Management Rollover Equity Sponsor Cash Equity Total Equity Total Capitalization LTM EBITDA = $120.0 million.

$ 0.0 150.0 200.0 350.0 200.0 550.0 50.0 200.0 250.0 $800.0 31.3% 100.0% 6.7x 68.8% 4.6x 43.8% 2.9x

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Leveraged Bank Debt

Terminology
Ranking Interest Rate Maturity Callability Fees to Underwriters Ratings Covenants Marketing Process Senior secured, most senior debt in the capital structure Floating, typically LIBOR + 250 bps and higher, quarterly payments Varies with credit profile, typically 5-8 years, but before more junior debt Typically prepayable at par 1.75% to 2.25% Usually BB+ to B+ (rating agencies now rate bank loans) Maintenance covenants, set out in Credit Agreement Sold via syndication process and confidential offering memorandum (bank book ) Diligence, commitment, launch, syndicate, fund

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Leveraged Bank Debt

Terminology
n Revolving Credit Facilities vs. Term Loans Revolvers allow multiple drawings (like a credit card) Term Loans are funded at closing

n Pro Rata Facilities Consist of Revolvers and A Term Loans (Term Loan A) Sold to traditional commercial banks Same LIBOR spread, 5-6 year maturities, even amortization

n Institutional Tranches Consist of B, C or D Term Loans Sold to over 100 institutions and funds Progressively higher spreads, 6-8 year maturities, minimal front-end amortization

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Leveraged Bank Debt

Only a Subset of the Broader Loan Market

$930 B Total Loan Market

$329 B Leveraged Loan Market

$73 B Sponsored Loan

Source: Loan Pricing Gold Sheets, Buyouts Magazine, Standard & P oors - 2003

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Leveraged Bank Debt

Historical Growth in the Market
350 $329

$300 $256 250 $243 $220 $185 $216 $265

$ billions

200

150

100 $50 50 $16 0 1993 1994 1995 $49

$71

1996

1997

1998

1999

2000

2001

2002

2003

Source: Portfolio Management Data 1993 -2000; Loan Pricing Corporation 2001-2003

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How Are LBOs Financed?

Hypothetical Example
Cum. Multiple of LTM EBITDA

($ in millions)

12/31/2003

% of Capitalization

Revolving Credit Facility - 6 Years Tranche A Senior Term Loan - 6 Years Tranche B Senior Term Loan - 8 Years Total Senior Secured Debt Senior Subordinated Notes due 2014 Total Debt Management Rollover Equity Sponsor Cash Equity Total Equity Total Capitalization LTM EBITDA = $120.0 million.

$ 0.0 150.0 200.0 350.0 200.0 550.0 50.0 200.0 250.0 $800.0 31.3% 100.0% 6.7x 68.8% 4.6x 43.8% 2.9x

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High Yield Debt

Terminology
Ranking Interest Rate Maturity Callability Fees to Underwriters Ratings Covenants Marketing Process Usually subordinated and/or unsecured Fixed, expressed as a coupon, varies with credit quality, semiannual payments Bullet maturity in 10 years 10NC5 and 35% Equity Clawback now standard 2.5% to 3.0% Usually B+ to CCC+ Incurrence covenants, governed by the Indenture Sold via SEC Prospectus / 144A Offering Circular Diligence, documentation, roadshow, price, fund

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Mezzanine Financing
Terminology
n Structure Rank / Return / Equity / All-In n Investors Mezz buyers in the market Banks / Other financial institutions n Issuers Perspective Leverage equity more; push risk / return profile Fill hole in cap structure Disclosure / Size

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LBO Market Activity

n LBO activity continues to be very strong n Extremely receptive financing markets Large amount of bank loan refinancings and new CLOs Substantial cash positions of high yield mutual funds n Large corporations divesting assets to reduce debt n Return of the jumbo LBO

$7.05 B

$4.75 B

$4.3 B

n Financial sponsors creating consortiums to cover large equity investments and diversify risk n Although the LBO market is back, sponsors remain disciplined
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III. Putting It All Together

The Analysis

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The Five Simple Steps of LBO Analysis

n Step #1: Evaluate the Story Is this a good debt story? What are the risks? What is the real EBITDA? n Step #2: Construct Sources & Uses n Step #3: Run the IRRs n Step #4: Does the LBO work?

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Step #1 Understand the Story

Dig a Little Deeper
n Is this a good debt story? Stability of revenues: Cyclicality? Contracts? Customers? Organic growth? Margins: Commodity risk? Supplier reliance? Pricing? Capex: Maintenance vs. discretionary? Working capital: Seasonality? Overall management? Management team: Track record? Acquisitions? n What are potential risks and mitigants? n Projections Are they realistic? How do they compare to historical?
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Step #1 Understand the Story

EBITDA Revisited
n What is the right time period to use? n Dont take EBITDA at face value look for adjustments n Common add-backs Restructuring charges Non-cash compensation Asset impairments Sponsor fees Money-losing businesses n Are adjustments really non-recurring? Look at historical financials Use common sense
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Step #2 Construct Sources and Uses

Sources Revolving Credit Facility Term Loan A Term Loan B Total Senior Debt Senior Subordinated Notes Total Debt Management Rollover Equity Sponsor Cash Equity $ 0.0 150.0 200.0 350.0 200.0 550.0 50.0 200.0

Uses Purchase Target Equity Refinance Existing Debt Transaction Costs $ 250.0 525.0 25.0

Total Sources

$800.0

Total Uses

$800.0

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Step #2 Construct Sources and Uses

The Typical Sources of Funds
n Bank debt (Senior debt) Start with 2.5x senior leverage Price term loan @ LIBOR + 3.00% Use 100% excess cash flow sweep Start with 4.5x total leverage Difference between total and bank is high yield debt Minimum high yield size of $150mm Price high yield @ 10.00% Minimum 30% contribution New sponsor cash equity vs. management rollover

n Total debt

n Equity contribution

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Step #2 Construct Sources and Uses

The Typical Uses of Funds
n Retire existing debt Existing covenants will typically prohibit post-LBO debt levels Dont forget tender/call premiums n Pay transaction fees & expenses Bank debt fees: 1.75% to 2.25% High yield fees: 2.50% to 3.00% Dont forget legal expenses n Purchase target equity Make this the plug to balance Sources & Uses for now

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Step #3 Run the IRRs

n Calculate returns depending on future exit strategy in Years 35 n Typical exit analysis contemplates outright sale of company Make base case exit EBITDA multiple = entry multiple n Deduct net debt in exit year to compute future equity value n Allocate equity to owners based on ownership Financial sponsor vs. management Exercise of warrants if appropriate

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Step #4 Does the LBO Work?

Ask yourself the following questions:
n Do the senior and total debt multiples make sense in the context of the overall purchase price multiple? n Are the coverage ratios adequate? EBITDA / Interest Expense > 2.00x (EBITDA - Capex) / Interest Expense > 1.50x n How is the bank debt amortizing? Is the bank debt completely repaid by year 7? n What are the results after running more realistic and downside cases? n What are the expected credit ratings?

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Step #4 Does the LBO Work?

Iterate Until The LBO Works For All Constituencies

Debt Holders: Feasibility

Equity Holders: Attractiveness

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Step #4 Does the LBO Work?

How Does the Implied Valuation Compare?
n Triangulate with Other Enterprise Valuation Techniques Deal Comps Common Stock Comps Other Recent LBOs n Can a financial sponsor beat a strategic? Synergy opportunities Merger plan analysis

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IV. How It Happens In Reality

The Tension between Buyer and Seller

The Scenario
n An attractive business is up for auction n Your client is a large private equity player n Tomorrow is the final bid deadline n You believe your client is competing vs. a large corporation and other financial sponsors n The corporate can pay tomorrow in cash n The seller wants to know youre good for the money n Your client wants guidance from you on: Maximum leverage Certainty of funds Financing conditions

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What Does the Seller Want?

n Seller generally wants to maximize selling price n But not all bids are created equal seller also wants certainty How long between signing and closing? Sponsor generally needs to raise the debt in this period Compare with corporate buyer with available stock/cash n Mere promise by buyer to raise the debt is insufficient n Seller wants legal commitment n Although Sponsor has committed financing, the letters typically have outs that weaken the commitment
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What Can the Buyer Do?

n Buyer must make seller comfortable that the financing risk is minimal by providing committed financing n Committed financing is usually comprised of a bank commitment and a bridge commitment The bank commitment typically represents the senior secured portion of the capital structure (i.e., Bank Debt) The bridge commitment typically represents the subordinated portion of the capital structure (i.e., High Yield) n Sponsor typically has access from its own funds but check absolute dollar size of equity needed
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The Commitment Letters

n The bank and bridge commitments are comprised of four letters Commitment letter that covers both facilities Fee letter for the bank facility Separate fee letter for the bridge facility Engagement letter for the take-out of the bridge facility

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