Issue 2001/03 February 2001
Time to Think About a Leveraged Recap?
Inside:
Similar in structure to leveraged buyout transactions, leveraged recapitalizations provide a management-friendly way for old-economy companies to boost equity returns. In this special issue we evaluate the rationale, mechanics and funding environment for leveraged recaps
Using Leverage to Boost Shareholder Value
2
LBO vs. Recap: A Look at the US Law
3
The State of the Debt Markets
4
Our Economic Outlook
5
The Landscape in Europe and Japan
6
The State of the Equity Markets
7
A Look Back at the 1980s
8
buyouts (LBOs) have always been an Leveraged option for managements of public companies whose underlying value is not reflected in their share price. The classic ‘going private’ LBO involved management teaming up with financial investors to buy the company from the public owners and drive value through restructuring. LBOs are topical once again, because so many mature, old-economy firms are trading at depressed valuations. Despite two Nasdaq corrections last year, valuations for old-economy firms still sharply trail those for the new-economy sectors. In many cases, conventional strategies have failed to improve valuations. Although some firms have pursued growth through acquisitions, there are limits to how fast they can push this strategy: integration risk, price risk and added leverage create a new set of worries for the market. And with compensation increasingly tied to share-price performance, managers’ frustration is rising visibly.
Recapitalizations Can Provide an Answer
Goldman Sachs 133 Fleet Street London EC4A 2BB England Sandra Lawson International Economist and Editor Gavyn Davies Chief International Economist Roopa Purushothaman Research Assistant http://www.gs.com/ ceoconfidential (44) 20 7774 8736
[email protected]
Financial leverage offers one way out of this bind. By undertaking a leveraged recapitalization, a firm can significantly increase its financial leverage and sharply reduce its publicly traded equity. This transaction stops just short of going private, thus avoiding the variety of legal and other associated challenges that accompany a going-private transaction. Shareholders—both new investors in the recap and those existing shareholders who retain their shares after the transaction—benefit from deleveraging, which magnifies operating returns and boosts returns on equity. Good candidates for this type of transaction are traditional LBO candidates: firms in mature, non-cyclical industries that have slow growth rates; generate strong and predictable cash flows; have low capital requirements; and have low levels of debt. The best candidates for this transaction are well-managed firms that consider themselves undervalued by the public markets and find themselves unable to lift their share prices meaningfully.
Important disclosures appear on the inside back cover of this document.
Leverage in the Global Environment Adding financial leverage may not be an obvious strategy in the current economic environment, but we do not expect the US or the world economy to suffer a sustained downturn. We forecast a further 150 basis point cut in US interest rates this year, with the bulk of these cuts coming in the first half. US growth should begin to rebound in the second quarter, leading to full-year growth of about 1.4%. Other regions should fare better, with European growth slowing modestly to 2.6% and Japanese growth remaining around 1.5%. After a slow second half in 2000, the high yield debt market has begun to revive. Spreads have tightened, and cash is flowing back into mutual funds. Still wary of riskier credits, debt investors are seeking exposure outside the media and telecommunications sectors. Accordingly, we anticipate a strong reception for high-quality, oldeconomy credits supported by strong management. Private-equity firms (also known as financial sponsors) may play an important role in these public recapitalizations. Working with incumbent management, these firms can effectively endorse the restructuring plan in the eyes of lenders and validate the stock valuation in the eyes of shareholders. Their imprimatur can be especially useful in an uncertain economic outlook. n
Despite Corrections, the Equity Market Still Strongly Prefers the New Economy to the Old Forward P/E Multiples Relative to S&P 500 P/E Old-Economy Sectors
Consumer Products Food Industrials Electric Equipment Aerospace & Defense Automobiles Housing Machinery
New-Economy Sectors 0.93 0.77 0.72 0.61 0.60 0.57 0.51 0.50
Internet Biotech Software Internet / IT Services Computer Hardware Telecom Services Media Semiconductors
Companies covered by Goldman Sachs Research.
2.62 2.44 1.63 1.42 1.33 1.24 1.22 1.19
Using Leverage to Boost Shareholder Value: Why and How allows a company to increase Leverage value for shareholders in three ways: 1) by monetizing future cash flows and returning that money to shareholders to reinvest; 2) by boosting the firm’s nearterm earnings growth rate and its return on equity; and 3) by creating new equitybased incentives for management.
The Spectrum of Leverage Financial leverage comes in several forms, ranging from an ongoing share buyback program to a full recapitalization of the company (see chart at right). Companies are familiar with share repurchase as a means to boost earnings per share and increase shareholder value. A leveraged recapitalization is a far more dramatic change in corporate strategy; in effect, the company employs the same capital structure that it would use in an LBO, but its equity continues to trade publicly. As leverage increases, the basis for the company’s valuation shifts from earnings to cash flow; returns come from deleveraging; and the shareholder base changes significantly.
Effecting the Recapitalization In a leveraged recap, cash can be distributed to shareholders in a number of different ways, depending on tax and timing considerations: 1. Share Repurchase. Shareholders can opt to tender their shares and (in the US) receive capital-gains tax treatment on the cash distribution. Shareholders who choose not to tender retain their equity stake and thus maintain exposure to potential share-price upside. Repurchasing large amounts of stock generally requires a large tender premium and a formal tender offer process. 2. Special Dividend. Alternatively, the cash can be distributed via a dividend. A dividend can be effected immediately with board approval, but it generally has unattractive tax consequences for US individual investors, who must pay ordinary-income tax rates on the distribution.
CEO Confidential
Spectrum of Leveraged Alternatives Share Repurchase Moderate Recap Financial Aspects Credit Ratings Debt-to-EBITDA Multiples EBITDA / Interest Bank / Short-term Debt High-Yield Bonds Equity Impact/Time Horizon Visibility Time Horizon Company Issues Effectiveness as a Raid Deterrent Risk of Financial Distress Post-Deal Debt Capacity Possible Growth Constraint Equity-Holder Issues Immediate Value to Shareholders EPS / ROE Ramp-Up Stock Liquidity Management Issues Insider Ownership Management Challenge
Recap / LBO
Investment Grade Cross-Over / BB Low BB / High B <2.5x 3.0x-4.0x 4.0x-5.0x >6.0x 3.5x-5.0x 2.0x-3.0x Up to 100% Up to 100% Max None None Max Limited Impact Moderate Impact Public Stub / Private Low 1-2 Years
Medium 2-3 Years
High 5+ Years
Lowest Some Highest Some
Moderate Moderate Moderate Moderate
Highest Highest Lowest Highest
Low Low Highest
Moderate Moderate Moderate
Highest Highest Lowest
Low Low
Moderate Moderate
Highest Highest
3. Recapitalization via Merger. By merging into a subsidiary for cash and new shares, companies can return cash to shareholders with the cash distribution taxed at capital gains rates. This structure (recently used by Ford Motor Company) has the advantage of avoiding the tender premium, but it does require a shareholder vote.
The Best Candidates for a Recap What makes a good candidate for a leveraged recapitalization? We answer this question in two ways: who can do such a transaction, and who should.
n they enjoy competitive advantages and
leading market shares in their industries; n they
have established and diversified customer bases; and
well-
n they do not already have high levels of
financial leverage. Companies that should consider this transaction are well-managed firms that, because of the maturity of their industry and/or their size, perceive themselves as undervalued by the public equity market. Continued on page 3
Companies that can undertake this transaction share several characteristics: n they operate in non-cyclical, mature
industries with relatively high barriers to entry; n they have stable financial profiles with a
history of consistent earnings, steady and predictable cash flows, and low capital requirements;
2
Contributors: Abby Cohen, Gwen DeLoach, Bill Dudley, Paul Efron, Terry Hughes, Kathy Jennings, Kevin Jordan, Jack Kelly, Eve Lesser, Kathy Matsui, Ed McKelvey, Sang Park, Michael Rabin, Ivan Ross, Amra Sabic, Jeremy Sloan, Lance Vitanza, Felicia Williams
February 2001
Using Leverage to Boost Shareholder Value Continued from page 2
In such cases, recaps may be the best means of creating value for shareholders and generating the earnings growth needed to improve valuations.
After the Recap The ‘stub equity’ that continues to trade after the recap is likely to trade quite differently than the pre-deal equity. Stub equity typically attracts a distinct investor base, one that has longer-term horizons and focuses on the stub’s higher rate of return. While performance still drives the share price, investors are more focused on cash flow than on earnings-per-share numbers. Returns will be driven by a higher return on equity and by the impact of deleveraging on the firm’s bottom-line growth rate. Deleveraging magnifies solid operating performance, boosting total returns.
The Role of Financial Sponsors Financial sponsors (also known as buyout or private equity firms) have traditionally been associated with full-fledged leveraged buyouts, but their role is not limited to these transactions. Financial sponsors can add significant value to leveraged recapitalization transactions, both by facilitating the leverage process and by contributing operational and management expertise. Sponsors participate in recapitalizations by purchasing extant or newly issued shares as part of a broader recapitalization that involves significantly increasing financial leverage and buying back stock from public shareholders. The proceeds from the sponsor’s investment may be used to fund a portion of the stock buyback and/or as growth capital. Sponsors can improve the company’s access to debt capital, allowing it to raise more money on better terms, by accessing its own strong relationships in the banking and high yield communities. In addition, the active participation of experienced investors in a recap can help to validate the story in the eyes of potential lenders. This can be especially helpful in CEO Confidential
difficult lending markets. Sponsors can also catalyze operating changes, reducing the level of risk shouldered by public shareholders and supplementing existing management. There are, of course, potential complications involved in enlisting a financial sponsor. One is governance: a sponsor is likely to seek several board seats and an activist role. A board may find it difficult to justify giving a sponsor the
degree of control it requires if this role is disproportionate to the sponsor’s ownership stake. A board may also find itself in a complex negotiation over the appropriate valuation for the sponsor’s investment when considered against the interests of the existing public shareholders. n
LBO vs. Recap: A Look at the US Law evaluating the merits of an LBO that takes a firm private against the merits of a Inleveraged recapitalization that maintains a firm’s public status, managements and boards of directors should consider the meaningful differences in the legal implications of the two alternatives. An LBO is a sale of the company. Under Delaware law (and the law of most US states), a sale imposes a fiduciary duty on the board to maximize short-term value. To meet this obligation, a board will typically form a Special Committee of disinterested directors to evaluate the proposal and will hire an independent financial advisor to advise the Committee and to evaluate the fairness of the transaction. While the Committee may or may not direct the financial advisor to explore other alternatives, the Committee will certainly be required to consider the financial attractiveness of any credible unsolicited offer. The board will potentially be subject to an enhanced level of judicial scrutiny—one that exceeds the normal judicial deference to the board’s exercise of its business judgement. In a practical sense, this means that directors are likely to find themselves obligated to accept a competing offer with superior short-term economics. In contrast, a recapitalization is not a sale of the company. If an unsolicited competing offer is made after a proposed recapitalization has been announced, the directors must of course still act as fiduciaries for shareholders. But they can reject an offer that they believe is not in the shareholders’ long-term interests. Even in situations where an outside party (such as a financial sponsor) gains the opportunity to acquire a significant but not controlling stake, the legal status of the recapitalization should not change. The optics of the transaction may, however, prompt the directors to form a Special Committee or to seek a fairness opinion from an independent third party. Granting management options as part of a recapitalization generally should not affect the legal characterization of the transaction or require a Special Committee. Instead the general principles of management compensation should apply. But an enhanced process might be in order if management were treated differently from other shareholders—for example, if they received increased equity in lieu of cash. n Goldman, Sachs does not provide legal advice. This discussion is based upon the advice of Skadden, Arps, Slate, Meager & Flom L.L.P. as to certain general principles of US law. In connection with this discussion it should be noted that the law in any given jurisdiction may differ from the general principles described above and that the specific facts of any particular case may dictate a different result.
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February 2001
The State of the Debt Markets debt markets suffered a dismal Thesecond half of 2000, hit by a rapidly decelerating US economy, weak equity markets, interest-rate concerns and a heightened focus on credit quality. In the wake of the Federal Reserve’s two interest-rate cuts in January, however, this gloom has given way to improved optimism and more accessible credit. The bond and bank markets have seen significant activity since the start of the year. But despite investors’ (and our) expectations of further rate cuts, the markets remain highly selective. Credit quality and timing are thus essential to the success of a leveraged recap.
High Yield Market Much Improved Following the Fed’s first rate cut, high yield new issuance through February 9 reached $19.6 billion, easily outpacing the total issuance for the fourth quarter of 2000. Heartened investors have responded by putting money into the market; year-todate net high yield mutual fund inflows through February 9 reached $3.3 billion. Current high yield investor demand bodes well for LBO and leveraged recap activity. With 56% of 2000 high yield issuance in the media and telecommunications sector, the dearth of industrial paper in the market has boosted demand for industrial issues.
High Yield Market Stages a Revival
The High Yield Market Has Returned for Select Leveraged Deals
CPKelco Advanstar Communications Travelcenter of America Seagate Technology* Perfomance Materials Dresser Equipment Group Michael's Foods**
Date
Transaction Value ($mn)
Expected Size of High Yield ($mn)
Total Debt / EBITDA
September 2000 September 2000 November 2000 November 2000 February 2001 February 2001 April 2001
1,150 900 731 2,000 1,400 1,550 800
230 150 200 210 200 250 200
4.7 x 5.9 x 4.7 x 3.4 x 4.1 x 4.4 x NA
* Total debt as a multiple of EBITDA minus capex. ** Expected April 2001. Source: MCM Corporate Watch; Goldman Sachs.
Excess cash, along with the market’s belief that the Fed is ready to provide needed liquidity, has helped to ease fears of a credit crunch. Will this last? Although lingering credit concerns may give investors pause, the technical picture is strong. Mutual funds, already flush with cash, expect strong net inflows from private investors, as pension funds, CBOs and other large institutions begin to look favorably on the relative value in high yield.
Capital Raised by US LBO Funds
Bank Debt Market Follows Suit The bank debt market generally follows the high yield debt market, but it reacts more slowly on both the downturn and the upturn. It is typically less sensitive to the performance of equity markets than is the high yield market. The recent rate cuts have helped to stabilize the bank debt market: the $9.8 billion of loan volume through February 9 represents a 16% increase over December’s volume. Recent trends in the bank loan market that directly affect recapitalizations include the higher use of bank debt to fund recapitalization and LBO activity; increasing interest among institutional investors; and the smaller presence of media and telecom issuers. The past few years have seen a striking change in the composition of the debt issued in highly leveraged transactions, as bank debt edges out high yield.
Source: BUYOUTS.
average bank-debt-to-EBITDA ratios have fallen just 0.5 times during the same period. n In the past year, the share of bank loans
used to fund recaps has outnumbered the share of high yield debt used for recaps by roughly six times. Changing Bank Loan Markets. The dynamics of the bank loan market have also changed as a result of mergers among financial institutions. The number of banks participating in 10 or more leveraged loans fell to 49 in 2000 from 110 in 1999. Continued on page 5
n Average total-debt-to-EBITDA levels Source: MCM Corporate Watch; Goldman Sachs.
CEO Confidential
have fallen from just below six times in 1996 to roughly four times today. But
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February 2001
The State of the Debt Markets Continued from page 4
In contrast, the number of institutional investors investing in syndicated credits rose to 205 in 2000 from 150 in 1999. The institutional market currently represents roughly 25%-30% of the total leveraged loan market. Institutional investors tend to show active interest in industrial issuers and are clearly focused on credit quality. Although the dynamics of the bank debt market can support increased leveraged recapitalization activity, credit remains a critical issue. Credit standards have tightened over the past four years; we do not expect them to ease until the market sees better corporate performance, fewer rating-agency downgrades and lower default rates. In general, media and telecom issues have not dominated the bank debt market in the way they have dominated the high yield market. Media and telecom issues
accounted for just 24% of new bank deals in 2000, compared to 56% of the high yield market. Bank debt investors’ preference for strong industrial paper is a good match with the high yield mutual fund inflows targeted toward similar industrial issuers.
Bank Loan Market: Average Debt Multiples of Highly Leveraged Loans
Mezzanine Finance Provides Another Source of Funds For smaller transactions, mezzanine finance can serve as a source of recap financing. Mezzanine—subordinated debt with equity warrants—is a privately placed alternative to high yield debt. The benefits of mezzanine finance include flexibility of structure and certainty of financing. Goldman Sachs, for example, manages $2.5 billion of mezzanine investment capital. The fund’s target investment size is $30-$200 million per transaction, which is enough to facilitate transactions in excess of $750 million. n
Highly leveraged loans defined as Libor+250 basis points prior to 1996; Libor+225bp since 1996. Media and telecommunications loans excluded. Too few deals in 1991 to form a meaningful sample. Source: S&P; Portfolio Management Data.
Our Economic Outlook: A U-Shaped Recovery May Be in Store global forecasts are based on the assumption that the aggressive easing in US monetary policy that is now underway will succeed in Ourhalting the strong downward momentum in the US economy before the end of the first quarter. We expect that US GDP growth will bottom out at -0.3% in the first quarter before rising steadily through the remainder of the year. Our full-year US forecast is for 1.4% growth. Financial markets expect a robust, V-shaped recovery in the second half of the year, and US economic history supports this expectation. In almost every business cycle over the past half century, real GDP has rebounded strongly in the period immediately following the trough in economic activity. With the exception of 1991, the economy consistently grew at an average annual rate of more than 5% during the first two quarters of recovery and at 4% during the first year. But the record for non-recessionary slowdowns—which the current episode is shaping up to be—is less clear. This is in part because these periods are not as well documented as recessions. When we look at the significant slowdowns of 1966-1967, 1986 and 1995, we find that growth did pick up into the 4%-5% range. However, the pickup developed more gradually and did not reach this range until at least a year after the onset of the slowdown. Beyond the question of timing, we see several fundamental obstacles to a V-shaped recovery. Our analysis of what we have termed the ‘Brave New Business Cycle’ points instead to a U-shaped outcome. n From a cyclical perspective, any revival in growth is apt to derive less support from three sources—pent-up demand for housing and
durable goods, restocking and renewed hiring—than has traditionally been the case. A tax cut of $30 billion to $50 billion, as we expect from the new administration, would only partially fill this void. n From a structural perspective, two imbalances—growth in productive capacity that could prove excessive and a huge private-sector
deficit—have the potential to keep consumer and capital spending anemic for a very long time. The picture is brighter in Euroland and Japan. Declining unemployment and expansionary fiscal policy in Euroland will help to keep consumption strong. We forecast only a modest slowing, to 2.6% from 3.4% in 2000. Accordingly, we do not expect the European Central Bank to cut rates aggressively. In Japan, despite gloomy recent data, we expect GDP growth to remain around 1.5%. Growth should be driven by private-sector capital spending in the first half and a recovery in external demand and personal consumption in the second. n CEO Confidential
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February 2001
The Landscape in Europe restructuring divisions and private firms that previously operated on a local scale.
experience with leveraged Europe’s recapitalizations has been limited, and buyout firms have traditionally played only a small role. In part this reflects European investors’ long-standing embrace of conglomerates, as well corporations’ uneasiness in selling assets to buyout firms. But this is changing. European conglomerates are unwinding, and companies that traditionally preferred trade sales of assets now look favorably upon sales to private-equity firms. Nonetheless, the buyout landscape in Europe still differs in several significant ways from the US: n The targets are different. While US
buyout activity often focuses on boosting returns at undervalued public companies, European activity leans toward consolidation plays in the region’s relatively fragmented markets. Private-equity firms are well-placed to accelerate the creation of pan-European industry leaders by combining and
LBO Activity in Europe
n The funding is different. While high-
yield debt underlies most leveraged recapitalizations in the US, the European high yield market is relatively small. Mezzanine financing fills this void, with the result that the European mezzanine market is more robust than that in the US.
Role of Private-Equity Firms In Europe’s still-politicized corporate landscape, private-equity firms make attractive buyers. They have few or no overlapping businesses, so they can avoid most competitive and regulatory problems. Their cash offers are attractive to those shareholders still reluctant to own foreign shares. And because they are responsible to fewer constituencies than are public companies, they often enjoy greater flexibility to undertake controversial restructurings, including layoffs and sales or closures of divisions.
Source: Thomson Financial Securities Data.
As conglomerates unwind, European private equity may find itself playing a role similar to the one it played in the US in the 1980s. There is ample scope for streamlining and efficiency gains. This transformation is not just about cutting costs, but more about bringing focus and attention to previously overlooked businesses. n
The Next Thing: LBOs in Japan? Japan today bears some resemblance to corporate America of the mid-1980s, with many firms vulnerable to takeovers. Corporate Roughly half of TSE-1-listed firms are trading below their book values, with many trading at discounts to their net cash balances. The catalysts for realizing value are proving to be both government-driven reforms and investor pressure for restructuring. A Better Environment in Tokyo. The Japanese authorities have made substantial progress in creating an environment that will facilitate corporate restructuring. The government has introduced reforms to simplify merger procedures and to allow stock swaps and corporate spin-offs. This follows steps toward accounting reforms, a new bankruptcy law and a more flexible stock-option system. Progress is slower but still visible in efforts to amend Japan’s Commercial Code and its corporate laws to provide legal defenses against hostile bids, while the government has not yet moved decisively on consolidated taxation. But the reforms should provide greater flexibility to ‘old Japan’ companies wishing to restructure—as well as to investors wishing to force restructuring on holdout firms. A New Takeover Climate. The previously unimaginable possibility of hostile takeovers in Japan is now a reality. 1999 saw a sharp increase in merger activity (although this fell off in 2000); this was the first time Japanese managements genuinely began to regard M&A as a strategic option. We expect a similar acceptance of hostile takeovers to develop, reflecting the unwinding of crossholdings; a new emphasis on corporate governance; deregulation; accounting reforms that spark better disclosure; and investor pressure to restructure. Shifting corporate ownership patterns are a key factor behind the pressure for restructuring. Shareholders are displacing stakeholders as the introduction of mark-to-market accounting undermines the case for crossholdings. Since shareholders tend to focus solely on share prices and valuations, this creates an opening for bidders willing to offer attractive premiums. Recent hostile bids show that individual investors are willing to tender their shares in a takeover bid. Foreign investors—who own some 19% of listed shares and as much as 30%-50% of some blue-chips—are also likely to respond positively. It seems quite possible that a buyer offering a strong premium could acquire 34% or even 51% of a target firm. Corporate Japan increasingly sees acquisitions as an opportunity for positive changes, rather than as a threat. The buyout market is still dominated by small transactions, but we expect larger deals to follow. This should help to boost Japanese corporates’ return on equity, just 1.83% for TSE-1 nonfinancials in fiscal 1999, to an estimated 10% by fiscal 2003. n CEO Confidential
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February 2001
The State of the Equity Markets past two years have seen a marked Thedivergence in performance between firms with good earnings growth prospects and those without. Although this divergence has softened somewhat, given the two Nasdaq corrections last year, the market’s interest in old-economy stocks appears to reflect caution and a desire for safe havens more than any real conviction. Adding to the pain of old-economy firms, the US equity market is becoming increasingly bifurcated even within oldeconomy sectors. Institutional investors remain eager to buy industrial giants, but they show markedly less appetite for smalland mid-cap firms. While ‘small- cap’ firms were once those with a market capitalization below $1 billion, that category now encompasses firms worth less than $5 billion. Firms below this threshold face a vicious cycle. Because they are too small to attract the attention of institutional investors, analysts drop coverage; this in turn virtually ensures that institutional investors will ignore them. With low trading volumes and little coverage, stocks are likely to languish even under the best fundamental conditions.
A Better Outlook for 2001 Nonetheless, we are more optimistic about the equity market’s prospects at the start of 2001 than we were at the start of 2000. Last winter, growth was unsustainably rapid, investors were risk-tolerant, margin debt was at a peak, and mutual-fund cash ratios were at a low. The aggregate equity market was moderately overvalued, but some sectors were at extreme valuation levels.
We see the current risk in equities as being time, not notably weaker prices. Valuations are appealing and cash is on the sidelines, but investors may continue to wait for signs that the economy has stabilized. Our economic outlook, detailed on the previous page, suggests that investors’ confidence should return as the slowdown of the first quarter gives way to growth that improves steadily throughout the rest of the year. n
This winter, attractive valuations have returned, capital is allocated more efficiently, and leverage has fallen in both portfolios and financial intermediaries. Old Economy Trades at Low P/Es Forward-Year P/E Relative to S&P 500 P/E 1990 1995 Automobiles 0.54 0.61 Aerospace & Defense 0.64 1.06 Electric Equipment 0.82 0.88 Industrials 0.75 0.90 Machinery 0.87 0.69 Packaging NA 0.92 Beverages 1.59 1.47 Consumer Products 1.02 1.18 Food 1.17 1.21 Housing 0.70 0.89
2001 0.57 0.73 0.61 0.72 0.50 0.39 0.95 0.93 0.77 0.51
Companies covered by Goldman Sachs Research.
©2001 Goldman, Sachs & Co. All rights reserved. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. We are not soliciting any action based upon this material. This material is for the general information of clients of Goldman Sachs. It does not take into account the particular investment objectives, financial situation or needs of individual clients. Before acting on any advice or recommendation in this material, a client should consider whether it is suitable for their particular circumstances and, if necessary, seek professional advice. Certain transactions, including those involving futures, options, and high yield securities, give rise to substantial risk and are not suitable for all investors. The material is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. Opinions expressed are our current opinions as of the date appearing on this material only. While we endeavour to update on a reasonable basis the information discussed in this material, there may be regulatory, compliance, or other reasons that prevent us from doing so. We and our affiliates, officers, directors, and employees, including persons involved in the preparation or issuance of this material may, from time to time, have long or short positions in, and buy or sell, the securities, or derivatives (including options) thereof, of companies mentioned herein. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without Goldman, Sachs & Co.’s prior written consent. This material has been issued by Goldman, Sachs & Co. and/or one of its affiliates and has been approved by Goldman Sachs International, which is regulated by The Securities and Futures Authority, in connection with its distribution in the United Kingdom and by Goldman Sachs Canada in connection with its distribution in Canada. This material is distributed in Hong Kong by Goldman Sachs (Asia) L.L.C., in Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch, in Japan by Goldman Sachs (Japan) Ltd., in Australia by Goldman Sachs Australia Pty Limited (ACN 092 589 770), and in Singapore through Goldman Sachs (Singapore) Pte. This material is not for distribution in the United Kingdom to private customers, as that term is defined under the rules of The Securities and Futures Authority; and any investments, including any convertible bonds or derivatives, mentioned in this material will not be made available by us to any such private customer. Goldman Sachs International and its non-U.S. affiliates may, to the extent permitted under applicable law, have acted upon or used this research, to the extent it relates to non-U.S. issuers, prior to or immediately following its publication. Foreign-currency-denominated securities are subject to fluctuations in exchange rates that could have an adverse effect on the value or price of, or income derived from, the investment. In addition, investors in securities such as ADRs, the values of which are influenced by foreign currencies, effectively assume currency risk. Further information on any of the securities mentioned in this material may be obtained upon request, and for this purpose persons in Italy should contact Goldman Sachs S.I.M. S.p.A. in Milan, or at its London branch office at 133 Fleet Street, persons in Hong Kong should contact Goldman Sachs (Asia) L.L.C. at 2 Queen’s Road Central, and persons in Australia should contact Goldman Sachs Australia Pty Limited. Unless governing law permits otherwise, you must contact a Goldman Sachs entity in your home jurisdiction if you want to use our services in effecting a transaction in the securities mentioned in this material.
CEO Confidential
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February 2001
A Look Back at the 1980s successful were the leveraged Howrecapitalizations and buyouts of the 1980s? We looked at 25 deals that occurred from 1984 to 1990, the period of greatest recapitalization activity. The historical record shows that these deals created substantial value for shareholders—both on the first day and over time. Shareholders, on average, experienced a 40% first-day ‘pop’ in the value of their holdings. That is, they received a cash distribution that, along with their equity holdings, was worth 140% of the value of the share price before the transaction was announced. The average cash distribution was worth 98% of the pre-announcement equity price, and in 40% of the transactions, the company paid out more than 100% of the pre-deal equity value. Shareholders also benefited from longerterm value creation. On a total return basis, approximately 60% of the firms in our universe outperformed the S&P 500 during the three years following the transaction, a notable feat given the slow-growth nature of the companies involved. 1980s Recaps and LBOs: Shareholder Payoff
Many of the raids during Management Stakes this period were Transactions Management Management Absolute initiated by financial 1984-1990 Stake Before Stake After Change investors pursuing High 40% 55% 25% leveraged acquisitions. Mean 8% 16% 8% To remain independent, Median 5% 13% 8% incumbent management Low 0.1% 0.1% -3% had to convince shareholders that its rising 42% on average. This probably own recapitalization plan was preferable to reflected several factors: the raider’s offer; that it could raise the company’s debt to levels comparable to the shift in equity valuation nA raider’s plan; and that it was willing to pay methodology. Before the mid-1980s, out the cash to shareholders immediately. the equity market relied primarily on Management usually argued that the earnings-based valuation metrics. One higher returns on equity that could be of the most enduring and important achieved through a recap should go to effects of the LBO era was its role in existing shareholders, not to a raider. shifting investors’ focus from earnings to cash-flow-based valuations. High The robust market for highly leveraged interest expense made EPS less relevant credits in the 1980s was crucial to many of for investors in firms that had undergone these deals, which were financed on a more recaps; investors more widely saw what aggressive basis than may be feasible now. could be done with financial Over 40% of the transactions had engineering and began to shift their EBITDA-to-interest coverage ratios below focus toward cash-flow performance. two times in the first year, while more than 35% were levered above four times total-debt-to-EBITDA.
Explaining the Value Creation Initial cash distribution. These first-day distributions averaged 98% of the preannouncement value of the equity. The ability to pay out such sums often reflected a sharp divergence between equity-market valuations, which focused on earnings, and debt-market valuations, which focused on cash flow. On an enterprise-value-toEBITDA basis, many firms traded near or even below the multiples of cash flow at which debt markets were willing to lend.
The Rationale Behind Recaps Recapitalizations became popular in response to the hostile takeover environment of the mid-1980s. Recaps and full-fledged LBOs were often used as defensive measures against unsolicited merger and takeover offers. In 76% of the deals we studied, management undertook a recap in response to a hostile acquisition approach. Recaps offered companies a way to maintain their independence by providing shareholders with an attractive economic alternative to a raider’s bid. CEO Confidential
Multiple expansion. Once the transaction closed, many firms immediately began to trade at higher EV/EBITDA multiples. Over a third of the firms in our universe saw a multiple expansion, with valuations
n Expectations of improved corporate
performance. The ‘discipline of debt’ forced managements to focus more intensively on cash flow. In order to generate enough cash to pay down the debt, companies undertook restructuring programs—cutting costs, improving the management of working capital and shedding unproductive assets—that generated higher margins and improved returns.
Management Compensation Management and employee ownership stakes increased in 70% of the deals we studied. These stakes grew as management rolled over existing holdings and received significant new options grants as part of the recapitalization transaction. The average management stake doubled to roughly 15% after the deal. n
1980s: Debt Ratios Pre- and Post-Recapitalization Absolute Debt / Debt / Transactions Change in Total Cap Total Cap 1984-1990 Debt / Total Before After Cap
Debt / EBITDA Before
Debt / EBITDA After
EBITDA / Interest Expense Before
Mean
31%
155%
124%
1.8
4.2
14.7
EBITDA / Interest Expense After 2.6
Median
25%
112%
81%
1.5
3.4
8.3
2.2
8
February 2001