Synopsis and Objectives
In November 2003, Maria Ober, a vice president of Deutsche Bank Securities, received a client request for financing the acquisition of a large hospital-supply distributor. The client needed to present the seller with an offering price and an indication of financial commitment within two weeks. The contemplated transaction entailed a highly-leveraged acquisition of the target. The tasks for the student are to value the target firm and projected synergies, assess the credit worthiness of the target (i.e., its ability to bear the high debt), and critically evaluate the general design of the transaction.
This case was developed to support the following teaching objectives:
Profile the highly leveraged acquisition and its financial structure. The particular perspective of this case is that of the creditor. Thus, the case complements other cases on leveraged buyouts that consider the view of the equity investor. Exercise skills in valuing a business. The case includes a completed financial forecast and an estimation of the internal rate of return for the equity investor. The student must assess the adequacy of the return and consider valuation insights based on peer firms and transactions. Exercise skills in credit analysis. The case gives ample information on projected performance, forecasted interest coverage, and credit rating standards. The student must assess whether the return to the lender is adequate in light of the assessed credit risks. Consider the impacts of changes in leverage, in control structure, and of a cross-border transaction with the attendant country risk and exchange rate bets.
Suggested Questions for Advance Assignment
1. Is the payment to the seller an appropriate amount? If not, why? If so, what is the source of value created that might justify the acquisition premium? 2. Intercontinental Capital, Ltd. (ICL) believes that it could increase the earnings before interest, taxes, depreciation, and amortization (EBITDA) margin of Consolidated Supply S.A. (CSSA) by 350 basis points (bp) through improvements in operations and product mix. What is the impact of this savings on the value of CSSA and/or the return to ICL? 3. Is this deal structure realistic in the sense of being attractive to the senior lenders, the investors in the senior notes, and subordinated debt? What risk rating would you attribute to the senior debt? What is the expected return to Deutsche Bank? 4. Is this deal structure attractive to the equity investors? 5. What modifications can you suggest to improve the deal from the standpoints of the lenders and/or the equity investors? 6. How should Maria Ober reply to ICL?
Note that this case is accompanied by a Microsoft Excel spreadsheet that supports student analysis: Case_33.xls. It is recommended that the instructor distribute this file to students along with the case.
A separate Excel file contains analysis that supports instructor preparation to teach the case: TN_33.xls. Under the terms of license of use, the instructor is not to distribute this spreadsheet or printed representations of its contents to the students.
This case can stand on its own when used with students who are generally familiar with the concepts of valuation, credit analysis, and acquisitions. To serve students who are less familiar with these concepts, suggested background readings would include: Robert F. Bruner, Applied Mergers and Acquisitions, (Hoboken, New Jersey: John Wiley & Sons, Inc., 2004): Chapter 9, “Valuing the Firm,” Chapter 13, “Valuing the Highly Levered Firm and Assessing the Highly Levered Transaction,” and Chapter 20, Section V, “Assessing the Financing Aspects of a Deal.”
Hypothetical Teaching Plan
This case may be taught in the usual class discussion format or used as a vehicle for team-based presentations. Using the latter format, the teaching plan should include an introduction, followed by team presentations, and conclude with general discussion and closing points by the instructor. The following plan depicts a standard class discussion format.
1. What is the problem in the case?
Maria Ober needs to recommend a credit decision on this deal. It would make sense for the instructor to begin with some discussion of how a senior credit officer structures the analysis for a credit decision. More importantly, the problem is not simply a yes-or-no decision on the loan, but rather, a more creative task of structuring and negotiating a deal that is sufficiently attractive to all parties.
2. What is CSSA worth?
A logical place to begin the analysis is with the appropriateness of the acquisition price. Are the asset values sufficient to support the loan? Is the buyer overpaying?
3. How much value would the improvement in the EBITDA margin add?
This section addresses the economic efficiencies that the buyer expects to harvest.
4. What credit rating should Maria Ober give to this financing? Is the return to the creditor adequate to compensate for the credit risk?
Here, the discussion turns to the more prosaic aspects of credit analysis.
5. Is this deal attractive from ICL’s standpoint? What might be done to improve the returns?
This section of the discussion turns to the creative structuring aspect of the problem. The returns to the equity investor seem skimpy. Students should be challenged to look for a way to improve the returns, rather than just reject the deal. 6. In summary, how should Ober respond to the request for financing terms?
This final section asks students to knit together the various analyses of the case.
The instructor could close the discussion with comments based on the epilogue and some general observations on the financing of highly leveraged acquisitions.
This is a complicated deal requiring careful analysis. On one hand, its very complexity will prompt some students to reject it. On the other hand, Deutsche Bank makes a business in such financings, largely because they are very profitable. A willingness to do the careful homework begets more financing business. Thus, the core problem is not to make a “yes or no” decision, but rather, to consider possible transaction designs that could improve the position of some parties to the transaction without necessarily worsening the position of others. Part of the problem for students is planning the analysis of this transaction. In this regard, students can draw on some scheme of credit analysis. A simplistic framework is the “6 C’s” of credit:
Cash flow: Is the firm’s expected cash flow large enough to meet the principal and interest payments? Collateral: If we have to foreclose on the loan, are there sufficient assets in the firm that we could sell to repay the loan? Capital: Is there enough other capital ranking in priority below this loan to withstand a reasonable cyclical downturn in this firm’s business? Conditions: Do the current economic conditions favor timely debt payments? Course: Is the use to which these funds will be put appropriate? Is the general strategy of this firm on course? Character: Are the managers who are involved not only sufficiently intelligent and skilled, but are they also inclined to honor the repayment commitment?
For many long-term bonds, creditworthiness is summarized in a bond rating. As the firm borrows more, the rating will decline. As the rating declines, the return that investors require will rise.
Valuation of CSSA
Students can pursue the question of CSSA’s value in a number of ways. One classic approach simply is to compare the internal rate of return (IRR) given in case Exhibit 10 (21.3%) to an appropriate benchmark. Since this IRR is a return to equity holders, the appropriate benchmark would be the cost of equity reflecting the leverage of the target firm. Using the capital asset pricing model (CAPM) with a beta that is relevered to reflect the leverage yields estimated costs of equity ranging from 9% to 13% (see Exhibit TN1). Against this standard, the valuation of CSSA looks attractive. But theory indicates that the levered beta formula ignores default risk, suggesting that these equity costs understate the return required by equity holders. Some students will offer benchmarks based on hearsay or work experience.
Private equity investors may look for equity returns in the 25% to 35% range. Indeed, the case mentions a typical expected return of 30%. Against such benchmarks, the return offered in this deal looks weak. The inconclusive assessment of returns invites an alternative approach to an economic judgment of the deal. Students could complete a standard valuation analysis, drawing on the wide range of valuation approaches supported by the case, and then judge whether the bid of $1.513 billion is too high or low. Exhibit TN1 presents a completed discounted cash flow (DCF) valuation analysis showing an estimated value of $1.883 billion, well in excess of the total purchase amount.
Exhibit TN2 summarizes the valuation results based on other approaches. The findings across the range of approaches are summarized in Exhibit TN3—the “football field” diagram allows the analyst to triangulate from many approaches. This synthesis of many approaches suggests that ICL is probably not overpaying and that there is likely to be plenty of asset value to underpin the total funded debt of $979 million.
Valuation of improvement in EBITDA margin
ICL, the buyer of CSSA, believes that it will be possible to increase CSSA’s EBITDA margin to 6.6%, which is the level of CSSA’s chief competitor. This 350-basis-point improvement in EBITDA margin is not reflected in the financial forecasts provided by ICL. The case implies that this improvement results from cost reductions. While we are given relatively little basis on which to judge the reasonableness of management’s belief, it is useful to consider the valuation impact if it comes true. Exhibit TN4 gives a DCF valuation of the savings. This uses a discount rate of 10%, a figure generally at the middle of the equity costs estimated in Exhibit TN1.
Arguably, cost savings are likely to be more certain than typical equity cash flows, so it might be reasonable to use a lower discount rate. But debating the appropriate discount rate for merger savings is a fruitless use of class time. The point should be to look at the relative magnitude. Exhibit TN4 suggests that the DCF value of the savings is quite sizable: $257 million to $391 million. Such savings would accrue to the benefit of the equity investors. Relative to the equity outlay of $534 million, the DCF value of the savings represents an enormous potential return. ICL will clearly be motivated to operate CSSA more efficiently.
The typical foundation for credit analysis is to spread the forecasted financial results across time and compute a series of analytic ratios with which to judge the credit risk of the borrower. This basic task has been completed and its results are given in case Exhibit 8. Plainly, Newco’s credit quality increases over time. The credit analyst will give the greatest attention to years 2003 and 2004, when Deutsche Bank’s exposure is the greatest. The ratio of EBITDA to interest (2.7× and 2.9×) falls between BB- and B-rated debt as shown in case Exhibit 11.
Case Exhibit 9 provides information on the coverage of two key covenants: Minimum interest coverage: The exhibit hypothesizes a minimum coverage of 2.00× in 2004, rising to 2.25× in 2005 and 2006. The estimated coverage ratio is in the range of 2.85×. The firm meets this covenant test, though there is a relatively thin margin for error. Maximum total leverage ratio: The exhibit hypothesizes a maximum debt-to-EBITDA ratio of 6.75× in 2004, falling to 5.25× by the end of 2006. The calculated ratios are comfortably within those limits, which suggests that the new company has some room to borrow more debt in unforeseen circumstances. With some idea of the riskiness of the financing, one can look at Deutsche Bank’s potential returns. Case Exhibit 14 presents a completed hypothetical analysis of the IRR to the bank from this deal. The estimated return is 12.28% after taxes. Because financial institutions generate large tax shields, it is also useful to look at the pretax return.
Case Exhibit 14 estimates the pretax return to Deutsche Bank as 23.17%. By any standard, these are huge returns for Deutsche Bank. The instructor should dwell on the possible sources of the high returns to Deutsche Bank. They are substantially created at the closing of the deal, in the form of fee income. This return may reflect market inefficiencies in competition. More likely, it reflects the return to unusual skill, willingness to bear underwriting risk, social networks, and information advantages. The bigger insight for students is that it pays better to be present at the creation of such transactions than it does to clip the coupons in later years. To conclude this section of the discussion, the instructor may walk students through the six C’s of credit to the extent that case facts allow (see Table TN1):
Table TN1. The six C’s of credit.
Cash flow: Is the firm’s expected cash flow large enough to meet the principal and interest payments? Reasonable, though not lofty, coverage ratios.
Collateral: If we have to foreclose on the loan, are there sufficient assets in the firm that we could sell to repay the loan? Good asset coverage, judging from valuation analysis. Capital: Is there enough other capital ranking in priority below this loan to withstand a reasonable cyclical downturn in this firm’s business? The $534 million in equity represents a moderate cushion against adversity. Conditions: Do the current economic conditions favor timely debt payments? Not a lot of information, but case Exhibit 12 reveals low interest rates and moderate valuation ratios. Certainly not depressed conditions. Course: Is the use to which these funds will be put appropriate? Is the general strategy of this firm on course? Strategy and use of funds seem OK.
Character: Are the managers who are involved not only sufficiently intelligent and skilled, but are they also inclined to honor the repayment commitment? ICL is certainly skilled and experienced. Not much information on character. In sum, the deal seems to be an acceptable credit risk and appears to offer a very attractive financial return to Deutsche Bank.
Conclusion: improving the deal and reaching a decision
If time permits, the instructor can invite students to consider how the deal might be improved to yield a higher return to ICL from the outset. The simplest answer is to lower the amount of equity; however, the deal already looks fully indebted as is. To reduce the equity investment will only drive away investors in the debt securities. If ICL can truly realize the cost savings it hypothesizes, then the increased cash flow may justify a subsequent increase in debt, followed by an extraordinary dividend paid to ICL. In short, the proof is in the pudding: if ICL can deliver on the operating efficiencies, it can earn a substantially higher return.
Students may be divided on what Ober should recommend. On the basis of the analysis offered here, a positive credit decision seems warranted. The instructor may wish to end the class with a vote of the students.
Ober gave a positive recommendation to support the deal, and Deutsche Bank went to work on the behalf of its client. In the spring of 2004, the deal closed on the terms outlined in the case. After two quarters of performance it was clear that ICL had successfully harvested the cost efficiencies that it had foreseen. This served to support ICL’s request for more debt financing. In December 2004, CSSA performed a “super hold co” financing—the shell holding company that was used to acquire CSSA issued $300 million in senior notes—after which ICL paid itself a $300-million dividend. This dramatically increased ICL’s equity returns on the deal. A year later, ICL retained Deutsche Bank to underwrite an initial public offering of CSSA’s equity. The premium that ICL anticipated on the sale of its shares further increased its returns.