Case:
You are a partner in a first time PE fund. Against all chances, you have been able to raise $300M from investors. The business plan based on which you got the funds from investors is called "Double Acquisition in Midsize Markets". The idea behind the plan is simple yet innovative. You search for relatively small companies whose core business-lines interact (e.g. competitors, upstream/downstream relationship, etc.). Within this group you identify pairs of companies which are prone to restructuring and whose merger is expected to yield a significant operational synergy. You buy-out both firms and merge them into a shell parent company you create for the purpose of the double acquisition.
Similar to a traditional LBO, the parent company finances the acquisition with debt. The process ends by selling the parent company as a whole once synergies are realized. Encouraged by the support you got from investors, you start the implementation of this strategy. For a long time you had the impression that cleaning services (i.e. commercial cleaning, office cleaning, etc.) and security services (i.e. static guarding, manned guarding, retail security, etc.) have strong complementarities, and hence potentially large operational synergies (e.g., amplifying costumer base by providing both services to the same businesses). You collect information about the mid and small size players in these industries, and end up with two candidates: MyCleaner Inc. and MyGuard Inc.
Since the implementation of the Double Acquisition strategy requires coordination between the two deals, you decide to take a friendly approach. You contact the management team of each company and present your buyout plan. You do not reveal, however, the plan to merge the two companies. So, none of the companies knows about the other. Both management teams are willing to consider a buyout proposal, if the right price is offered. They provide you with their operational forecast and planned capital expenditures for 2011-2013 as well as their long run expectations. These forecasts are presented in Exhibit 1. You also learn from the management teams that neither company has a significant amount of leverage in place. Since both firms are private, there is no publicly available information about their equity. Instead, you decide to collect information about the firms' competitors whose equity is publicly traded. This data is summarized in Exhibit 2. You also learn that the yield to maturity on a 5-year
Treasury Bond is 2.10%.
In order to acquire both firms you incorporate the parent shell company in Delaware and name it MergerCo. After consulting with your partners and reviewing the forecasts provided by both management teams, you conclude that the merger of these two target firms is expected to yield the following operational synergies: the merged firm will have a 2010 revenue equals to the sum of both firms' 2010 revenues, a growth rate of revenue equals to the maximum of both firms (for the short and long run), and a cost of sales, as well as corporate expense, equal to the minimum of both firms. All other operational items will scale up to the new level of revenue. These findings are summarized in Exhibit 3.
The fund policy does not allow for more than a third of the committed capital to be invested in a single venture, and MergerCo is considered to be a single venture for this purpose. In order to expand your sources of funds, you contact an investment bank which specializes in mid-size transactions and you ask for help in obtaining debt financing. After reviewing your business plan, the investment bank comes up with a menu of contracts. Exhibit 4 describes the debt contracts that are available. You are allowed to choose only one contract from the list. Apart from the amount of principal and the level of interest rate, all contracts have the same conditions. In particular, they have a maturity of 5 years, all the assets of the merged firm are put as collateral, and the merged firm is required to pay-out principal if it has available cash flows.
Please help with the following analysis:
1. What is the current market risk premium (beginning of 2011)?
2. Calculate the EBITDA and the UFCF of each of the target firms (as a standalone firm) for years 2011-2014.
3. You learn that the management team of MyCleaner and MyGuard require a premium of 40% and 30%, respectively, on the current (beginning of 2011) value of their equity (that is the DCF valuation of equity given the pre-acquisition capital structure and management teams' expectation about future performances as a standalone firm). Do you have enough funds to execute the double acquisition strategy (including the available debt financing)? What is the minimal amount of debt you will have to undertake in order to finance the deal?
4. What is the present value (beginning of 2011) of the operational synergy from the merger of MyCleaner and MyGuard?
Hereafter please make the following assumptions:
-The UFCFs of the merged firm for years 2011-2014 are given by 15,18, 20, and 22, respectively.
-The required return on the assets of the merged firm is given by 12%.
-On aggregate, the target firms require $160M for 100% of their equity.
-All other assumptions remain the same.
5. While neither of the target firms is currently financed with debt, you believe that on the long run (beginning of 2014 onward) the merged firm should stabilize on a higher leverage ratio, 20% (D/V). Assuming that at that level of debt the competitive interest rate is 8%, what is the present value of the interest tax shield at the beginning of 2014?
6. Suppose that at beginning of 2014 the merged firm will be at its target capital structure and that you will be able to sell the firm at its fair value (i.e. at the value derived from a DCF approach). Assuming you raise debt and takeover both targets at the beginning of 2011:
a. Under which debt contract the outstanding debt level at the beginning of 2014 is the closest (in absolute terms) to level of debt under the target capital structure?
b. Which debt contract maximizes the total value of the merged firm in 2011 (post acquisition)?
c. Which debt contract maximizes the equity value of the merged firm in 2011 (post acquisition)?
d. As the equity sponsor, which debt contract will you choose? Does it matter whether you are financially constrained and cannot withdraw more than $100M from the fund? Under the assumption that you are not financially constrained (in the above sense), does your answer depend on how much you need to pay for the target?
7. Despite the variety of alternatives, you feel unhappy with the interest rate you are being charged for. You shop around and find the following attractive (but obscure) debt financing opportunity (Contract D): you can borrow $120M at an interest rate of 9%. The loan is for 5 years. However, there are mandatory principal payments as follows:
|
Year
|
Mandatory payment as a percentage of the outstanding principal at the beginning of the year
|
|
1
|
5%
|
|
2
|
10%
|
|
3
|
15%
|
|
4
|
15%
|
|
5
|
100%
|
For example, at the end of the first year you have to pay down (in addition to interest) 5%X120M=6M. At the second year you have to pay down (in addition to interest) 10%X124M=12.4M, and so on.
You are also required to use any available cash flows to pay down principal, in addition to the mandatory payment (so the effective down payments might be higher). Would you meet the mandatory principal payments for years 2011-2013 if you decide to finance the buyout (which takes place at the beginning of 2011) using contract D?
8. While considering the attractiveness of Contract D (mentioned in question 7), debt market conditions have deteriorated. You find out that the mandatory payment requirement in year 2 has gone up to 15%. All other parameters of the contract are unchanged. Worrying that the new offer will expire soon, you decide to take it without checking your ability to service this stringent debt contract. You use the raised debt (the entire amount) in order to finance the acquisition of both targets at the beginning of 2011. Two years have passed (you are now at the end of 2012) and so far all operational forecasts have accurately fulfilled themselves. However, you find out that MergerCo is not able to meet the mandatory payment requirement of 2012. By how much is MergerCo short of funds? As an equity holder, would it be in your best interest to inject money, service the debt, and thereby keep the merged firm as a going concern (the time is the end of 2012)? In answering this question please make the following assumptions:
a. If debt is not serviced the merged firm MergerCo will be liquidated via auction of its assets.
b. If the firm is liquidated, the auctioneer can expect to get 80% of the value of the assets of MyCleaner as a standalone firm, and 70% of the value of the assets of MyGuard as a standalone firm.
c. Outstanding principal is paid in full to lenders before existing equity holders can get any portion of the liquidation proceeds.
d. As long as the debt is serviced in full, the firm will not be liquidated and will continue to operate as usual (e.g., the cost of borrowing will not increase).