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Management sponsored LBO's: considerations for valuation.

Richard E Kaufman, Professor of Finance and Carl H. Walther, Professor of Finance respectively, Department of Management, School of Business Administration, The California State University, Sacramento, Sacramento, CA, U.S.A.

Introduction

Management buy-outs -- new firms created by managers breaking off from existing firms -- have for several reasons become a familiar phenomenon on both sides of the Atlantic. Managers are motivated by increased financial rewards and a desire to satisfy personal ambitions (Garvin 1983, pp, 5-7; Osborne 1990, p. A10). Corporations are motivated by buy-over-make cost advantages and a desire to release capital for other more lucrative ventures (Wright 1986, p. 450). In Europe, the future growth potential for such firm spin-offs appears significant as managers recognize the potential from new economies of scale and of scope in the single market environment, and the benefit of production cost differentials between community members, and technology transfer.

Past research of the management buy-out process has focused primarily on: shareholder wealth (Torabzadeh and Bertin 1987, pp. 314-315; Lehn and Poulsen 1989, p, 771; Briloff 1990, p. 188), and economic considerations (Wright and Coyne 1985, p. 137). Managers motivation to make offers to buyout portions of their parent companies can be summarized from the literature to include the following issues:

(a) Managers recognize opportunities to extend coverage of contracts over the limit which could otherwise be reached by the internal organization (Kaplan 1989, p. 615).

(b) Managers may perceive attractive exterior markets for intermediate goods, produced internally by the firm. These markets may not be consistent with the main objectives of the firm (Butler and Carney 1983, p. 214).

(c) Allocation of funds makes it worthwhile for managers to divest to a new entity where more favorable financing can be obtained, not otherwise available to the parent due to capital covenants (Leleand 1989, pp. 24-26).

(d) Managers posses insider information advantages and corporate cultural values over other corporate competitors who might provide the same services or goods in the wake of a vacuum created by such a divestiture (Dalton 1989, pp. 38-39).

Traditionally, the corporate decision as presented in diversified make-or-buy decision models is based on net present value selection rules. Recently, however, the surge of leveraged buy-outs has introduced in the literature an approach to externalize transactions within the firm by managers which alters the basic assumptions for net present value calculations (Wright 1986, pp. 450-451). Externalization of transactions in the management LBO often benefits economies of scale which exceed the benefits possible from internalization. An example is the production facilities found in vertical-structured organizations which are underutilized because of corporate-structured goals being expanded through concentric or horizontal diversification (Monteverde and Teece 1982, pp. 321-323). A second premise for externalization of transactions might be increased economies of scope where production of multiple products in the large organization become exhausted. In such instances, a subsidiary may be divested throught leveraged financing to form an independent, specialized entity in a more efficient way rather than becoming absorbed into a larger, specialist company.

The performance of management-sponsored buyouts has been mixed. Wright suggests that a large percentage of divestitures by current managers through leveraged financing arrangements disappear during the first year for one reason or another (Wright 1986, pp. 456-459). Such failures seem inconsistent with the trend of entrepreneural business ventures since LBO spinoffs are usually in the hands of experienced managers. Wright's attrition rate is comparable to many venture capital sponsored projects where risk is inherently high. Tennant suggests that current managers high rate of failure is possibly the result of unrealistic and unachievable goals. Over-exuberant managers, operating in an atmosphere of easy financing sometimes overlook good business planning and strategy (Tennant 1989, pp. 88-89). It is apparent that in addition to these behavioral reasons little attention has been paid to the asset pricing process and the importance of valuation. The literature suggests that there is general laxity to conduct discreet cash flow analysis and adequate capital budgeting before undertaking buyout decisions, especially where there are attractive offers under extreme leveraged positions (Leland 1989, pp. 19-20). This may be due to the fact that early buy-out deals consisted of large publicly traded firms where the valuation process was not observable. In the case of the smaller, privately held firms or vertically integrated departments, it was simply not considered. The price paid by management for the spin-off assets, however, is a major determinant of the spin-off's future profitability and therefore, the investors' rate of return. The buy-out price, based on economic decisions of both parties is the result of negotiations between the management buy-out team and the stockholders of the corporation which leads to the question of valuation for both parties. We attempt to develop a valuation model for each of the parties, and to show how the interactive solution of each model may represent a fair and feasible price that is favorable to both parties.

Assets transferred from the parent company to the books of the managers new corporate structure or entity generally consist of management/employees, production equipment, rights, patents, and/or operating procedures. After the acquisition such assets may be used in the same fashion as before. In other words the assets may not be moved or changed at all, and thus the purchase has all the similarities of a purchased lease arrangement. There are differences between this transaction and the purchased lease in the context of a Make or Buy decision. Discount rates and tax rates applicable to the new business entity cause different discounted cash flow values (Kaplan 1989, p. 611). This bookkeeping anomaly may significantly alter the outcome of Net Present Value. Additional revenues and cost reductions which might be obtained through economies of scale and scope may become available to managers in the future. These are sometimes offset by increased financing costs of the new company in the LBO, whose risk-adjusted discount factor generally is greater than the parent's discount factor. In addition, after-tax costs are normally higher since the managers are operating in a lower corporate tax bracket. Such offsets in a discreet analysis can affect the general outcome of a decision.

Managers' Considerations

Generally, managers consider making an initial offer to purchase the assets under consideration. The size of this offer may be affected by a number of factors. But realistically it is limited by the initial debt and equity capacity of management's new corporate entity, particularly if management does not want to (or cannot) share control with outside equity investors. Management's indifference point can be obtained by setting the difference between the present value of the parent's annual annuity payments for goods and services and the present value of management's estimated annual operating costs equal to managements' offer to purchase the assets from the parent. Under the assumption that future operating costs can be reasonably estimated, management can model the purchase offer of the spin-off assets over a range of values through the adjustment of the annual annuity payment for goods and services provided to the parent. A high initial offer could be accompanied by a high annual annuity payment, and visa versa. From management's viewpoint, the optimal balance between an initial cash offer and later annuity payments is determined by the debt and equity capacity of management's new business entity. The managers' discreet analysis for valuation thus becomes:

(1) 0 = |sigma.sub.t=0,n~ |(|phi.sub.t~ - |theta.sub.t~)F|y.sub.t~~ - |delta.sub.t=0~ - |beta.sub.t=0~

where: |phi.sub.t~ = Annual annuity payment received by the managers.

|theta.sub.t~ = Annual operating cost.

|delta.sub.t=0~ = Fair salvage value of assets paid by the managers.

|beta.sub.t=0~ = Management offer to parent (premium above fair salvage value of assets).

F|y.sub.t~ = Managers' risk-adjusted present value discount factor for period (t).

Management's offer for the spin-off assets therefore can be seen to consist of the sum of the fair salvage value of the assets (|delta.sub.t=0~) and a premium above the fair salvage value of the assets (|beta.sub.t=0~).

The equilibrium situation in equation (1) above often gives way to additional net present values through greater use of the assets from externalities of diversification (economies of scope and scale) by the managers. Basically, however, the model assumes equilibrium on the assumption that there are differences in discount rates and tax rates between the parent and management's new corporate entity and that there are no economies of scale and scope. Any additional net present value gains or losses to management resulting from economies scale and scope are then weighed against these other tax rate and discount rate factors. Management may or may not consider sharing such expected additional value with the parent, either in the form of a higher-than-equilibrium purchase price or a lower than equilibrium annual annuity payment, or both.

The Corporation's Considerations

There are three possible areas of endeavor in a management offer for a portion of the company's assets. First, the parent corporation may elect to do nothing in the face of an offer, in which case it would consider the buyout offer an opportunity forgone. Second, it may accept an offer from the management buyout team, in which case it would consider the up-front cash offer and what it would cost to purchase the replacement goods and services externally and over the horizon time frame. Third, it may accept an offer from a third party competitor (lessor), who might desire to step into the vacuum left by the managers. In this case the company could bargain with both to obtain the best deal for itself. The parent company could then evaluated a management or third party lessor offer against the cost of providing its own goods and services internally. Such a comparison would be a discreet valuation process of expected future cash flows from capital budgeting. The three parties involved in the analysis are: the parent firm, the managers pursuing the LBO, and a third party lessor who might compete for providing services to the parent. The management buyout offer, or an offer from a third party lessor would be attractive if the following relationships exist for the parent:

(2) V |is less than~ |V.sub.|alpha~~ |is greater than~ |V.sub.|mu~~

where:

|V.sub.|alpha~~ = Present value of cost to parent if the management buyout offer and third party lessor offer are not accepted.

|V.sub.|mu~~ = Present value of cost to parent if the management buyout offer is accepted.

V = Present value of cost to parent if a third party lessor offer is accepted.

The discreet analysis of the present values for these alternatives takes the following form:

(3) |V.sub.|alpha~~ = |sigma.sub.t=1,n~ {|theta.sub.t~ - |delta.sub.t=n~} F|x.sub.t~ + |theta.sub.t=0~ + |beta.sub.t=0~

(4) |V.sub.mu~ = |sigma.sub.t=1,n~ {|phi~} F|x.sub.t~ - |delta.sub.t=0~ - |beta.sub.t=0~

(5) V = |sigma.sub.t=0,n~ {|omega~} F|x.sub.t~ - |theta.sub.t=0~ + |beta.sub.t=0~

where:

|theta~ = Annual operating cost plus annual investment in plant/equipment.

|phi.sub.p~ = Annual annuity payment made by parent to managers' new entity for replacement goods/services.

|omega~ = Annual lease payments made by parent to outside third party lessor for replacement of goods/services.

|delta.sub.t=0~ = Present value of fair salvage value(*) of parent's spin-off assets from equation (1).

|delta.sub.t=n~ = Present value of salvage value at t = n.

|beta.sub.t=0~ = Management offer (premium above fair salvage value of assets) from equation (1).

F|x.sub.t~ = Cost of Capital discount factor for parent per period.(**)

Both the fair salvage of the assets (|delta.sub.t=0~) and management's offer (|beta.sub.t=0~) on the right side of equation (3) represent an opportunity cost to the parent's alternative of continuing to provide its own goods and services in the future. In the case of the third party lessor the management offer (|beta.sub.t=0~) remains an opportunity cost, however, it is assumed that management sells the assets. This last condition has significant implications for the third party lessor who competes with the managers. If (4) is set equal to (5), the present value of payment to the lessor (|omega~) is reduced by 2|beta.sub.t=0~, a condition which the lessor may not be able to profitably absorb. Externalizing the offer (|beta.sub.t=0~) changes the perspective of the normal Buy (of a lease) model for a number of reasons as already explained, but in large part because of the managers' insider knowledge of its business worth. By definition then, the management buyout offer is favored over the third party lessor offer because of the degree of this external factor. And the lessor, therefore, does not become a rational competitor. We can observe this phenomenon in another perspective by setting (3) equal to (5), and noting that the LBO offer (|beta.sub.t=0~) cancels out, leaving the traditional Make or Buy decision model, with the usual internal considerations.

Equation (2), therefore, is reduced as follows under the rational assumption that there is no third party:

(6) |V.sub.|alpha~~ |is greater than~ |V.sub.|mu~~

Another significant characteristic of the above model is the relationship between management's premium offer and the parent's annuity payment for future goods and serviced in equation (4). The greater the initial offer (|beta.sub.t=0~), the greater is the leverage management has in negotiating a higher annual annuity payment. In other words, since the parent's cost of capital is likely to be lower than the risk-adjusted discount rate of management's new corporate entity, the annual annuity payments are magnified when there is a low initial offer. A parent firm's net advantage to buy out becomes less attractive by the compount amount of the difference in discount factors. This is explained further in the illustration following this section.

A parent company's indifference point is obtained when the present value cost to operate without the divesture is the same as the present value cost of the annual annuity payments for goods and services, minus the purchase price offered by management (Make or Buy indifference point). For this reason, valuation modeling should assume a constant internalization of transactions for both of the parent's alternatives. The parent will then substitute managements' initial offer (|beta.sub.t=0~) and the accompanying annuity payments which satisfy managements' equilibrium condition in equation (1) into equations (3) and (4). The present value difference between (3) and (4) is the net buyout advantage (NBA) to the parent in the accept/reject decision of the LBO offer.

NBA = |V.sub.|alpha~~ - |V.sub.|mu~~

(7) NBA = |sigma.sub.t=1,n~ {|theta.sub.t~ - |sigma.sub.t=n~} F|x.sub.t~ - |sigma.sub.t=1,n~ {|phi~} F|x.sub.t~ + 2|delta.sub.t=0~ + 2|beta.sub.t=0~

where:

NBA = Parents net buyout advantage to accept the manager's LBO.

An Illustration

In the following example we assume that the ABC Company has an operating department which is vertically integrated into the structure of the firm. If the managers believe that the department is operated below capacity, they might decide that additional economies of scale and scope beyond the current corporate charter are possible, and seek to provide new or additional economies of scale and scope beyond the current corporate charter are possible, and seek to provide new or additional goods and services to other outside firms. Current stockholders, however, wary of the firm's additional market risk, may resist change of the firm's charter and goals.

The managers decide to leverage a buyout for a portion of the firm's assets by making an offer to the board of directors of ABC company. Management wishes to divest Department X into a separate entity; however, Department X will contractually continue to provide the same goods and services to the parent. The board recognizes this offer as an opportunity to reduce the company's asset base and to increase the value of its future cash flows, which would in turn increase return on investment (ROI). Since the assets remain in place, and are collateralized by the bank in the leveraged arrangement with the managers, the firm's only additional risk is the mortgage option with the bank to buy the assets back.

A summary of the five-year operating budget for Department X is shown below in Figure 1.

Budgetary costs of operations and opportunity costs for the division for the next five years, as summarized in Figure 1, conform to the discreet parent LBO decision model in formula (3):

(3) |V.sub.|alpha~~ = |sigma.sub.t=1,n~ {|delta.sub.t~ - |delta.sub.t=n~} F|x.sub.t~ + |delta.sub.t=0~ + |beta.sub.t=0~.

The term |beta.sub.t=0~ is represented by a $500,000 premium on line 3; |delta.sub.t=0~ is represented by the $111,850 fair salvage value of the department's assets on line 2; |delta.sub.t=n~ is represented by the present value of the $10,000 salvage value of these TABULAR DATA OMITTED same assets sold in year five, but discounted at a salvage risk of 12 percent back to the present value of $5,674 on line 9. In addition, the division has undertaken working capital debt and long term debt to invest in maintenance of productive capacity in the form of a term loan for the amount of $259,140, whose principal repayments are shown on line 7. The final sum of costs |sigma.sub.t=1,n~ {||phi~.sub.t~} is represented by the sum of the after tax cash flows shown singly for each of the five periods and at time zero (1991) on line 8. When these are discounted at the parent's after-tax cost of capital |F.sub.x~, which in this case, based on the contractual nature of the cash flows, is equal to the parent's after-tax cost secured borrowing of 6.004%, and added to the discounted salvage value, the total cash outflow for each period is the |V.sub.|alpha~~. The parent's total present value cost of operating the department over the next five years is $9,583,013.

Figure 1 assumes that management's new business entity has the debt and equity capacity to meet the initial capital outlay of $500,000 (line 3) and $111,850 (line 2), and this before-tax amount must be translated into the aftertax expense for the managers. As shown below, Formula (1) is used for this purpose and the cash flows for management's new entity are captured in Figure 2.

(1) 0 = |sigma.sub.t=0,n~ |(|theta.sub.t~ - |phi.sub.t~)F|y.sub.t~~ - |delta.sub.t=0~ - |beta.sub.t=0~

The annuity value (|phi~), which equates managements' total cost, consisting of the initial investment and the annual operating costs, is found through iteration. Since the managers are assuming additional operating risk and leverage risk, the discount factor F|y.sub.t~, representing the new entity's risk-adjusted cost of capital, is greater than the parent's discount factor, F|x.sub.t~. Also, the new entity's tax rate is lower than the parent's tax rate as a result of the new entity's lower taxable income.

In part I of Figure 2, management's annual operating cash flows before tax are assumed to be the same as the parent company's cash flows from Figure 1. In other words, no additional economies are assumed to arise in this illustration for the new entity as the new entity's revenue is derived only from selling goods and services to the parent. Management's revenues and costs are converted to after-tax cash flows at management's lower tax rate of 31%. Part II of Figure 2 identifies the premium offer of $500,000 above the fair salvage value of the equipment and is amortized. The equipment is depreciated straight-line over five years, and the present value of the amortization/depreciation tax shelter is calculated using management's discount factor of 12%. We find the value of (|phi~) through trial and error to be an annual after-tax annuity payment of $2,475,150. In this scenario, therefore, the premium paid by management was chosen to be the independent variable and annual annuity payment was the dependent variable. The present value of management's cash flow is adjusted to zero ($33 rounded to zero).

TABULAR DATA OMITTED

The annual annuity payment to management ($2,475,150) for goods and services is an after tax figure from managements viewpoint, which amounts to a before tax payment of $3,587,174. The parent, however, who must pay this amount, has a tax rate of 36.8% which makes it's after tax cost $2,267,094. Accordingly, when (|phi.sub.p~) is substituted into the parent model (4), the present value cost to the parent is:

(4) |V.sub.mu~ = |sigma.sub.t=1,n~ {|phi.sub.p~} F|x.sub.t~ - |delta.sub.t=0~ - |beta.sub.t=0~

|delta.sub.t=0~ = 111,850(1 - t) = 70,689(after tax)

|beta.sub.t=0~ = 500,000(1 - t) = 316,000(after tax)

where: t = 0.368

|V.sub.mu~ = |sigma.sub.t=1,5~ {2,267,094} F|x.sub.t~ - (70,689) - (316,000)

= 9,548,786 - (70,689) - (316,000) = 9,162,097

The final step is the comparison of values from (3) and (4) into (7).

(7) NBA = |V.sub.|alpha~~ - |V.sub.|mu~~

NBA = 9,583,012 - 9,162,097 = 420,915

Since the managers' model in equilibrium did not take into consideration any additional cash flows from future additional economies of scale and scope, the net buyout advantage to the parent company in this case is entirely the result of differences in discount rates and tax rates between the parent and the manager's new entity. The net buyout advantage to the parent company's stockholders is $420,915, and therefore, the rational decision would lead the board of directors to accept the manager's offer.

Conclusion

Externalization of transactions by a firm's managers in an LBO offer has created a new set of guidelines in the discreet analysis of present values. In this paper, the quantitative focus shows that the changes in discount rates and tax rates for the new entity produce changes in the value of both newly formed structures where there is output consistency over the horizon. Why is this significant? Increases in value lead to greater motivation to divest without many of the other externalities of transactions commonly assumed. Changes in risk and tax rates affect stockholder wealth for both entities: the parent company benefits from increased asset utilization at the same output; the newly formed company benefits from tax advantages and lower venture capital risk due to an experienced management group and established product market. Additional wealth creation may even be possible for the managers' entity through increased asset utilization from new business, resulting in greater production economies of scale and scope. Such additional value may be shared with the parent either in the form of a lower payment for goods and services or in the form of a higher premium paid for the assets. In either case the sharing of additional value would then increase the net buyout advantage to the parent. However, the third party lessor is found to be a fictitious competitor in the rational marketplace. It is apparent that the third party lessor, who might want to compete against managers undertaking an LBO offer, is at a distinct disadvantage from the outset. While there may be several reasons for this, it is primarily because lessors fail to have the same corporate information as the buyout team. The LBO valuation model shows that the initial cash offer accelerates the attractiveness of the net present value advantage for managers. The higher the initial cash offer, the higher the NPV.

Managers who make an offer to parent company stockholders assess the increased risk of leveraged financing and venture capitalization against tax advantages of the greater leverage and lower corporate tax rates for future cash inflows. The availability of up-front cash and the resulting risk-adjusted discount rate establish the cash flow requirement over the horizon in order for the managers to be indifferent. With these constraints adjusted, the attractiveness of diversification and other externalities are an advantage in wealth. This means that once the new business entity's initial debt and equity capacity is determined, the annual (or monthly) annuity payment agreement from the parent firm for future goods and services is part of the offer. Managers' motivation for such an offer is predicated on eventually being able to increase the utilization rate of the assets after the purchase from the parent. Managers seek to develop additional business opportunities in order to develop greater economies of scale and scope. There is a caveat, however. It is dangerous to carry the bidding for the parent's assets to the other extreme by going negative in the manager's LBO indifference model in anticipation of additional business in the future. Greater production economies of scale and scope may not materialize reliably to make up for the fund shortage from bidding beyond the managers' indifference point. The situation observed by Tennant (1989) is all the more crucial. As demonstrated in this paper, it is better to assign an expected high-risk-adjusted discount rate to the new entity to account for future new business risk, and to hold the indifference model to zero under the assumption that additional economies of scale and scope will not materialize over the early years following the buyout.

References

Alchian, A. and H. Demsetz, "Production, Information Costs and Economic Organization," American Economic Review, (1972), pp. 777-795.

Briloff, A.J., "LBOs and MBOs in the Takeover Alphabet Soup: Some Questions for Lawyers, Answers from an Accountant," The Journal of Corporate Law, (Winter 1990), pp. 171-198.

Butler, R. and M. Carney, Managing Markets: Implications for the Make-Buy Decision," Journal of Management Studies, (1983), pp. 213-231.

Coyne, J. and M. Wright, "Cash Flow: The Reality After the Honeymoon," Accountancy, (April 1984), pp. 154-156.

Dalton, D.R., "The Ubiquitous Leveraged Buyout (LBO): Management Buyout or Management Sellout?" Business Horizons, (July-August 1989), pp. 36-42.

Diamond, S.C., "LBO Recapitalization Financing -- A Second Way Out," Journal of Commercial Bank Lending, (December 1987), pp. 4-8.

Eastwood, J.C., A. Seth, and R.F. Singer, "The Impact of Leveraged Buyouts on Strategic Direction," California Management Review, (Fall 1989), pp. 30-43.

Garvin, D.A., "Spin-offs and the New Firm Formation Process," California Management Review, (January 1983), pp. 3-20.

Jensen, M.C., "The Corporate Takeover Controversy: Analysis and Evidence," Midland Corporate Finance Journal, (Summer 1986), pp. 6-32.

Kaplan, S., "Management Buyouts: Evidence on Taxes as a Source of Value." Journal of Finance, (July 1989), pp. 611-633.

Lehn, K. and A. Poulsen, "Free Cash Flow and Stockholder Gains in Going Private Transactions," Journal of Finance, (July 1989), pp. 771-788.

Leland, H.E., "LBO's and Taxes: No One to Blame but Ourselves," California Management Review, (Fall 1989), pp. 19-29.

Lipper, A., "LBO's Based on Insider Information," Venture, (August 1987), p. 7.

Monteverde, K., and D.J. Teece, "Appropriate Rents and Quasi-vertical Integration," Journal of Law and Economics, (October 1982), pp. 321-328.

Osborne, D., "Management Buy-Outs Over the Ocean and Across the Channel," Wall Street Journal, October 8, 1990, p. A10.

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Torabzadeh, K.M. and W.J. Bertin, "Leveraged Buyouts and Stockholder Return," Journal of Financial Research, (1987), pp. 313-319.

White, G., "The Making of an MBO," Accountancy, (August 1986), pp. 95-99.

Wright, M., and J. Coyne, Management Buyouts, (1985), London: Croom-Helm.

Wright, M., "The Make-Buy Decision and Managing Markets: The Case of Management Buyouts," Journal of Management Studies, (July 1986), pp. 443-464.

Wright, M., J. Coyne, and K. Robbie, "Managing Management Buyouts: Lessons for Would-be Entrepreneurs," Entrepreneurs: Blueprint for Action; Centre for Management Buy-out Research, Univ. of Nottingham, U.K., (1988), pp. 49-56.

* Salvage value of the spin-off assets if they were sold by the parent in their entirety to the highest bidder at a fair market price. For the purpose of this discussion this salvage value was considered equal to the book value of the assets.

** F|x.sub.t~ may vary from |V.sub.|alpha~~ to |V.sub.|mu~~ to V based on different risk for each situation.
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Title Annotation:leveraged buyouts
Author:Kaufman, Richard F.; Walther, Carl H.
Publication:Management International Review
Date:Jul 1, 1992
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