Introduction
A leveraged buyout (LBO) is the process through which a company is acquired by another one that gets a significant amount of capital from borrowed money. This act is a process that involves the buyer putting up the assets or expected profits of the newly acquired company as collateral to the financial institution that is giving out the loan (Haddad, Loualiche, Plosser, & National Bureau of Economic Research, 2016). This type of purchase carries significant risk for the buyer since the ratio of borrowed money to the invested money is usually 9: 1. The borrowed money accounts for eighty to ninety percent of the total cost of acquisition. The company runs a risk of bankruptcy because the interest payments may be larger than the corporation’s operating cash flow.
Congoleum Corporation Leveraged Buyout
In the summer of 1979, the head managers of First Boston Corporation approached those of Prudential Insurance Company in a bid to agree to an LBO for Congoleum Corporation. First Boston Corporation wanted to purchase Congoleum with the backing of one of the largest insurance firms in the whole country. Prudential had dabbled in a lot of local investments and had a stake in over 1400 companies up until the year 1978. Prudential had an annual turnover of $6 Billion that dwarfed the financial capabilities of First Boston Corporation. It was, therefore, crucial to get the backing of this giant company for the purchase to go through.
Congoleum Corporation was a company that dealt in three product markets: home furnishing, ship building and automotive parts production. The company was doing well in the year 1978 with assets worth $323 million, a revenue base of $576 million while earning $42 million in that fiscal year. The company was doing relatively well with all product segments selling fast. The company had patented most of its designs of sturdy, long-lasting home floors which were sold to the home renovation industry. Some of the patents of the company generated revenue in the form of royalties paid by mimics of the design. The royalties paid ranged from $13 to $17 million per annum. The company made good quality and popular ships through its shipbuilding branch Bath Iron Works (BIW). This sector of the corporation had been attributed to the immense growth of the company due to the significant market share it held compared to its competitors. The third segment that created automotive spare parts generated an income of $115 million as well as operational revenue of $10 million per year (Congoleum Corporation, 2003). All these stated figures showed that the company was performing well and was expected to record tremendous growth over the coming years.
Acquisition Strategy
Cassidy and the officers from First Boston Corporation had proposed the formation of a holding company that would be used to take over Congoleum Corporation. The purchase would be at a value equivalent to $38 per share. The strategy involved a two-step process that begins with the purchase of all the stocks of BIW at $92.3 million followed by buying the remaining assets of the company for $371.3 million. At this point, the buyer would assume the name of Congoleum Corporation and set out to pay the required taxes. The tax basis of the newly acquired company would be much more than that of the original company by several hundreds of millions. This increase in tax may serve to tie both parties to the purchase as well as give the seller enough grounds to cover the liabilities of the company. The total cost of acquisition was $379.6 million that was shared out among the investors as follows:
Valuation of Congoleum Leverage Buyout
For the acquisition to be deemed a good investment, an evaluation of the costs, debts as well as projected income has to be carried out. The plan was to buy all the stock at a value of $38 per share where it had been trading previously at close to $24 per share. The cost of the takeover, as well as the debt and its interests, needs to be factored. The projected earnings that the company would make will determine how good an investment the move is.
Cost of Purchase
Buy stock $38 * 12.2 million shares of the company = $463.6 million
Expenses accumulated during the takeover = $7 million
Total = $470.6 million
Equity of the company at time of acquisition = $117.30 million
Debt financing = $327.10 million
Preferred stock sold at 13.5% each costs $26.20 million
Sources of debt:
1. Bank borrowings of $125 to be paid back at an interest rate of 14% in instalments of $16.6 million each year.
2. Senior notes $115 million to be paid back at 11.25%
3. Subordinated notes of $92 million paid back at 12.25% with annual instalments of $7.64 million each year.
4. $12.2 million in debt that the company already had before its purchase
The earnings of the company were projected to grow by 8% after 1984. At this time, the capital spending is expected to reduce due to depreciation and paying off of debts owed to the company (Bagaria, 2016). There are two ways of analyzing the equity that the company would have by the end of 1985. An estimate of the expected cash flow to the organization from 1980 to 1984 is done by subtracting the total expenditure from the post-tax operating income. The cost of capital for the each year is based upon the equity and debt of each year. The debt is set to reduce on a yearly basis as per the arrangement between the debtor and the newly purchased company.
The second method of calculating is by using the book value of equity rather than the projected market value when calculating the debt-equity ratio (McDonald, 2015). The cash flow and the cost of capital in 1985 with the growth rate of 8 percent. All these data can be used to estimate the terminal value of equity in the firm at the end of 1984.
Terminal value = FCFE (1985)/ (ke, 1985-08)
= $72.09/ (0.1421-0.08) = $1161 million
The expected cash flow and the terminal value discounted to the present = $820.21 million
It is, therefore, apparent that the company will have an increased equity value by the end of 1984 of over $800 million. Since the price of the purchase was $470 million, the LBO represents a good investment for all the parties involved.
Conclusion
In conclusion, a leveraged buyout is an attractive way of acquiring a company without putting too much capital at risk. Almost 90 percent of the funding to make an acquisition is borrowed money that is considered a debt that needs to be repaid. In an ideal situation, the company that was recently purchased should be able to pay off the debt through its operation. Congoleum Corporation was acquired under an LBO by First Boston Corporation with the lender being Prudential Insurance Company at $38 per share. The total cost of the purchase was $470 million. An analysis of the expected cash flow for the company from 1980 to 1985 minus the expenditures on operational costs and debt repayment shows a value of $820.20 million. This amount is a profit from the initial purchase price and is, therefore, a good investment option for all parties.
References
Bagaria, R. (2016). High yield debt: An insider's guide to the marketplace.
Congoleum Corporation. (2003). Concept. Mercerville, NJ: The Company.
Haddad, V., Loualiche, E., Plosser, M. C., & National Bureau of Economic Research. (2016). Buyout activity: The impact of aggregate discount rates.
McDonald, M. (2015). Petsmart: A case study in private equity buyouts. London: Henry Stewart Talks.
