Leveraged

Buyouts

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A Practical Guide to Investment Banking and Private Equity

PAUl PigNATAro

Leveraged

Buyouts

Cover Design: WileyCover image: numbers © iStockphoto.com / wragg; gold lights © iStockphoto.com / vizualbyte

Copyright © 2014 by Paul Pignataro. All rights reserved.

Published by John Wiley & Sons, inc., Hoboken, New Jersey.Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Pignataro, Paul. leveraged buyouts : a practical guide to investment banking and private equity / Paul Pignataro. pages cm. — (Wiley finance series) includes index. iSBN 978-1-118-67454-3 (cloth)—iSBN 978-1-118-67458-1 (ePDF)— iSBN 978-1-118-67445-1 (ePub) 1. leveraged buyouts. 2. Consolidation and merger of corporations. 3. investment banking. 4. Private equity. i. Title. HD2746.5.P54 2013 658.1'62—dc23

2013023885

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

This book is dedicated to every investor in the pursuit of enhancing wealth. Those who have gained, and those who have

lost—this continuous struggle has confounded the minds of many. This book should be one small tool to help further said

endeavor; and if successful, the seed planted will contribute to a future of more informed investors and smarter markets.

vii

Preface xiThe Heinz Case Study xiiHow This Book Is Structured xiii

Part One

Leveraged Buyout Overview 1

ChaPter 1Leveraged Buyout theory 3

Cash Availability, Interest, and Debt Pay-Down 3Operation Improvements 4Multiple Expansion 4What Makes Good Leveraged Buyout? 4Exit Opportunities 5Is Heinz a Leveraged Buyout? 5

ChaPter 2What Is Value? 7

Book Value 7Market Value 7Enterprise Value 8Multiples 12Three Core Methods of Valuation 14

ChaPter 3Leveraged Buyout analysis 19

Purchase Price 19Sources and Uses of Funds 22IRR Analysis 33

Contents

viii Contents

Part tWO

Leveraged Buyout Full-Scale Model 49

ChaPter 4assumptions 51

Purchase Price 57Sources of Funds 63Uses of Funds 69

ChaPter 5the Income Statement 75

Revenue 76Cost of Goods Sold 76Operating Expenses 77Other Income 78Depreciation and Amortization 80Interest 80Taxes 81Nonrecurring and Extraordinary Items 82Distributions 82Shares 83Heinz Income Statement 84Last Twelve Months (LTM) 108Income Statement—Projections 116

ChaPter 6the Cash Flow Statement 133

Cash Flow from Operating Activities 133Cash Flow from Investing Activities 137Cash Flow from Financing Activities 137Financial Statement Flows Example 138Heinz Cash Flow Statement 144Heinz Last Twelve Months (LTM) Cash Flow 154Cash Flow Statement Projections 160

ChaPter 7the Balance Sheet 179

Assets 179Liabilities 182Heinz Balance Sheet 184

Contents ix

ChaPter 8Balance Sheet adjustments 199

Goodwill 200Heinz Balance Sheet Adjustments 208

ChaPter 9Depreciation Schedule 221

Straight-Line Depreciation 222Accelerated Depreciation 222Deferred Taxes 227Projecting Depreciation 231Projecting Amortization 241Projecting Deferred Taxes 244

ChaPter 10Working Capital 247

Asset 247Liability 247Operating Working Capital 248Heinz’s Operating Working Capital 251Projecting Operating Working Capital 262Operating Working Capital and the Cash Flow Statement 271

ChaPter 11Balance Sheet Projections 279

Cash Flow Drives Balance Sheet versus Balance Sheet Drives Cash Flow 283

Balancing an Unbalanced Balance Sheet 301

ChaPter 12Debt Schedule and Circular references 309

Debt Schedule Structure 309Modeling the Debt Schedule 310Circular References 329Automatic Debt Pay-Downs 337Basic Switches 339Finalizing the Model 339

ChaPter 13Leveraged Buyout returns 351

Exit Value 351Returns to 3G Capital 355

x Contents

Multiple Expansion 361Debt Pay-Down 364Conclusion 364

Part three

advanced Leveraged Buyout techniques 365

ChaPter 14accelerated Depreciation 367

MACRS 367Accelerated versus Straight-Line Depreciation 372

ChaPter 15Preferred Securities, Dividends, and returns to Berkshire hathaway 377

Preferred Securities 377Preferred Dividends 378Returns to Berkshire Hathaway 388

ChaPter 16Debt Covenant ratios, and Debt Fee amortization 395

Coverage Ratios 395Leverage Ratios 397Debt Fee Capitalization and Amortization 399

ChaPter 17Paid-in-Kind Securities 409

aPPenDIxeSappendix 1: Model Quick Steps 417appendix 2: Financial Statement Flows 419

Income Statement to Cash Flow 419Cash Flow to Balance Sheet 420

appendix 3: excel hot Keys 421

about the Companion Website 423

about the author 425

Index 427

xi

In the 1970s and 1980s, the corporate takeover market began to surge. As a means to continue to enhance corporate wealth and leadership,

growth through mergers or acquisitions flooded the corporate environment. Although such mergers and acquisitions had existed for decades, the mid-1970s led the multibillion-dollar hostile takeover race. This was followed by a surge in the 1980s of the leveraged buyout, a derivative of the takeover, culminating with the most noted leveraged buyout of its time, the $25 billion buyout of RJR Nabisco by Kohlberg Kravis Roberts in 1989.

A leveraged buyout, most broadly, is the acquisition of a company using a significant amount of debt to meet the acquisition cost. Arguably, the increase in leveraged buyouts in the 1980s was partly due to greater access to the high-yield debt markets (so-called junk bonds), pioneered by Michael Milken. Access to such aggressive types of lending allowed buyers to borrow more money to fund such large acquisitions. The more debt borrowed, the less equity needed out-of-pocket, leading to potentially higher returns. This concept of higher returns for less equity sparked interest among many funds and even individual investors, and extended worldwide. From buyouts of small $10 million businesses to the recent $25 billion potential buyout of Dell, small investors, funds, and enthusiasts alike have been fascinated by the mechanics, aggressiveness, and high-return potential of leveraged buyouts.

This book seeks to give any investor the fundamental tools to help ana-lyze a leveraged buyout and determine if the potential returns are worth the investment. These fundamental tools are used by investment banks and private equity funds worldwide. We will evaluate the potential leveraged buyout of the H.J. Heinz Company, determining its current financial stand-ing, projecting its future performance, and estimating the potential return on investment using the exact same methods used by the bulge bracket investment banks and top private equity firms. We will have you step into the role of an analyst on Wall Street to give you a firsthand perspective and understanding of how the modeling process works, and to give you the tools to create your own analyses. Whether you are an investor look-ing to make your own acquisitions or a fund, these analyses are invaluable in the process. This book is ideal for both those wanting to create their

Preface

xii Preface

own analyses and those wanting to enter the investment banking or private equity field. This is also a guide designed for investment banking or private equity professionals themselves if they need a thorough review or simply a leveraged buyout modeling refresher.

The heInz Case sTudy

PITTSBURGH & OMAHA, Neb. & NEW YORK--(BUSINESS WIRE)—H.J. Heinz Company (NYSE: HNZ) (“Heinz”) today announced that it has entered into a definitive merger agreement to be acquired by an investment consortium comprised of Berkshire Hathaway and 3G Capital.

Under the terms of the agreement, which has been unanimously approved by Heinz’s Board of Directors, Heinz shareholders will receive $72.50 in cash for each share of common stock they own, in a transaction valued at $28 billion, including the assumption of Heinz’s outstanding debt. The per share price represents a 20% premium to Heinz’s closing share price of $60.48 on February 13, 2013, a 19% premium to Heinz’s all-time high share price, a 23% premium to the 90-day average Heinz share price and a 30% pre-mium to the one-year average share price.

(Heinz Press Release, February 14, 2013)

In this press release dated February 14, 2013, Heinz announces the possibility of being acquired by both Berkshire Hathaway and 3G Capital. We will analyze this potential buyout of Heinz throughout this book. Heinz manufactures thousands of food products on six conti-nents, and markets these products in more than 200 countries worldwide. The company claims to have the number-one or number-two brand in 50 countries. Each year Heinz produces 650 million bottles of ketchup and approximately two single-serve packets of ketchup for every man, woman, and child on the planet. The company employs 32,000 people worldwide.

What is the viability of such a buyout? How are Berkshire Hathaway and 3G Capital finding value in such an investment? What are their poten-tial returns? There is a technical analysis used by Wall Street analysts to help answer such questions. We will walk you through the complete buyout analysis as a Wall Street analyst would conduct that analysis.

Preface xiii

It is important to note that the modeling methodology presented in this book is just one view. The analysis of Heinz and the results of that analysis do not directly reflect my belief, but rather, a possible conclu-sion for instructional purposes only based on limiting the most extreme of variables. There are other possibilities and paths that I have chosen not to include in this book. Many ideas presented here are debatable, and I welcome the debate. The point is to understand the methods and, further, the concepts behind the methods to equip you properly with the tools to drive your own analyses.

how ThIs Book Is sTruCTured

This book is divided into three parts:

1. Leveraged Buyout Overview 2. Leveraged Buyout Full-Scale Model 3. Advanced Leveraged Buyout Techniques

In Part One, we explain the concepts and mechanics of a leveraged buyout. Before building a complete model, it is important to step through, from a high level, the purposes of a leveraged buyout and the theory of how a leveraged buyout works. A high-level analysis helps us to understand the importance of key variables and is crucial to understanding how various assumption drivers affect potential returns.

In Part Two, we build a complete leveraged buyout model of Heinz. We analyze the company’s historical performance and step through techniques to make accurate projections of the business’s future performance. The goal of this part is not only to understand how to build a model of Heinz, but to extract the modeling techniques used by analysts and to apply those tech-niques to any investment.

Part Three also adds more modeling complexity, ideal for those who already have basic experience modeling leveraged buyouts. Adjusting sce-narios, advanced securities such as paid-in-kind (PIK) securities and pre-ferred dividends, and the capitalization and amortization of debt fees add more complexity and will further your understanding of using leveraged buyouts in practice.

The book is designed to have you build your own leveraged buy-out model on Heinz step-by-step. The model template can be found on the companion website associated with this book and is titled “NYSF_ Leveraged_Buyout_Model_Template.xls” To access the site, see the About the Companion Website section at the back of this book.