GLG Institute Professional Education On Anything. Anywhere.

GLG InstituteProfessional Education On Anything. Anywhere.

SM

Private Equity: Understanding Leveraged Buyouts

Jake Cohen, Affiliate Professor of Accounting & Control and Business Law at INSEAD

GLG InstituteOctober 19thNew York City

GLG InstituteProfessional Education On Anything. Anywhere.

Professor Jake Cohen is an Affiliate Professor of Accounting and Control and Business Law at INSEAD and the Director of the INSEAD-PricewaterhouseCoopers Research Initiative. Professor Cohen teaches courses in Financial Accounting, Corporate Financial Reporting & Analysis, Financial Statements Analysis, Mergers & Acquisitions and Corporate Restructurings, and Business Law in both INSEAD's Singapore and Fontainebleau, campuses. Prior to teaching at INSEAD, he was a Senior Teaching Fellow in the Accounting & Management group at the Harvard Business School and Professor at the Harvard Extension School in Cambridge Massachusetts. At Harvard University, he taught courses in Business Analysis, Valuation, and Creating Value through Corporate Restructuring, Mergers and Acquisitions, and was recognized for outstanding teaching. Prior to teaching at Harvard for four years, he taught at Syracuse University as an accounting professor, where he was named 'Professor of the Year' and was selected as the graduation keynote speaker at the school's commencement ceremony. He currently sits on the Syracuse University Accounting Department's Advisory Board.

Professor Cohen worked as a tax accountant at KPMG LLP in Philadelphia and as a mergers and acquisition tax attorney for PricewaterhouseCoopers LLP in New York City. He currently consults and trains investment bankers at such firms at The Blackstone Group, Credit Suisse, Bank of America, Houlihan Lokey Howard & Zukin, and others. He has also tutored CEOs and Members of Board of Directors of Fortune 500 companies, such as Aetna, Astra Zeneca, Jones Lang LaSalle, and others.

Presenter Biography

GLG InstituteProfessional Education On Anything. Anywhere.

Financial buyers in mergers and acquisitions Identifying attractive buyout targets Understanding the drivers of private equity transactions

Capital markets regulation Interest rates

Risks and concerns in current buyout market Cases to discuss: Hertz, Toys R Us, Dunkin Donuts, Ducati,

Coles, Serena Software

Table of Contents

4

What is Private Equity?

Private equity is an asset class that has evolved substantially in the last couple of decades.

It is an alternative investment strategy that involves investing in privately held companies.

The key feature is the private nature of the securities purchased.

Investments in private equity are illiquid.

Investors in this marketplace must be prepared to invest for the long-haul; investment horizons may be as long as 5 to 10 years.

5

Private Equity Partnership Structure

The predominant organization form of private equity investing is the limited partnership structure.

Limited partnership consist of limited partners (LP) and general partners (GP).

The LPs of the partnership are the investors, i.e., the main providers of capital. These are typically wealthy individuals, endowments, pension funds, and other institutional investors.

The GP of the partnership are responsible for the day to day management of the partnership’s investment, as well as general liability for any lawsuit that may be brought against the fund. LPs must not be actively involved in the day-to-day operations of the funds if they are to maintain limited liability status.

6

Structure

An important element of limited partnerships is that the general partners also commit investment capital to the fund. This ensures that the GP and LP interests are well aligned.

Private equity partnerships are typically self-dissolving entities that have a life span of about 10 years. This limited life span highlights the point that the funds must seek exits of their investments to realize return for their investors.

7

General Partner Compensation

GPs of the partnership are compensated through a fixed management fee, as a percentage of committed capital, and profit sharing of investment gains known as carried interest, or simply, carry.

While the fee and carry vary across partnerships, the 2-and-20 is a standard that many funds gravitate towards.

2-and-20 means that the annual management fee is 2% of the committed capital, and when final investment gains are realized, 20% of the profits go to the GP as their profit share.

8

“Money Goes, Where Money is Treated Best”

“Top quartile buyout funds have generated annual returns in excess of 40% returns in the past 20 years. The average net annual returns of the industry have been 13.3%, and the S&P 500 index has returned 12.1% per year”

Source: Blaydon and Weinwright, “The balance between debt and added value,” Financial Times, September 29, 2006

9

Financial Buyers in Mergers & Acquisitions

LBO percent of M&A

2001 3%,

2002 9%

2003 8%

2004 10%

2005 11%

2006 25%

LBO Percent of M&A

0%

5%

10%

15%

20%

25%

30%

2001 2002 2003 2004 2005 2006

Year

Perc

enta

ge

10

Industry players

Key US Players Key European Players

Bain Capital (Staples Inc.)

The Blackstone Group (Wyndham Int’l)

The Carlyle Group (Dunkin Donuts)

Forstmann Little & Company (Revlon)

Goldman Sachs Capital Partners

Hellman & Friedman (DoubleClick)

Hicks, Muse, Tate & Furst (Jimmy Choo)

JP Morgan Partners

Kohlberg Kravis Roberts & Co. (RJR Nabisco)

Silver Lake Partners (Serena Software)

Texas Pacific Group (Ducati)

Warburg Pincus

Apax Partners (Tommy Hilfiger)

Candover

Cinven

CVC Capital Partners (Kwik-Fit)

Permira (HMV)

Terra Firma Capital Partners

3i

11

Recent Funds Announced

Warburg Pincus $8 billion

Goldman $8.5 billion

Carlyle $10 billion

Blackstone $15.6 billion

KKR $16.5 billion (not yet closed)

12

Private equity firms are external change agents

Get companies to be more attentive to what their customers need and what their shareholders need. Private equity threat companies in the public markets to operate more leanly. Because if they don’t, they could be taken over.

Now with larger and larger funds as well as the growing trend of club deals, buyout shops are able to go after the larger companies, leading to those companies becoming more responsive – forced to change given more shareholders activism.

13

Classes within Private Equity

Venture Capital

Mezzanine Financing

Leverage Buyouts

Distressed investing

14

Leveraged Buyouts (LBO)

LBOs are a way to take a public company private, or put a company in the hands of the current management, MBO.

LBOs are financed with large amounts of borrowing (leverage), hence its name.

LBOs use the assets or cash flows of the company to secure debt financing, bonds or bank loans, to purchase the outstanding equity of the company.

After the buyout, control of the company is concentrated in the hands of the LBO firm and management, and there is no public stock outstanding.

15

Successful LBO Strategies

Finding cheap assets – buying low and selling high (value arbitrage or multiple expansion)

Unlocking value through restructuring:

Financial restructuring of balance sheet – improved combination of debt and equity

Operational restructuring – improving operations to increase cash flows

16

Value Creation

Management incentives and agency cost effects

Increased ownership stake may provide increased incentives for improved performance

• Better aligns manager / shareholder interests

• Lower agency costs of free cash flows: debt from LBO commits cash flows to debt

• Debt puts pressure on managers to improve firm performance to avoid bankruptcy

17

Value Creation

Wealth transfer

Wealth transfer from current employees to new investors – low management turnover (but sometimes new mgmt. team), slower growth in number of employees

Tax benefits in LBO constitute subsidy from public and loss of revenue to government – LBO premiums positively related to tax benefit

• Net effect of LBO on government tax revenues may be positive due to gains to shareholders and increased profitability

• Many of tax benefits could be realized without LBOs

18

Value Creation

Asymmetric information and underpricing

Managers, investor groups have better information on value of firm than shareholders

Large premium signals that future operating income will be larger than expectations – investor group believes new company is worth more than purchase price

Other efficiency considerations

More efficient decision process as private firm

Influence of favorable economic environment

19

Mortgage Analogy

20

Mortgage Analogy (cont.)

21

Leverage Amplifier – the double edge sword

Return on investment > cost of debt

Cost of debt > Return on investment

22

Apax Partners

“Funds advised by Apax Partners look for companies that have strong, established market positions and the potential to expand into new markets. Our global presence and reach allows us to support such initiatives effectively.”

Source: Apax Partners website, http://www.apax.com/en/aboutus/index.html

23

Bear Stearns Merchant Bank

“BSMB focuses on designing capital structures for its investments which minimize risk and prudently take advantage of leverage. In addition, BSMB will customize transaction structures in order to help address circumstances unique to specific situations. Following the investment, BSMB provides value to the portfolio company in numerous ways including: active board participation, helping establish best practices, providing assistance in recruiting and including the company in its portfolio-wide purchasing program among other activities.”

Source: Bear Stearns Merchant Bank website, www.bsmb.com

24

Carlyle

http://www.thecarlylegroup.com/eng/company/l3-company735.html

25

Disadvantages of Public Equity Financing

Costs of compliance with rules and regulations

Disclosure of competitive information

Management's time spent on meeting statutory demands and investor relations

Greater scrutiny from the public and authorities

26

Capital Markets Regulation

Securities and Exchange Commission (SEC)

Department of Justice (DOJ)

State Securities Commissions

State Attorneys General

Self-Regulatory Organizations (SROs)

27

Sarbanes Oxley Act - Sec. 404 – Management Assessment of Internal Controls

(a) RULES REQUIRED.—The Commission shall prescribe rules requiring each annual report required by section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)) to contain an internal control report, which shall—

(1) state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and(2) contain an assessment, as of the end of the most recent fiscal year of the issuer, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.

(b) INTERNAL CONTROL EVALUATION AND REPORTING.—With respect to the internal control assessment required by subsection (a), each registered public accounting firm that prepares or issues the audit report for the issuer shall attest to, and report on, the assessment made by the management of the issuer. An attestation made under this subsection shall be made in accordance with standards for attestation engagements issued or adopted by the Board. Any such attestation shall not be the subject of a separate engagement.

28

Regulation

“Sarbanes Oxley makes companies act much more risk averse. RegFD significantly restrained or constrained information that gets out to the market.”

29

Dunkin Donuts

Dunkin' brands has been sold to a group of private equity firms for $2.43 billion, Bain capital, the Carlyle Group and Thomas H. Lee Partners. What was the reason to buy?

30

Serena Software

Acquired by Silver Lake Partners. Silver Lake focuses exclusively on large, technology companies that it feels are, underappreciated but also have substantial unrecognized growth potential.

“We felt that Serena was, underappreciated by the equity markets. Really misunderstood.”

“By taking the company private we can take a bit of a longer term view on how to grow and run the company and invest a bit more aggressively in areas we think will help us build a stronger, more successful company and not have to focus on making earnings every 90 days.”

Source: CNBC Interview of Serena Software CEO

31

Beat by a Penny, Miss by a Penny

“I think that, both on the sell side and the buy side analysts tend to focus just on earnings and earnings is how the measuring stick for the success, health or failure of a company.

You make earnings or beat by a penny or two, obviously you know what you're doing and your business is great. You miss by a penny, there is something horribly wrong. It's just not that way. I think that, truly understanding the value that certain technology provides to companies, sometimes is just difficult to understand. Therefore, the metric becomes just earnings.”

Source: CNBC Interview of Serena Software CEO

32

Investing in Technology

Traditionally not an area of private equity investment

Recently, private equity has entered this space

33

Coles Myer

“KKR, unable to engage the CML directors unless they are prepared to offer more than $14.50. If KKR was prepared to offer that price (and that would have depended on the outcome of its due diligence) it suggests that it shares CML's view that there is potentially much more value in the group, and believes that it is capable of unlocking it - where, to date, CML hasn't succeeded.

But any increase in the bid price would reduce the bidder's IRR (internal rate of return) and mean a transfer of some of that value away from the

bidder and to CML shareholders.”

Bryan Frith, “Hostility Looms as Coles and KKR bicker over the price,” The Australian, September 27, 2006

34

Risks and Concerns in the Buyout Market

Rising interest rates

Higher asset valuation - overpayment

Political backlash

More regulation of Industry “US private equity shaken by revelation of price collusion

probe” October 11, 2006

Economic slowdown

Failure of exit strategy

GLG InstituteProfessional Education On Anything. Anywhere.

Specialized, professional education from proven industry thought leaders and academic

authorities

Hundreds of Education Seminars on any topic in any major market around the world 

Over 600 Seminars a year

GLGi clients receive two seats to ALL Seminars in ALL practice areas

Puts the power of programming into the hands of the GLG community

GLGi’s new website www.glginstitute.com enables clients to: Propose Seminar topics and locations

View and RSVP to scheduled and proposed Seminars

Manage a personalized “My Seminars” page

Forward details to a colleague or friend

About GLG Institute

GLG InstituteProfessional Education On Anything. Anywhere.

Matthew Creedon

SVP Accounting & Financial Analysis (AFA)

Gerson Lehrman Group

850 Third Avenue, 9th Floor

New York, NY 10022

212-984-3682

[email protected]

Christine Ruane

Senior Product Manager

Gerson Lehrman Group

850 Third Avenue, 9th Floor

New York, NY 10022

212-984-8505

[email protected]

GLG Contact Information

GLG InstituteProfessional Education On Anything. Anywhere.

By making contact with this/these Council Members and participating in this event, you specifically acknowledge, understand and agree that you must not seek out material non-public or confidential information from Council Members. You understand and agree that the information and material provided by Council Members is provided for your own insight and educational purposes and may not be redistributed or displayed in any form without the prior written consent of Gerson Lehrman Group. You agree to keep the material provided by Council Members for this event and the business information of Gerson Lehrman Group, including information about Council Members, confidential until such information becomes known to the public generally and except to the extent that disclosure may be required by law, regulation or legal process. You must respect any agreements they may have and understand the Council Members may be constrained by obligations or agreements in their ability to consult on certain topics and answer certain questions. Please note that Council Members do not provide investment advice, nor do they provide professional opinions. Council Members who are lawyers do not provide legal advice and no attorney-client relationship is established from their participation in this project.

You acknowledge and agree that Gerson Lehrman Group does not screen and is not responsible for the content of materials produced by Council Members. You understand and agree that you will not hold Council Members or Gerson Lehrman Group liable for the accuracy or completeness of the information provided to you by the Council Members. You acknowledge and agree that Gerson Lehrman Group shall have no liability whatsoever arising from your attendance at the event or the actions or omissions of Council Members including, but not limited to claims by third parties relating to the actions or omissions of Council Members, and you agree to release Gerson Lehrman Group from any and all claims for lost profits and liabilities that result from your participation in this event or the information provided by Council Members, regardless of whether or not such liability arises is based in tort, contract, strict liability or otherwise. You acknowledge and agree that Gerson Lehrman Group shall not be liable for any incidental, consequential, punitive or special damages, or any other indirect damages, even if advised of the possibility of such damages arising from your attendance at the event or use of the information provided at this event.

IMPORTANT GLG INSTITUTE DISCLAIMER