The LBO: an increasingly complex acquisition process

When a quick look is taken at the short but eventful history of the leveraged buyout (LBO) market in France, what is striking is the extent to which the use of this technique resembles and differs from those of its origins.

The LBO first appeared in France between 1985 and 1990, achieving its first phase of popularity. It experienced its first growing pains during the 1991-1996 economic crisis and has been making a strong comeback since 1997. The first cycle is complete.

At present, transactions are larger, more and more complex and therefore increasingly longer to close. However, their principles, implications and fundamentals remain the same: an in-depth analysis done over a reasonable period of time and impeccable due diligence services while putting the investor’s ego on hold.

In this respect, it could be suggested that the experience of everyone in this sector should not be taken as the number of years but the number of economic cycles. At least this approach would have the great merit of reminding everyone just how new the sector is: barely one and a half cycles in France and two cycles in the UK, a market considered more mature. Therefore, professionals must keep in mind that we are all at a very early stage, particularly when one considers that ascending half-cycles should be counted as a negative experience!

In view of this development of the market, it appeared interesting to review the new complexities that have had to be faced over the last few years in major deals. The examples reflect two similar transactions CDC Private Equity has performed over the last two years Nexity and Cegelec even though these companies operate in different industries.

Complexity of relations with the seller

Although financial sponsors are increasingly invited to bid by corporate sellers, these trade sellers are often wary of financial investors because they know little about how these financials investors operate. They consider that financial sponsors are not so reliable and are less inclined to pay “the right price” than trade-buyers.

The reality appears to be less dogmatic. In the case of a very strategic asset a corporate buyer will often be quicker, less demanding in terms of the level of due diligence required and ready to pay a “strategic premium” because it may benefit from synergies. This sort of clear-cut example is rather rare.

A financial sponsor is often more reliable and more determined than a trade buyer as long as a certain number of prerequisites are met. In particular, an equity sponsor will seek a target which is a leader in its markets, an acceptable level of risk, a recurrent and high level of cash flow.

Opportunities for development and/or a potential for increasing margins and last but not least a top quality management team.

In terms of price, financial sponsors are sometimes criticised for paying less than trade buyers and for practising “hair-cutting”.

Even though it is often difficult to make a trade seller understand that a significant strategic premium should only be paid when the divested unit benefits from outstanding qualities, it is quite common to see financial sponsors offering the same price as trade buyers. It should be known that because of pressure from financial markets and greater shareholders awareness, trade sellers are increasingly reluctant to let the buyer leave with all or part of the future synergies without paying for it. Financial sponsors have reached a level of maturity and analysis that enables them to pay “the right price”.

Moreover, corporate buyers are also used to cutting the price at the end of negotiations and almost systematically try to enforce the seller’s warranty. It is more seldom for equity sponsors that have negotiated over a longer period of time and which have conducted more stringent due diligence to do this.

Finally, financial sponsors can provide a better and more efficient answer to a number of a seller’s constraints such as the desire to sell a group of companies at once, to layoffs in the group acquired, or when it may be necessary to negotiate with the tax authorities to make the deal happen. It is also an efficient way for listed companies to take into account the constraints of financial markets such as strict confidentiality and timing and it enables companies to announce business divestments to analysts under the best circumstances.

In this respect, the Nexity and Cegelec transactions were very similar: the corporate sellers (Vivendi and Alstom) wanted to sell off a non-strategic subsidiary in a short period of time, in the form planned and not in fractions and through an operation that, where possible, should be friendly in regard to management. The price was determined upstream – the buyer was to make a moral commitment not to question the price except in the case of unsatisfactory due diligence results and through making cash payment allowing them to reduce their financial leverage.

From this point of view, a financial sponsor, linked to a group which had the reputation of being professional and keeping its word, seemed to have satisfied their requirements in terms of timing and price, while the trade buyers considered were obviously unable to provide satisfactory answers.

Corporate complexity

Before reaching a favourable outcome, sponsors have to face an increasing level of complexity, particularly at corporate level.

The strategic and industrial analysis must be multiplied by the number of countries, markets, plants, products (etc.) and by implications of such matters as: separation costs, impact of past and future economic relationship with the seller and the scope of the takeover, often very complex, which has to be analysed and defined as best as possible.

That is why deals of this type take longer and longer to close particularly in cases like Nexity, a conglomerate which had more than 10 subsidiaries, or like Cegelec, a group with 25,000 staff present in 20 countries through six different business units.

Financial complexity

Complexity is also increasing on a financial and accounting level. First of all, it is increasingly difficult to find a group with accounts and reporting records that are homogenous over a period of several years.

Accounts are increasingly presented on a “pro-forma” basis and over a very short period, like two years plus, sometimes, current trading. This makes any financial analysis very difficult since no serious reference to the historical record can be established unless the auditors perform a massive amount of work. Naturally, this does not correspond with the timing expected by the seller. The same problems arise in the case of balance sheet and cash flow analyses.

Moreover, it is extremely difficult to obtain simple and clear answers to such simple and clear questions as: “Does turnover growth come from a volume effect or a price effect?” For a group which develops several thousand products, operates in several countries and has many markets, naturally the answer is difficult to obtain. And yet establishing an opinion regarding questions that are as fundamental as resistance to cycles or the real basis of the activity’s development is vital for the financial buyer.

In this context, the management’s assistance and its involvement in the transaction, sooner or later during the process, takes on its full importance.

Due to the size of the deals, it is increasingly important to make an in-depth analysis of the valuation. Valuation is no longer based solely on traditional financial models but should also take into account valuations of listed comparable companies, transactions between companies active in the same industry and the main valuation models (of the DCF or EVA type). That is why, in addition to internal analysis done by the sponsor, this exercise involves also an external study from an investment bank. It is aimed at reassuring the investor (or not!) and the debt finance provider as regards to the valuation that could be expected at exit in case of an IPO, for example, and therefore the price it should pay at entry.

Complexity of structuring and legal and tax implications

For large transactions, financial structuring has changed a lot compared to the fairly straightforward structures put in place when LBOs emerged. Tax planning has become the rule in order to make the most of the future flows and dividends generated by each company in the group and to structure the acquisition debt accordingly.

The legal structure (number of Newcos, their location and the type of acquisition used for each entity of the target: acquisition of shares or assets) is determined in consequence and has to address numerous constraints: that of the seller, the target group, the buyers and the managers. Therefore, the final structures are increasingly complex and international and quite often a considerable proportion of the expected return comes from the structure of the transaction.

As such, 100 per cent bank funding can be obtained for the acquisition of certain entities within the group acquired. This funding could be guaranteed by mechanisms based on put and call options with a third party through which they are secured while enabling the buyer to keep the expected gains on the sale of the said entity. This gain will then produce an “infinite” yield since no equity was used to perform this part of the acquisition.

The “asset deals” in foreign countries, the depreciation of brands or, the double-dip mechanism on interest charges for certain funding are some examples of the wide range of structures involved in this type of operation. Of course, they are only justified when the size of the transaction enables the cost to be “depreciated”.

Finally, the follow-up of the transactions after completion generally takes long hours of work, especially when the group’s strategy involves external growth and when non-core entities have to be sold off.

To conclude, it appears that the development of the market, the techniques and the size of companies have led teams to structure themselves differently and, naturally, to become specialised according to the size of the target.

As regards large-scale operations, their natural complexity constitutes a difficulty but is also a great opportunity for those who can respond to these constraints.

But, it should not be forgotten that, despite its complexity, the technique is only a tool, which should be used with common sense considering that there is no technical part that cannot be solved. At the end of the day, an LBO is nothing more than a commercial transaction between a buyer and a seller which have the same goal as the first