4.7. An example of an LBO – the RJR Nabisco case (1988)

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En provenance du cours de Moscow Institute of Physics and Technology

Mergers and Acquisitions – The Relentless Pursuit of Synergy

4 notes

Moscow Institute of Physics and Technology

Mergers and Acquisitions – The Relentless Pursuit of Synergy

4 notes

Cours 4 sur 5 dans Specialization Understanding Modern Finance

The area of mergers and acquisitions (M&As) is special in finance. Incredible amounts of money are employed in such transactions. Deals draw a lot of public attention and dispute. Oftentimes, stories look more like fairy tales rather than financial reality. The key idea in any M&A transaction is to create value through a potentially synergetic activity. To this end, it is important to have a clear motive and implementation plan. Of special importance are the correct valuation, proper financing, and actual deal completion. But this is not the end – value mostly accrues from the post-merger integration. The understanding of the motives of various stakeholders is instrumental in the analysis of the potential creation of value. The learners will gain insight into the core value creating M&A strategies. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. Finally, the Course is very helpful in successful completion of the Specialization’s Final Project.

À partir de la leçon

M&A Financing. LBOs and MBOs

In Week 4 we study M&A financing. Motives, theories, and deal mechanics are fine – but where’s the money? If a transaction is friendly, a stock payment is likely to help. But what if there’s a conflict? Then a lot of cash is needed, and a lot of debt must be issued. One way is issuing junk bonds. We discuss both facts and myths about junk bonds. Then we consider LBO and MBO transactions. First, we analyze how a company may be taken private through heavy borrowing and further gradual debt repayment. We illustrate the mechanics of an LBO/MBO transaction on a detailed example. Finally, comments on a famous LBO case – RJR Nabisco – are provided.

4.1. M&A financing an overview11:09

4.2. Junk bonds (1) – facts12:11

4.3. Junk bonds (2) – legends11:14

4.4. Joint venture as a form of a merger7:42

4.5. LBOs and MBOs (1) – a way of financing11:04

4.6. LBOs and MBOs (2) – an example22:33

4.7. An example of an LBO – the RJR Nabisco case (1988)10:46

Rencontrer les enseignants

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now let's discuss the famous case that- well,

this transaction took place in 1988,

and this is the legendary leveraged buyout of RJR Nabisco,

the food and tobacco giant,

that was completed by the very well-known company KKR,

that stands for the names of its founders Kohlberg, Kravis and Roberts.

And in this example,

we will see so many things in

just one and the same transaction that it's worth while really going in some detail.

Well, this transaction as many of you know,

produced a lot of interest to it and then later there were

famous books written about that one of which is Barbarians at the gate.

So, but now I would take sort of air dryer approach and in just a few numbers,

we will wrap up what happened there.

So first of, all the company was RJR Nabisco like I said,

a large food and giant holding company and their transaction took place in 1988,

almost 30 years ago.

The main background is like that.

There was a battle between the management of this company and the outside buyer KKR.

So they were competing and before that all started,

the initial price of the stock was $71,

then it even went down a little bit but then it started this competitive bidding process.

And the result was that KKR won

this battle at the bid

of $109 a share.

Now, the question arises whether it's good or bad,

a lot or not a lot,

did that produce value or did it destroy value?

And in order to illustrate this,

we'll take the value drivers for this case

that the case was studied at many places including the Harvard Business School.

So these numbers are quite well known up there in the Weston book,

and for now I will just use these numbers as a model approach.

So the value drivers

for this company were like this.

So x subzero

to $850 million.

Now, tax rate was about 40 percent.

Now, the re-investment rate B 30 percent,

and this return on investment was a high 47 percent because

the company was doing fine and there was a lot of

cash flow and that was supposed to be a certain turn around,

the shake up of this company.

So the growth forecast was quite optimistic.

So, as we can see that results in

the growth rate of 14 percent a year and again the model was classic,

so the supernormal growth for 10 years at

this high growth rate and

then the weighted average cost of capital was taken to be 12 percent.

That was the fine number for this period and for that kind of company.

So that is the whole set of

value drivers but that produces the total value of the company.

The company had debt,

and debt outstanding at that time,

that was $5.4 billion,

and because here we talk about pure share of stock numbers we

also have to keep in mind the number of shares outstanding.

So it was 223.5

million of shares outstanding.

Here was just debt.

Now, all these numbers,

they can be used in our classic model that we studied in week three,

and they produced the following results.

So let me put it here, valuation results.

First of all, the total value of the company given these value drivers,

it happens to be around $30.2 billion.

From this, we have to subtract that,

that was 5.4 billion.

And that gives us the first important number, equity value.

That was in this case about $24.8 billion.

Now, we recall that there are 2 to 3.5 million shares.

So on a per share basis,

we have the next line

that's value per share.

And that is $111.1.

So, so far, we're just doing some valuation

and we are not having any idea whether it's good or bad.

But, now we combine that with the winning bid,

KKR winning bid of 109.

And that gives us the key finding which is NPV per

share is just $2.1.

So we can see that that was a huge transaction,

that people were talking billions.

They were raising up again.

This case also is used when we study Junk bonds

or was it financier of about five billion dollars in Junk bonds.

Lots of loaves and overview and see how thin a margin is.

If KKR went up to 112,

it would be a negative NPV project.

Now maybe because it was a success and the success still did create

value although a modest amount against the background of these huge numbers,

but still that shows to you all the things,

it nicely illustrates all the key things,

issues, and problems that we've discussed so far namely.

When you seek competitive bidding,

that is potentially value destroying.

So that involves some hubris,

that involved widow's curse, whatever.

And at the same time,

you can see that even if you won and there's still positive NPV that translates into

hundreds of millions of dollars of made money and very nice returns on this transaction.

So here I'm about to wrap up this week,

and we discussed not exactly the leash but rather financing in this forth week.

And what we found was that financing is not the only,

and some times not only primarily the situation in which we

just ask the question where can we get this amount of money,

and what is the means of payment.

When we did find this money,

and we enjoyed this or that means of payment namely stock for stock,

or cash or whatever else,

and then we see that sometimes this very means of payment may

indirectly contribute to value creation as has been shown in these LBO cases.

And then, we arrive at the question that cannot

be even labelled as final because that's with us all the way throughout this course,

and to significantly stand throughout this whole specialization is,

if there is value created,

then where does it go?

Who pockets this value?

Or in our less enthusiastic words,

what is the breakdown of the value arriving at special groups of stakeholders?

And in what follows next week,

we will discuss some of these value creating strategies in some detail.

So what exactly must be done?

And then we will see how the value that is being

created is distributed between different stakeholders.

So that will be along with the whole path of this course.

So not only do we try to identify the sources of value,

we find the way how we can reach this value creation.

And then if we did so, where it goes.

I wish you all good luck with the assignments for this forth week,

and I'll see you next week.

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