PE LBO

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Questions and Answers

What triggers a default in debt contracts?

  • Failing to make scheduled payments or violating debt covenants (correct)
  • Making early payments
  • Decreasing collateral
  • Increasing interest rates

Debt restructuring involves the renegotiation of existing debt contracts only to change their interest rate.

False (B)

Debt restructuring is suitable for firms facing ______________________________ distress.

pure financial

Match the following debt restructuring procedures with their characteristics:

<p>Private workout = Lower legal and professional fees, shorter duration, no information leakage, and no judge intervention Formal bankruptcy = Debt and equity holders receive new financial claims, and a reorganization plan is proposed by management and approved by creditors and a judge</p> Signup and view all the answers

What are the key features of Chapter 11 bankruptcy?

<p>Under Chapter 11, debt and equity holders receive new financial claims, and a reorganization plan is proposed by management and approved by creditors and a judge.</p> Signup and view all the answers

What are the consequences of coordination problems in debt restructuring?

<p>Complicated restructuring efforts (B)</p> Signup and view all the answers

Lenders can be 'soft' by increasing interest payments or collateral.

<p>False (B)</p> Signup and view all the answers

The two main procedures for debt restructuring are ______________________________ and formal bankruptcy.

<p>private workout</p> Signup and view all the answers

What is the main purpose of a Leveraged Buyout (LBO)?

<p>To acquire a controlling interest in a company using debt and equity (B)</p> Signup and view all the answers

LBOs are considered low-risk investments.

<p>False (B)</p> Signup and view all the answers

What is a key characteristic of a good LBO target?

<p>Resilient cash flows</p> Signup and view all the answers

The typical holding period for an LBO investment usually ranges from __ to __ years.

<p>5 to 7</p> Signup and view all the answers

What is the primary goal of an LBO sponsor?

<p>To achieve high returns on equity (D)</p> Signup and view all the answers

Match the following famous examples of LBOs with their respective acquirers:

<p>RJR Nabisco = KKR Hilton Hotels = Blackstone</p> Signup and view all the answers

Management fees in private equity funds are typically 5% of funds under management.

<p>False (B)</p> Signup and view all the answers

What was the outcome of Eurotunnel's financial restructuring efforts?

<p>Eurotunnel remained over-indebted, leading to a significant debt buy-back strategy and eventual placement under judicial protection in 2006.</p> Signup and view all the answers

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Study Notes

Debt Restructuring

  • Debt restructuring involves renegotiating existing debt contracts to change characteristics (e.g., interest rate, maturity) or converting debt into equity.

Default and Financial Distress

  • Default occurs when a firm fails to make scheduled payments or violates debt covenants.
  • Direct costs of financial distress include lawyers' fees, consultant fees, and transaction costs to liquidate assets.
  • Indirect costs involve reluctance from non-financial stakeholders to do business with the distressed firm.

Applicability and Procedures

  • Debt restructuring is suitable for firms facing pure financial distress (temporary payment issues), but not for those in economic distress (negative NPV projects or declining performance).
  • Two main procedures for debt restructuring: private workout and formal bankruptcy (Chapter 7 or Chapter 11).

Private Workout vs. Formal Bankruptcy

  • Private workouts have lower legal and professional fees, shorter duration, no information leakage, and no judge intervention.

Chapter 11 Bankruptcy

  • Under Chapter 11, debt and equity holders receive new financial claims, and a reorganization plan is proposed by management and approved by creditors and a judge.

Lender Behavior and Coordination Problems

  • Lenders can be "tough" by increasing interest payments or collateral or "soft" by reducing interest or principal amounts and extending maturity.
  • Coordination problems in debt restructuring include bank runs and holdout problems, where creditors might not cooperate or rush to claim their share.

Case Study: Eurotunnel

  • Despite multiple restructurings, Eurotunnel remained over-indebted, leading to a significant debt buy-back strategy and eventual placement under judicial protection in 2006.

Leveraged Buyouts (LBOs)

  • An LBO is the acquisition of a controlling interest in a company using a significant amount of borrowed money (debt) along with equity from the sponsor.

Financing and Characteristics

  • Financing typically includes equity from the sponsor and a significant amount of debt raised from banks.
  • LBOs are considered high-risk but potentially high-reward investments, with the high level of debt creating a risk of bankruptcy.

Target Characteristics and Exit Strategies

  • Good LBO targets have resilient cash flows, strong earnings history, market-leading position, growth potential, and strong management.
  • Exits can be through an IPO, sale to another LBO fund, or a trade sale.

LBO Principles and Leverage

  • Sponsors aim to achieve high returns on equity by acquiring a target with significant leverage, paying back debt using the target’s dividends, and exiting at a higher value.
  • Leverage increases ROE by magnifying returns from equity investment, but it also increases the risk of financial distress.

Examples and Holding Period

  • Famous examples of LBOs include KKR's buyout of RJR Nabisco and Blackstone's acquisition of Hilton Hotels.
  • The typical holding period for an LBO investment ranges from 5 to 7 years, during which the debt is paid back and the target is prepared for exit.

Private Equity Fund Management

  • General Partners charge 1.5%-2% management fees on funds under management and 20% carried interest, provided the hurdle return (often 8% per annum) is exceeded.

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