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VC + IB exam 2

Terms in this set (92)

borrower
- the company that borrows the money
- can be the parent company or a subsidiary
- always know which other entities in the corporate structure guarantee the loan
lenders
- banks or financial institutions that lend the money
- agent banks and syndicate banks
agent bank
the lead lender
- arranges and places the loan
- acts as conduit to distribute information from company or to lenders
- acts as conduit to distribute cash payments between the borrower and lenders
- lead negotiations with the company
- maintains records regarding lenders and payments
syndicate banks
the other lenders in the group
interest
- most loans have floating interest rates (base rate + ____%)
- LIBOR is the most common base rate for corporate loans
- Loan interest is usually payable quarterly
term loans
- type of loan that is similar to a bond
- most corporate bond investors also invest in term loans
- term loans are the most frequent traded type of loan
- term loans are more commonly used by borrowers rated below investment grade
- can be secured (1st lien or 2nd lien) or unsecured
- pay up front and then pay them back (car loan)
- most can be paid early if you want in america (callable at any time)
- loan is borrowed once and has a fixed maturity
- most term loans require principal payments prior to maturity
- most term loans can be called or prepaid at any time by the borrower
- typical term loan maturities are 5-7 years
revolving credit facilities ("revolvers")
- like a credit card
- most common type of loan to investment grade companies
- also used by companies rated below investment grade
- a revolver is a credit line under which a company can borrow up to a certain amount of $ until maturity
- the borrower can borrow and repay the loan multiple times
- all outstanding principal must be repaid at maturity
- typical revolver maturity is 1-5 years (shorter than term loan)
- letters of credit ("LC's) can also be issued under a revolver
- LCs are an instrument under which the lender agrees to make a payment if something goes wrong in a contract that the borrower has entered into a 3 way party (used in construction, waste disposal, and import/export businesses)
- the lenders get paid 3 ways on a revolver (1. interest is paid on the amount of principal borrowed, 2. fees are paid on letters of credit, 3. fees are paid on unused availability (total amount that can be borrowed minus amounts already borrowed and outstanding LCs))
- reasons why companies use revolvers: provide funding to cover seasonality, cyclicality, and other swings in their business; backup funding for commercial paper; to provide letters of credit; to provide borrowing capacity in case opportunities arise or a recession occurs; to fund acquisitions, major expansion projects, etc.)
types of defaults
payment default, technical default
- most credit agreements provide a grace period --> a specified number of days that the borrower is given to fix the problem before the lends can take action
payment default
the company fails to make a principal or interest payment
technical default
the company violates a covenant or another part of the credit agreement
security and collateral
-collateral is an asset or assets that secure a loan
- most common assets used as collateral are accounts receivable, inventory, PPE (land, buildings, and equipment), intangibles (brand names, trademarks, patents, etc.) and stock of subsidiaries (cant use goodwill and people as collateral, foreign subsidiary stock or assets sometimes cant be used due to tax issues)
- a lien provides the lender with the right to seize the collateral if the borrower defaults
- a loan can have a first or second lien (1st lien has priority over the 2nd lien)
- the a company has multiple loans, they can each be secured by different collateral
- assets that are not serving a collateral are called unencumbered assets
private information
-loans are not public securities like stocks and bonds are
- lenders can receive private information (unlike bondholders and stockholders)
- having private information restricts the ability of an investor to trade bonds or stocks of the borrower
credit agreement
The legal document that describes the loan and the responsibilities and rights of the borrower and lenders --> its major sections are:
- definitions: describes the significant terminology used in the credit agreement
- loan terms: interest rate, maturity, repayment schedule, currency, ability to prepay, etc.
- covenant (see section below)
- representations and warranties: conditions that lender and borrower must satisfy before money can be borrowed - compliance with laws, properly incorporated, accurate and up-to-date financials, very important for revolvers, which can be borrowed multiple times, amendment and waiver procedures, procedures for and limitations on owning and trading the loan and minimum sizes, borrowers can sometimes veto traders between lenders
covenannts
rules of the loan that state what the borrower must do and cant do
- loans typically have more covenants than bonds
- borrowers have to inform leaders each quarter as to whether or not they are in compliance with their covenants
affirmative covenants
things that the borrower must do
- timely filing of financial statements
negative covenants
things that the borrower is not allowed to do
- limitations on liens (secured debt limit)
- limitation on total debt
- restricted payments (limit payments (dividends, etc.) to junior debt and equity)
-change of control (requires lenders to be repaid if company is sold)
- transactions with affiliates (limits deals with managers and other insiders)
financial covenants (aka maintenance covenants)
- finance ratios that the borrower must stay over or under
minimum interest coverage: usually uses EBITDA/Interest expense ratio
Maximum leverage: usually uses Debt/EBITDA ratio
"covenant lite" loan
a loan with zero or one financial covenants
- gives lenders less control over the borrower
- lenders will demand higher interest rates for covenant lite loans
Options a lender has when a borrower violates a covenant
1. do nothing
2. demand repayment of the loan (and seize collateral if they cant make the repayment)
- could cause bankruptcy for the borrower
3. waiver - bank agrees to ignore a covenant violation for a period of time
- lenders usually get a fee for doing it and sometimes get a higher interest rate
4. amendment - covenant or other parts of the credit agreement is modified
- usually requires a majority of 2/3 vote by lenders to approve
- lenders usually get a fee and higher interest rate for approving it
- maturity and collateral are difficult to amend - usually require a 100% vote
who invests in loans ?
banks - dominate the market for revolvers, also invest in term loans
hedge funds - mostly term loans
mutual funds - mostly term loans
CLOs (collateralized loan obligations) - a special-purpose entity that has loans in its portfolio
key differences between bonds and loans
interest rate - bonds are usually fixed, loans are usually floating
interest period - bond interest is paid 2 times per year, loan interest is paid 4 times per year
security- bonds are usually unsecured, loans are secured
legal status - bonds are securities, loans are not
information - bondholders can only receive public info, lenders can get private info
liquidity - bondholders are usually less liquid and harder to trade than bonds
maturities - loans usually have shorter maturities
callability - loans can usually be prepaid or called at any time, bond can not be
covenants - loans usually have more covenants than bonds, bonds usually dont have financial covenants
documentation - loan credit agreements are usually more complicated than bond indentures, loan credit agreements are also usually amended more often than bond indentures
advantages to companies for using loans as a source of financing
- floating interest rate is good rates are falling
- easier to repay early if company has excess cash flow
- more flexible documentation
- revolvers allow for more flexible borrowing schedule
- revolvers allow for more flexible borrowing schedule
- revolvers provide the ability to get letters of credit
- fewer holders to deal with
disadvantages to companies for using loans as a source of financing
- floating interest rate is bad if rates are rising
- loans are usually secured
- loans have shorter maturities
- loans have stricter covenants than bonds
- representations and warrantees can be a problem with revolvers
reasons to invest in loans instead of bonds
- better covenant protection
- collateral reduces risk of not getting paid
- floating interest rates are good if interest rates are rising
reasons to invest in bonds instead of loans
- if you expect interest rates to fall
- higher yields
- longer maturities are available
- bonds are less callable
- better liquidity for trading
- simpler documentation
synergies
put 2 companies together through merger and aqusition
2 + 2 = 5
cost synergies
headcount, purchasing, manufacturing cost
- saving money
headcount synergies
(layoffs) - faster way to achieve synergies in the USA
- fastest and most commonly used
purchasing synergies
getting volume discounts due to being a bigger company
manufacturing and distribution synergies
closing duplicative plants and warehouses
- takes more time and money and can be disruptive
revenue synergies
selling one companies products to the other companies customers
- hard to forecast
- making more money than they could before
- cross selling companies products to other companies customers
key integration and synergy issues
- damage to employee morale from overly aggressive headcount cuts
- firing the wrong people or too many people
- integrating the two management teams (egos and different corporate cultures can be a problem)
- union or government resistance to layoffs or plant consolidations
- timing delays
- severance costs
- costs and other problems consolidating manufacturing plants
- quality issues, need to move and install equipment, training workers, duplicate manufacturing facilities during transition
paying for acquisitions
6 ways to pay for deals: cash, debt, preferred stock, common stock, assets, contingent payments
paying for acquisitions: cash
- sends a strong signal to the seller
- less market risk
- buyer gets full benefit from synergies (and takes all of the risk)
- buyer usually has to borrow the money (bonds or loans) - results in increased leverage
paying for acquisitions : debt
an IOU to pay in the future is usually the least preferable
- default risk
- time value of money
paying for acquisitions: preferred stock
not as frequently used due to lack of maturity
paying for acquisitions: common stock
can be good or bad
two ways to do it - fixed number of shares or fixed $ amount
- fixed share amount is risky if buyer share price changes
- fixed $ amount protects the buyer if their share price rises
- fixed $ amount protects the seller if the buyers share price falls
issuing stock dilutes acquirer shareholders
- dilutes voting control and potentially EPS
- problem for family controlled companies
issuing stock avoids needs to increase debt in order to raise cash
- sometimes stock is the only way highly leveraged companies can pay
issuing stock sends a weaker signal to seller than issuing cash
- benefits and risk of synergies shared between acquirer and seller in stock deals
- stock deals are more complicated, because you have to analyze 2 stocks
paying for acquisitions: assets
gold, land, oil, etc.
- can be illiquid and have storage costs- sometimes hard to convert to cash
- more frequently used in emerging markets
paying for acquisitions: contingent payments
seller only receives value if the company does well
two types:
earnout - seller get a % of profits above a certain target level
options (aka warrants) - can be converted profitably into shares if the buyers share price rises above a certain level
contingent payments often used to bridge valuation gaps between buyers and sellers
target company
the company being acquired in a deal
acquirer
the company that is doing the buying
types of M&A deals
acquisition, sale of company, divesture, merger, leveraged buyout, leveraged recapitalization
divesture
sale of part of company
merger
to similarly sized companies combine
leveraged buyout
companys management buys their own company
leveraged recapitalization
company takes on debt to do a large share buyback
reasons for doing M&A deal
to achieve strategic goals, financial reasons, to satisfy the needs of founders and other key shareholders
M&A deals to achieve strategic goals
- entering and exiting existing markets
- entering and exiting product categories
- to eliminate competitors
- to diversify
- to get rid of problem pieces of the company
M&A deals for financial reasons
-business is undervalued or overvalued
-increase growth rate of company's revenues and earnings
key components of the M&A process
strategy, valuation, financing, legal, government approvals, impact on employees and other stakeholders
key components of the M&A process: strategy
why is the company doing the deal??
strategy for getting the deal done
key components of the M&A process: valuation
what is the business worth?
key components of the M&A process: financing
how to get the cash required for the deal
key components of the M&A process: legal
what are the laws and other rules that must be followed while doing the deal?
state of incorporation
- every corporation must choose a state in which to incorporate
- each state has different laws regarding corporations and corporate transactions
- Delaware is the most common state for incorporation
Bylaws and Certificate of Incorporation
documents that outline the rules for each corporation
includes the following:
- size of board and election procedures for directors
- voting requirements for major decisions (ex. sale of company)
- types and amounts of stock the company can issue
- procedures for issuing additional shares of stock
- shareholder meeting and notification requirements
can include measures to make hostile takeovers more difficult
- supermajority voting requirements
- staggered multi-year board terms
- poison pill (ability to issue new shares to dilute a hostile acquirer's stake)
can be changed via a shareholder vote (and sometimes by a board vote)
- procedures for changing them are usually included in the bylaws
independent director
a director is independent if they are not an employee of the company and have no significant conflicts of interest
- should be a majority
role v. management and shareholders
- directors are elected by shareholders to represent their interests
- board is in charge of overseeing management
- conflicts of interest can occur when management has board seats
key decisions made by board members
- hiring, firing, and paying auditors
- hiring, firing, and paying top management team (board also must approve incentive system for management bonuses)
- share insurance, share buybacks and dividends
- major acquisitions and divestures (including sale of the company or merger with another company)
- fiduciary duty
- business judgement law
fiduciary duty
directions must act in the best interests of the company and its stockholders (and stakeholders in certain states)
business judgement law
directors must be well-informed (do their homework), act in good faith, and not have any conflicts of interest
key stakeholder groups
stockholdes
employees and labor unions
creditors (lenders, bondholders, suppliers)
customers and suppliers
local governments and communities
retirees (pensioners)
shareholders vs. stakeholder
directors have primary responsibility to shareholders, but should also consider need of their other stakeholders
- the degree to which directors must balance the needs of shareholders and stakeholders varies by state in the USA
the takeover process
1. offer is received by the target company
2. independent directors evaluate the offer
- they hire investment bankers, lawyers and accountants to help them
3. directors make recommendation to shareholders
4. shareholders vote
5. government approval may be required
6. deal is completed if shareholders and government approve it
friendly deal
target wants to be acquired
hostile deal
target does not want to be acquired and puts up a fight
- usually requires a higher price to get the deal done
responsibilities of directors when a takeover offer is recieved
-form a special committee of independent directors
- hire experts (investment bankers, lawyers, accountants, etc.)
- determine the value of the corporation
- determine if the offer is fair
- study the feasibility of defensive moves
- make a recommendation to shareholders to accept or reject the offer
how to determine if the offer is fair
price
- amount
-method of payment (cash, stock, debt, other securities)
other deal terms and considerations
- timing
- legal issues
- fees involved in the deal
- if there are conflicts of interest
- contingencies (things that must happen for the deal to occur) : due diligence, financing, government approval, need for additional contracts (key employees, union contracts, key suppliers and customers), impact on stakeholders (in some states)
hostile takeover strategies for acquirers
toehold, tender offer, proxy fight, litigation
toehold
acquirer buys a minority interest in the target companys equity
- all purchases must be publicly reported when the total holdings exceed 5%
tender offer
acquirer offers to purchase shares from the shareholders
- buypass the management and the board of directors
- shareholders decide whether they want to tender (sell) their shares
- shareholders have roughly one month to decide
- acquirer must purchase any shares that are tendered
- if successful, the acquirer will own a majority of the shares and control the company
proxy fight
use of a shareholder vote to achieve objectives
- acquirer calls a shareholder vote elect new directors or change the bylaws
- if successful, it can make it easier to take over the company later
litigation
intimidate the board by threatening to sue them
takeover defenses
- publicly campaign to convince shareholders that the offer is unfair
- stir up political opposition
- litigation (delaying tactic)
- finding other bidders (white knight)
- hold an auction to sell the company (highest bidder might not be the friendliest)
- change bylaws (increase required majority, change board terms)
- poison pill
- leveraged recapitalization
- "pac man" defense
poison pill
issuance of large number of new shares - dilutes potential acquirer
Leveraged recapitalization
take on debt to finance a massive share buyback or dividend
- improves the value of the company by increasing the tax shield
- could cause the company to become over leveraged
"pac man" defense
target attempts to acquire the acquirer (rarely used)
antitrust
rules in US and europe to prevent monopolies
- all big acquisitions and mergers in the US and EU are subject to antitrust approval
- antitrust problems can often be solved by divesting part of the target company
- some industries also have additional approval requirements for deals: airlines and railroads, military equipment, broadcasting, utilities, banks and insurance companies, telecommunications
merger agreements
final agreement in transaction
spells out the final terms of the deal
- price
-method of payment
- representations and warranties (conditions that must be satisfied before the deal closes - no violations of laws, financing in place, required contracts in place)
-indemnification (seller guarantees to reimburse buyer if certain problems cost money to fix)
activist investors
activists buy a significant minority stake in a company by purchasing share in the public markets
- they are usually not trying to acquire the whole company
their goal is to try to force the company to take actions that will increase the share price
- changes to the management team and board of directors
- aggressive cost cutting (layoffs, plant closing, etc0)
- divestures (sale of part of the company)
- sale of the company
they use many of the same tactics of as a hostile acquirer
- buy a toehold in the companys stock to get taken more seriously as a significant shareholder
- proxy fight to get a seat on the board or change the company's bylaws
- threaten litigation to put pressure on management and the company's board of directors
defenses against an activist investor
- try to ignore them
- try to convince the company's other shareholders that the activists strategic ideas would damage the company and its stock
-give the activist a seat on the board and prove to them that there is already a good strategy in place to increase the company's share price
- repurchase the activists shares at a profit to the activist
divestures
a sale of part of the company
reasons for divesting a business
-no longer fits with strategy
- weak returns on investment or weak future prospects
- need to raise cash or pay down debt
- market is overvaluing the business
- to avoid antitrust
divesture methods of payment
cash, common stock, preferred, debt, assets, earnouts, warrants
- cash is usually best for seller (especially if they have to pay capital gains taxes)
divesture: division vs. subsidiary
- a subsidiary is a separately incorporated entity
- a division is a part of a subsidiary or. apart of the parent company (not separately incorporated)
things to consider when divesting a business
what is it worth?
is now the right time to sell?
could it be worth more in the future?
how does it fit the companys strategy?
what will they do with the money?
are their buyers for it at a reasonable price?
how is the business being divested connected with the rest of the company?
- will agreements need to be put in place to have it continue to provide goods or services to the rest of the company after it is sold?
does the deal impact any bond or loan covenants?
will the sale generate a gain that is taxable?
does selling the business raise or lower the IRR of the overall company?
will the divesture improve or dilute the companys EPS?
will anyone (customers, suppliers, unions, government) be opposed to the deal?
divesture tax considerations
-taxes are based on gain on sale (sale price - cost basis)
- old businesses often have a low cost-basis - potential tax problem
Buying assets vs. buying stock
when you buy stock you get all of the businesses assets and liabilities
- when buying a division, you can not buy stock (must buy assets and liabilities)
buying assets allows you to choose which assets and liabilities you want
- avoid problems with legal, environmental and pension liabilities
sellers usually want to sell stock - gets rid of problem assets and liabilities
buyers often want to buy assets - avoid taking on problem assets and liabilities
sellers usually demand a higher price when selling assets (to compensate them for the risk associated with the remaining liabilities)
divesture: indemnification
guarantee by seller to reimburse buyer if specific future problems occur
often used to entice to get buyer comfortable taking on problem assets and liabilities
risk of seller bankruptcy (seller would be unable to pay)
divesture: ways to sell a business with problems assets and/or liabilities
do it as a stock deal, but at a lower price
do it as a stock deal, but include indemnification
do it as an asset deal (seller retails problem assets and/or liabilities) at a higher price
divesture: tax free spin-off
the subsidiary being spun off is given to the company's existing shareholders
- each shareholder gets a share of the new company and keeps their share of the existing parent company
- they can choose whether to hold on to the new stock or sell it
deal is tax free since no money changes hands
divesture: subsidiary IPO
shares of subsidiary are sold to the public through IPO
- the subsidiary becomes a public company, with the parent company still owning a large % of shares, but not 100% anymore
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