# Analysis of a Leveraged Buyout - Financial Management

The following example illustrates some of the steps and considerations involved in typical LBOs. Suppose that, as part of a corporate restructuring, Universal Industries, Inc., has recently decided to sell its Gray Manufacturing Division, a manufacturer of industrial products. The Gray division’s top management, together with several private investors, are considering buying Gray and operating it as a separate company.As is fairly typical of LBO candidates, Gray is in a mature industry and its products have a low probability of becoming obsolete. In addition, Gray’s fixed assets have a present market value greater than their book value.

Diversified Industries’ Expected EPS Growth with and Without the High-Tech Products Acquisition

The Gray division’s financial statements listed in show that the division presently has an annual pretax loss of $1 million, and therefore its return on stockholders’ equity is negative. The Gray management group intends to return Gray to profitability by various cost-cutting and other measures. Gray’s parent company, Universal Industries, could also have initiated cost-cutting measures to attempt to return Gray to profitability. However, partly because of Universal’s new corporate strategy to get out of the industrial products business, it has chosen instead to sell Gray. Following negotiations between the Gray management group and Universal Industries, the management group agreed to purchase all of the assets of the Gray division for$30 million. The Gray management group plans to take the following steps to complete the LBO transaction.

1. The management group has put together equity totaling $5 million. Some of these funds will come from liquidated Universal Industries retirement and employee benefit plans. In LBO terminology, equity is sometimes referred to as “ground floor financing.” 2. The management group has arranged for short-term commercial bank financing, agreeing to pledge Gray’s accounts receivable and inventory as collateral. This level of financing is called either “second floor” or “top floor” financing. 3. The management group has also arranged to finance the remaining portion of the buyout with subordinated long-term debt financing from an investment banking firm specializing in providing financing for LBOs. This subordinated debt is called “mezzanine” financing because of its position between the ground floor and the second floor financing. Mezzanine financing is high-risk capital because the company’s fixed assets do not provide sufficient collateral for the debt. In addition,Gray’s cash flow forecast for its early years as a separate entity indicates that it may experience some difficulty in servicing its debt obligations. As a result, the investment bankers providing the mezzanine financing have insisted that the debentures include attached warrants to provide additional opportunities for return other than the debt’s interest payments. Because these debentures are highly risky, they are referred to as junk bonds. (Recall from that the term junk bond is frequently applied to a debt issue rated Ba or lower by Moody’s or BB or lower by Standard & Poor’s.) Leveraged Buyout of Gray Manufacturing Division 4. The management group intends to initiate a major cost-cutting program as soon as Gray becomes a separate company. They plan to cut unnecessary personnel at all levels, and for the remaining employees, they plan to cut salaries and employee benefits. In return, howeverthey do plan to offer key employees stock options, and all employees will participate in a bonus plan. In addition, Gray personnel will no longer have to provide reports to Universal, which in turn reports to its stockholders and the Securities and Exchange Commission, and the Gray managers themselves will no longer be spending time talking to security analysts. 5. The management group has determined that Gray’s fixed assets (real estate and equipment) have a market value of approximately$16 million, or about twice their present book value. As a result of the LBO, the fixed assets will be written up to their market value and depreciated on the basis of the higher value. The increased depreciation charge will shelter a greater portion of Gray’s cash flow from federal income taxes, all other things being equal.

This example illustrates many of the steps a buyer usually takes in an LBO.