Pacific Investors Acquires California Kool in a Leveraged Buyout

question 66

Essay

Pacific Investors Acquires California Kool in a Leveraged Buyout
Pacific Investors (PI) is a small private equity limited partnership with $3 billion under management. The objective of the fund is to give investors at least a 30-percent annual average return on their investment by judiciously investing these funds in highly leveraged transactions. PI has been able to realize such returns over the last decade because of its focus on investing in industries that have slow but predictable growth in cash flow, modest capital investment requirements, and relatively low levels of research and development spending. In the past, PI made several lucrative investments in the contract packaging industry, which provides packaging for beverage companies that produce various types of noncarbonated and carbonated beverages. Because of its commitments to its investors, PI likes to liquidate its investments within four to six years of the initial investment through a secondary public offering or sale to a strategic investor.
Following its past success in the industry, PI currently is negotiating with California Kool (CK), a privately owned contract beverage packaging company with the technology required to package many types of noncarbonated drinks. CK's 2003 revenue and net income are $190.4 million and $5.9 million, respectively. With a reputation for effective management, CK is a medium-sized contract packaging company that owns its own plant and equipment and has a history of continually increasing cash flow. The company also has significant unused excess capacity, suggesting that production levels can be increased without substantial new capital spending.
The owners of CK are demanding a purchase price of $70 million. This is denoted on the balance sheet (see Table 13-15 at the end of the case) as a negative entry in additional paid-in capital. This price represents a multiple of 11.8 times 2003's net income, almost twice the multiple for comparable publicly traded companies. Despite the "rich" multiple, PI believes that it can finance the transaction through an equity investment of $25 million and $47 million in debt. The equity investment consists of $3 million in common stock, with PI's investors and CK's management each contributing $1.5 million. Debt consists of a $12 million revolving loan to meet immediate working capital requirements, $20 million in senior bank debt secured by CK's fixed assets, and $15 million in a subordinated loan from a pension fund. The total cost of acquiring CK is $72 million, $70 million paid to the owners of CK and $2 million in legal and accounting fees.
As indicated on Table 13-15, the change in total liabilities plus shareholders' equity (i.e., total sources of funds or cash inflows) must equal the change in total assets (i.e., total uses of funds or cash outflows). Therefore, as shown in the adjustments column, total liabilities increase by $47 million in total borrowings and shareholders' equity declines by $45 million (i.e., $25 million in preferred and common equity provided by investors less $70 million paid to CK owners). The excess of sources over uses of $2 million is used to finance legal and accounting fees incurred in closing the transaction. Consequently, total assets increase by $2 million and total liabilities plus shareholders' equity increase by $2 million between the pre- and postclosing balance sheets as shown in the adjustments column.hasi¹ Delta;Total assets = ΔTotal liabilities + ΔShareholders' equity: $2 million = $47 million -$45 million = $2 million.
Revenue for CK is projected to grow at 4.5 percent annually through the foreseeable future. Operating expenses and sales, general, and administrative expenses as a percent of sales are expected to decline during the first three years of operation due to aggressive cost cutting and the introduction of new management and engineering processes. Similarly, improved working capital management results in significant declines in working capital as a percent of sales during the first year of operation. Gross fixed assets as percent of sales is held constant at its 2003 level during the forecast period, reflecting reinvestment requirements to support the projected increase in net revenue. Equity cash flow adjusted to include cash generated in excess of normal operating requirements (i.e., denoted by the change in investments available for sale) is expected to reach $8.5 million annually by 2010. Using the cost of capital method, the cost of equity declines in line with the reduction in the firm's beta as the debt is repaid from 26 percent in 2004 to 16.5 percent in 2010. In contrast, the adjusted present value method employs a constant unlevered COE of 17 percent.
The deal would appear to make sense from the standpoint of PI, since the projected average annual internal rates of return (IRRs) for investors exceed PI's minimum desired 30 percent rate of return in all scenarios considered between 2007 and 2009 (see Table 13-13). This is the period during which investors would like to "cash out." The rates of return scenarios are calculated assuming the business can be sold at different multiples of adjusted equity cash flow in the year in which the business is assumed to be sold. Consequently, IRRs are calculated using the cash outflow (initial equity investment in the business) in the first year offset by any positive equity cash flow from operations generated in the first year, equity cash flows for each subsequent year, and the sum of equity cash flow in the year in which the business is sold or taken public plus the estimated sale value (e.g., eight times equity cash flow) in that year. Adjusted equity cash flow includes free cash flow generated from operations and the increase in "investments available for sale." Such investments represent cash generated in excess of normal operating requirements; and as such, this cash is available to LBO investors.
The actual point at which CK would either be taken public, sold to a strategic investor, or sold to another LBO fund depends on stock market conditions, CK's leverage relative to similar firms in the industry, and cash flow performance as compared to the plan. Discounted cash flow analysis also suggests that PI should do the deal, since the total present value of adjusted equity cash flow of $57.2 million using the CC method is more than twice the magnitude of the initial equity investment. At $56 million, the APV method results in a slightly lower estimate of total present value. See Tables 13-14,13-15, and 13-16 for the income, balance-sheet, and cash-flow statements, respectively, associated with this transaction. Exhibits 13-1 and 13-2 illustrate the calculation of present value of the transaction based on the cost of capital and the adjusted present value methods, respectively. Note the actual Excel spreadsheets and formulas used to create these financial tables are available on the CD-ROM accompanying this book in a worksheet, Excel-Based Leveraged Buyout Valuation and Structuring Model.
-What are the advantages and disadvantages of using enterprise cash flow in valuing CK? In what might EBITDA been a superior (inferior) measure of cash flow for valuing CK?

---

Definitions:

Corporate Governance

The set of rules that controls a company's behaviour toward its directors, managers, employees, shareholders, creditors, customers, competitors, and community.

Independent Directors

Independent directors are members of a board of directors who do not have a material or pecuniary relationship with the company or its related entities, ensuring unbiased decision-making.

Board Size

Refers to the number of directors serving on a company's board, important for governance and strategic decision-making.

Poison Pill

Shareholder rights provisions that allow existing shareholders in a company to purchase additional shares of stock at a lower than market value if a potential acquirer purchases a controlling stake in the company.