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ACC 424 Financial Reporting II

ACC 424 Financial Reporting II. Lecture 3 Mergers & acquisitions Special topics. Special topics. Leveraged buyouts (LBOs) Spinoffs Takeover defenses. Reasons for interest. Frequency of these activities Unusual accounting for LBOs Mixture of purchase & pooling. Leveraged buyouts.

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ACC 424 Financial Reporting II

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  1. ACC 424Financial Reporting II Lecture 3 Mergers & acquisitions Special topics

  2. Special topics • Leveraged buyouts (LBOs) • Spinoffs • Takeover defenses

  3. Reasons for interest • Frequency of these activities • Unusual accounting for LBOs • Mixture of purchase & pooling

  4. Leveraged buyouts • LBO’s differ from ordinary acquisitions in two obvious ways: • A large fraction of the purchase price is debt-financed • (some or all of this debt is below investment grade, “junk”); and • The LBO usually “goes private” • The remaining equity in the LBO is held by a small group of investors. • An LBO led by management is a management buyout (MBO)

  5. Leveraged buyouts • In 1970’s & 1980’s many MBO’s were of large diversified firms’ unwanted divisions • In 1980’s MBO/LBO activity shifted to buyouts of entire businesses including large mature public co.s • LBOs continued in the 1990s albeit at a smaller scale

  6. LBO Motivations • Incentives • Managers increased stake • Leverage (Free cash flow) Kaplan (JFE, 1989) found increases in profitability & reductions in capital expenditures for 48 MBOs 1980-1986 • Interest tax shields Ruback (HBR 1989) estimates $1.8 billion of $8 billion RJR Nabisco gain due to tax shields

  7. Chronology of largest LBORJR Nabisco, 1988, $25 billion • 10/28/88 CEO Johnson’s LBO announcement • Group to buy stock for $75 cash per share • Price moves to $75 from $56 in one day • RJR’s bond prices fall • Co. “in play”, other offers forthcoming • 4 days later Kohlberg, Kravis & Roberts (KKR) bid $90 • $79 cash plus payment in kind (PIK) preferred shares valued at $11 (dividends in more preferred shares) • Committee of Independent Directors established (advised by Lazard Freres)

  8. Chronology of largest LBO(Continued) • 11/30/88 bidding closed • Johnson group vs KKR • KKR bid $109 per share: $81 cash; convertible subordinated debentures $10; and PIK preferred shares, $18. • Johnson group bid $112 in cash & securities • Board chose KKR because Johnson’s security valuations “softer” & generous management compensation package

  9. RJR Nabisco postscript • Reduction in leverage • Higher junk bond interest rates led KKR to make • An additional equity investment in mid 1990 • An exchange offer of cash & equity for $753 million junk bond in, 12/90 • Return to public company • In 1991 RJR sells $1.1 billion of public stock • KKR sale of stake • KKR progressively sold off its investment. Remaining stake sold in 1995 at roughly the original purchase price • RJR spins off its tobacco operations • 3/99 RJR announced sale of its overseas tobacco unit to Japan Tobacco & spinoff of US tobacco business • Spinoff apparently a reaction to Carl Icahn’s proposal of an alternate slate of directors • In 1997 Icahn accumulated stock for proxy fight but sold out for $130 million profit • Icahn wanted to spinoff the food business

  10. Common LBO Structure • Establishment of a holding company with no substantive operations • (Newco) to buy all the equity of an operating company (Oldco) • After the acquisition the two companies merge • surviving co. often takes Oldco’s name • Many embellishments of this form

  11. RJR Nabisco LBO Structure • RJR Nabisco LBO had the preceding structure with • RJR Nabisco being Oldco • A new company “Acquisition” being Newco • 3 other new companies being created as holding companies above Acquisition • Capital • Group • Holdings • Terms of the deal for RJR Nabisco Common Stock: $ 81 cash $ 18 Group preferred $ 10 Holdings senior converting Debentures $109 per Common Share

  12. RJR Nabisco LBO Structure

  13. LBO accounting • LBOs have accounting standards issued by Emerging Issues Task Force (EITF) • EITF formed by FASB to identify new issues that might require standards • EITF has 15 members drawn from public accounting, industry, FASB & SEC • EITF can, if it reaches consensus (13 of its 15 members), provide standards for new, narrow or specialized issues for which no guidance exists • EITF has issued standards on LBOs, the primary one being EITF Issue No. 88-16 Basis in Leveraged Buyout Transactions, May, 1989.

  14. LBO accounting • Problem with conventional acquisitions accounting • LBOs heavy debt use can lead to negative equity if pooling used • Management wants to avoid negative equity (as in full cost & stock option compensation standards) so wants purchase method • Standard motivated by concern that control may not have changed • Is that likely to be a problem? Why? • Standard • aimed at preventing basis increases in transactions that are not at arms length • can result in mixture of pooling & purchase methods • If a company has had an LBO the financial analyst should adjust for its effects on the time series of accounting numbers

  15. LBO accounting • Central issue is whether there can be a change in the carrying basis of Oldco’s assets • Without a change in control of Newco that meets the standard’s tests, there can be no change in carrying basis. This then is the first issue to investigate • Given there is a qualified change in control the standards limit the extent to which fair value can be used. The second issue is the calculation of those limits

  16. Change in control • For a change in control to occur, one of the following three events must happen: • A single shareholder who did not control Oldco obtains control of Newco. Management as a group qualifies as a single shareholder for this purpose • If two or more parties effect the buyout, • the new control group (defined below) consists entirely of new shareholders or • The new control group has no subset that had unilateral control of Oldco • So it is important to define who has control of Newco; who is the control group

  17. Change in control • The new control group consists of: • Management (unless it doesn’t participate in promoting the transaction & has no meaningful equity interest in Newco) • Stockholders with increased residual interest (“bulls”) & a residual interest of at least 5% in Newco. • Residual interest is the proportionate interest remaining after assuming satisfaction of liquidation or redemption features of other equity securities (see next slide for example) • Stockholders with equal or decreased residual interest (“bears”) who pass either • a 20% voting interest test or • a 20% capital-at-risk test (see homework problem E 2.5)

  18. Change in controlResidual interest example - E2.4

  19. Residual interest example Problem E2.4 • Harmon’s residual interest in New Company Total Harmon Preferred stock A 10,000 - Preferred stock B - - Voting common stock 10,000 1,000 Nonvoting common stock 50,00015,000 70,00016,000 Harmon’s residual interest in New Company = 16,000/70,000 = 22.9% • Harmon’s residual interest increased. (he is a “bull”). His residual interest in Target was18% • As a bull with a residual interest in New Company > 5%Harmon is a member of the new control group

  20. Asset valuation • If none of the three conditions (slide 16) are met there is no control change & no change in the carrying basis of Oldco’s assets when merged into Newco. • This could result in a negative equity (see example in text) • If one or more of the three conditions are met, the assets have a new basis in Newco. • Portion will be measured at predecessor basis (a stockholder’s basis in the stock) • original cost plus earnings minus dividends or if that cannot be observed • proportionate interest in book value • The rest will be measured at fair value (see next slide)

  21. Valuation of net assetswith a change in control Composed of: • predecessor basis to the extent of the lesser of individual shareholders in the new control group’s residual interest in Oldco or Newco • predecessor basis to the extent of the residual interest in Newco of continuing stockholders who are not members of the new control group. The residual interest of these stockholders must be at least 5% individually & 20% in aggregate • fair value for the remaining net assets provided the monetary test is met at the 80% level. If the monetary test is <80% fair value is limited to the percentage of the total. • The monetary test is the percentage of all consideration paid to Oldco stockholders that is monetary (cash & financial instruments having a fixed & determinable dollar value)

  22. Asset valuationSimple example P2.3

  23. Asset valuationSimple example P2.3 • The 3rd test for a control change is met - no subset of control group has unilateral control of Oldco • The new control group consists of: • the private investor group who have no shares in Reynolds-Morris so the lesser of their residual interests for valuation purposes is zero • management whose residual interests are (80,000/2,000,000 = .04) 4% in Reynolds-Morris and 15% in the new company. The lesser is 4% • There are no continuing stockholders other than members of the control group • The monetary test is met since the other 96% of Reynolds-Morris receive monetary consideration • Hence 96% of the excess of fair value over predecessor will be recognized

  24. Asset valuationSimple example P2.3 RM Associates Balance sheet prior to LBO Assets Cash ($1.2m + $15m) $16,200,000 Shares in Reynolds-Morris (80k$12) 960,000 Total assets $17,160,000 Equities & Liabilities Bonds payable (net) $15,000,000 Stockholders’ equity 2,160,000 Total equities & liabilities $17,160,000

  25. Asset valuationSimple example P2.3 • Valuation of investment in Reynolds-Morris • Management group (predecessor basis) 4% of $8,500,000 $ 340,000 • Fair value (96% of $24,000,000)23,040,000 • Total valuation $ 23,380,000 • Payment to nonmanagement shareholders of Reynolds-Morris • Cash (1,920,000 shares @ $8) $ 15,360,000 • Notes (1,920,000 shares @ $4) 7,680,000 • Total valuation $ 23,040,000

  26. Asset valuationSimple example P2.3 RM Associates Balance sheet after LBO Assets Cash ($16.2m - $15.36m) $ 840,000 Shares in Reynolds-Morris 23,380,000 Total assets $24,220,000 Equities & Liabilities Notes payable $ 7,680,000 Bonds payable (net) $15,000,000 Stockholders’ equity 1,540,000 Total equities & liabilities $24,220,000 Note that the $620,000 drop in stockholders’ equity from $2,160,000 in the balance sheet before LBO to $1,540,000 after is due to the revaluation of the 4% of shares from $960,000 to $340,000

  27. Asset valuationSimple example P2.3 • Allocation of the value of the investment in Reynolds-Morris Current assets Fair value .96$7.3m $ 7,008,000 Predecessor basis .04$6m 240,000 $ 7,248,000 Plant & equipment Fair value .96$19m $ 18,240,000 Predecessor basis .04$15.5m 620,000 18,860,000 Liabilities Fair value = predecessor basis (13,000,000) Subtotal $13,108,000 Investment value 23,380,000 Goodwill $10,272,000

  28. Asset valuationSimple example P2.3 Reynolds-Morris-Stevens Corp. Balance sheet after merger Assets Current assets ($7.248m + .84m) $ 8,088,000 Plant & equipment 18,860,000 Goodwill 10,272,000 Total assets $37,220,000 Equities & Liabilities Current liabilities ($7.68m+3m) $10,680,000 Long-term liabs ($15m+10m) 25,000,000 Stockholders’ equity 1,540,000 Total equities & liabilities $37,220,000

  29. Spinoffs • Spinoff • Divestiture of a subsidiary by distributing its stock to the parent company’s shareholders • Examples • In 1995 ITT split itself into 3 separate firms • Interests in hotels & gambling • Electrical businesses • Financial services • Eastman Kodak’s 1993 divestiture of Eastman Chemical

  30. Reasons for spinoffs • Tax advantages • Santa Anita Park example in text • Regulatory reasons • AT&T • Widen investors’ choice • Legal liability • Improve efficiency • Management concentrate on activity where it has comparative advantage • Eliminate cross-subsidization • Easier to value each unit and reward managers appropriately

  31. Spinoff’s Advantage over Share Sale • Spinoffs are tax free if at least 80% of shares are spun off • Taxes on sale depend on whether a s.338(h)(10) election is made or not • If election is not made the taxable gain on sale is difference between sale price and parent’s basis in the shares • If election is made the sale is treated as a sale of assets • Parent has taxable gain on sale • Subsidiary receives increase in basis of assets and higher depreciation deductions • Typically tax on gain would exceed PV of tax shield on increased depreciation making the sale tax-disadvantaged relative to the spinoff

  32. Accounting for spinoffs • Recorded at book value • A spinoff is a nonreciprocal transfer of a nonmonetary asset (like a property dividend) • Normally such a transfer is recorded at the asset’s fair value • But, APB Opinion 29 excepts a spinoff from that treatment and requires it be recorded at book value • Net assets & earnings shown in discontinued operations prior to separation • After spinoff decision is made but before implementation under APB Opinion 30 • Book value of net assets of unit being divested is separated in balance sheet as net assets of discontinued operations • Earnings is separated under discontinued operations in income statement

  33. Spinoff example P 2.7

  34. Spinoff example P 2.7

  35. Spinoff example P 2.7

  36. Spinoff example P 2.7

  37. Spinoff example P 2.7

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