Qantas Company Leverage Buyout - Case Study Example

Qantas Company Leverage Buyout Students Name: Institutional Affiliation: Department Course: Date: Introduction Over the past few years, there has been an increase in investment by private equity funds in Australia. Private equity fund is describe in the paper as an acquisition of public company trading in the Australian Stock Exchange (ASX) by a group of investors who make the company a private entity by delisting it from the stock exchange. Usually, a significant proportion of the financing for the buyout is in form of debt financing. The factor therefore makes the private equity be associated with leverage buyouts (LBOs). The effect on a purchased company through an LBO is an increase in the gearing ratio. The equity component in an LBO is normally provided for by a private equity fund which raises the fund from a range of investors who share a common goal[Nie08]. The private equity fund has a manager who makes decisions on management of fund assets. The investors usually have their money locked for seven to ten years or until divestment occurs. LBO transactions in recent times have accounted for seventy per cent of the funding used for purchase. The debts are split into senior and subordinated components. The senior debt has accounted for of the raised debt used in recent deals in Australia. A large proportion of the debt is initially provided large Australian and overseas bank in the form of syndicated loans with the issuing bank seeking to on-sell part of the loan to other investors like other banks and insurance companies or hedge the credit risks using derivatives[Axe09]. A subordinated debt is a debt provided by institutional investors like insurance companies, pension funds and hedge funds. The Australian retail investors also participate through the purchase of hybrid securities. The loans are syndicated only if they are greater than $100 million. Acquired companies are given credit ratings. A payment of around 200 basis points above the comparable swap rate is characterized by senior debt, and subordinate debt is characterized by 400 to 450 basis points above the swap rate[Sim11]. Large transactions are increasingly common with use of nan-amortizing debt where capital repayments are not made for a pre-consented period of time. The structure minimizes the effect derived from higher gearing on the short-term cash flow of the company. Such a factor enable the company bear a significantly amount of debt financing than it might have been able to afford given other scenarios. The structure however has a negative effect on the company cash flows when the principal repayments fall due. Reasons why the company is an attractive target for LBO Some companies are more suitable for an LBO than others based on the following reasons; a. Low distress costs- a company with a high distress costs are not suited for an LBO because few would want to do business with such a company. A negative relationship exist between firms that produce unique products and high leverage ratio[Nie08]. A high development costs and research costs is usually the explanatory variable for firms that produces unique products. It is very hard for a company with a high distress cost to get bank loans which is a prerequisite for an LBO. b. Market position- investigating a market position of a LBO candidate requires a lot of time and due diligence. A firm with a strong market position is a preference to debt investors and a buyer. Such firms have qualities like a strong customer relationships, brand name, superior products and services than competitors and economies of scale. A firm that show such qualities not have barriers of entry in the market and have a likelihood to continuously generate cash flows. c. Strong cash flows- it is crucial fora potential LBO firm to have a stable incoming cash flows. Debt investors would want to make sure the firm has the ability to generate adequate cash flows because of periodic interest payments and debt repayment. The buyers and investors carry out due diligence to invest the cash flow. Three scenarios are usually carried with the aim of getting prepared for fluctuations as a result of the economy or firm specific reasons[Kap08]. The scenarios include; better than the expectations, as per the expectation and worse than the expectation. d. High asset base- a debt investor have preference on firms with a high asset base because it will work as guarantee for debt repayment in the event of bankruptcy[Nie08]. In case the proportion of total assets in tangible assets is higher and also exceeding the firm needs, a sell- out of some of the assets is appropriate in order to increase cash flow. e. Strong management- a buyer will always have a closer look at the management team before deciding if a company is a good candidate for LBO. The buyer will look at the management team either as an asset and keep them or make changes with an aim of increasing the firm value. To fulfill a buyer goals, the management should be made of a brilliant team whether before or after an LBO. f. Growth opportunity- Buyers are eager to buy a firm with a potential growth. An increase in growth leads to sales increases which may in turn lead to increased cash flow. Thus it will be easier to pay interest rates and debt repayment[Axe09]. The value of the firm will also increase which enhances the opportunity to exit. In case the firm hasn’t experienced a strong market position, a strong rate of growth can generate economies of scale and other benefits derived from a strong market position. g. Efficiency opportunities- Private equity fund will always look for efficiency opportunities when analyzing a firm through due diligence[Nie08]. Their aim is to get possibilities that can improve the operational efficiency, lower costs of the firm, rationalize the supply chain, change terms for suppliers or customers, cut marketing and capital expenses and outsource parts that are non-profitable. The financial sponsors however, should be careful in cutting areas that may hurt customer retention and opportunities for growth. It is also inappropriate to cut back on research and development that could spell in the long run disaster to the company. Thus, a sponsor work and analysis is of great importance in order to choose a right candidates for a LBO. h. Low capital expenditures- firms that have low capital expenditures have low investment needs and also improves the ability for cash flow increment. When carrying out due diligence, investors usually assess the capital expenditures[Sim11]. They differentiate expenses that are necessary for business operations. If the firm can prove to have a strong growth, high profit margins and a right business strategy, it is an ideal candidate for LBO. i. Low Tobin’s q- it is described as the ratio of the firm’s assets market value to the firm’s assets current replacement costs. The formulae is indicated as follows Tobin’s q = AMV/ACRC Where AMV is equal to the firm’s asset market value And ACRC is equal to the firm’s assets current replacement costs The measure is described in details as follows; If Tobin’s q is equal to 1, assets market value is perfectly reflecting the company recorded assets. If Tobin’s q is greater than one, assets market value is higher than assets recorded thus it indicates existence of some unmeasured assets and the firm is using its resources effectively. It is ideal for a buyer and debt investors to finance the LBO. If Tobin’s q is less than one, assets market value are lower than assets recorded and the company is undervalued. It indicates the firm is not using its resources effectively. The company is therefore not an ideal investment for an LBO. Business overview of Qantas Airways Qantas Airways Limited is an airline based in the Sydney suburb of Mascot and Sydney Airport serves as its main hub. Its main business is passenger transportation using two complementary airline brand Qantas and Jetstar. The airline has a market share of 65% of the domestic market in Australia and 18.7% of all passengers travelling in and out of Australia. It also operates other airlines as subsidiaries and also specialists in other markets like Q Catering. The company operates in 65 domestic and 27 international destinations across the world. It operates a total of 312 aircrafts from different aircraft manufacturers and also of different sizes in terms of passenger capacity. It has an estimated 33,265 employees. The FY 2013 saw a turnover of A$15,902 million and a net profit of A$6 million with 48.2 million passengers. Finance structure of the LBO and an estimation of the share price of LBO The capital needed when undertaking an LBO must come from some sources. The task is fulfilled through construction of a finance structure[Nie08]. The financial structure is described as where the capital comes from and where the capital goes to. The ratio of debt to equity is 70/30 but the debt is made up of a combination of different types of debts at different rates. The most common capital structure is made of the following components; i. Bank debt or senior secured credit debt. It has the highest and lowest cost of capital. The component has a low flexibility because the borrower needs to maintain a designated credit profile and keep certain ratios to be able to get a loan. The bank debt is described using a revolver credit facility and term loan facilities[Kap08]. Revolver loan facility has the ability to freely repay and re-borrow as long as the conditions are in credit agreement. A term loan has a specified maturity and during payment will pay amortization according to the schedule. The term loan is further classified as either A, B, C or any other letter according to terms of the schedule. ‘A’ term loan has a short term thus high repayment. ‘B’ term loan is a larger loan with smaller amortization but a longer life. The loan is usually a market standard for LBOs as it has a maturity of seven years. ii. High yield bonds are loans with no amortization but a big payment at maturity often seven to ten years after issuance. The interest rates are paid during the period on a fixed but higher interest rate than those for bank debts[Nie08]. The higher interest rate or coupon payments compensates an investor the higher risks associated with the bonds. The high yield bonds are flexible and riskier because it has less restricted covenants, longer maturity and lack of mandatory repayments. iii. Mezzanine debt. The debt has a low ranking and high interest rate with high flexibility. It is a non-convention funding that comprises equity based options and lower priority debt (subordinated). It’s undertaken by investors not eligible for a bank loan due to lower requirements. Thus, it has higher interest rates and offers flexibility in the aspect of repayment thus making it a highly negotiable instrument. iv. Equity contribution. It’s simply the amount of equity contributed when buying a company by the private equity fund. The financial structure of the private equity fund will be comprised of the following proportions; 45% of is financed by the bank loan i.e. the senior secured debt as a ‘B’ term loan. The loan as a higher priority compared to the senior subordinated loan as because in case of bankruptcy, it will be repaid as the first option[Nie08]. The 20% of the finance structure in the LBO will be financed by the use of high yield bonds i.e. senior subordinated bonds. The 35% of the finance structure is financed by equity contribution. It is also known as initial investment. The investment is made up of amounts contributed by the members of the private equity fund. It is on this component that the private equity fund will expect to derive a high return. Sensitivity analysis and offering price to shareholders of Qantas The sensitivity analysis in the paper will be described using the cash returns from the investment in Qantas.  Offering price to shareholders Risk of a potential LBO The risk of financial distress The private equity fund in LBO loads the company with a lot of debt to maximize returns. The factor results in high debt servicing costs[Axe09]. In some cases the private equity fund might miscalculate the LBO or a severe recession strikes thus making the company cash flows unable to meet the obligation leading to bankruptcy. Risk associated with cost cutting The common characteristic of an LBO is cost cutting or streamlining the company operations to maximize revenues which if this will be aggressively done it might hurt a company long term competitiveness. Reductions hurt the company brand in the form of advertising, quality assurance and innovation and support services. Risk of change in management. The company top executives might be replaced. It’s the desire for a private equity fund to retain the top management for their expertise and knowledge. However, they might be replaced for a more qualified and competent executives which might potentially lead to a change in the strategic direction of the company. Exit strategy risk. It’s a typical occurrence for a private equity firm to exit after a number of years and thus taking cash out of the business[Sim11]. An LBO exit takes the form of IPO where the company stocks are sold to the public, recapitalization of the business or get sold to another private equity fund. The scenarios take different risks like when it’s sold to another private equity they might object how a company was run. Possible Exit strategies in LBO Private equity fund will enter into LBO transactions with a view towards increasing a company value and realizing a positive return when it exits its investments. An ideal exist usually occurs between three to seven years after the initial investment. The exit strategy will include; Secondary LBO- the exit strategy entails a private equity selling the portfolio company to another private equity in a leveraged buyout transaction[Kap08]. A possible rationale for this type of exit is that the private equity and current management believe the buyer will add more value to the portfolio company as it goes to the next stage of development. The private fund may also sell if the portfolio company has reached its minimum investment time period and has already created a high return rate on its initial investment. Initial Public Offering (IPO) The exit strategy has a potential high return provided there is investor demand for equity and a stable favorable public market conditions. However, an IPO has high transaction costs and the public may view an exit strategy as a lack of confidence on the future prospects of the company. Trade sale A private equity realizes gains in a portfolio company through sale to a strategic acquirer. Strategic buyers’ intention is to hold acquisition over a long term period thus gaining a greater competitive advantage and market share[Axe09]. The trade sale usually command the highest sale price and as such is a preferred exit strategy option by a LBO investor. Potential returns Exit Enterprise &Equity values EBIT 2017 3855.1 Exit Multiple 0.9 Enterprise Value 3469.5 3rd year loans Loan B 0 High yield loan 383 Exit equity 3086.4 The potential returns at the end of the third year when the private equity fund exits the LBO of Qantas will be calculated from the initial investment of $2681.98 million to the exit equity of $3086.4 million. Cash return = Equity value at exit/ Initial equity investment =3086.4/2681.98 =1.15 Bibliography Nie08: , (Nielsen, 2008), Axe09: , (Axelson, 2009), Sim11: , (Simkovic, 2011), Kap08: , (Kaplan, 2008), Read More