Bankruptcy and Restructuring

1 Introduction

Companies get into financial distress (bankruptcy) for internal or external factors:
Internal factors include companies that are not able to pay interest payments, not filing
accounts on time. These can be cause by bad management or bad luck related to the
company, such as a product development gone wrong. External factors include
developments in oil prices, currencies, GDP, and crises. These can lead to a violation
of any of their covenants, which are rules imposed on them by bond investors. Then
investors can take the company to bankruptcy court, or…..

When a debt covenant is violated by the borrower, the lender has a range of alternative
responses, including the following (non-exhaustive list):

• Waive the violation and continue the loan

• Waive the violation and imposition additional constraints
• Require penalty payment
• Increase interest rate
• Demand immediate repayment of the loan
• Increase collateral
• Terminate debt agreement

There are several options to deal with bankruptcy. We look at these next:

1 Bankruptcy and Insolvency

1.1 Insolvency

The bankruptcy law indicates that a company is in a state of insolvency at the time it can not
regularly meet its enforceable obligations. The law establishes a system of strict liability in the
event that in the two following months when the insolvency situation has been known, no
voluntary bankruptcy has been filed. If after this period no voluntary competition is requested
and the creditors request the necessary competition, it is presumed guilty with the consequent
personal and patrimonial responsibilities.

For a company in distress financial situation, if it does not react urgently, as time passes it will
be more difficult to avoid a situation of financial insolvency.

The definition of distress situation is the imminent and serious danger to the survival of the
company
The Bankruptcy Law was born with the philosophy of preventing more than cure, wanting
companies in crisis to continue their validity through an agreement between creditors,
facilitating restructuring and resurgence, and only ultimately proceed with their liquidation.

The companies that are in this state of insolvency are those that can not normally comply with
their acquired debts or their obligations. The administrator who does not call a contest in this
situation, will cause the critical state of the company to become more serious, and will be
responsible for his bad performance, having to respond with his personal patrimony the
damage to the creditors.

The manager can even request the tender in a prudent manner, when, for different reasons, it
foresees that in the future the company will incur insolvency, or that the permanence and
continuity of the business activity will be complicated.

The main cause of business and commercial failures is due to poor management; This is
responsible for more than 50% of the cases that end like this. The main reasons for this
mismanagement can be translated into: exaggerated expansion, inadequate financial advice,
deficient working group, and high production costs. In summary:

• People who can apply for the contest: Any individual or legal entity

• When to apply: As soon as there are indications that the company will not be able to meet
the payments, the Voluntary Contest can be requested, allowing a better control of the
situation

• How the court acts: The judge declares the bankruptcy and designates the insolvency
administrators, who will be in charge of supervising the activity of the company. They compile
the list of creditors and an inventory of the assets, starting, in parallel, with an investigation to
see responsibilities or irregularities in the administration. Once the contest has been declared,
all executions against the debtor are halted, which will only pay off the debts at the end of the
process. The best alternative is to reconcile an agreement, for this the approval of half plus
one of the creditors is necessary. Otherwise, there will be a liquidation process, sale of all the
properties and division of what remains among the creditors.

1.2 Bankruptcy
The last option that must be taken in a company is to declare bankruptcy, since after starting
its liquidation process it is also the beginning of the legal death of the company.

Bankruptcy in the legal sense occurs when losses cause accounting net equity to be below half
the capital stock.

Types of bankruptcy

There are two main types of bankruptcy: voluntary and involuntary.

Volunteer: In any institution that is not a municipal or financial institution can initiate a
bankruptcy petition on its own behalf. The insolvency is not necessary to formally initiate the
bankruptcy voluntarily, nor the company must have incurred in one of the bankruptcy legal
acts.

Involuntary: Involuntary bankruptcy is initiated by a stranger, usually a creditor. An involuntary

bankruptcy petition against a company can be initiated if one of the following conditions is
met:

a) The company has past due debts for a value that exceeds its payment and liability
capabilities with third parties.

b) Creditors who can prove that they have unpaid claims added against the company.

c) The company has incurred an act of bankruptcy within the four months prior to the initiation
of the bankruptcy petition.

Priority of claims

It is the responsibility of the insolvency agent to liquidate all the assets of the company and
distribute the result among the holders of comparable claims. The courts have established
certain procedures to determine if the claims are comparable.

The order of priorities is as follows:

1. The expenses of administration of the assets in bankruptcy

2. The wages earned by the workers, for three months immediately prior to the initiation of
bankruptcy proceedings.

3. Taxes paid by the bankrupt company that are owed to the government or to any other
government subdivision.

4. Debts for services received within three months prior to the date of bankruptcy. Lease
payments are included in this category.

5. The claims of secured creditors that receive the proceeds of the sale of the assets. If the
product of these in the liquidation is insufficient to satisfy the guaranteed claims, the secured
creditors generally become creditors of the unpaid sum.

6. Claims of general and subordinated creditors. Claims from unsecured or general creditors,
unpaid claims from secured creditors and claims from subordinate creditors receive equal
treatment in full. The subordinate creditors must pay the necessary amounts (if this is the
case) to the priority creditors.

7. Preferred shareholders who receive a sum equal to the par value or assigned value of the
preferred shares.

8. The common shareholders that receive any remaining funds, which are distributed based on
an equity per share. If the capital of common shares has been classified, there may be
priorities.
1.3 Insolvency measurement: Altman's Z-Score
The formula Z score was published in 1968 by Edward I. Altman, who, at that time was
assistant professor of finance at New York University. The formula can be used to predict the
probability of a company going bankrupt in the next two years. The Z-Score is used to predict
corporate insolvencies and as a control measure to calculate financial problems in academic
studies.

In the initial tests done by Altman in 1968 it was found that Altman's Z-score achieved a 72%
success rate in the prediction of bankruptcies in the two years after the analysis, with a type II
error (false negatives) of 6% . In other subsequent tests covering three periods during the
following 31 years (up to 1999) the model obtained an efficacy between 80% and 90% in the
prediction of risk one year after the analysis with Type II error (classifying companies as broken
when not they are) between 15% and 20%

Since 1985 the Z-score has gained acceptance among auditors, managers, experts and data
systems used for the evaluation of loans. It is calculated as:

EBIT Net working capital

Z = 3.3 + 1.2
Total assets Total assets
Sales Market value of equity
+ 1.0 + .6
Total assets Book value of debt
Accumulated retained earnings
+ 1.4
Total assets

A score of Z less than 2.675 indicates that a firm has a 95 percent chance of becoming
bankrupt within one year.

However, Altman’s results show that in practice the area between 1.81 and 2.99 should be
thought of as a gray area.

In actual use, bankruptcy is predicted if Z  1.81 and nonbankruptcy if Z  2.99.

1.4 What should you do before a company in Crisis?

To get out of a financial crisis situation, you need to act fast:

1. Stop short-term outgoing cash flows (Cash Out)

2. Renegotiate debts, both long and short term. Renegotiation with suppliers and customers is
important; as well as long-term debts.

3. Present a feasibility plan to successfully and lastingly overcome the inability to meet their
payment obligations.
This often involves modifying the financial structure, moving maturities to longer terms than
agreed, selling non-productive assets, managing the cash flow, eliminating unprofitable
customers-products, etc. and even the modification of the commercial structure to
economically optimize the activity.

What is the analysis process?

1. Situation diagnosis

2. Emergency measures

3. Viability plan

4. Negotiation with third parties

5. Closing of the refloating

First steps: Situation diagnosis

As a first step, a diagnosis is made of the company's situation, in order to identify the
appropriate decisions and measures in crisis management.

Emergency measures

Emergency measures will be taken regarding the money supply (suppliers, customers and
stocks), financial entities, communication management, products, sales and expenses.

Viability plan

Practical tool to carry out the refloating of the company. This contains the analysis of the
company, which supports the recommendations, lines of action in the short, medium and long
term. It also includes the design of debt reconversion strategies and the restructuring of
agreements with the different stakeholders involved. suppliers, financial entities, employees,
clients, ...)

In a feasibility plan, the objectives are:

a) Achieve the viability of the company.

b) Plan the viability of the company in a horizon of 3 to 5 years.

c) Description of the market, existing or to be created, and financial justification of the means
chosen to sell the products or services therein.

d) Obtaining sustainable competitive advantage over time and defensible against competition.

e) Definition of corporate, departmental and individual viability objectives

f) Analyze the deviations from the objectives and act accordingly.

g) Instrument of internal and external communication increasing the motivation of the

members of the company
h) That managers have the necessary information at all times for the correct decision making
and achieve the desired growth

Negotiation with third parties

The objective is to transfer the Viability Plan and the new desired financial structure to the
banking pool of the client, suppliers, customers, institutional creditors, etc. If the Viability Plan
contemplates it, the sale of non-productive assets and / or non-assets to the activity will be
negotiated, in payment of the company's debts and investors will be searched for capital
increases or substitutions.

Debt Refinancing: Strategic considerations

• Understanding of the main risks and weaknesses of the refinancing and minimization /
mitigation of same.

• Project and contract risk: the need for maximum solidity and credibility.

• Financial Model

Closing of the Refloating

Formalization of the new financial structure negotiated with the financial system, commercial
suppliers, creditors in general, etc. by signing new contracts or renewing previous agreements.
Throughout the process there is the possibility of presenting to the Voluntary Creditors'
Contest. It has to define a control system (control panel) with which to control compliance.

2 Leveraged Buy-Outs (LBO)

2.1 Description of the LBOs

LBO stands for Leveraged Buy-Out and is defined as a transaction in which the promoter
acquires control of the shares of another company and uses a large amount of debt to finance
the purchase. (Between 50% and 80%). The assets of the target company are used as collateral
for the return of the debt used.

Since they began in the 80s of the twentieth century, companies of all sizes and industries
have been subject to LBO. However, due to the importance of the ability to repay the debt, the
target companies must meet a series of requirements to be candidates for an LBO. These are:

1. Low level of debt. Because they have to absorb the acquisition debt of the buying company.
2. Stable cash flows. In order to calculate the ability to repay debt and thus the maximum level
of leverage that can support.
3. Tangible assets that can be used as debt guarantees.
4. Growth potential.
5. Undervalued.
The Sponsors are normally private equity or managers, who want to take over a target
company. This LBOs usually takes the form of Triangular Merger, so they use the structure of
an SPV (Special Purpose Vehicle), which is generically called NewCo, which is the one that
collects the necessary financing to buy the target company. The NewCo is a newly formed
company that is used as a financial vehicle with the aim of buying another company, so this
vehicle will disappear when the merger is completed.

The debt issued by the NewCo is a mix between principal and subordinated loans. The
segment of debt with lower risk is called Senior, while the subordinate segment adopts several
names: Mezzanine or Mezzanine Debt. This can be exchanged into equity and is usually paying
a high interest rate (10% above risk free), and is of short maturity (about 7 years). The

With the free cash flows generated by the target company the debts contracted by the NewCo
will be amortized. This is so that the high interest rate is avoided. However, the cash might
have been better spent on investing in real projects! The assets and the cash can not be used
because they can not be used to amortize the acquisition debt. Article 81 of the Companies
Law of 1989, on Assistance

For the acquisition of own shares, the company may not anticipate funds, grant loans, provide
guarantees or provide any type of financial assistance for the acquisition of its shares or shares
of its parent company by a third party. How much time has to elapse between the purchase
and the merger so that it is not understood that there was financial assistance: three years.1

2.2 Advantages:
A successful LBO can provide a small business with certain advantages. On the one hand, it can
increase commitment and management effort because managers will have a greater
shareholding in the company. In a publicly traded company, managers usually have only a
small percentage of the common shares, and therefore can participate only in a small fraction
of the resulting profits. Likewise, when employees are involved in a leveraged purchase, and if
their participation increases, they become more involved in the success of the company.
Another potential advantage is that LBOs can often revitalize mature businesses. In addition,

1
Law 3/2009, of 3 April, on Structural Modifications of Commercial Companies in its article 35 "merger
after acquisition of a company with indebtedness of the acquiree" establishes that in case of merger
between two or more companies, if any of them would have incurred debts in the three years
immediately preceding to acquire control of another that participates in the merger operation or to
acquire assets of the same essential for their normal operation or that are of importance for their
patrimonial value, will apply following rules:
• The merger project must indicate the resources and the terms foreseen for the satisfaction by the
company resulting from the debts contracted for the acquisition of control or assets.
• The report of the directors on the merger project must indicate the reasons that would have justified
the acquisition of control or of the assets and that justify, where appropriate, the merger operation and
contain an economic and financial plan, with expression of the resources and the description of the
objectives that are intended to be achieved.
• The experts' report on the merger project must contain a judgment on the reasonableness of the
indications referred to in the two previous issues, determining whether there is financial assistance.
In these cases, the expert report will be necessary, even when it is a unanimous agreement of merger.
by increasing the capitalization of the company, an LBO allows it to improve its position in the
market.

2.3 Risk Capital

The Risk Capital (CR) is the activity consisting of the taking of participation in the capital of a
company that is not listed on an organized market in order to sell it in the future and obtain a
return.Venture Capital companies are divided into Venture Capital dedicated to newly created
companies and Private Equities dedicated to operating companies. The former assume much
more risk than the latter, which is why they demand greater profitability. In Spain, most of it is
Private Equity. The origin of the CR is in the USA after the Second World War. Europe came, via
the United Kingdom in the sixties.

2.3.1 Development phases:

When it comes to classifying investments it is not valid to look at size references. The usual
thing is to take as a reference the state of development of the company at the moment it
receives the resources. In the sector there is a fairly defined terminology, which distinguishes
the following types of investments:

• Seed (Seed): It is an investment in which there is technological risk. The contribution of

resources is prior to the start of the production and massive distribution of the product or
service. It is a contribution that can have very diverse destinations, ranging from the definition
of the product or service itself to the testing of a prototype or the development of a market
study. The required investment volumes are usually reduced in relation to those needed in the
following phases. Therefore, the investor must anticipate the future needs of resources and
potentials.
• Start-up: Financing the start of production and distribution. It participates in companies of
new or very recent creation, considering as such all those that have not yet begun to generate
benefits. In the United States, participation in the creation of society is usually defined as Start-
up, differentiating it from Other early stages (other initial phases) when the company is
already incorporated, but has not started to generate profits.
Investment in this phase has a long maturation period and it also usually requires the injection
of resources later to finance growth.

• Expansion: Financial support to a company with a certain trajectory to enable its access to
new products and / or markets, or the growth in which it is introduced.
These are investments of lower risk and greater volume. The lower risk is given by the
existence of historical data and references of suppliers, customers and financial entities that
considerably reduce uncertainty. However, the risk continues to exist due to the change in size
that is to be achieved. It receives the name of bridge financing (Bridge financing) any
investment of expansion that pretends the taking of participation in a company as a previous
step to its entrance in the stock markets.

• Acquisition with leverage (Leveraged / Management Buy-Out (MBO) and Management Buy-
In (MBI) These are purchases from companies in which a substantial part of the price of the
operation is financed with debt, partly guaranteed by the assets of the acquired company. ,
and with instruments that are halfway between the own and foreign resources (mezzanine
financing or mezzanine financing).

There are different modalities, such as the Management Buy-Out (MBO), in which the
purchasers belong to the management team of the company itself; or the Management Buy-In
(MBI), in which the purchasers belong to the management team of another company; or a
mixture of both: Buy-In Management Buy-Out (BIMBO). Reorientation (Turnaround) Financing
a change of orientation in a company in difficulties. It usually involves a change in the
management team, so some operations are included among the MBI.

2.4 The history of the LBOs

The first LBO in history was made by McLean industries when it bought the Pan-Atlantic
Steamship Company and the Waterman Steamship Corporation in 1955. In the McLean
agreement, it borrowed $ 42 million and got 7 million more by issuing preferred shares. When
the agreement was closed, 20 million of the Waterman box had been used to pay off 20 million
debt.

Although in the 60s it was used by large investors to buy companies, the LBO boom came in
the 80s.

Some authors attribute the invention of the LBO to Kohlberg, Kravis, Roberts (KKR). More
specifically to Jerry Kohlberg. This seems somewhat exaggerated, but it is true that, although
the invention of the LBO can not be attributed to KKR, it can be said that they perfected it. The
most famous operation carried out by KKR was the acquisition of RJR Nabisco.

2.5 Example:
In the 1980s, RJR Nabisco was a large conglomerate, which mixed its activity in the food sector
with the production of tobacco. The company, then led by Ross Johnson, was the result of a
long succession of mergers and acquisitions. The most important products he made were Oreo
cookies and Winston and Camel cigarettes. In the 1980s the tobacco industry was threatened
by new health regulations and reports that accused tobacco of increasing the incidence of lung
cancer.

In October of 1988 an investment group led by Ross Johnson put on the table a proposal of
LBO for 75 dollars a share, which represented 17,000 million dollars. With this operation, the
company stopped quoting on the stock market and the managers secured their extraordinary
position and bonuses. Once out of the orbit of the stock market they could restructure the
company.

To finance this purchase operation, Johnson had the issue of high yield bonds (with ratings
below BBB), in the hands of Shearson Lehman Hutton. But the proposal encouraged other
bidders to make their offers: The first to present a procurement counteroffer were KKR,
followed by Forstmann Little and First Boston Group.
Based on financial analysis and estimates, each bank and financial company bet more and
more, one after the other, with the idea that the value of RJR Nabisco's businesses, once
separated, was higher than the initial offer of 17,000 million euros. initial dollars.

From the start, the management team had an advantage because it was the first to make the
offer and controlled the company's information. The rest of the bidders did their best to
understand the figures that would make a leveraged purchase possible and put a target price
on the entire business of RJR Nabisco. After an auction process that ended on November 28,
1988, the conglomerate was acquired by KKR for 24,880 million dollars, at 109 dollars per
share. For shareholders, this represented a 45% profit over the initial offer that Johnson's
group had made.

2.6 The LBO scheme

The typical scheme of an LBO is the following (also refer to diagram below):

1. A Private Equity (PE) Venture Capital Fund is set to buy into a target company and forms a
Special Purpose Vehicle called NewCo. Managers can also be involved as in a Management buy
out (MBO). These are the raiders or buyers.

2. NewCo gets into debt with a group of banks and investors who provide about 70 - 80% of
the funding in loans, senior debt, and Mezzaninne debt (which can be converted into equity).
Interest rates are high, so it makes sense for the debt to be short term. With this money, the
raiders buy part of the shares of the target company from the old shareholders.

3. Once purchased, the two companies merge (the NewCo and the target company) and
recasts the debts of the NewCo with the target company

4. After a period of time, between five and ten years, the Company or the Venture Capital
Fund, after having financially improved the resulting company, sells it.
Generally, companies that are subject to an LBO are not usually listed on the stock exchange,
or in their case, they frequently stop doing so to be managed by the buyers. Later they usually
return to trading in the markets, but after having had a more professional management. These
companies are usually family businesses, in which the founder is about to retire or leave the
company, or companies that require financing for their expansion projects.

Within the operations of LBO, mention must be made of the operations of Secondary Buy-Out,
which occurs when a company or venture capital fund has acquired a company and over the
years decides to sell it to another venture capital company.

LBO operations have contributed to the development of different debt and securitization
instruments. The key to an LBO operation is its financing, which is carried out in installments.
The first of these is the capital contributed by investors. In most operations, this represents
around 30% of the total funding of the LBO. When the SPV acquires the target company, it is
the owners of the equity that come to control this company; as the promoters are those who
have acquired this equity, they will be the ones who manage the target company.

Once the capital of the SPV is completed, an objective is sought. At the moment in which it is,
the operation is organized and the promoters seek financing through debt. The banks are
responsible for providing financing at first, and more or less quickly, to distribute the debt
among other investors, either by syndicating the loans, or by selling it to funds or other
investors, such as securitization products. , type CDO.

The debt of an LBO operation takes the form of Senior debt and subordinated debt. The Senior
Debt has as collateral the assets of the target company and, normally, it is divided into several
tranches, depending on the type of amortization and the term. Section A has a fixed
repayment plan and a term between six and seven years. Tranches B and C usually have
amortization at maturity (bullet amortization) and longer maturities. Subordinated Debt can
take the form of Mezzanine, Second Lien and Payment-in-kind-notes. The term of the
Mezzanine Debt usually exceeds five years and is amortized at maturity. The SecondLien Debt
is a hybrid between the senior and the mezzanine, and the rights of its holders, in the case of
liquidation of assets, are placed behind those of the senior. The so-called pay-ment-in-kind-
notes (PIK) are debt that carries an option for the holder to be paid with bonds or stocks,
accumulating cash and principal of the debt. The cost of indebtedness is directly related to the
type of debt issued, taking into account that the cost of the different tranches is determined
by the risk of the same.

The structure of the financing of LBO's operations depends, ultimately, on the volume of each
operation and the peculiar characteristics thereof, without losing sight of the fact that, in
Europe, investors show a high preference for the Senior.

Bank financing, at the beginning of an LBO operation, sometimes takes the form of bridge
loans. In this way, it is usual for banks to become direct suppliers of financing through loans at
the beginning of the operation. In this type of operation, the lenders obtain the agreed
interest on the debt plus the commissions agreed upon. The cash flow of the company that is
the object of the operation provides the resources to face the debt burden.
The operations of Leveraged Buy Out are considered not very liquid and the investment made
in them usually has a horizon between five and seven years in practice. The divestment in
these operations is carried out by selling the assets of the target company at the best possible
price, either through its sale to third parties, or through a public offering of shares if the
company is not quoted on the stock exchange, or through its sale to other venture capital
funds. (secondary buy-outs).

The degree of leverage of private equity operations is very high. Sometimes, the leverage
increases with recapitalization operations, which sometimes allow increasing dividends for the
capital providers. The profitability of these operations is based, to a large extent, on the
difference between the purchase price and the sale price of the company that is the object of
the operation, and, given the low costs of the debt, there has been an incentive to leverage.

2.7 When does an LBO make sense?

Imagine that a company has $800 million in assets, and $800 million in equity. A LBO raider,
such as a private equity company, can borrow $ 400 to buy half the shares and take control of
the company. The money can come either from a syndicate of banks, by issuing junk bonds, or
by issuing “Mezzanine debt”, which is risky debt that can be converted to equity. Actually the
raider will create a special purpose vehicle (SPV) that will borrow money first, and then use it
to buy the target. The raider does not need personal money to do the deal!

Balance sheet
(in $ millions)

Assets Liabilities

800 old Debt 0

Equity 800

800 800

The deal makes sense if the raider sees more value in the assets, perhaps by better
management. Assume the raider can get $1300 million from the assets ($500 are synergies).
Then the new balance sheet looks like:

Balance sheet (in

$ millions)

Assets Liabilities

800 old Debt 400

500 Synergy Equity 900

1300 1300
Notice how the equity has increase to $900 million, and since the raider owns half, his shares
are worth $450 million. These came from nothing, no personal investment!

We have assumed that only half the company was purchased, but it could be that up to 100%
is bought, so more borrowing needed. We have assumed that no premium was paid, but it is
common to have a premium of up to 40%, so less profit for the raider. For bondholders, an
LBO is bad news: if there were current bonds existing, because after the operation, debt will
increase! Also it is possible that the raider uses extra future cash flows from the company to
pay back debt, not for investment. As debt falls, the value of his equity will rise if assets are
unchanged.

3 Restructuring

3.1 Spin-off
A Spin-off is the process by which a pre-existing entity creates a subsidiary from another,
which breaks away from the former into a separate company. The current shareholders of the
parent company receive shares in the subsidiary, while the main company does not usually
keep shares itself (although sometimes up to 20% are kept). Control is now in the hands of the
subsidiary. Importantly, the parent company receives no cash. In addition, since new shares
are issued, there is dilution.

The reasons for a spin-off can be the following:

1. The retention of talent: It is about not letting out valuable employees, of becoming partners
in new business projects

2. New business niches: If the company has found a new economic niche. And although initially
it is understood that they can be developed within the company, at some point it is possible to
find a more appropriate framework outside of it, its corporate culture, its structure, etc.

3. Improvement of management: There are organizations that consider that it is managed

better from closer, in smaller units.

4. Business survival: spin-offs are common in business crisis processes. The company is
scrapped trying to save the salvage, sometimes taking place part of them by the former
managers or employees (MBOs).

5. Tax, commercial or labor planning: For fiscal reasons, consolidation of accounts, application
of agreements or certain labor regulations.

6. Financial strategy: it is about raising funds to develop a specific business unit without this
implying entry into the matrix.

3.2 Carve-outs
Equity Carve-Out are also known as IPO Split-Off is a way of business reorganization by which a
company creates a subsidiary and takes it to the stock market (IPO) while maintaining control
of the management. It only offers part of the stock on the stock exchange, which is offered to
new investors. Therefore, and importantly, the parent receives cash while also retaining
control. Generally, 20% of the company is offered in IPO.

The advantage of this type of restructuring is that, if the parent wants to divest the subsidiary,
the IPO gives an idea of the value of the company.

In the end, it is a financing system that is used at times when other ways of obtaining financial
resources encounter serious difficulties. Although the partial sale is the most frequent,
retaining control of said subsidiary, the sale of all the shares owned may also occur. In this
way, shareholders are atomized and the resources needed by the parent company to continue
with their activity are obtained.

The reason for carrying out an operation of this type is usually the belief that the value of the
separate subsidiaries is greater than that of the business group as a whole. Therefore, the
group manager can try to sell part of its subsidiaries to generate a value that the market would
not recognize if it kept all the capital of the subsidiary under the parent's ownership.

Sometimes, once the company has gone public, the parent company decides to distribute the
shares that it still has in its portfolio among its shareholders, considering this distribution as a
substitute for the annual dividend. The subsidiary is no longer controlled by the parent
directly, but is still controlled by the "hard core" of the parent company.

Examples of equity carve-out operations include American Express in 1987 when it sold 39% of
Shearson Lemon, or DuPont in 1998 when it sold 30% of Conoco. An example of this operation,
with subsequent distribution of the shares of the subsidiary is also made in 1998 by Cincinnati
Bell when it sold 15 million shares of its subsidiary Convergys, and then distributed among its
shareholders the remaining 137 million shares of said subsidiary .

3.3 Asset sale or Divestiture

The sale of assets means that companies will relieve their operations of items valued for cash
or other compensation. While retail companies will often sell inventory assets to generate
income, accounts receivable, investments, property, equipment or facilities are also salable
assets.

Companies will usually sell fixed assets when they do not have more value for the company.
For example, a manufacturer could sell the machine that produces players once it reaches the
mark of 10,000 units produced. After this point, the value of the equipment could decrease
significantly.

Selling fixed assets could result in an extraordinary profit or loss that companies must report
on their financial statement. This is usually written against net income, increasing or
decreasing profits. Reporting these sales as extraordinary ensures that individuals understand
that the item will not consistently use the company's operations.
Example 1: More complicated LBO:
Imagine that a company has $500 million in assets, and $500 mln in equity. An LBO raider, such
as a private equity company, can borrow $ 250 mln to buy half the shares and take control of
the company. The raider will create a special purpose vehicle (SPV) that will borrow money
first, and then use it to buy the target. The raider does not need personal money to do the
deal!

The initial balance sheet is below.

Initial B/S
(in $ millions)

Assets Liabilities

500 Old Debt 0

Equity 500

500 500

1. Assume the raider can increase the value of the assets to $700 mln (i.e. $200 mln are
synergies). How does the new balance sheet look like?

2. What is the value of equity of the raider?

3. What is the value of equity of the previous shareholders who did not sell to the raider? Did
they make the right decision?

4. What is the minimum synergies required to make the deal beneficial for shareholders who
do not sell?

5. If the raider buys 50% of the company, but paid by investing own equity, what is the value of
equity after the deal? (assume $200 mln synergies).

6. If the raider buys 100% (not 50%) of the company, paid by borrowing, what is the value of
equity after the deal? (assume $200 mln synergies).

7. If a premium of 20% was offered to old shareholders, all paid in borrowing, then what is the
value of equity (assume $200mln synergies).
 Updated B/S
(in $ millions)

Assets Liabilities

500 Old Debt 250

200 Synergy Equity 450

700 700

Note that the equity is owned half by the old shareholders who did not sell, and half by the
raider.

2. The value of equity of the raider is half of 450 = 225. Remember no equity was invested by
the raider.

3. Value of equity of the previous shareholders who did not sell = half of 450 = 225, so a bad
decision not to sell for 250!

4. if synergies were 250, then equity = 500, so half = 250 (no loss made).

5. The value of equity is half of 700 = 350 (but raider had to also invest 250 in equity, so net is
100). Therefore borrowing is better!

6. Borrowing will be 500, so the value of equity is 200

7. pay 300 in debt, so half equity = 200 = half of (700-300)