Leveraged Share Repurchases (Buy-Backs): An Illustrative Example

One reason many writers discuss leveraged share repurchases in general terms only is that they involve a company’s current income statement and balance sheet, as well as a pro forma balance sheets and income statements. Further, to see the impact on a company and its shareholders, the changes between the existing financials and the pro forma financials must be analyzed.

This post presents an example of a leveraged share repurchase that will help bring the noted benefits for both a company and its owners, both selling and remaining, into clear focus.

Leveraged share repurchases can accomplish a number of beneficial results for a company, its selling shareholder(s), and the remaining owners:

Selling Owners. Leveraged share repurchases can provide opportunities for partial or total liquidity, create a means for diversification of wealth, and provide for liquidity on a tax-advantaged capital gains basis.
Company and Remaining Owners. Leveraged share repurchases can enhance a company’s return on equity, increase the expected growth in value for its remaining shares, provide a dividend pickup for remaining shareholders, and enhance the price/book value multiple for its valuation. Such transactions can also serve to optimize a company’s capital structure and, importantly, help to keep management attention on repaying debt and managing the company for higher returns.

We learned of these benefits in the last post, in which a leveraged share repurchase was described as An Alternative for Personal Liquidity and Ownership Transition.

In spite of efforts to be brief, this is a lengthy post. However, it is well worth reading and sharing with your fellow owners and advisers.

We will now look at an example leveraged share repurchase in as simple and straightforward way as I know how. The example is meant to be like a real company, like yours, perhaps. Think about the example and try to relate its lessons to your own company and personal situation.

The Situation

Sample Company (“the Company”) has sales for the most recent year of $250 million. Your company may be smaller or larger. Sample Company manufactures a wide range of products for the extraction industries, broadly defined, and some of its products are branded. In spite of its significant size for a private company, the Company is a relatively small player in its overall industry. The situation, before consideration of a leveraged share repurchase, looks as follows:

Sample Company is a profitable C corporation, with EBITDA margin (earnings before interest, taxes, depreciation, and amortization) of just under 10%, and a net profit margin, after taxes, of 4.4%. For perspective, EBITDA is $24.2 million and net income is $10.9 million.
Return on equity for the last twelve months was 8.6%, and has been trending downward in recent years as prior leverage has been paid down and as attractive reinvestment opportunities have been limited.
The Company has $16.4 million of interest-bearing debt, which is offset by $20.5 million in cash. The current ratio is 4.4x, suggesting that there is substantial liquidity on the balance sheet.
Working capital as a percentage of sales is about 32%. For perspective, the median working capital to sales ratio for the public companies most similar to the Company is about 20%.
The balance sheet is funded with $126 million of equity, which comprises 72% of assets.
For purposes of this discussion, we have valued the equity of the Company at $149 million based on an EBITDA multiple of 6.0x, which is the median multiple for the group of public companies I mentioned. In arriving at this value conclusion, we have subtracted debt from the MVTC (“market value of total capital”) and added back the cash.
The Company is currently paying an annual dividend totaling $3.0 million, which represents a dividend payout ratio (from net income) of 27.5%. The dividend has been at or near this level for several years.

Based on this description, and the financial analysis that made it possible, Sample Company is an attractive candidate for a leveraged share repurchase transaction. The founding shareholder, who owns 30% of the 1.0 million shares outstanding, is ready to retire, and his interests have been gravitating towards working with several charities. He is willing to sell his stake to the Company if a reasonable transaction – for him and the Company – can be worked out.

Preparation for the Transaction

We conducted a detailed financial analysis on behalf of the Company’s board of directors outlining the parameters of a transaction that met the goal above – reasonable for both the Company and the selling shareholder. Together with the Company’s CFO, we made a comprehensive presentation to the Company’s primary lender regarding financing for the potential leveraged share repurchase, and were favorably received. Financing was available on reasonable terms.

The Company’s attorney reviewed the transaction and opined that there were no issues with state law and that the Company’s board was duly authorized to engage in a transaction. The Company’s CPA, in consultation with their national tax office, determined that there were no disadvantageous tax consequences to the Company, and that the sale by the retiring owner should be treated as a capital gains transaction.

Transaction Assumptions

Based on the above, the key assumptions of the leveraged share repurchase can now be summarized:

The transaction is for the 30% block of shares being sold by the retiring owner. We have to make a decision regarding the use of cash on the Company’s balance sheet, which would reduce the need for borrowing. Given the Company’s ongoing profitability, ability to generate cash, and the availability of a line of credit, the decision was made to use all of the cash in the transaction.

The effective valuation multiple was 6.0x EBITDA. The board of directors requested that we formalize our initial calculations in the form of an appraisal for documentation of the transaction, which we did.

The current dividend level is $3.0 million on an annual basis, and the decision was made to leave the dividend intact at that level.

In a transaction, when cash is used, there is a loss of earnings on the former balance, so the pro forma recognized that there would be no interest earnings on the Company’s prior cash balances. Similarly, the assumed rate on all debt, based on the discussions with the bank, is 6.0%. All pro forma debt is charged at this rate, so interest expense will increase by the amount of additional debt.

The Company’s accountants determined that there should be no change in the blended federal and state income tax rate following the transaction, so the effective rate of 36.2% was used in our pro forma calculations.

We conducted two sets of pro forma calculations. The first valued the business at the same multiple of 6.0x EBITDA as the initial pricing. The second allowed for an increase of the price/earnings multiple from the calculated multiple of 10.6x net income in the first pro forma up to 13.7x net income, which was the pre-transaction p/e multiple. This assumption provides for the potential that the Company’s valuation might rise in favor of the transaction, or at least, provides an indication of future benefits of more rapid growth as the new debt is paid down.

Transaction Mechanics

As noted above, the Company’s equity was initially valued at $149 million. The 30% block is worth $44.8 million at that value, so we need to finance that amount. The financing is summarized in the table below:

The $44.8 million purchase price will be financed with $20.5 million of existing cash and $24.3 million of additional debt. In actuality, the existing debt of $16.4 million was refinanced, together with the new debt, providing for total long-term borrowings of $40.7 million, as indicated above.

It was important to the bank and the Company’s board of directors that there be a clear understanding of the impact of the transaction on the Company’s balance sheet. We provided the summary balance sheet ratios as part of the more detailed analysis:

Where the table suggests that the pro forma results on the right are reasonable, we made comparisons with the group of guideline public companies or with other industry metrics to reach those conclusions. The bottom line is that the Company is reasonably capitalized following the transaction, which met a concern of all parties.

We’ve examined the balance sheet, so now we need to see what impact the transaction has on the Company’s income statement. Since this is a financial transaction, there will be no impact on the Company’s sales or normal operating expenses. Interest income and interest expense, however, will be impacted, as will earnings and the outstanding number of shares.

As seen above, Pro Forma #1 indicates there is a 9.5% reduction in net income, which falls from $10.9 million actual to $9.9 million on a pro forma basis. The reduction in earnings is the result of the loss of interest income and increased interest expense, which is offset somewhat by the tax benefit of higher expenses and, therefore, lower income taxes. Note, however, that the number of shares outstanding was lowered from 1.0 million to 700 thousand, or some 30%. The difference in these two percentages, where the share reduction is greater than the lower earnings, lies at the heart of the financial engineering qualities of leveraged share repurchases.

We all know there is no such thing as a free lunch. In paying for the shares in the leveraged repurchase, the Company’s value will be reduced dollar for dollar, unless that reduction is offset by favorable market perceptions of the repurchase. We see this reduction below.

So, the Company has a lower pro forma market value of equity, which falls from $149.4 million to $104.6 million, or 30%. That makes sense, because the difference is the very same $44.8 million that is paid out in the transaction to the selling owner. So with this sharp reduction in the market value of the Company’s equity, what are the benefits?

Transaction Benefits

At the outset, we discussed a number of potential benefits from leveraged share repurchases. We are now in a position to see these benefits for Sample Company and its shareholders. First, we know that the retiring shareholder is walking away with $44.8 million in gross proceeds which will be taxed at capital gains rates. The benefit to him of achieving total liquidity and the ability to diversify his wealth are readily apparent. What about the other promised benefits to the Company and to the remaining shareholders?

Benefits to the Company

As result of this leveraged share repurchase, Sample Company will experience a number of favorable benefits, which are offset somewhat by transaction impact on pro forma results. Two readily apparent benefits of the transaction are the enhancement in return on equity and enhancements achieved by a more optimal capital structure. Equity is being substituted for lower cost debt, which decreases the overall weighted average cost of capital (WACC), which reflects the portion of debt and equity present in the Company’s capital structure. What this latter benefit means is that the shareholders can benefit from the transaction at a reasonable, or acceptable increase in risk.

The table above shows that while the net margin is reduced by 9.5% (from actual 4.4% to 3.9%), return on equity rises from 8.6% to 12.1%. In percentage terms, that’s more than 40%. This leveraged share repurchase “engineers” an increase in return on equity from single digit levels to respectable double digits. The cost, in terms of leverage, are reasonable. Note that the transaction had no impact on EBITDA, which remains unchanged post-transaction. Assuming reasonable leverage, a leveraged share repurchase will have no impact on the operations of the business. Excessive leverage, on the other hand, would significantly increase risk and could potentially impair normal operations and the ability to generate sales and earnings.

Interest coverage (EBITDA/Interest Expense) is a healthy 9.9x post transaction, and the important measure of Debt/EBITDA remains conservative at 1.68x. Remember that the valuation multiple is 6.0x EBITDA, so there is substantial coverage here.

The company’s Interest-Bearing Debt/Equity ratio rises from a nominal 13.0% to a reasonable 50.2%. We saw in a table above that the ratio of Debt/MVTC, which is the most relevant measure, is only 28% post-transaction. So the “cost” of the transaction for Sample Company in terms of increased leverage and risk is acceptable. So there are clear benefits to Sample Company.

Benefits to Remaining Shareholders

We now turn to the important potential benefits of leveraged share repurchases for the remaining shareholders of the Company. If the owners of Sample Company are going to provide the retiring owner with $44.8 million and no further risk associated with the Company, there needs to be clear and compelling benefits to the remaining owners. This was an important consideration for the board of directors, of course.

The pro forma results of the leveraged share repurchase have the following key results or impacts for remaining owners:

We already mentioned the reduction in shares outstanding. That is an important driver of the transaction results. Since the Company was valued at $149.41 per share ($149.4 million divided by 1.0 million shares), and since the selling shareholder was paid that same amount, the pro forma value for remaining shareholders is the same, or $149.41 per share. This assumes the Company is valued at 6.0x EBITDA and that the post-transaction price/earnings multiple falls from 13.7x to 10.6x. We will finish this analysis with a look at what happens if there is any price/earnings multiple expansion as result of the transaction.

From the remaining shareholders’ viewpoint, we make the following additional observations:

With 30% fewer shares outstanding and with pro forma net income falling only 9.5% (see above), earnings per share (EPS) increase from $10.90 (or 29.3%) to $14.09 per share. That’s a benefit worth thinking about!
Given the assumption that the Company’s dollar dividend will remain constant at $3.0 million, and that the dividend will be spread over 30% fewer shares, the dividends per share for remaining owners rise 42.9% to $4.29 per share (from $3.00 per share). Note that the pro forma dividend payout ratio remains reasonably conservative at 30.4%, reflecting only a modest increase from actual. The dividend payout ratio for the guideline public companies we examined reflects a median of 44% by way of perspective.
The dividend yield to remaining owners rises from 2.0% to 2.9%, which in itself is a significant increase in annual returns.
Note that while the book value per share decreases modestly, the more important ratio of book value per share increased from 119% to 129%. There is more intangible asset value attributable to each post-transaction share than before.
The highlighted box focuses on a 10% interest as representative of any interest in the Company. As with the value per share noted above, the post-transaction value of the assumed 100 thousand share block remains the same, or $14.9 million. That, however, masks two key benefits of the transaction.
The 100 thousand shares reflected a 10% ownership interest in the company pre-transaction. After the transaction, the same 100 thousand shares represents 14.3% of the equity ownership of the Company. This means that for every dollar of future increase in equity value, this remaining block will capture 14.3% of it, rather than 10.0%. This is an substantial benefit of the transaction.
To put the impact on dividends in a more personal perspective, the initial 10% block received $300 thousand in annual dividends. Post-transaction, the same 100 thousand shares (14.3% of the total shares) will receive $429 thousand in annual dividends.

It is clear, I think, that the proposed leveraged share repurchase is favorable from the viewpoint of remaining owners. Their modestly increased financial risk of exposure to the Company is well-offset by enhanced returns, increasing current dividend income, and a greater relative share in future appreciation.

Increased Focus on Shareholder Returns

An interesting thing about leveraged share repurchases like the above example is that they do tend to focus management attention, not only on repaying debt, but also on continuing to achieve satisfactory returns for shareholders. They tend to keep management attention on maintaining a more optimal capital structure, as well.

There is a tendency among many closely held and family businesses to retire debt and accumulate excess assets when reinvestment opportunities are not very attractive. There often is a reluctance to pay dividends, or even substantial dividends, for a variety of reasons, most of which are damaging to shareholder returns (yes, even for the controlling owners who are reluctant to pay dividends). If the ownership of a company talks itself into engaging in a leveraged share repurchase, chances are that its management and owners will continue to be focused on achieving acceptable financial returns from the business following the transaction.

While management is focused on repaying debt, they will also notice that the repayment of debt, absent significant reinvestment opportunities, will tend to dampen return on equity. This will place attention on the potential for future leveraged share transactions or the implementation of a dividend policy to provide current returns to owners. With a combination of these policies, management and the board can “engineer” reasonable returns for investments in a business, even in a slow growth environment.

Future Appreciation Potential

The pro forma analysis thus far assumes there is no impact on equity value as result of the leveraged share repurchase. Often, when public companies engage in significant share repurchases, there will be an increase in share prices. For this to happen, there has to be an expansion of the valuation multiples from pro forma levels (as noted above).

To provide an indication of the potential price appreciation, we have assumed in Pro Forma #2 that Sample Company’s original price/earnings multiple of 13.7x would be maintained – or, more realistically, that it might be achieved over time with improving perceptions of management’s performance. The entire pro forma analysis has not been reproduced here. Rather, we are focusing on the potential for price appreciation that is often seen in public companies following significant share repurchases.

Note the following from the table above:

In Pro Forma #1, the Company was valued the same on a total capital basis as in the actual pre-transaction situation, or at 6.0x EBITDA. This means that the MVTC was unchanged (at $145.3 million). The reduction in equity value for Pro Forma #1 reflects the impact of reducing MVTC by the pro forma debt amount, and equity value was lowered.
In Pro Forma #2, the potential range of price increase is reflected by maintaining the original 13.7x pre-transaction price/earnings multiple of 13.7x. To reach this value, the EBITDA multiple was increased to 7.3x, and the market value of equity rises to $135.2 million, or $193 per share (from$104.6 million in Pro Forma #1). This is a 29% increase from Pro Forma #1, and is highlighted in brown above.
The price/book value multiple increases from 129% in Pro Forma #1 to 166% in Pro Forma #2, so if any multiple expansion occurs, selling shareholders will benefit from higher intangible asset value per share.
The value of a given block (or share) increases 29% from either pre-transaction or Pro-Forma #1 because the value per share remained unchanged in Pro Forma #1.

I would not represent to the board of directors or the shareholders of Sample Company that its future share price would increase because of the leveraged share repurchase. However, a valuation analyst looking at the post-transaction enterprise could, indeed, have a more favorable view of the Company, its management, and its outlook. If that more favorable view reflected more favorable comparisons with guideline public companies in terms of return on equity and expected growth in earnings, then a higher EBITDA multiple might be justified. This would be particularly true if the Company’s management took steps to assure a maintenance of the improved return on equity on a going forward basis.

Conclusion

Leveraged share repurchases are a tool of corporate finance. They are used extensively by public companies and by private equity firms. And, the leveraged share repurchase tool is available to closely held and family business owners. I hope that business owners who read this post will think about this concept in terms of their own companies. Talk about this concept with your fellow owners and board of directors. Provide a link to the post to your key advisers. Begin the conversation if it is appropriate for you. The timing is good:

Valuations for most mainstream private companies are at reasonable levels such that transactions can occur that are beneficial for selling shareholders, companies and remaining owners.
Interest rates remain at relatively low levels, and lower interest costs enhance the benefits of leveraged share repurchases.
Performance for many of our closely held clients is reasonable and their outlooks are decent in light of current economic forecasts.
Many private companies have waited too long to engage in transactions of this nature, and many aging owners need to sell out or to begin to diversify their holdings. They and their companies need to take action.

Business advisers who may read this post, feel free to share with your clients. You will be providing an excellent service to bring this idea to the forefront in appropriate situations. The four posts linked below continue the highly relevant to discussions regarding ownership and management transitions. Because that is the thrust of this post. The leveraged share repurchase can be an effective tool when planning for ownership transition in a closely held or family business. However, it is not the only tool.

As always, if you wish to talk with me about any business or valuation-related matters, or to discuss management or ownership transition issues in complete confidence, give me a call (901-685-2120) or email (mercerc@mercercapital.com).

Until next time,

Chris