Going With The Flow

Leveraged buyouts based on cash flow, rather than assets, are what's hot.

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At 54, Alfred L. McDougal was still having a good time running his $28-million Chicago textbook company, but his co-founder and the other 11 original investors were ready to cash out. To get the funds, they could have sold McDougal, Littell & Co., but that would have left McDougal out in the cold. They could have gone public, but they felt that that would be an expensive hassle and, besides, the risk was high that within a year the company would become a takeover target for one of the mammoth publishers. Again, McDougal might be left out in the cold. They left it up to him to find a solution, and the one he came up with gave him control of the company and gave them their money. He arranged a leveraged buyout calculated not on the company's assets, which were limited, but on its cash flow, which was strong.

While cash flow-based LBOs have been around for several years, their use has mushroomed recently. PruCapital Inc., for example, The Prudential Co. of America's corporate capital group, arranged 80% of the LBOs in its current portfolio in just the past two years. More than half of these are in the Midwest. The beauty of cash-flow LBOs for such low-asset companies as McDougal's is the amount of money that can be raised. In asset-based LBOs, a lender looks at the book value of a company's assets -- inventory, fixed assets, receivables -- and lends against them to approximately 80% with the loan secured by those assets. Cash-flow lenders base their loans on a projection of revenues and earnings, and can provide as much as three times book value, usually in a combination of debt and equity financing.

Most companies that use this sort of financing are looking to transfer the business from one generation to the next (resolving estate tax problems in the process), or from one founder to another, as in the case of McDougal. Often the financing is set up to provide the new owners not only with the purchase price, but also with additional capital to undertake expansion plans. An example is Consolidated Stores Corp., a Columbus, Ohio-based "close-out" retail chain. Through a cash-flow LBO, some of the original shareholders sold their holdings in the company to the remaining original shareholders and to some venture capitalists. They used the capital raised beyond the purchase price to enter an aggressive growth phase. Consolidated expanded from 40 stores in the fall of 1984 to 104 by November 1985. Last year, with the business well established and sales growing, the company went public, and ranked ninth on INC.'s list of best-performing new issues of 1985 (see INC., February, page 86). Another major user of cash-flow LBOs are managers who want to buy profitable divisions being cast off by larger companies.

Part of the reason for the flurry of activity these days in cash-flow LBOs is that while financiers will consider almost any type of company that can demonstrate strong cash flow, definite projections, and good management, they do have an ideal profile in mind. And it's one that happens to fit many of the companies founded in the Midwest in the 1950s, whose founders now want out. Star Forms Inc., a company in Moline, Ill., is typical.

Star Forms was founded by John H. Harris in 1959, first producing general business forms, but since the mid-1970s specializing in continuous-feed forms and paper. With the boom in personal computers, sales, which had been growing steadily, began to soar -- shooting up from $20 million in 1979 to $100 million in 1985. Last year, at age 70, Harris decided to cash out, and his son Hunt, who had been active in the business since 1971, looked for a way to buy out his parents and siblings. Like McDougal, the Harrises decided against either going public or selling Star Forms. They looked into traditional lending sources, but found that the book value wouldn't gave them what they knew the company could provide in earnings. Then they turned to PruCapital, and arranged a cash-flow LBO in May 1985 that brought them about three times the book value of Star Forms.

Star Forms was in many ways a perfect candidate for PruCapital. It was a stable company with high revenues and high earnings, yet low fixed assets -- exactly what any cash-flow lender would like to see. Even though the founder was leaving, the company's management was solidly in place. And it was the right size. According to Marc J. Walfish, the regional vice-president of PruCapital in Chicago, the firm favors transactions in the middle market, companies with purchase prices from $10 million to $150 million. PruCapital finds smaller deals less appealing because of the expense involved in arranging any LBO, regardless of size. And there aren't that many closely held companies in the region that top $150 million.

To help determine Star Form's value, the first thing PruCapital asked to see was the company's audited financial statement for the past year and a financial history for the previous four years. While that's a common stipulation among cash-flow lenders, formal audits are not necessarily a rigid requirement. Each deal is individually structured, and much depends on how the lender views the company's strengths and weaknesses.

While PruCapital had Star Forms prepare a five-year business plan, "the rest of the due diligence on the industry and markets is done by PruCapital," Walfish explains. "In evaluating them, we look first for good cash flow, and for us that means that it shows the ability to pay off between one-third and one-half the debt portion in a five-year period.

"Second, we look at earnings, because they convert to cash flow. Price is calculated as a percentage of earnings, and averages between four to six times operating earnings before interest and taxes."

Both the Harrises and PruCapital declined to discuss the specifics of their deal, but, according to Walfish, PruCapital's cash-flow LBOs generally take the following form:

* About half of the debt financing is arranged at a fixed rate. The rate is a function of the risk, and currently at PruCapital averages from 3% to 4% over long-term Treasury securities on a 10-to-15-year loan.

"While the rate is usually a bit higher than the conventional loan rate, you must remember that a company involved in this kind of financing is a highly leveraged, not a conventional, borrower," says David Katz, an associate investment manager in the Chicago office.

* The remainder of the debt financing is arranged on a floating rate.

* A "blind spot" is often applied on the fixed-rate portion of the loan for three to five years. Principal payments are not required during that period, so that the burden of the financing doesn't hit the new owners all at once.

* PruCapital takes equity in the form of nonvoting common stock, and its average debt-to-equity financing is in the neighborhood of 10 to 1.

PruCapital's share of stock has been as low as 20% and as high as 70%. "It depends on the transaction and what managers put in," Walfish explains. "Our shares are nonvoting and held for investment purposes, and this is where we make our long-term gains, whereas in the loan portion of the financing, where our return is capped, we earn current yield." Some lenders like PruCapital require equity, but that is not always the case. It all depends on how the deal is put together. McDougal, for instance, got an expanded line of credit from the Harris Trust & Savings Bank, in Chicago, and bought back equity from the other investors. They hold unsecured personal notes to be paid out over six years. And it is common, in cases such as his, to receive part of the financing from the seller.

David Katz points out that PruCapital's financing to a company like Star Forms is basically unsecured since "we don't want to depend on assets to repay the debt. Because we are involved in all levels of the financing, including equity, if times get tough we have an additional incentive to work with management to overcome problems." PruCapital takes no part in the day-to-day operating control of an LBO portfolio company. Though it is not a requirement, PruCapital does prefer that third parties sit on the board as voting equity holders. There may be key managers or outsiders knowledgeable about the particular industry, and the expectation is that because of their own financial commitment, they will do whatever they can to keep a company on track.

Standard covenants in the loan agreement require the company not to pay dividends or pledge assets, and to maintain a minimum amount of working capital and abide by restrictions on future borrowing. "Through such a structure, we can finance, for every dollr needed for the purchase price, 90? in debt, a debt-to-equity ratio of about 9 to 1," says Walfish. "These financings make it possible for an individual or management team to own a significant portion of the equity in a company by coming up with as little as 4% to 5% of the purchase price."