Hertz A + B

Many fleet cars were bought with an option to sell them back to the manufacturer. Such vehicles were called “program cars”, as distinct from “risky cars” which were not covered by a put option. Roughly 85 % of Hertz’ domestic fleet and 74 % of its international fleet were program cars. Program cars will become more expensive in the future due to the fact that Ford and GM adopted new market strategies that deemphasized lower-margin sales of program cars Risk cars exposed the company to residual value risk. Generally less expensive than program cars. What could be the possible motivations for CD&R to buy (syndicated) Hertz? • Under exploiting of the firm’s potential due to mismanagement. Hertz managers were overconfident. The senior guys were absolutely convinced that they were running the most efficient, most productive, well-organized, well-oiled machine in the industry. • The room for increasing the operational efficiency. Value creation through cost savings. • Potential improvement of the capital structure. Lower cost of capital through extensive securitization. • Hertz was undervalued. • Unique strong brand • On airport market leadership • Good historical performance Operational Efficiency Improvements • U.S. RAC on airport operating expenses CD&R estimated that labor per transaction, administrative, and other costs had increased 41 %, 65 % and 30 %. • U.S. RAC off-airport strategy CD&R proposed to slow expansion, focus selectively on profitable growth, and close locations that failed to achieve positive contribution. • European operating SG&A expenses Hertz’ operational SG&A expenses as a percentage of revenue were nearly three times higher than those in the U.S. • U.S. RAC fleet costs Despite its scale advantages, Hertz historically had higher fleet costs than those of key competitors. • U.S. RAC nonfleet capital expenditures Reduce future capital spending to a level more in line with competitors • HERC, Return On Invested Capital (ROIC) HERC managers earned maximum bonuses year after year, despite the low returns on capital. CD&R expected to realize significant savings by changing managers’ incentives to focus on ROIC. Risks with the investment? • Hertz’ business was mature and capital intensive • The industry was highly exposed to cyclical changes in travel activity and to severe disruptions such as the September 11 attack. (Operational Risk) • Well established competition in all its major markets. • New complex financing structure • Hertz would be required to implement many changes in its operations in order to thrive as independent, privately owned company. • Hertz’ managers were afraid that the deal would be followed by layoffs and possibly even a breakup.

Value drivers in Hertz case • Higher operating margins due to lower costs (operational improvements) • Lower WACC (extensive use of ABS)

Hertz Vehicle Financing and Hertz International would own the domestic and international RAC fleets, respectively. OpCo would own the rest of Hertz’ assets, including HERC and its equipment fleet.

The structure was designed to achieve 4 primary goals 1. Stability CD&R wanted Hertz to be able to survive a severe business downturn without having to restructure. 2. Flexibility The structure had to provide flexibility to accommodate the large volumes in car purchases and sales that enable Hertz to manage seasonal, cyclical and other fluctuations in rental activity. 3. Liquidity The structure was intended to provide sufficient liquidity to enable Hertz to exploit for future growth and expansion, again, without refinancing. 4. Lower cost of capital CD&R intended to obtain funds at substantially lower cost than under Hertz’ existing structure. CD&R expected most of the value created by the transaction to come from improvements in Hertz’ existing operations rather than expansion into new markets. Securitization • Higher transaction cost (creation of SPE) • Reducing agency problems through increased external monitoring • Raising large amount of debt that is off the consolidated balance sheet (hidden average) • Liquidity enhancement (transforming illiquid assets into liquid securities)

Convertible Debt • Higher cost of capital • Lower transaction costs • Reducing agency problems through preventing managers from opportunistic behavior • Limits company’s ability to issue additional debt due to on-balance sheet increase of leverage (potential underinvestment problem) • Doesn’t put any restrictions on fleet management

Benefits of ABS • Makes otherwise illiquid assets tradable • Lower costs • Bankruptcy remotes reduces the specific corporate credit risk for investors • ABSs have usually higher credit rating • Reduces asymmetric information costs • ABSs usually over-collaterized → alleviates adverse selection and moral hazard • Lower cost of capital due to increased debt capacity

Proposed Capital Structure FleetCo Debt ($9 billion) • $5,3 billion ABS debt in US, 3-7 years • $2,0 billion hybrid ABS/ABL structure internationally, 3-7 years • Seek additional $1,7 billion committed but unfunded ABS capacity in US & Europe, to fund expansion and cyclical swings. Equity ($1,8 billion) • $1,5 billion of equity from Hertz • $200 million 5 year letter of credit • ABS and insurance agreement require FleetCo to hold $100 million in cash • Equity was owned by OpCo TOTAL: $10,8 billion D/E ratio = 9/1,8 = 5 WACC calculation:

OpCo Debt ($6,7 million) • $1,4 billion ABL revolver sized against pool of assets in OpCo, CD&R expected to draw only $400 million at closing. Maturity 5 years. • $1,85 billion conventional loan 7 years to institutional investors • $2,25 billion senior unexpected notes (9,50% interest) and $800 million senior subordinated notes (10,75% interest), 8-10 years Equity ($2,3 billion) • $2,3 billion in equity • Three members of CCM would have identical financial interest in Hertz

TOTAL: $9 billion D/E = 6,7/2,3 = 2,91

x 4,74 +

x 7,25 = 5,89 %

Hertz B In September 2005, CCM, a consortium of private equity firms led by CD&R signed a contract with Ford to buy Hertz for $5,6 billion. However, CCM would need another $15 billion to close the deal. How the SPE works • The SPE would buy the rental cars and lease them to the parent. • The SPE financed itself by issuing notes – Asset Backed Securities – that were secured by the cars and associated repurchase agreements negotiated with car manufacturers. • The SPE received lease payments from the parent in exchange for the use of the cars and additional payments when the cars were sold at the end of the lease term. • Cash received by the SPE was then used to pay interest and principal on the notes. • Whether the notes received an investment-grade rating depended on how much equity the parent contributed and how many cars served as collateral for a given amount of debt. The required amount of cash was called the “liquidity level”. • Finally, to tap as large a market for the ABS notes as possible, the notes typically would be guaranteed as to principal and interest by a highly rated insurance company. This credit enhancement boosted the rating of the notes and lowered the interest rate paid by the issuer. The issuer in turn paid a fee to compensate for the guarantee. Benefits of an SPV/SPE • Don’t have to be consolidated on the originator’s balance sheet. (off balance sheet) • Mitigate adverse selection and moral hazard • Lower discount rate • Reduces firm’s borrowing costs The Hertz deal would be more complicated than usual ABS deals, for primary 3 reasons 1. Though the structure had been used successfully in the U.S., it had not been done on a large scale outside of U.S. 2. The contemplated ABS issue was very large – at $5,3 billion, the U.S. portion alone was twice as large as the existing market. 3. Previous rental car ABS issues had been underwritten on a “best effort” basis rather than as firm commitments fully underwritten. The latter represented a binding promise by the underwriter to deliver the full amount on specified terms and pricing. In May Moody’s and S&P downgraded Ford to BB+ and GM to BB. The downgrading affected the ABS issuing in several ways. • As OEMs creditworthiness declined, so did the value of their promise to repurchase program cars in the future. • The same exposure affected OEM receivables held by the rental car companies – amounts on the OEMs owed for program cars they had bought back but not yet paid for in cash. • Although OEM had no obligation with respect to such cars, credit analysts reasoned that used cars might lose considerable value following the bankruptcy of the company that made them. This in turn would further diminish the collateral securing an ABS issue. • Hertz owned more cars built by Ford than any other manufacturer. Together, Ford and Gm accounted for more than 60 % of Hertz’ fleet In October 2005S&P placed both Ford and GM on negative Credit Watch. One week later, S&P downgraded GM from BB to BB-, and Moody’s placed GM on negative Credit Watch. This caused to a meeting between Hertz, Ford, Deutsche Bank, and Lehman Brothers. They hoped that sound, data driven analyses of the ABS market and wholesale used car markets would convince the agencies that no matter what happened to ford and GM, the value of Hertz’ fleet would not fall dramatically. The simple goal was to obtain a BBB rating. If a BBB target could be met, CD&R believed that Hertz could purchase a guarantee for the notes – an “insurance wrap” – that would bring their rating up to AAA. MBIA and Ambac would do the “wrapping” – thus selling the papers as AAA which means that they take the

risk between BBB and AAA in exchange for 30 basis points. However, MBIA and Ambac had mixed incentives. Even Lehman Brothers and Deutsche Bank had mixed incentives. Instead of upgrading OEMs ratings, a change was made in the rating system which boosted the enhancement levels for all the OEMs. Under the new system, securitizing Hertz’ U.S. fleet with its heavy component of Ford and GM would require an enhancement level of more than 25 % with liquidity of 4,5 %. • The old enhancement level of Hertz would have been somewhere around 12%. But since the rating agencies change the model used for assessing the enhancement level, Hertz new enhancement level would be almost 30% on a pre-tax basis. • This new enhancement level posed a serious problem for the ABS financing. They also threatened the LBO financing for the OpCo. Corporate EBITDA, the measure of operating CF against which OpCo planned to borrow, was computed after fleet debt service. With the new enhancement level this would be much more expensive and would thus reduce corporate EBITDA. • A 1% increase in enhancement level would lead to $80M more equity needed in FleetCo, which needs to be financed at OpCo. In this case the increase was somewhere around 10%, which means $800M more equity at FleetCo that needs to be financed. Ford acknowledged some responsibility for the problems and agreed at signing a contribute $200 million letter of credit to boost FleetCo’s equity base. The private equity sponsors had simultaneously agreed to put in another $200 million of equity. But neither side had anticipated how large the problem would become in the end of October. Bad as it was, the problem would get still worse if Ford and GM deteriorated further in the eyes of the rating agencies. Finally, as CD&R sought to lock in terms for Hertz’s complex capital structure, interest rates were rising. Why should Ford accept the deal? • They needed the money • $5,6 million is probably more than they could receive in an IPO 1.

2. 3. 4.

5.

6. 7.

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Risk-Map Market risk a. Changes in asset prices (downgrade in Ford, GM etc for Hertz, cars) b. Downturn in economy, less consumption of durable goods (cars) → downgrade for GM, Ford → value of fleet decreases c. Downturn in economy → demand on secondary market down d. Interest rate risk, fluctuations e. Currency risk, fluctuation in currency Funding risk a. Cash in-flow doesn’t mach cash out-flow Market liquidity risk a. Hard to sell notes, liquidity in market Liquidity risk b. Late payments (cash flow mismatch) c. Structural inflows is not interest bearing but out-flows is; when LIBOR etc goes up → out-flows might exceed in-flows Credit risk a. Customers can’t make payments b. Direct I. Firm/customer which one has an arrangement with c. Indirect I. Firm which one has no direct dealings with defaults or, e.g. house bubble which decreased the purchase power among consumers Legal risk a. Legal problems in every department b. If further downgrading, GM might not be able to buy back program cars Operational risk a. Failure in computer systems, supervision and control b. Failure in production process c. Natural disasters which might lead to unexpected large losses Financial risk

a. Financial risk are those that a firm is not in the business of bearing (non core) Business risk a. Business risk are those that the firm must bear in order to operate its primary business (core) The following models are a result of dissatisfaction with prices of terms of insurance companies. Rent-a-captive Owners of rent-a-captives are usually reinsurance companies. All companies belong to the same legal entity→give rise to lemon problem→solution Protective Cell Company. Protective Cell Company Same idea as rent-a-captive but every company belongs to separate legal entity. Cedant should all not be exposed to the same risk. Traditional securitization The securitized assets are refinanced by various notes/bonds with different risk and maturity profiles, and hence ratings. By going straight to the capital market the issuer bypasses commercial banks that could have financed the same assets through secured bank loans. 9.

Securitization allows issuers to raise funds and improve their liquidity position without increasing their onbalance sheet liabilities. Issuers lower their financing cost (cost of capital) from issuing securities by the performance of segregated credit exposures. 1. 2. 3. 4. 5.

Reduce both economic cost of capital and regulatory minimum capital requirements Diversify asset exposures Curtail balance sheet growth Overcome agency costs of asymmetric information in external finance (e.g. underinvestment and assetsubstitution problems) Improve asset-liability management, as the issuance of securitized debt funds assets whose future cash flows are matched to the repayment schedule of the debt investors

Corporate issuers also greatly benefit from limited information disclosure and the retention of capital control. The issuers also retain much of the earning power of securitized assets. The seller does not only receive cash flows from servicing fees, but also holds an equity claim on any residual revenue of the SPV. Synthetic securitization SPVs may also support synthetic securitizations, where issuers create generic debt securities, so called creditlinked notes (CLN), out of derivative structured claims on securitized assets to reduce economic cost of capital and raise cash from borrowing against existing assets and receivables. Synthetic transactions only transfer unwanted risk exposure of a specifically defined asset pool without placing assets under the control of investors through a transfer of legal title. Drivers (originator/seller perspective) • Fund/-Profit Management Cheaper funding, diversification of funding sources • Portfolio/-Risk Management Transfer/sale of risk (without resource), optimization of the overall balance sheet’s risk structure in case of new investments using the newly generated liquidity • Balance sheet management Generation of liquidity, reduction of risk weighted assets/increase of ratio, asset liability management, increase in profitability by investing newly generated liquidity in higher yield assets • Arbitrage Purchase, repackage and sale of risk • Other Transforming formerly illiquid assets such as mortgage loans into liquid instruments (ABS bonds), leading to price information/market valuation of a specific loan portfolio, positive rating implication Drivers (investor perspective) • Benefiting from investments in new asset classes • Benefiting from the flexibility of ABS structure in that the investors’ specific needs in terms of risk profiles, term structures or liquidity issues can be met

•

Benefiting from the fact that the performance of ABS bonds is generally independent from the originator’s/seller’s credit risk • Higher yield. ABS bonds offered higher coupons/spreads compared to corporate bonds as well as a relatively high rating stability Cash Collateralized Debt Obligations (CDO) A CDO is an ABS structure, in which the securitized products issued have principal and interest backed by a pool of debt instruments collateral Cash CDOs are CDOs in which securitization is employed to convey credit sensitive assets to an SPV that in turn issues securities backed by those credit-sensitive assets Synthetic CDOs are structures in which a SPV engages in a synthetic securitization instead of an actual asset acquisition by selling credit protection using credit derivatives CDOs backed entirely with loans as collateral are called collateralized loan obligations (CLOs) whereas bondbacked CDOs are called collateralized bond obligations (CBOs) A Balance sheet CDO is undertaken specifically because the owner of an asset portfolio seeks to divest itself of some or all of those assets. Balance sheet CDOs generally do not have independent collateral managers. The originator is often a bank. As such, balance sheet CDOs are usually comprised of loan assets. What are the reasons for banks to undertake such a strategy? • Customized Credit Risk Transfer • CDOs allow a firm to sell a single portfolio of assets to different groups of investors who may have specific risk appetites for particular loss exposures within the portfolio • From the investor standpoint, CDOs allow investors to hold highly specific risks associated with firms, thus enabling them to diversify away firm-specific risks and better diversify across loss layers and trigger points. • Monetization of Assets • Because the original assets are sold for cash, the risk management and corporate financing impacts of the CDO structure cannot be divorced. • Reducing Adverse Selection Costs • Another benefit of securitization can be reduced adverse selection costs for the originateor leading to a lower WACC. • Funded Credit Protection • The up-front cash flow associated with the securitization of assets in a balance sheet CDO not only has a financing impact on the originator, but it also affects the credit risk of the originator. • Regulatory Capital Arbitrage • Optimizing the regulatory capital charge facing the originator is another powerful motivation underlying a lot of bank balance sheet CDO activity to date. An Arbitrage CDO, by contrast, is undertaken primarily as an investment management tool. In other words, the corporate financing objectives of the owner of the original assets are not a driving consideration. Instead, arbitrage CDOs represent the efforts of collateral managers, and structuring agents to combine the tools of asset management with financial engineering to try to offer investors a new and superior investment product. Arbitrage CDOs can be Cash Flow CDOs or Market Value CDOs. The difference concerns the sources of funds to feed the interest and principal waterfalls and the associated coverage triggers Of particular concern to an arbitrage CDO manager is the so-called CDO funding-gap, which is the difference between the yield on the asset portfolio and the yield on the CDO liabilities. The higher the funding gap, the higher the interest rate can be for the CDOs highly subordinated debt and the higher the expected return on equity.

Internal Credit enhancement Internal credit enhancements are credit enhancements that are provided by a participant inside the structure. Choosing multiple levels of subordination is an internal credit enhancement. That is, it redistributes the total credit risk of the underlying asset pool across investors in securitized products, but does not change the total amount of credit risk born by investors in the securitized products in aggregate. Apart from subordination, the most common form of internal C/E is overcollateralization (O/C. A structure is overcollateralized when the assets exceed the fixed liabilities or debt. O/C is a way of increasing the value of equity in the structure Direct Equity Issue An obvious way to create O/C in a structure is for the SPE to issue debt with a smaller notional or par amount than the amount of collateral acquired to back those securities. That would of course create a problem for the SPE. If the SPE has $100 in assets and issues only $80 in debt, the surplus $20 would indeed constitute O/C. But from where did the $20 come? - One possible answer is to issue $20 in equity to an inside or outside investor. Holdback Another way to easy create O/C is through holdback. Holdback is the difference between the price actually paid by the SPE to acquire assets from the originator and the true value of those assets. The SPE might issue $80 of debt and $1 of equity and then spend $81 on assets that have a true value of $100. This would create a $19 O/C as a credit enhancement. Cash Collateral Account Another easy way to get O/C funded by the originator is for the originator to deposit money in a cash collateral account (CCA). A CCA serves a cash reserve against losses and provides a credit enhancement to all the securities issued by the SPE. Excess Spread The gross excess spread internal to a structure is the difference between interest earned on the collateral assets and interest paid on the debt liabilities of the SPE. The net excess spread is the gross excess spread minus senior fees and expenses. External Credit Enhancement External credit enhancements in a structure represent credit risk transfer from the SPE to another firm. Insurance, Wraps and Guaranties Suppose the full P&I of the $80 million in senior debt is wrapped. In the event that the underlying assets have a market value below $80 million, the wrapper will assume the responsibility and making up the difference so that senior bondholders are fully repaid. A financial guarantee could accomplish the same thing. The SPE would simply buy a guaranty of the underlying $100 million in collateral assets with a deductible of $20 million and a policy limit of $100. Letter of Credit An alternative to credit insurance product is a letter of credit (LOC). The SPE would simply obtain a $80 million LOC from a bank, where the bank is writing the LOC as it would a financial guarantee. Credit Default Swap The SPE could also enter into a senior/sub basket credit default swap (CDS) with the $100 million in collateral assets serving as the reference portfolio and a $20 million deductible. The CDS would then provide complete credit insurance to the SPE for losses above $20 million. (The first $20 million in losses would be absorbed by the subordinated debt tranche or perhaps the internal credit enhancements in the structure.)

Put Option on Assets A put enables the SPE to sell the collateral assets to the put counterparty for a fixed price. In the event that the underlying collateral defaults and reduces the market value of the collateral assets, the put can be exercised and the collateral sold for a fixed cash amount. Asset Backed Commercial Paper (ABCP) There are mainly 3 differences between ABS and ABCP. 1. The securities in an ABCP program are short-term commercial paper (CP). Unlike ABSs, ABCP issues neither trade in an active secondary market nor have long maturities. Instead, the paper is typically held to maturity by end investors for holding periods of often only a few months. 2. ABS conduits usually involve a one-time conveyance of assets to the SPV, and the SPV then winds down after the receivables are repaid and the securities fully paid off. In a typical ABCP program, by contrast, the SPV continually purchases new assets or receivables and rolls over outstanding commercial paper issues. 3. While ABS issues generally are senior-sub, multi-class structures, the ABCP only issue a single type of securities, and all holders of the CP issued by the SPV have equal seniority in the SPV’s capital structure.

Case Soft Bank What effects will the credit downgrade have on the bond issuance? • Debt claims against focal firm’s assets • Defense against hostile takeover • Effects of the LBO • Increased TFP (Total Factor Productivity) • Increased operating income & net cash flow • Significant increase in operating returns Negative aspects • Decreased tax shield – Trade-off Theory • Financial distress costs • Debt overhang • Already shows signs of first-stage financial distress • Negative net cash flow and earnings • Financial distress costs • Loss of competiveness  Limited access to capital markets • Forced to sell assets • Become financially squeezed • Probability of default ↑ Softbank is planning to issue fixed-rate long term bonds. Decreased credit rating What will the credit downgrade have on the bond issuance? • Downgraded to non-investment grade • Increased interest rate → decreased liquidity • Market price of the bond ↓ Why issuing convertible debt? • Control the asset substitution problem • Resolve the overinvestment problem • Mitigate the adverse selection problem • Lower cash yield requirement • Flexible capital • Rating agency equity content • Tax deductibility of coupon payments • Rapid access to market Macroeconomic Risks • Exchange rate • Interest rate • Foreign loans • Joint venture • MUST analysis Synergies • Softbank paid premium for Vodafone • Economies of scope • Diversification • Soft Bank paid too much? • → empire building?

Conclusion • Fixed-rate instrument not recommended • We recommend convertible debt • We think they should commence the acquisition due to synergies and changes in the telecom market

The Takeover of Manchester United

Advantages with LBO • Maximizes the value of the firm • Tax benefits • Force effective self-monitoring Disadvantages • Costs higher than benefits • Over-leveraged • Underinvestment • Debt overhang Financial structure before LBO • Financial flexibility • Financial Slack • High Cash Load Financial structure after LBO • Increased monitoring • Risk of debt overhang • Problems to raise new financing in the credit market. • Underinvestment problem Financial flexibility best explain the Optimal Capital Structure for a sports club Less debt on balance sheet than traditional is “optimal” → better for a sports club. Miller & Modigliani • Prop 1 The market value of a firm is constant regardless of the amount of leverage that the firm uses to finance its assets. • Prop 2 The expected return on a firm’s equity is an increasing function of the firm’s leverage