Butler Capital Partners (Butler) is an investment fund founded in 1990. Butler closed its first private equity fund, European Strategic Fund, in 1991. This first fund was mainly focusing on small family owned enterprises and on divisions of larger companies. Mainly of his first success he closed in 1998 his second fund, Private Equity II, and Butler became one of the largest independent funds in France. With his second fund he would focus on investments in France on a larger scale. On April 29, 1999, a new investment opportunity arose for Butler: Autodistribution (AD). AD is an entrepreneurial firm and has become the largest independent automotive parts wholesaler in France by the end of the 1990s.
This report starts with an analysis of the opportunities and risks for the AD deal and determines whether Butler should make a proposal or not. Hereafter, a valuation of AD is given. In the next paragraph the chances for European expansion are evaluated. Then the structure of the compensation package to Chavanne is determined and at the end a short conclusion of this case is given.
1. Should Walter Butler Submit a Proposal for AD? What is the nature of the opportunity?
Autodistribution in the auto market
First we focus on the future outlook for AD in the auto market. In 1962 AD started as an automotive parts purchasing association controlled by independently owned affiliates. By the 1980s, AD began to acquire wholesales and the purchasing power of AD grew. In 1976 the network of AD expanded abroad, through an international subsidiary of AD (AD International). At the end of 1998 AD was the largest independent wholesaler of automotive parts in France and even in Europe.
The outlook in the auto market is favorable with a growth of 2 to 3% in the foreseeable future due to the growing number of cars in circulation, an aging car fleet, increased technical complexity of car parts, new legislation requiring more frequent vehicle inspections and deregulations to meet European standards.
To maintain its good position in the market and to generate sustainable growth, AD made four strategy elements to forward the company. First, it will pursue an aggressive acquisition program to build up the organization. For the approximately first three years it will focus on expanding in France and thereafter it will make acquisitions outside France (in Europe). Second, it will increase efficiency within the organization's existing subsidiaries. Third, it will improve central organization through the elimination of back-office expenses and better coordination of logistic. Finally, it will increase the purchasing power of the central buying unit (CBU) by increasing demand garnered through acquisitions made before, increase the percentage of purchases affiliates and subsidiaries made through CBU and/or by increasing the supplier base. With these four elements of AD's strategy it expects that AD will make/keep a powerful presence in not only France, but also in whole Europe.
Looking at the company information at exhibit 19a, AD has performed quite well in 1998 compared to UK companies and most of the US companies. For example the net income multiple for AD, two UK comparable companies (Partco and Fine List) and the average are 21.63, 11.6, 7.6 and 18.44 respectively. The revenues of AD in 1998 are 884.40, while the revenues of the two UK companies are 696.96 and 620.90 (in millions of USD). However, the range of revenues between the US companies is really big. Furthermore, one can see from the figures that AD has relatively high sales, but small margins on those sales (see gross margin).
Overall, given the information above, we can note that the position for AD in the auto market is strong.
Opportunities, risks and some constraints
As concluded above, AD is currently an attractive company in the auto market. But, to solve the question whether Butler should buyout this company, let us first analyze the opportunities and risks for the buyout.
Let us first focus on the interesting opportunities, which exist in the deal for AD. Butler found some important development opportunities for AD: (1) an increase in penetration rate of AD's CBU among the affiliates by setting up an efficient IT system for purchasing, (2) external growth opportunities in France by integration of affiliates or acquisitions of independent wholesalers, (3) expansion opportunities in Europe provided by the fragmentation of the industry, (4) low competition on acquisitions because of the lack of players able to afford a dynamic build-up strategy, (5) strong growth potential of industrial supplies segment and (6) potential of development of fleet maintenance and agreements with insurance companies. These opportunities will result in an increase in gross margins through acquisition of independent wholesalers and integration of affiliated wholesalers. Furthermore, a reduction of operation costs can be the result, because of the IT system. With the existence of an efficient IT system, the margins can be improved or the prices can be cut and these effects are even stronger with consolidation / expanding in the European market. Besides these opportunities there is an opportunity for an e-business market. Butler stated this as ?one edge over the competitors'. Thus by expanding the business (through e-business, acquisitions, integration) and making use of the new technology systems, AD could realize significant margin improvement. These high margin improvements are expected to increase from 32.3% in 1999 to 36.5% in 2005. In addition the increase in sales from acquisitions is expected to almost double in the next 7 years according to the data . When these data are reliable, the opportunities create significant value. The valuation in the next paragraph, which takes these opportunities into account, shows us that the value of the company (including the above described opportunities) is higher than the price of the deal. Furthermore, we will elaborate on the European expansion opportunities in paragraph 3.
However, at the same time some risks are also involved in this deal. First, the lack of international experience can create risks. Except Chavanne, no one at AD had had any real international experience. Besides this, an even more important risk is the execution risk. This execution risk was caused by the lack of structure. With changing the culture of the company this risk could be reduced, but with the relatively long established management this could be a problem. Although these risks will not completely disappear, with some changes in the company these risks can at least be reduced. By changing the management of AD in a more diverse and dynamic group with international backgrounds, the execution risk and risk from the lack of international experience is reduced. In addition, the presence of Chavanne in ADs management also partly reduces this risk, because of his international background. Besides the opportunities and the risks some constraints exists. First, the evaluation period for the proposal is very short. Second, there was little information available in the data room, which made it somewhat hard to evaluate financing by the banks. Third, there were potential liabilities with the company. Finally, the price is set and according to other valuations it looked ?fully priced'. Although the price for the AD deal is fixed, some flexibility still exists in the capital structure of AD, which could create value. However, even this flexibility is limited. The capital structure should be structured in a way that it is in line with the build-up strategy and the equity return that is fair to its risk. According to the case, the main sources for Butler's proposal are the following: capital from Butler (which was however also restricted), management (to align incentives also), private equity funds, existing AD shareholders and a French bank with which Butler had worked before. The bank, which accounted for more than 50% of the sources of the deal, also imposed some constraints on the capital structure by its original term sheet . The following elements where of concern: (1) pricing levels were quite high, (2) the bank required that most of the fees (that should be paid to the bank) were due even if our bid was not selected, (3) the bank required that a formal working capital facility put in place and (4) the bank required that all equity would be paid upfront.
By analyzing the proposed capital structure, we can conclude that this deal is highly leveraged. A large amount of debt is senior debt, which is an advantage here. Senior debt has a significant lower interest rate (than subordinated debt and even the 30-year government bond now) and since the outlook of AD is favorable this is a relatively cheap way of financing. However, the interest rate on both senior and subordinated debt is floating (based on the EURIBOR) and this can create some extra risk, which can be hedged though. Since four out of the six major French banks were effectively eliminated from providing financing, it will be hard for Butler to renegotiate on the term. But if it is possible to renegotiate an important point for renegotiation is the fee, which is needs to be paid even if the bid is not selected, and the use of an informal working capital facility. When no fee needs to be paid when the company does not get the deal, there will, then, be no extra costs of making the deal.
Thus, overall, this investment will be an investment including some significant amount of risk and constraints. However, since the current position of AD is strong and its outlook for the future is favorable, mainly due to the opportunities, the deal is worth it when the risk will be reduced as described above. In addition, Butler already manages another private equity fund, which focuses mainly on small family owned companies and on divisions of larger companies, and thus with taking this deal it increases the diversification and thus reduces the risks for this company. Furthermore, there is a trend already visible in the increased competition in the large end of the private equity market. By knowing this right now, it is worth it to take already deals, which turn out to be interesting, before competition for deals gets even harder. Although there will be a serious contender, BC Partners, Butler has a good build-up strategy compared to BC Partners, which is a very important factor in this AD deal. Thus Butler should submit his proposal.
2. Valuation of AD and expected return: Free Cash Flow Method
To value AD we use the Free Cash Flow Method. To calculate the free cash flow streams in the future, we need to use the financial statements of AD. To look what AD will do in the future, we have to make assumptions. A part of these assumptions can be found in exhibit 18 of the case description.
To derive the free cash flow for AD, we used the following computation of the free cash flow:
+ Depreciation / amortization
- Changes in working capital
- Capital expenditure
= Free cash flow
Assumptions (amounts x1.000FFR)
Growth 1999 2000 2001 2002 2003 2004 2005 2006
Organic sales growth 2,0% 3,9% 3,7% 3,5% 3,0% 2,5% 2,5% 2,5%
Sales from acq. 378.457 582.407 676.137 762.195 778.440 871.750 701.900 706.600
Margins 1999 2000 2001 2002 2003 2004 2005 2006
Gross profit 32,2% 33,2% 34,2% 35,2% 36,0% 36,3% 36,5% 36,6%
EBITDA 7,500% 7,750% 7,975% 8,225% 8,625% 8,700% 8,825% 8,925%
Depreciation 1,20% 1,23% 1,23% 1,23% 1,23% 1,23% 1,23% 1,23%
Financial income 3.000 2.000 2.000 2.000 2.000 2.000 2.000 2.000
CapEx debt 1,875% 1,875% 1,875% 1,875% 1,875% 1,875% 1,875% 1,875%
Other debts 0,750% 0,750% 0,750% 0,750% 0,750% 0,750% 0,750% 0,750%
Goodwill 16.000 20.000 25.000 29.000 34.000 40.000 45.000 50.000
Extrordinary expenses 5.000 8.000 9.000 10.000 11.000 12.000 13.000 14.000
Other info 1999 2000 2001 2002 2003 2004 2005 2006
Tax rate 40,0% 36,7% 36,7% 36,7% 36,7% 36,7% 36,7% 36,7%
NWC days 55 55 55 55 55 55 55 55
CapEx 60.000 68.000 77.000 88.000 99.000 110.000 121.000 132.000
Acq. Multiple 0,275 0,275 0,300 0,300 0,350 0,350 0,350 0,350
CapEx debt 50.000 250.000 400.000 400.000 400.000 400.000 400.000 0
Other 215.000 255.000 355.000 445.000 625.000 820.000 890.000 910.000
Table 1: Assumptions for expected return and valuation
The assumptions that we used to calculate the future key figures for AD are given in table 1. In addition to these assumptions, we used a discount factor of 10% for the future cash flows of AD. We assumed the working capital for the years 1999-2006 to be 11.2% of total net turnover, as mentioned in exhibit 19a of the case description.
1999 2000 2001 2002 2003 2004 2005 2006
Net income 248.051 305.789 354.753 415.911 488.497 547.297 604.502 667.766
Depreciation / amortization 22.890 27.898 33.845 38.928 45.145 52.498 58.987 65.610
Changes in working capital -90.583 90.944 103.488 115.248 116.256 124.768 108.864 112.112
Capital expenditure 60.000 68.000 77.000 88.000 99.000 110.000 121.000 132.000
Free cashflow to Equity 301.524 174.743 208.111 251.591 318.386 365.028 433.625 489.265
1,10 1,21 1,33 1,46 1,61 1,77 1,95 2,14
Present value 1999 274.113 144.416 156.357 171.840 197.693 206.049 222.518 228.246
Table 2: Calculation of free cash flows AD 1999-2006
In table 2 one can find the calculation of the free cash flows for the years 1999-2006. Overall, we can see a growth in the free cash flow stream of AD.
After having calculated these numbers, we have to value the firm AD. This can be done by getting the first seven streams of free cash flow and take the eighth year as a terminal year, because in our opinion the growth opportunities after 2002 should also be taken into consideration (and those opportunities have got a significant effect). The growth rate in this time period is assumed to be 2.5% per year. The growth rate for the terminal year (2006) is assumed to be 3.5%. By doing this, we get the next calculation (see table 3 on the next page):
PV FCF 1.372.985
Terminal value 3.511.470
Present value incl terminal value 4.884.454
Table 3: Valuation of AD
The present value of the first seven years (1999 to 2005) is FFR 1.372.985.000. We took 2006 as the terminal year. The terminal value is calculated as follows:
FCF 2006 / (0,10 ? growth rate in 2006) / discount factor for 2006 to basis year
The adjustment that is made is due to the fact that we have to bear in mind that these amounts won't be paid to the company on one day, but they can be paid every day in the year. Therefore, we adjust the present value incl. terminal value with (1+0,10)^0,5.
The whole calculation gives a value of AD of FFR 5.122.859.000.
By performing a sensitivity analysis regarding the value of AD, one can see how the value of AD changes when the discount factor or the growth rate changes. In table 4 one can see how the value of AD changes when the discount factor and/or the growth rate changes. In the valuation above the discount factor was assumed to be 10% and the growth rate was assumed to be 3.5%. When this would change to 11% and 3% respectively, the value of AD would change to FFR 4.153.304.000. This means that this change in assumptions changes the value with about FFR 1.000.000.000.
Discount factor 9,00% 10,00% 11,00%
Growth 2,50% 5.431.100 4.631.811 4.026.766
3,00% 5.759.763 4.859.798 4.153.304
3,50% 6.148.183 5.122.859 4.377.632
4,00% 6.614.286 5.429.764 4.590.657
4,50% 7.183.968 5.792.470 4.836.456
Table 4: Sensitivity analysis of the value of AD
3. Chances for European expansion?
Just as in France, the international auto parts after-market is highly fragmented. The four largest markets, Germany, France, England and Italy, do not have a real market leader. Therefore, the European market seems ready for an consolidation wave in which relatively small companies are taken over to create a large company with more purchasing power. There are several opportunities in European expansion. First, the markets are similar in many ways. Growth is at a moderate 2-5%, car fleets are aging, the technical complexity of car parts is increasing, there is new regulation that requires more frequent compulsory car inspections, and last but not least there is deregulation from the European Union (EU) that enables AD International (ADI) to move to new market segments.
This deregulation is a great opportunity for ADI, since in all markets (except Germany) customers increasingly turn toward fast-fitters and general auto part suppliers. This development in the market, combined with ADI getting access to market segments that were formerly dominated by car dealers due to regulatory issues, gives ADI an excellent European growth opportunity. As stated in the case, ADI was already capable of producing 95% of the number of parts in a car, so the legislation that opens up for example the body parts market (presumably from 2002) gives ADI new growth opportunities.
ADI's international contacts also increase the probability of European success. The large international affiliates network allows ADI to profit from the information they have on international markets. Even though there is not much international orientation in the company at the moment, competitors are probably facing the same problem to a larger extent, giving ADI an informational advantage.
Besides that, the expansion of the EU could give ADI new opportunities on the medium to long term. The EU at the time already started negotiations with countries from Central and Eastern Europe. These countries were facing rapid economic and welfare growth and could be, if they would eventually join the EU, good growth markets.
Overall, growth opportunities in the European markets are good, and ADI seems to be the perfect candidate to move into consolidation of the European auto parts business.
4. What kind of incentives should Butler offer to Chavanne?
The connection between Chavanne and Butler
Paul-Marie Chavanne joined Strafor Facom (SF) as COO in 1997. He became CEO of SF in June 1998. SF was a publicly listed, leading industrial product manufacturer of specialized tools in France. Before his employment at SF, Chavanne held various functions for the French Treasury and the French Finance Ministry in the 1980s. He was also a manager and member of the Board of Peugeot-Citroën (a French car manufacturer) from 1992 to 1997. Chavanne left Peugeot-Citroën because he wanted to act like an entrepreneur and not like an organizer. He also wanted to broaden his horizon in an international context. Chavanne accepted the position of COO (presently: CEO) at SF because of the chance to lead such an entrepreneurial organization that had an international focus.
Immediately after Chavanne became CEO of SF, he started negotiations with AD about a potential merger. Before these negotiations, SF already had very close ties with AD: SF was a long-time supplier of products to AD. The interest in AD consisted of two parts. The first one is obviously the opportunity of a (backward) vertical integration. The second one is the opportunity that AD had to expand throughout Europe. Because AD consisted of an entire international network and both the French and the European market for automobile parts were fragmented, Chavanne saw a lot of opportunities.
In February 1999, SF and AD's shareholders signed an agreement. This agreement implied that SF would buy 100% of AD in 1999. On March 24 1999, Fimalac (another diversified industrial products manufacturer) placed a hostile takeover bid on SF's shares. Both the management board of SF and AD's shareholders rejected the bid, because they were frightened that Fimalac would not have the resources to develop both SF and AD business at the same time. Because of this, Chavanne was searching for a "white knight". A white knight is a company institution (in this case: Butler) that makes a friendly takeover bid to a target company (in this case: SF/AD) that is being faced with a hostile takeover from another party (in this case: Fimalac). The original idea was to find a white knight for the SF/AD business. Partly due to time constraints imposed by the closing of the AD deal, the final goal was to find a separate buyer for only AD. That is the point (April 1999) when SF/AD became aware of Butler. At the end of April 1999, Walter Butler (the founder of Butler) had not only to decide whether or not he should make an offer on AD (see question 1), but he also had to decide what compensation package should be offered to the new CEO of AD. Chavanne had indicated a strong interest in this CEO position.
Executive compensation package
The executive compensation package that Butler should offer to Chavanne, should have the purpose to motivate him to take the right actions that will create shareholder value in the long run. In general, there are three critical dimensions in designing a compensation package: the determination of the level of the total benefits, the composition and the relation between pay and performance. A well-designed compensation package should take into consideration all three dimensions. Let's now consider the potential different parts of the compensation package.
First of all, we recommend Butler to offer Chavanne a relatively low fixed (base) salary. The weaknesses of fixed payments are related to a lack of motivation to manage a company. If all management payments were fixed, managers clearly had very little incentives to run a company as best one can and to act in the interest of the shareholders. However, a relatively low fixed salary should be compensated somehow.
Because Butler was successful in "cherry picking" companies (and buying them), turning around those companies and selling them, Butler should offer Chavanne a relatively high bonus opportunity when the "turnaround process" succeeds. This part of the package will provide better motivation incentives and also require for managers that are not risk averse, reasonable optimistic and confident about their ability to create value. According to the information given in the case reader, this matches largely with Chavanne's nature. The pay-for-performance part of the compensation package tries to solve the principal-agent problem. The principal-agent problem is the problem of motivating agents (i.e. Chavanne) to act on behalf of their principals (i.e. Butler).
A stock value based performance package could also align the interest of Chavanne with the interest of Butler: creating long-term shareholder value. Stock options are preferable to shares, because shares still have value even though the share price falls sharply, in contrast to call options. To prevent the horizon problem (stock options provide incentives for short-term behaviour by CEO's), Butler should provide stock options with a certain vesting period. To prevent the gaming problem (stock options provide incentives for illegal behaviour), Butler should strengthen internal controls and he should also monitor the behaviour of Chavanne. However, Chavanne should not be restricted too much in his freedom, because he should display an entrepreneurial management style with a certain degree of risk taking, so that the turnaround of AD will succeed. To prevent that Chavanne takes too little risks (the risk taking problem), he should be rewarded with vested out-of-the-money call options.
To summarize, in our opinion Butler should offer Chavanne a compensation package that consists of relatively low fixed salary, a relative high bonus opportunity when the turnaround succeeds and a considerable portion of out-of-the-money call options.