Case Work: the Advisory Group helps a hedge fund meet IRR goals.

A hedge fund used a leveraged buyout to acquire a distressed foreign company.

Fund managers worried that a low tax basis in some of the properties would result in heavy capital gains taxes, which would weigh down IRRs. Among the sale properties, one went to contract which had a zero tax basis. This would trigger a 40% capital gains tax, or $12 million on the $30 million sale.

To elevate IRRs, a Net Lease Capital strategy would defer the tax, and then pay down the expensive financing used in the buyout. An array of retail net lease properties was assembled as exchange property. Using the credit based finance associated with investment grade tenants who occupy this class of property, the fund would then finance out 91% of the properties’ value, or $27.3 million in cash. The fund would use these proceeds to pay down the high rate financing taken to leverage the buyout just three days prior. Rent income from the exchange property covers debt payments, and the fund derives all the remaining value of its acquisition.

Illustration:

Distressed company, X, is valued at 100, of which 80 is deemed to be real property, and 20 is cash and other assets. X can’t afford to sell its real property due to the 40% capital gains tax (32) that a sale would trigger.

Buyer offers 90 for X in a stock purchase and borrows 90 to effect the transaction. The terms of the deal require X to sell its 80 of real property to finance the acquisition. Buyer has obtained 20 of value subject to 40% capital gains tax on the 80 property sale, and subject to the cost of financing.

To defer the tax, buyer acquires 80 of credit tenant property after the 80 sale of X’s property in an exchange. To reduce the cost of financing, buyer pulls out 72 in credit tenant financing immediately after the exchange, which buyer uses to pay down most of the high rate loan that buyer used to acquire X.

Buyer retains 10 of assets with an equity investment of 8.

The investment looks like this:

This produces an IRR of 125%. The buyer may now pay off the remaining loan balance of 8.

The investment now looks like this: