Ideal LBO Candidates? (*Q)
Valuation: lower-mid-range EBITDAx (compared to industry comps)
STABILITY = major theme / most impt
1) Valuation/low price: co is relatively undervalued compared to its peers
2) STABLE & PREDICTABLES CASH FLOWS (so it can service debt) … this is the most important one, after price
2) is mature, steady, practically boring
3) strong defensible market position (gives it ability to weather economic downturns)
4) has limited CapEx and product development requirements
5) is undervalued or has synergy opportunities (might be synergy opps if PE sponsor already has a portco in same industry that it can combine with the target)
6) is owned by a motivated seller (privately held co where owners want to cash out their investments, or, a large co eager to sell off non-core subsidiaries … how can you gauge commitment / motivation of seller? look at how many shares they’re rolling over)
7) has a viable exit strategy [i) IPO - not full exit, ii) M&A - full exit, premium, or secondary buyout, iii) special dividends / recap]
Others, from BIWS:
- INDUSTRY: fast-growing and highly FRAGMENTED industry (so the co can make add-on acquisitions)
- have opportunities to cut costs and increase margins
- have a strong management team
- have a strong base of assets to use as collateral for debt
- have a realistic path to an exit, with returns driven by EBITDA growth and Debt paydown rather than multiple expansion
—
IS: low fixed costs, high recurring revenue, relatively high EBITDA margins; rev growth not necessarily essential
BS: significant fixed assets for use as debt collateral
CFS: stable CFS! minimal capex is deal (ex: mature co’s w/ lots of assets, but not spending much on new assets). minimal WC requirements helps.
Co’s Capital Structure - does it affect viability as LBO candidate?
- No - in LBO, the existing cap structure would be “wiped out” anyways & replaced w/ new one.
- But, can still matter a bit: ex - if existing Debt has penalty fees associated. w/early repayment
Qualitative factors that PE firms look at?
- Strong management team
- Industry/market - fragmented market is better
- Exit strategies & sources of return: prefer markets w/ feasible exits; target IRRs of 20-25%; avoid deals overly dependent on “multiple expansion”
Exit strategies & sources of return factors that PE firms look at?
- prefer markets w/ feasible exits;
- target IRRs of 20-25%;
- Key drivers of return: mostly from EBITDA Growth and/or Debt Payment; avoid deals overly dependent on “multiple expansion”
Financing related factors that PE firms look at?
- financing method & debt capacity
- credit stats & ratios
- credit rating
Critical analysis in LBOs?
- Compare IRR to Discount Rate
Simple LBO model
1) Set up transaction assumptions: includes purchase price + sources & uses
2) project out the co’s CFs and debt repayment
3) make the EXIT ASSUMPTIONS, calculate IRR & MoM multiples, assess returns drivers
Purchase price assumption for private companies?
almost always based on multiple of EBITDA
What is an LBO?
- PE firm buys a co w/ combo of debt & equity (cash), MOSTLY DEBT -> operates co for a few years -> sells co at the end to earn a return
- when PE firm is holding the co: use co’s CFs to make 1) debt interest expense payments and 2) debt principal repayments
Why does an LBO work?
- in an LBO: PE firm trying to minimize up-front cash payment as much as possible, and maximize use of debt to fund the deal.
- this works b/c: time value of money.
–> reducing upfront purchase price = boosts returns –> easier to get high IRR
–> can use co’s CFs to repay debt & make interest payments over time ==> better than holding onto those CFs
–> when PE firms sells co: uses proceeds to repay debt
Walk me through a basic LBO model (*Q)
1) set up transaction assumptions (incl. purchase price):
- make assumptions for pp, debt & eq, int rate on debt, co’s operations (rev growth & margins)
2) create sources & uses schedule:
- show how deal will be financed (incl. how much investor eq PE firm will contribute) and what capital will be used for
3) project co’s CFs & debt repayment
- project co’s IS & partial CFS –> to FCF
–> project out how much debt principal co will repay each year, based on avail CFs & after interest payments
4) make exit assumptions & calculate the returns
- assume Exit multiple (ex: EBITDA)
- calculate IRR & MOM multiple: based on proceeds PE firm earns when selling at the end vs. investor eq at beg.
Why do PE firms use leverage when buying co’s?
=> leverage AMPLIFIES returns.
- if you make money: make even more w/ leverage & PE firm has more capital avail for other investments/acqs
- if you don’t: make even less w/ leverage (b/c have to make int payments & repay principal still)
Legal structure of an LBO? How does it benefit PE firm?
-PE firm does not directly hold the co. The co is held by a holding co, owned by pe firm.
- holding co acqs the real co
- banks & other lenders lend to holding co
- benefits PE firm b/c not “on the hook” for the co’s debt: it is up to co itself to repay it
- co itself raises debt to purchase a certain # of shares (+ PE firm uses inv eq to buy remaining shares)
==> co is borrowing money so PE firm can do the deal
Minimum Cash Balance assumption in an LBO
rationale: all co’s need some minimum cash balance to run biz –> not ALL of cash can be assumed to fund deal or repay debt
- even in cash-free/debt-free deals: when deal closes, t’s cash goes to zero but immediately is brought up to (replaced w/ new balance) min cash balance for daily operations
- factored in: 1) if excess cash is assumed to fund deal and 2) when calculating CF avail for debt repayment
Minimum Cash Balance - how to estimate if co does not disclose?
1) look at historically how low it has fallen; or
2) make it a % of total expenses of total cash expenses
Management Rollover - effect on Sources & Uses on an LBO model?
- management rollover = management keeping certain % of the co
effect:
- contributes as a source of funds –> pe firms needs to buy less of the co ==> reduces amount pe firm has to pay (debt and/or inv eq)
- pe firm has reduced ownership after deal closes
Variables that impact LBO most?
1) purchase & exit prices –> purchase & exit multiples
2) amount of leverage used
lower PP ==> higher returns
higher exit price ==> higher returns
more leverage ==> higher returns (as long as co can meet its debt obligations)
3) other: revenue growth, EBITDA margins, interest rates and principal repayment on Debt
LBO - how to use to value a co? Why do we say it set a “floor valuation”? (*Q)
- set a targeted IRR (ex: 25%) –> work backwards: what maximum price can pe firm pay to reach this IRR?
- “floor valuation” b/c: pe firm almost always pays less than what a strategic acq would (lack of synergies + don’t want to hold long-term)
–> constrains valuation from the beginning, unlike other methods
LBO Valuation vs. DCF Valuation (*Q)
- LBO = “what MAXIMUM CAN we pay for this co, if we want to achieve a target IRR over next X years?” –> constraining values based on target (IRR) you are trying to achieve
- DCF = “What COULD this co be worth, based on the PV of its future cash flows?”
PE Firm vs. Strategic Acq
- unlike strategic, PE firm does not want to hold co long-term.
–> cares about boosting returns –> so, cares about using leverage & reducing cash up-front to boost returns - unlike strategic, the co here (rather than buyer) assumes the debt -> pe firm takes on less risk than strategic buyer
Reason why PE firm would buy co in a “risky” industry? (ex: tech)
- even in “risky” industries, there are mature co’s w/ stable CFs
- even if risky or struggling co, PE firm may have specific goals: industry consolidation, turnarounds, divestitures
How can PE firm boost its returns in an LBO? –> Factors that impact returns?
- Purchase Price - reduce
- Exit Multiple and Exit Price - increase
- Leverage (debt) used - increase
- Co’s growth rate (organically or via acquisitions) - increase
- Improve operational efficiency: reducing expenses (cutting employees, consolidating buildings, etc.) -> increase margins
- Exit faster
How to determine how much debt can be raised in an LBO? Reasonable leverage & coverage ratios
1) LOOK AT DEBT COMPS: shows types, tranches, and terms of debt that similarly sized co’s in the industry have used recently
- use median Debt/EBITDA levels from recent, similar LBOs or highly levered public comps
2) Test these assumptions by projecting the co’s leverage (Debt/EBITDA) and coverage (EBITDA/Interest) ratios over time.
If they hold up reasonably well – e.g., the company’s coverage ratio always stays above 2x – then you might stick with the original numbers. If not, you have to try different assumptions.
- general rules:
1) Debt/EBITDA: never lever a co at 50x; even in bubbles, leverage rarely exceeds 10x
2) EBITDA/Interest: # between where co can pay for its interest w/out much trouble, but not so high that co could clearly afford to take on more debt
Transaction Assumptions - how to est Interest Rate on Debt? (assume no debt comps)
- use default spreads (similar to cost of debt method in WACC calculation:
1) look at yields of 10-yr govt bonds (of co’s govt)
2) calculate co’s interest coverage ratio & leverage ratio ==> get a sense of its credit rating
3) look up co’s default spread based on this credit rating (spreads of similar co’s) –> add that to 10 yr bond-yield
