LBO Valuation and Strategy

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Advanced Corporate Finance & Strategy
©Michal Kaszas
ISTI Valuation & Strategy Specialist
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Welcome!

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Know WindowKnow-Window

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Purchase of a company by a small group of private investors where the purchase price is
financed with high levels of debt that will be repaid from the target’s future cash flows as
quickly as possible and equity participation of management is relatively high
Three main elements of LBO’s
• Small group of private equity investors/financial buyers also called sponsors or
promoters that acquire the target together with existing/new
management/employees
• Financing with high debt levels mainly against the future cash flows of the
company with the objective to repay the debt as soon as possible. High debt service
levels will induce management to curb wasteful investments and force improvements
in operating performance
• Management are given incentives (via equity participation) to align the companies
objectives with financial buyers thereby mitigating agency costs
LBO Basics

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• Spin-Off or Carve-Out of a division/business
• Family owned business without succession
• Public-to-Private acquisitions
• Secondary/Tertiary buyout
LBO Company Feed

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• High and stable cash flow – if the main means of value creation of a LBO is to pay
down debt, unrecognized strong cash flow is an attraction
• Attractive nature of the companies assets – so it can serve as collateral for the
senior debt holders and enhances the borrowing base
• A fat cost base – too high SG&A or COGS or too high capex / working capital
outflows. LBO funds may seek to reduce these costs with existing management or
replace them with more cost-cutting-orientated players
• Competent and experienced management - that understands requirements of the
investors and focuses on debt service and operating improvements
Ideal Candidates

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• A poorly understood / out of favor industry – this allows the PE player to exploit
undervaluation at the bottom of the cycle while exiting at the peak (competition for
the target is not strong)
• An unconsolidated market – allowing the fund to purchase undervalued assets,
merging them to create a larger player, while extracting synergies (buy-and-build)
• Appropriate size – although financial sponsors have teamed up to make larger
purchases, the traditional route has been small to mid-sized takeouts
• Equity undervaluation – this allows the PE player to purchase listed firms at a value
price and allows to realize values on a break-up
Ideal Candidates 2

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• A liquid debt and equity market – both are currently not very
supportive
• A visible exit within 3-5 years – either an IPO or trade sale, however
given the current status of the capital markets and the reluctance of
most strategic buyers, secondaries are popular means of exit
• An attractive exit price – the largest sensitivity to LBO models are the
purchase price and the exit multiples applied. The transatlantic multiple
gap appears to be a good way of multiple expansion
LBO Environment

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Characteristic of an LBO
Assets
500
DEBT
150
Equity
350
Assets
500
DEBT
400
Equity
100
Assets
600
DEBT
200
Equity
400
20% Increase
in Assets
400%
Increase in
Equity Value
T=0

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Improvements in operating profitability:
‣ cost saving opportunities
‣ revenue enhancements (internal/external)
‣ group synergies
Reduction of operating capital:
‣ reduction of working capital requirements
‣ reduction of value destroying investment
Financial leverage and tax shields on interest
expenses
Multiple expansion/arbitrage:
‣ add-on acquisitions at a lower acquisition
multiple than the expected exit multiple
(multiple arbitrage)
‣ exit of the target as a whole at a higher multiple than
the entry multiple (multiple expansion)
Return Opportunities
Hard Factors
Recent academic research shows that operating
cash flows of LBO’s firms have improved on
average with 10-20% within three years after the
deal (e.g. Kaplan and Schroar (2007))

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• Increasing management ownership and high debt service levels results in stronger
incentives for management to effectively and efficiently run the business
• LBOs reduce the agency cost as information-asymmetry between management,
equity and debt providers will become smaller (e.g., more sensitive information can
be disclosed to the shareholders of a privately held firm vis-à-vis listed firm)
• Decision processes can be more efficient under private ownership versus a
listed company hence strategic actions can be taken more speedily (e.g., add on
acquisition)
• Internal control-mechanisms work more effectively under private ownership
(e.g., replacing bad performing management)
• Private equity players may bring in expertise/network: “smart money” (e.g.,
support with acquisitions)
Return Opportunities
Soft Factors

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Overview of Debt Instruments

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Sources & Uses of Funds

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• PE Houses usually aim for 20-35% IRR
• Some key drivers of IRR for PE House
• Initial Equity
• EBITDAGrowth
• Exit Multiple & Timing
• Debt Level at Start
• Management Share
Calculating IRR for PE House

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LBO Exit Routes
Strategic
Sale
55%
Listing
3%
Secondary
LBO
40%
Other
2% High Scrutiny,
High-Discount Area
Preferred
Exit Routes
Cost of Capital
Arbitrage

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LBO Exit Routes

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Exit Multiple depends
on Exit Route
IPO Discounts are driven by:
❖ Equity market performance and volatility
❖ Investor price sensitivity and sentiment
Investors are currently very price sensitive
with several transactions pulled, downsized
or experiencing price range cuts
‣ Potential competing equity supply
❖ Significant price cuts indicate significant
price pressure and inherent IPO discounts
❖ A good proxy for IPO discount is
immediate aftermarket performance
IPO Discounts in Europe is
currently 10-15% of EV

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Optimal Timing of Exit
Time is usually your enemy
18.5%
19,2%
21,2%
25,1%
19%
18,2% 17,1%
I
R
R
Years

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DCF Valuation of LBO
Q&D Valuation
• PE Enterprise value t=0 equals the initial debt level plus the present value of the residual exit
equity value at t=T discounted at the required IRR of the private equity investor
• Initial debt level = multiple x EBITDA at t=0
• Residual exit equity value = exit multiple x EBITDA at t=T minus the net debt at t=T
DCF Valuation
• Calculate the “normal” enterprise value at t=0 based on the Recursive APV method:
- FCF discounted at unlevered costs of capital
- Tax shields on debt discounted at the cost of debt
• Subtract from the calculated enterprise value a 20% PE discount to get PE enterprise value
• Initial equity investment = PE enterprise value minus initial debt level

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LBO Structuring
Realistic
Exit Strategy
Typical Initial
Level
Funding Debt
providers
satisfied?
Deal
attractive for
management
?
Realistic Exit
Strategy and
multiple
Any Legal
Constraints?
Optimal use
of Tax
shield?
Viable
Forecasts?
IRR Target
satisfied?

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