Valuation Modelling and Framework in a Leveraged Buyout
A Leveraged Buyout (LBO) is a strategy used by investors, typically private equity firms, to acquire a company using a significant amount of borrowed money (or leverage) to finance the purchase. LBO used to be popular from the 70s to 90s but this aggressive form of M&A died down at the turn of the century. We revisit a bygone era where we review the valuation framework in an LBO.
What is a Leveraged Buyout and the Valuation Techniques
In an LBO, the assets of the company being acquired, along with the assets of the acquiring company, often serve as collateral for the loans. Because of the high debt involved, LBOs are often associated with companies that have stable cash flows, as this cash flow can be used to pay off the debt over time.
In an LBO, the structure is typically debt-financed where the acquiring firm will contribute a small amount of equity (e.g. 10% to 20%) and the rest of the purchase price is financed using debt such as bank loans, high-yield bonds or mezzanine financing.
The goal of an LBO is often to take a public company private or to spin off a portion of an existing business by selling it. Once the acquisition is complete, the private equity firm will typically look to make operational improvements or financial engineering moves to increase the value of the company.
After a few years, the private equity firm will aim to sell the company (either by taking it public again through an IPO or selling it to another company) at a higher valuation or to generate returns by extracting cash flows.
The most Famous LBOs in History
There are different opinions of the most famous LBO in history. Based on Deal Room by M&A Science, the list of 10 most famous LBO is:
RJR Nabisco (1989): $31 billion
McLean Industries (1955): $49 million
Manchester United Football Club (2005): $790 million
Safeway (1988): $4.2 billion
Energy Future Holdings(2007): $45 billion
Hilton Hotels (2007): $26 billion
PetSmart (2007): $8.7 billion
Alltel (2007): $25 billion
Kinder Morgan (2006): $22 billion
HCA Healthcare (2006): $33 billion
A typical LBO and Valuation Analysis Framework
A general LBO analysis covers five steps:
Cashflows projections: Develop an integrated model of the business that projects EBITDAa ndcash available for debt repayment over the investment horizon(typically three to five years)
Terminal value for the valuation: Estimate the multiple at which the sponsor can be expected to exit theinvestment at the end of the investment period
Pro-forma capitalisation: Determine a transaction structure and a pro forma capital structure thatresult in realistic financial coverage
Internal rate of return: Calculate the IRR to the equity sponsor
Adjustments: Adjust the transaction and capital structure needed to triangulate the IRR, leverage and valuation.
The Discounted Cashflows Valuation Method in the LBO Analysis
The same financial projections developed for a Discounted Cashflows Valuation can be used to build a LBO financial model. The free cashflows are expected to be used to service debt, with positive cashflows to equity coming at the exit or liquidity event.
The amount and predictability of free cashflows dictate whether a company is an attractive or viable LBO target.
Cashflows are not discounted. The terminal value drives valuation and is calculated on using multiples. The multiple of exit-year EBITDA is generally used to determine the valuation of the enterprise in any possible exit scenario.
The Valuation Model and the Capital Structure
In the valuation and cashflows model, the financial modelling of the sources and uses of capital is critical to determine the correct valuation of the LBO. We need to consider the following:
Sources of capital should show the entire proforma capitalisation of the company, including new debt, new equity and rolled-over debt and equity.
Uses of funds should address all parts of the target's existing capital structure and transaction-related leakages.
Sources must equal uses. Any debt or equity that is rolled-over show up under both sources and uses of funds.
The different components of capital include:
Senior debt - Such debt is usually provided by an investment or commercial bank. The debt is usually secured and has the most restrictive convenants. Further, the debt is first in line during liquidiation and has the lowest coupon rate.
Subordinated debt - This is usually supplied by an investment or commercial bank in a mezzanine fund. This debt is riskier and is typically unsecured. The debt has bullet structures and have a tenor of about 10 years.
Mezzanine securities - There are different types such as convertible debt, exchangeable debt and convertible preferred stock. The expected IRR is in the 15% to 20% ragne.
Common equity - This is provided by the financial sponsor. This capital is the highest risk and the cost of capital is the highest. The minimum annual return is more than 20%.
The Valuation Model in a LBO
When valuing a leveraged buyout (LBO), there are several key points to consider. These factors are crucial for the private equity firm, investment group, or any acquiring company to ensure that the LBO will provide a satisfactory return on investment.
We provide a practical valuation framework in an LBO:
Purchase Price: The acquisition price of the target company, including any premiums being paid over the current market value.
Debt: The amount and types of debt used in the acquisition, including terms, interest rates, and maturities.
Equity: The equity contribution from the acquiring entity or entities.
Cash Flows: Cashflows used in the valuation include:
Historical and Projected Cash Flows: Understand the company's historical performance and future cash flow projections. This will be crucial to determine the company's ability to service its debt.
Free Cash Flow to Equity (FCFE): Determines the cash flow available to equity holders after all expenses, reinvestments, and debt repayments.
Operational Improvements: Potential to increase profitability through operational efficiencies, cost-cutting, revenue growth strategies, and asset sales.
Exit Strategy: These are the common exit strategies:
Holding Period: The expected time the private equity firm or acquiring entity intends to hold the company before selling.
Exit Multiple: The anticipated valuation multiple at which the company might be sold in the future.
Potential Exit Channels: Whether the exit will be through a sale to another company, an initial public offering (IPO), or another method.
Synergies: If the acquirer is a strategic buyer, cost savings and revenue synergies that arise from the merger can be crucial for valuation.
Risk Assessment including industry risks: Understanding the industry's dynamics, trends, and potential future challenges.
Conclusions about the Valuation Model in a LBO
When performing an LBO analysis, it's essential to be thorough and often beneficial to use a combination of the above methods to triangulate a reasonable valuation range. Different methods might yield different valuations, and understanding the drivers and assumptions behind each method can help in making informed investment decisions.
The Discounted Cashflows Valuation method is the most common valuation method in and LBO.
This is a fundamental valuation method that projects the target company's future cash flows and then discounts them back to their present value using a suitable discount rate (usually the company's weighted average cost of capital or WACC).