Big background resources04
Leveraged Buyout

After most analysis, sensitivities are built to test the outputs. In a LBO analysis, the outputs are the returns (CoC and IRR).

Returns are tested in function of:

Time: it is important to see what the impact is if the participation is sold 3 years after acquisition or 6 years after

Transaction multiples: what happen if exit multiple are lower, equal or higher than the acquisition multiple? What can we afford in term of entry valuation?

Operations: this will depend on the asset. Some companies may be extremely seasonal and will show strong swings in working capital (it will be important to stress this vs. return) or the investor may be worried about fluctuation in certain raw materials prices (what happen to the returns if prices increase by 10%?) etc…

1. Build operating model

Build the operating model for the target company. The most important financial aggregates will be the ones which will allow you to calculate a detailed cash flow before debt service (payments of debt principal and interests). The LBO transaction implies a completely new capital structure (more debt and more diverse tranches of debt). You will want to know if the company can support the new cap structure!

 

2. Valuation

Once you have the key financials, you need to know how the company is worth. Here it’s a usual valuation exercise: comps (precedent transactions and trading comps) and DCF.

 

3. Sources and uses

When you know how much the company is worth, you need to know how much the financial sponsor will pay for it in total: don’t forget transaction costs – it’s not free to raise debt and you will have to pay advisors (legal, financial etc..).

This step requires to think about the structure of the transaction: how much debt can you put in the transaction? What type of debt? And ultimately, what is the equity check (what the PE shop will have to put on the table)?
You will be able to answer these questions by looking at recent transactions in the same sector, by judging the appetite of banks in financing the asset etc…

 

4. New capital structure, new set of forecasts

When you have your new capital structure, you can then modify the operating model of the company: new interests to be paid, new type of debt to be repaid.
The forecasts will start from what is called “pro-forma” financial (pro-forma for the transaction).

 

5. Credit statistics

Once you have your new set of forecasts, it is very important to know if it works! By “it works”, we mean “can the company support the heavy amount of debt?”. Credit statistics are some of the most important measures in a LBO, you will calculate ratio such as leverage or interest cover ratio in order to see 1) if the company can repay the debt and 2) if the company can repay the debt quickly. If the company can’t support the capital structure you set up, you have to modify it (lower the debt, use other debt instruments – loan, PIK note, high yield bonds etc…).

 

6. Returns

When you have your sustainable capital structure, you need to calculate the returns for the financial sponsor. 2 key measure of return: 1) Cash on cash (“CoC” multiple) – you invested £100 and you get back £200 when you liquidate your investment, you made a 2.0x CoC – and 2) Internal rate of return (“IRR”) which a value of return in percentage and taking into account the factor time.

Bear in mind that expected returns vary in function of the type of financial investor. A pension fund will expect a 10%-14% IRR while a Venture Capital firm will expect at least 30%-40%.

Here, Par value is 100 so you lost 20 cents on the dollar (100-80). 
That twenty cents is divided by five since you still have five years left on the investment (20/5=4). 
So the current yield on the note is 14% (10+4=14).

The rule of 72 allows you to estimate compounded growth rates.

Estimated CAGR = 72/years to Double Money

Assuming that no dividend are paid through the period and do dividend recap:

IRR = [(Equity Value at Exit)/(Equity Value at Entry)]^(1/# of years of the investment) – 1

A cash sweep is the use of excess free cash flow to repay debt. It means that there is no “fix” planned repayments for the debt, instead, whenever the company generates an excess in cash (above an agreed threshold), this excess cash is used to repay the debt.

Usually bank debt is cheaper than high yield debt. It will be cheaper because less risky than high yield debt (“junk bonds”). Bank debt will be more senior so in case of liquidation, banks will receive the money first. In addition, bank debt will be more likely to be secure against the company assets.

“PIK” stands for Payment In Kind. A PIK interest means that the company does not have to pay the interest in cash at each period. PIK interest will add up and will have to be repaid at maturity.

 

  • Increased leverage 
  • Might offer lower cost of capital (since cheaper than equity) with less equity dilution
  • Interest paid on Mezzanine debt is tax deductible where dividends are not
  • Senior creditors benefit from the cushion of the junior debt 
  • Debt under mezzanine arrangements is often payable after certain years (PIK interest), delaying obligation to buyer

A leveraged buyout (LBO) is an acquisition which is heavily financed by debt. It means the acquisition will require less equity contribution (the “equity check”).

LBO are usually structured by financial sponsors which can play with 3 main leverage or value drivers (time is a strong factor in LBO transaction, so the faster you generate value, the better):

Financial leverage

As mentioned, the transaction is heavily levered. The main assumption is that the acquired company will be able to repay the debt along the holding period. If the debt is repaid and the EV of the company remains constant, the transaction generates value for the equity holder:

 

 

Operating leverage

If the company grows and expand during the holding period, it will generate value for the equity holder. If the company was acquired when it had an EBITDA of £10m and sold with an EBITDA of £15m and everything else remains equal, equity holders are winners:

 

 

Multiple expansion

If the acquired company is in a sector which is not particularly popular, acquisition multiples may be low. If 5 years after acquisition the sector became hot, acquisition multiples may be higher:

 

When you look at the impact of a particular item on the 3 financial statements, you need to approach the financial statements one by one:

  • Income Statement: PIK interests decrease earnings before tax so taxes are lower
  • Cash Flow Statement: PIK interests are not paid by the company yet so they have to be added back in the Cash Flow Statement. Due to lower taxes, cash flow is higher
  • Balance Sheet: PIK interests increase debt position

Operating leverage is related to the composition of the cost structure: fixed costs vs. variable costs. In other words, it is a measure of how revenue growth translate into operating income (EBIT) growth.

 

High operating leverage

It means the company’s cost base has a strong proportion of fixed costs. If Revenue increase, it will less and less be “used” to cover the costs and more and more dedicated to cover the operating profit and generate more margin.

 

 

Low operating leverage

The company’s cost base has a low proportion of fixed costs and a high proportion of variable costs. If sales increase, margin growth will not be as high as in the case of a company with high operating leverage.

 

A covenant is a condition written into a loan agreement, which, if broken, can trigger an event of default. There are generally two sorts of covenant: maintenance covenants and incurrence covenants.

Covenants are check points, which have to be verified at specific dates. If the companies complies with the covenants, everything is fine, if it does not, the debt holders can take actions to recover their money.

If Company ABC has a 12% WACC, it means that shareholders and debt providers are requiring a 12% average return. Company ABC should not go for investments providing returns (IRR) lower than its WACC as it would not generate enough value to satisfy both debt and equity providers.

In this case, the answer is “no”.

A Revolving Credit Facility (“RCF”) is a line of credit where the Company pays a commitment fee and is then allow to draw on the facility whenever it has a need (generally operating need).

It means that the Company will pay a fee, to be able to borrow money (the amount is capped) whenever it wants, to finance particular swing in working capital or other operating needs. When the Company draws on the RCF (for example £20m out of a £50m RCF), it will pay interest on the drawn amount and will continue paying the commitment fee on the undrawn amount (£30m).

The company repays the drawn amount whenever it can (as it is the most expensive part of the RCF, vs. undrawn amount).

1. Build operating model

Build the operating model for the target company. The most important financial aggregates will be the ones which will allow you to calculate a detailed cash flow before debt service (payments of debt principal and interests). The LBO transaction implies a completely new capital structure (more debt and more diverse tranches of debt). You will want to know if the company can support the new cap structure!

 

2. Valuation

Once you have the key financials, you need to know how the company is worth. Here it’s a usual valuation exercise: comps (precedent transactions and trading comps) and DCF.

 

3. Sources and uses

When you know how much the company is worth, you need to know how much the financial sponsor will pay for it in total: don’t forget transaction costs – it’s not free to raise debt and you will have to pay advisors (legal, financial etc..).

This step requires to think about the structure of the transaction: how much debt can you put in the transaction? What type of debt? And ultimately, what is the equity check (what the PE shop will have to put on the table)?
You will be able to answer these questions by looking at recent transactions in the same sector, by judging the appetite of banks in financing the asset etc…

 

4. New capital structure, new set of forecasts

When you have your new capital structure, you can then modify the operating model of the company: new interests to be paid, new type of debt to be repaid.
The forecasts will start from what is called “pro-forma” financial (pro-forma for the transaction).

 

5. Credit statistics

Once you have your new set of forecasts, it is very important to know if it works! By “it works”, we mean “can the company support the heavy amount of debt?”. Credit statistics are some of the most important measures in a LBO, you will calculate ratio such as leverage or interest cover ratio in order to see 1) if the company can repay the debt and 2) if the company can repay the debt quickly. If the company can’t support the capital structure you set up, you have to modify it (lower the debt, use other debt instruments – loan, PIK note, high yield bonds etc…).

 

6. Returns

When you have your sustainable capital structure, you need to calculate the returns for the financial sponsor. 2 key measure of return: 1) Cash on cash (“CoC” multiple) – you invested £100 and you get back £200 when you liquidate your investment, you made a 2.0x CoC – and 2) Internal rate of return (“IRR”) which a value of return in percentage and taking into account the factor time.

Bear in mind that expected returns vary in function of the type of financial investor. A pension fund will expect a 10%-14% IRR while a Venture Capital firm will expect at least 30%-40%.

The leverage is the amount of debt in a company.

When you decide to assess the leverage capacity of a company, you want to know the maximum leverage of the company.

When you want to assess a maximum leverage you need to make sure that the company can repay 1) interest expense and 2) the principal.

To do so, it is important to look at cash flow before debt service, its evolution and sensitivity to different parameters (sales growth, costs evolution etc…). This cash flow will have to be sufficient to 1) pay interest, 2) pay principal and 3) gives some headroom to allow the company to grow or face bad situations.

You can back-calculate the maximum leverage by taking the amount you can afford to give up to the debt holder.

To assess maximum leverage, you need to also look at the market: are companies in this sector very levered? Are banks landing money to this type of companies?

To assess leverage for a target, the financial sponsor need to be sure that the company can repay the debt quickly and gives space for equity value creation! If you have too much debt, equity value might get to 0 if things go badly!

First an information memorandum is a 50-to-100 page book on the company to be sold. You will find in it financial information (historical and forecast), market overview, strategy, management team etc…

If it come from the sell-side advisor, it’s a marketing document, so it will be fairly “optimist” in term of projections.

Let’s consider you are a regular private equity firm, you will target roughly 20%-25% IRR. So if, with very optimistic number you get a 15% IRR in your model, it probably means the investment would not work for your investor profile.

You can ask additional questions to the seller to clarify the situation (as you don’t make investment base on excel), but you would probably exit the process or bid very low (as other buyers could have the same approach).

Cash on cash is an absolute measure of the return from an investment (you invest $100 and you get back $200, your CoC is 2.0x).

IRR (internal rate of return) is a time-relative measure of the return from an investment. You can make 2x your money in 2 weeks or in 10 years! IRR will take time into consideration.

For this question, you would prefer 2.0x your money as it corresponds to a 26% IRR over 3 years.

Sources of funds: debt and equity
Uses of funds: current debt paydown, paying equity holders, transaction fees etc.

Sum of Sources = Sum of Uses

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