Big background resources07
M&A and general valuation

Enterprise Value is a measure of a company’s value. It is the value of the capital employed by the company: the market value of the company’s machines and commercial activities.

You need to think of the Enterprise Value as the theoretical takeover value: the price an acquirer would have to pay to be the only master on board. In an event of a buyout, where the acquirer would purchase the equity and the debt but would use the cash and cash equivalent sitting in the company.

Enterprise Value is equal to Market Value of the equity (market capitalization of a listed company) + total financial debt – cash & cash equivalent + minority interests – investment in joint ventures and associates.

Be aware that Enterprise Value calculation is not always that straight forward and often requires adjustments to get as close as we can to market value.

 

This question is asked to see if you know the different valuation methodologies, so fairly simple! More questions may follow to get more details on each one of them.

 

Trading Valuation

This applies only to listed companies. It is a stand-alone valuation approach (no control included and does not reflect an acquisition value). You simply look at the market capitalization, which will give you the equity value and at the market value of the debt (if available, otherwise you take the book value). To this you make the usual adjustments such as Minority interests, operating leases, investment in associates etc… and you get to Enterprise Value. It is the basis for the calculation of your trading multiples!

 

Comparables – Trading Comparable

You would get to a standalone valuation of a company. Here, you will benchmark the company you want to find the value for with listed companies. You create a set of listed comparables and will calculate the relevant valuation multiples.

 

Comparables – Precedent Transactions

With precedent transactions you will find a transaction value for the company (including control premium) as you will benchmark it with comparable companies acquired in the past (how much were they usually acquired for?).

 

Intrinsic valuation – Discounted Cash Flow Analysis

The discounted cash flow is the only intrinsic value methodology available (only relies on the company’s cash flow generation profile).

 

Transaction Value – Leveraged Buyout Analysis

With LBO analysis, you look at the value would have in the eyes of a financial sponsor (how much could they pay for it?).

FCF (Free Cash Flows) is a measure of financial performance (cash generation), which is equal to cash flow from operations – capital expenditure: it show how much cash a company is able to generate after paying capex to maintain and grow the business.

Free cash flow to the firm is calculated as follow:

 

Enterprise Value is equal to Market Value of the equity (market capitalization of a listed company) + total financial debt – cash & cash equivalent + minority interests – investment in joint ventures and associates.

Cash can be used to repay debt. This is why Net Debt is used in Enterprise Value Calculation (Total Debt – Cash & Cash equivalent). When you think about Enterprise Value, you need to think about the net spending, from an acquirer to be the only remaining stakeholder in place (buying the equity and the debt).

 

If you follow Modigliani-Miller theory, it does not change anything. Enterprise Value is the value of the capital employed by the company. Debt and equity are just financing the capital employed. It is a bit like 4 = 2 +2 but 4 = 1 + 3 too.

Let’s say a company has a $300m Enterprise Value.

As a reminder, EV = Equity + Net Debt and Net Debt = Financial Debt – Cash.

If you raise more debt for your company and do nothing with it (you don’t buy other machines for instance) and you just keep the money at the bank, you are just increasing your debt liability, but also your cash balance. The net impact is 0 in term of Net Debt and in term of Enterprise Value:

 

Operating leases are off-balance sheet items, financial leases are on the Balance Sheet. While they are technically different, operating and financial leases are not that different in economic nature.

Financial leases are treated as debt in the calculation of Enterprise Value, why would operating leases not?

To adjust Enterprise Value for operating leases (and consider them as capitalized, i.e. a balance sheet item), the analyst has to 1) recognize the value of the lease on the balance sheet and 2) make related adjustments in the Income Statement.

 

Capitalize the lease

Through an operating lease, the Company will pay a rent over the period of the contract. The capitalized value of the lease is the present value of the future payments (rents).

To discount the different payments, the cost of unsecured debt pre-tax (at the moment of the signature of the contract) is used.

 

Related adjustment on the Income Statement

If we now consider that the operating lease is capitalize as a financial lease, the Income Statement has to be adjusted. The rent is not a rent anymore and is now going in financial costs below EBIT.

 

 

In practice, it is fairly rare to use this method. Rating agencies, such as Moody’s indicate an estimate of the value of a capitalized operating lease as being: rent x 8, which, in this case, would have given 10 x 8 = $80.

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%.

Most of the time, Discounted Cash Flow valuation will give the higher valuation. DCF is an intrinsic value methodology. It will grasp the full value of the company.

It is also a control-based methodology (including control premium), which gives higher valuation.

In conclusion, it is very likely that:

  • DCF > LBO (WACC for a DCF is usually lower than the WACC in a LBO transaction)
  • DCF > Trading Comparable

Here is an overview of a “Football Field”, a summary valuation page which is often shown in books to potential clients and clients:

 

It depends on the asset you are valuing and the type of investor/ acquirer:

  • DCF: if the asset has a finite life, very predictable cash flows DCF will be very “precise”. If you take the example of a Gold Mine, it is fairly easy to forecast cash flows and the life span of the asset. Depending on the type of investor, it will be very accurate to use DCF, more than comps (perfect comps do not exist)
  • LBO: accurate for Private Equity investors
  • Precedent transactions: good proxy for an acquisition valuation, if the transactions are really recent. Be carefully to pay attention to the type of acquirer (Financial sponsor or Strategic). Precedent transaction multiples will take into account 1) a control premium and 2) a valuation of the synergies (if the acquirer is a Strategic)
  • Trading comparable: good proxy for standalone valuation

This is question is asked to check if you know how to run through a DCF analysis. Here are the steps: 

 

Key Numbers

Get the operating model for the company (either received by the company itself or built by you).
Unlever the cash flows: strip away all the different items linked to capital structure: interest expense, interest income, dividends, preferred shares, debt repayment, new debt, new equity etc…

 

Forecasts

Extrapolate financials: you will have research to back up 2,3 or 4 years of forecasts, therefore you will have to extrapolate your financial to a normalized year over the DCF horizon (c.10 years, but it depends on the business) 

 

Free Cash Flow to the Firm

Calculate the unlevered free cash flows to the firm:
EBITDA
– taxes (calculated on EBIT as you strip away interest expense, interest income…)
+/- variation in working capital
– capex
= FCF 

 

Discount Rate

Calculate the discount rate: the weighted average cost of capital (“WACC”), the blended cost of debt and equity 

 

Terminal Value

Calculate the Terminal Value, based on normalized year. You have 2 methods: 1) Gordon Shapiro approach or 2) the multiple approach. The terminal value is the Enterprise value of the company at the end of the horizon, once the company is completely mature. Be careful there are businesses which do not have terminal value (e.g. a gold mine is running out of gold at some point). 

 

Enterprise Value Calculation

Discount the cash flows and the Terminal Value. Sum everything and you get the Enterprise Value

In the DCF analysis, you have to discount cash flows for each period of your horizon forecasts. For year 1, you will discount the respective cash flow over 1 period, for year 2 you will discount the respective cash flow over 2 periods etc…

This implicitly assumes that the company receives the total cash flow at the end of each year.

 

 

However, cash flow is not receive in one lump sum at the end of the year, but rather all along the year.

 

 

The mid-year convention in a DCF suggests that, instead of assuming the cash flow is received at the end of each year, it is received in the middle of the year, which average out all the cash flows along the same year. It means that cash flow for year 1 will be discounted over a period of 0.5, cash flow for year 2 over a period of 1.5 etc…

 

WACC is the weighted average cost of capital. It is the average return expected by both debt and equity providers. It is calculated as follow:

WACC=E/(E+D)* Re+D/(E+D)* Rd*(1-t)

Where E is the amount of equity, D the amount of debt, Re the cost of equity, Rd the pre-tax cost of debt and t the tax rate.

It is used in DCF analysis to discount cash flows. It is also an interesting piece of information on a company as it will give a hint on what type of returns it could expect from its investments (at least equal to WACC).

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”.

Beta is a measure of volatility, or systematic risk of a security or portfolio of investment vs. the market. Beta is calculated using regression analysis and:

Beta formula

Beta < 0 means the share price would potentially react in the opposite direction as compared to the market
Beta = 0 means share price is uncorrelated to the market
Beta positive means share price will react in the same direction as the market
Beta = 1 means share price will move in the same direction and amplitude as the market
Beta > 1 means share price will over react the market in the same direction

Step 1: Select the universe of transactions – Through your deal team and people who have the knowledge internally – Using screening tools (CapitalIQ, Megermarket)

Step 2: Pull together the financials (EV, EBITDA etc)

Step 3: Spread the comps

The Capital Asset Pricing Model (“CAPM”) is just the equation which allows you to calculate the expected return from an asset compare to the market:

Re = β x (Rm – Rf) + Rf where Re is the expected return of the asset, β is the associate Beta of the asset, Rm is the return from the market and Rf the risk free rate

Where you can find the different pieces of the puzzle:

  • Rm: Bloomberg or Ibbotson. Ibbotson regularly produces a report market returns
  • Rf: Bloomberg or other financial information provider (CapitalIQ, Thomson One, Factset etc…) – risk free rate corresponds to long term “risk-free” return from government bonds
  • Beta: either from Bloomberg or Bara or it can be calculated or benchmarked 

To find the cost of equity, use the CAPM:

Re = Rf + Beta * (Em – Rf)

Beta: go to Bloomberg or Bara (another database) – check how they calculate Beta (over what period, is it 1, 2, 3 years?). You have 2 types of Beta: 1) raw and 2) adjusted. Raw Beta is a pure application of the formula. Adjusted means that the data provider makes a little tweak in the calculation. For instance, Bloomberg would do: 1/3 * 1 + 2/3 raw Beta which means Bloomberg adjusted Beta is more “smooth” and closer to the reaction of the market.

Rm: Bloomberg or Ibbotson. Ibbotson regularly produces a report market returns

Rf: Bloomberg or other financial information provider (CapitalIQ, Thomson One, Factset etc…) – risk free rate corresponds to long term “risk-free” return from government bonds

Beta: either from Bloomberg or Bara or it can be calculated or benchmarked

It will be levered Beta, which means they will take into account the leverage of the particular company. It is also called Equity Beta as reflecting both the operating and financial risk of the company/asset.

When do you calculate a synthetic Beta

When you want to get the WACC for a company, you need to figure out its cost of equity, which according to the CAPM is: β * (Rm – Rf) + Rf where Rm is the average return of the market and Rf the risk free rate. β is a measure of the correlation of the company’s share price to the market.

If the company is not listed or if you consider that the share price has not been trading in a “reasonable” way (i.e. the company is going through a distressed situation) or the company is not listed, you need to find what could be its Beta in order to calculate its cost of equity.

 

How do you calculate it

  1. Create a comparable set of companies: companies with in the same sector, geographies, activities, etc…
  2. Gather the following information: 1) current market capitalization, 2) latest total debt number, 3) tax rate for each company and 4) Beta (through Bloomberg or Bara). The Beta you got are “levered” Beta
  3. Unlever the Betas of the comparable set of companies (βL is the levered Beta, βU is the unlevered Beta and t the tax rate):

    Unlevered Beta

  4. Calculate the average of the Unlevered Betas. Relever average Unlevered Beta with target capital structure of the company. Target capital structure can be the average of the peers in the comparable set selected to gather the unlevered Betas

From the most quick and dirty to the most advanced way of calculating your credit spread. By the way, credit spread is the difference between your cost of debt and the risk free rate. It is the extra risk which has to be paid vs. risk free rate.

Way 1: quick one

Calculate the weighted average cost of debt for the company. The company will have different tranches/ type of debt with different associated interest rates. Calculate the credit spread for each of the tranches of debt and calculate the weighted average.
Example:
$100 Loan @6% 
$20 PIK @10%

The combine interest expense will be $8, which imply a combine interest rate of 6.7%. If the interest free rate is of 1.5%, the credit spread is 5.2%.

 

Way 2: more detailed

Let’s go a bit more in details! Let’s now take the “right” risk free rate for each tranche/type of debt. The different tranches may have been structured at different period with different maturities.

Example:
$100 Loan @6% with maturity in 5 years 
$20 PIK @10% with maturity in 10 years

Governments issue bonds with different maturities. To be more precise, let’s take a 5-year maturity government bond with interest rate 1.8% for the $100m loan and let’s take a 10-year maturity government bond with interest rate 1.5% for the $20m PIK.

We can now calculate the credit spread for each of the tranches:
Loan: 6% – 1.8% = 4.2%
PIK: 10% – 1.5% = 8.5%

Calculating the weighted average credit spread gives us: 4.2% * 100 + 8.5% * 20 = 4.9%

 

Way 3: current yield

Way 3 is the same as Way 2 except you would take the yield for the different tranches of debt, and the current yield for the risk free rate. You will be able to find this on Bloomberg. While this method is longer, it will be closer to market value, and God knows bankers lover market values and cash value!

 

Way 4: benchmark and current yield

If your company is private and does not disclose details regarding its capital structure or if you think that the current cost of debt is not representative, in the long run (because the company goes through a restructuring or distressed situation or other), you can benchmark the cost of debt and the credit spread.
You need to create a set of comparable debt issuances in the sector. For each of them, you apply “Way 3” and you can then calculate the average credit spread!

Once you have your normalized year in your DCF, the terminal value is fairly easy to calculate:

 

Multiple method

You look at comparable and you estimate the level of trading multiples at the end of the horizon forecast. As it could be 10 years you understand why it is fairly open to discussions… If comps are trading at 10x EBITDA today, you can probably assume that it might go down to 6x 10 years later (there is no real rule here, trust your feeling and general understanding of corporate finance).

Once you have your multiple, you apply it to your EBITDA in the normalized year to find the terminal value.

 

Gordon-Shapiro approach

The Gordon-Shapiro formula considers that the company will get a certain stage of maturity where cash flow will become some sort of annuities and would grow in line with inflation: the perpetuity growth rate. With this method, terminal value is extremely sensitive to the WACC and the perpetuity growth rate “g”. Finding g is not a science, trust your gut and where you feel the valuation should be. Here is the formula where (g is the perpetuity growth rate):

Gordon Shapiro

Both methods are often used to cross check one to another. If a 7x multiple (in the multiple approach) implies a 6% perpetuity growth rate… it means the multiple is probably way too high.

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:

 

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.

A merger model is the analysis of the combination of 2 companies either through a merger or through an acquisition.

The inputs in this analysis are de operating models of both companies and the structure of the transaction. The outputs are the combined financials (pro-forma financials), accretion/dilution, combined leverage and impact on the shareholding structure.

1. Forecasts

The first step of this analysis is to build (or receive from the client) the operating models/ forecasts for both companies with a 3-to-5 horizon forecast.

 

2. Structure of the transaction

What type of acquisition will it be? 100% stock, 100% cash or a combination of both?

Build the “sources and uses” for the transaction: how much the acquirer will have to pay to acquire the target, and how the acquirer will finance the acquisition.

 

3. Combination and adjustments

The combination of 2 companies is more or less a sum or their financials. Estimate and include synergies. Adjust for combine number of shares (new issue vs. shares of the target cancelled).

 

4. Impacts

Calculate combined earnings per share (“EPS”) and assess the accretion/dilution effect. Also analyze the impact on combine leverage (if the acquisition was finance by debt/cash) and shareholding structure.

Theoretically, the company with higher D&A will have a higher valuation. The company with the higher D&A will benefit from additional tax shield and pay less tax. While it will pay less tax, D&A are not a cash item so will be added back to the calculation of the Free Cash Flow. All in all, FCF will be higher if the company has higher D&A, which will result in a higher DCF valuation.

 

 

It makes some sense. If you have 2 identical companies, you will put additional value on the one which have the machines. If something goes wrong, you can sell the machines!

Synergies are the additional value resulting from a merger. When company A is looking to acquire company B, it is to create A+B+Synergies and not only A+B. Synergies are part of the rationale behind mergers and acquisitions.

There are 2 type of synergies:

Cost synergies

Relatively “easy” to quantify. They consist in reduction of workforce (redundant positions in the 2 companies), elimination of surplus facilities and plants, reduced overheads (consolidate functions such as accounting, legal, IT, marketing etc…), potentially increase in purchasing power etc… (i.e. economies of scale).

Revenue synergies

Relatively “hard” to quantify. A combine company may have the power to sell more product in one go (bundle), selling products to new customer bases etc…

Usually, we do not take into account revenue synergies in modelling and analysis as they are very hard to quantify. Regarding cost synergies, they are either driven in cost base reduction over a certain period of year or as a percentage of target revenue.

In any case, synergies are not free! In order to be implemented, the company will have to actually spend money in restructuring (“restructuring charges”): it costs money to lay-off people or close plants.

Synergies are usually “phased-in”. If the deal is expected to generate $100m of synergies over the next 3 years. It means that in year 1, 20% of this target will be achieved, in year 2 75% and 100% in year 3 and going forward.

 

 

In practice, when the deal go forward, consultant are higher by the acquirer to quantify the potential synergies and how they can be implemented.

In this question, your answer cannot be “I am building a merger model, and we will see”.

It requires you to compare the Price Earnings ratio (P/E) of both the acquirer and the target.

1. Transaction 100%

It means the acquirer will use its shares to buy the target’s shares (by way of new issue of shares).
If P/E of acquirer > P/E target, the deal will likely be accretive: the acquirer uses high-valued earnings to buy additional less-valued earnings.

Example: Company A has a P/E of 15x and Company B has a P/E of 10x. In the situation where Company A would acquire Company B, the transaction will likely be accretive for Company A’s shareholders.

 

2. Transaction 100% cash

In this situation, the acquire will use cash/debt to finance the acquisition

You have to make the same type of comparison as in the previous example except, instead of using P/E of the acquirer, you will use P/E cash of the acquirer (i.e. what is the cost of cash?).

P/E cash is define as: 1 / [(1 – t) x cost of debt] where t, is the tax rate.

Example: Company A wants to acquire Company B, which has a P/E of 10x. Company A will use 10% interest debt to finance the acquisition. It has a 30% tax rate. Company A’s P/E cash is then equal to 14.3x. The transaction will likely accretive for Company A’s shareholders has its P/E cash > P/E Company B

 

3. A mix of stock and cash    

For a mix, you can make an estimate by calculating an average of the P/E cash and P/E, but it’s becoming too approximate. In that case it is better to start building a model.

Let’s say ”A” wants to sell its company for $10m based on a success of a special project (in the company), but ”B” wants to spend only $7m for the acquisition because ”B” is not that confident in the success of the specific project. ”A” and ”B” can signed a SPA where you would have an ”earnout”.

 

It means that ”B” will pay $7m to ”A” now and a certain amount, correlated to the success of the project later (called the earnout).

An earnout is just a differed payment in an acquisition, which is dependent on the success of the company. It can be linked to gross sales for example.

 

Earnouts are popular among private equity investors, who do not necessarily have the expertise to run a target business after closing, as a way of keeping the previous owners involved following the acquisition.

 

This is a pretty old article, but interesting: article 

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.

You would use the usual suspects: DCF, LBO, Comps.
Be careful to use adjusted aggregates (for instance EBITDA adjusted for exceptional items linked to the distressed situations such as advisors fees, debt fees etc…).

“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.

 

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

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.

Enterprise Value is equal to the value of the Net Debt + the value of the Equity. If for some reasons, the company cash flows are decreasing and the outlook is bad, it Enterprise Value will decrease. As Equity is the most junior financing instrument, it will be the first to take a hit in term of value: Equity Value decreases.

 

 

In practice, if Enterprise Value decreases a lot, the debt will also take a hit (much less than equity). If debt holders and investors are too uncertain about the future of the company, debt will loose value (will the company be able to fully meet its obligations?).

  • 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

Accretive. Generally when a company with a higher multiple acquires a company with a lower multiple, the transaction is accretive. This is true because the acquirer is paying less for every pound of earnings than the market is currently valuing.

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

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!

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

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

Sum of Sources = Sum of Uses

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…

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.

 

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).

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.

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).

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