Leveraged Buyout (LBO)

LBO valuation reflects the EV based on what a financial sponsor/buyer is willing to pay for the company given certain assumptions. (See table below) All other value driver forecasts are the same as in DCF/EVA.

The LBO analysis is useful in determining what a financial sponsor is willing to pay for the company and gain an acceptable return on its investment.

The LBO analysis - main steps

• Determine forecasts
• Determine new capital structure - leverage levels
• Determine time of exit and exit multile (normally the same as entry multiple)
• Determine the IRR return requirements and solve the acquisition Enterprise Value based on these and above assumptions.

Financial investors return requirements

Financial investors return is based on three factors:

• Debt repayment or cash accumulation (based on cash flows from operations)
• Operational improvements - revenue growth, EBITDA margin improvement etc.
• Multiple expansion - exit multiple is higher than entry multiple

LBO based buyers (financial investors a.k.a. private equity investors) seek to boost their return on equity by increasing leverage, hence if the cost of debt is lower than the return the firm generates, each dollar of leverage improves the return on equity, since there is money left after debt interest payments. Financial investors use the internal rate of return (IRR) to evaluate their potential return on equity.

In a private equity fund, IRR is the net return earned by investors from the fund’s activity from inception to a stated date. The IRR is calculated as an annualised effective compounded rate of return at which the net present value of cash flows equal zero.

Financial investors normally demand a return between 20% to 30%. In some situations the required return might be lower: special very secure and long-term investments (such as infrastructure investments), very large deals, in harsh economic environment where funding is very scarce etc.

Exit Strategies

A financial investor has a limited investment horizon, since the invested equity a financial investor invest is funded by a fund. The only way the fund can pay-back money to its investor is at termination, and termination can only occur after the equity investment has been terminated, hence the investment has been exited.

Normally financial investors has a expected holding period of 3 to 7 years. Some financial investors with special focus have much longer holding periods, this normally includes infrastructure related financial investors.

A financial investor normally has a very clear strategy before the initial investment, i.e. a financial investor might intend to buy the target company in-order to achieve a solid platform from which they can grow through numerous follow-on investment in order to create a company big enough to be floated on a stock exchange.

Basically, the financial investor has three exit options: sale to a strategic buyer or another financial investor, float the company (IPO) or a recapitalisation of the company.

Exit multiples

The LBO modeling is based on an assumption of exit value of the company. The normal assumption is that entry and exit multiple should be the same - everything else should be based on solid argumentation. If it is possible for the financial sponsor to sell the company at a higher multiple than the entry multiple, the multiple pick-up will boost the IRR. The potentially higher value of the company at the time of exit compared to the time of entry is normally based on improved operations, hence it is the higher EBITDA and not a higher exit multiple that drives the higher exit enterprise value.

The LBO analysis - complete overview of pre-modeling assumptions

• The result: calculate the maximum EV a financial sponsor can pay given certain requirements with regards to equity return (required IRR) and debt levels
• Determine value drivers and forecasts. As in the DCF and EVA model, the LBO model depends on EBITDA and cash flow forecasts as these determine the amount available for debt repayment over the investment horizon
• Determine entry assumptions
• IRR requirements: a financial investor has committed capital to a fund, this fund has a required return on equity investments. Any given investment completed by the fund should meet this requirement. In LBO modeling the acquisition Enterprise Value is found through back solving for a given Internal Rate of Return (IRR) given assumptions regarding forecasts, debt levels and repayment schedules and exit assumptions.
• Transaction costs: each transaction includes costs, hence the acquisition Enterprise Value is not equal to the financial sponsors investment, since the financial sponsor encounters costs related to different advisors engaged in the transaction.
• Common equity:
• Entry date: is the date of which the transaction is completed
• Total debt: one very important assumption with regards to LBO modeling is the debt assumptions. This includes how much debt the financial sponsor can leverage the company - there will be a recapitalisation of the company with a new capital structure following the change of ownership.
• Total senior debt/EBITDA: often in LBO modeling the total senior debt available by banks is assumed as certain EBITDA multiple. Based on this purpose EBITDA is normally based on last years actual, the forecasted EBITDA is security level, hence the lending is based on actual figures and not forecasts.
• Total financing debt/EBITDA: there is also other sources of funds available. The total debt in the new capital structure is assessed also necessary to determine in LBO modeling
• Determine exit assumptions
• Exit EV/EBITDA multiple: since a financial investor normally has a short investment horizon, the LBO modeling includes a complete sale of the company at the time of exit. The standard assumption with regards to exit value is that the company can be sold at the corresponding entry multiple. The entry multiple is a residual found when calculating the price range that supports the investors return requirements.
• Exit date: in the LBO modeling it is necessary to determine the time of exit - as in the DCF model where it is necessary to determine the time of the terminal period. The difference is that the time of exit has nothing to do with a stable growth period, but only depends on the investors investment horizon.
• Determine sources of funds: there a numerous type of funds that an investor could include:
• Senior debt tranche A – amortised
• Senior debt tranche B – bullet loan - everything is repaid as a bullet at some period of time in the end
• Senior debt tranche C – bullet
• Mezzanin - bullet
• Shareholder loan - it is typical that a financial investor includes a shareholder loan in order to minimise the tax burden.
• Common equity - this is the equity investment that the financial investor invests directly in the company. It is not the total investment done by the financial investor since they also incur costs related to advisors etc. (important to include these costs in the IRR calculation)

Which companies are more likely to be acquired by a financial investor?

There are many different case specific situations where other reasons (different from those stated below) are important. The following company specific characteristics are normally assumed to work in the favor of a financial investor

• Stable cash flow from operations
• Following the stable cash flow, the company and industry should be mature and steady
• The company should have a leading position
• Limited investments needed in maintenance and expansion (CAPEX)
• CAPEX should preferably be related to maintenance
• Limited investments in working capital
• Limited need for operational cash (cash tied-up in operations)
• Solid asset base
• Strong management
• Numerous exit possibilities
• Currently undervalued
• Seller is interested in an exit
• Currently low leverage
• No existing unfavorable interest rate swaps
• Significant improvements (potential)
• Strong growth opportunities

There are numerous other important factors outside the company that are perhaps even more important to financial investors. Perhaps the most important factor is the accessibility and cost of leverage. Not to forget the industry: competition, drivers, political focus etc.