LBO tutorial Financial Buyers

Financial buyers are very different from strategic buyers. Recall from the tutorial 'Corporate Valuation - Merger Consequences Analysis' that strategic buyers measure their affordability by accretion/dilution, synergies, and the financing consideration's impact on the acquirer's credit rating. Financial buyers are different in the sense that their time horizon is much shorter (typically 3-5 years per LBO investment). Financial buyers raise capital from investors, such as high net worth individuals, insurance companies, endowments, pension funds, and other institutional investors, and then actively search for undervalued companies to acquire. Typically, they use more debt in the acquisition than a strategic buyer would. Financial buyers usually benchmark their success through a measurement called internal rate of return (IRR), which will be covered in detail later in the tutorial. An acceptable IRR for a financial buyer depends on the financial buyer itself, market conditions, and the type of investment. Financial buyers have acceptable thresholds for their investments. Typically, private equity targets returns of 20-25% or higher. Financial buyers are also referred to as financial sponsors, LBO firms, buyout firms, or private equity buyers. Private equity technically covers non-publicly traded ownership, encompassing early stage investments (venture capital) as well as investments or buyouts of mature companies. This tutorial will focus solely on LBO transactions.

Lenders
Lenders provide the debt financing to support the initial purchase of the target company. Important questions lenders ask include: Is the risk level of the deal reasonable? Too much debt could create a huge future cash flow obligation for the company through interest payments and repayment of principal. Can the company reasonably support the amount of leverage? What is the certainty of the interest payments and principal repayments? Lenders want their coupon to be paid on time and principal to be amortized, according to the pre-determined schedule. What is the confidence in the financial buyer? The financial buyer is like the captain of the ship and will be (directly or indirectly) making management hiring decisions, running or advising on operations, and handling valuation and financing issues. What is their past track record? What is their strategic plan for the company post-LBO? There are two basic types of lenders in an LBO: senior debt holders and subordinated debt holders. We will explore the characteristics of these types of debt in more detail later in the tutorial.

Selling Shareholders
The last party involved in the transaction is the selling shareholder(s). Their primary motivation is to

get the best price for their equity. If the purchase price and premium paid are high enough, the selling shareholders are more likely to accept an LBO transaction. The key requirement for an LBO to work is that all three parties involved must be satisfied. There may be a situation where a potential deal makes sense for the financial buyer and lender. But if the offer price is not high enough for the seller, then there is no deal. Later on we will examine how the three parties have very different motivations.

Senior Debt
Commercial and investment banks typically provide a large part of an LBO's capital structure in the form of bank loans; hedge funds are also a growing source of loan capital. These loans are usually secured by the assets of the company, making them lower risk than other forms of capital. In the event that something goes wrong, banks have seniority of claims on the assets. As a result of this seniority, bank loans are typically referred to as senior debt.

Senior debt usually comprises 3050% of total capital structure of an LBO. Their returns earned are based on the interest rate charged on the loan. The interest rate is based on the current yields in the credit markets: 7-9% has been a typical historical range. Loans normally have a maturity of between five and eight years, making them of shorter duration than the other pieces of the capital structure. Thus, banks are repaid before the bondholders and other capital providers. Due to the riskiness of debt itself, the senior debt lenders will limit how much debt they will lend to the LBO transaction. When the amount of senior debt is maximized, the financial sponsor will need to tap into the subordinated debt market. Senior debt is debt that has priority claim over other debt holders in the event of bankruptcy or liquidation. It typically comprises a revolving credit facility and a series of bank term loans. Senior debt is typically bought by commercial and investment banks as well as institutional investors such as pension funds and insurance companies. Much like a credit card for an individual, the revolving credit facility allows the company to draw down (borrow) on the facility when needed and pay off the balance with any excess cash flow. Like a traditional home mortgage, a bank term loan has scheduled interest and principal payments. Senior debt holders are 'senior' in the capital structure, meaning they are first in line in case the company is liquidated due to a default. Sometimes senior debt is backed by the operating assets of the business ('securitized'), further lowering the financial risk. Because the senior debt is less risky, the senior debt holders charge a lower interest rate.

Subordinated Debt
Financial institutions, high yield funds, merchant banks, and hedge funds typically purchase the subordinated debt. This debt is typically unsecured (not backed by the assets of the company), making it riskier than other forms of capital. Furthermore, subordinated debt typically has a longer maturity (of between eight and ten years), than the other parts of the capital structure. In addition, they are typically 'bullet' structures (where no amortization occurs over the life of the debt, and the full principal is repaid at maturity). As a result of subordination and longer maturities, subordinated loans require a higher coupon (historically in the 10-12% range) and usually comprise between 15% and 35% of the total capital.

Subordinated debt holders rank below senior debt holders in terms of liquidation preference. They are typically bought by hedge funds, high yield funds, merchant banks, and commercial institutions like insurance companies. Because of the higher risk, the subordinated debt carries a higher coupon. In the event of a default, subordinated debt holders won't be paid until the senior debt holders are paid off. Therefore, subordinated debt is more risky and carries a higher interest rate.

Topic 3
Deleveraging & maximizing value After the deal has been structured and the buyout completed, the financial buyer is focused on maximizing value over the next few years. Typically, the financial buyer will look to exit their investment after around 3-5 years. In between the transaction close and exit time periods, the financial buyer can create value in several different ways, as follows: 1. Deleveraging 2. Operating improvements 3. Multiple expansion 1. Deleveraging

> >

the financial buyer's motivations and techniques parallel those of the "home flipper". the financial buyer wants to pay off as much of the mortgage as possible because paying down the mortgage increases the owner's equity value in the home. This has a dual impact on value creation: a. the firm becomes less risky in terms of its capital structure because it has less debt and less interest expense to cover b. the residual equity value increases.

Deleveraging
The goal of deleveraging is to use free cash flow to delever as soon as possible. Free cash flow in this instance is the remaining operating cash flow after allowing for capital expenditures and other investments in the business. Capital expenditures are commonly one of the biggest cash uses for a company and are typically an important focus in an LBO. If capital expenditure requirements are high, this generally makes companies less attractive as LBO candidates. If a company is making inefficient use of capital expenditures, this might make for an attractive target. Every dollar that is forgone in capital spending can by used to pay down debt. However, often capital expenditures are not discretionary and the business would suffer if they were to be reduced. Thus, managers must look for other ways to improve cash flow without cutting capital expenditures. To do so, they often attempt operating improvements to boost free cash flow.

Operating Improvements
Operating improvements can potentially increase the available cash flow generated by a company. Operating improvements can come in many forms.

Sales growth Sale growth is often called top line growth and is done in a number of different ways. Companies can create growth through market expansion (enter in new markets) or through market share gains (improve positions in current markets). Margin improvement Margin improvements and improved efficiencies also boost cash flow. It must be remembered that making operating improvements is easy to do on a paper but harder in reality. Presumably, existing managers are already trying to increases sales growth and maximize profits in public company. Improving margins has a double impact: - It allows for more free cash flow to pay down debt, thus increasing the residual equity value. - it allows you to sell for a higher price even with no multiple expansion by selling off from a higher level of EBITDA. It can be potentially tough to improve operations much more than a company has already done. However, recall that the financial buyer looks for undervalued companies that may be running inefficiently. The financial sponsor may bring industry expertise or a fresh operating strategy to the company. The financial buyer can look to merge portfolio companies to unlock potential synergies.

Multiple Expansion
So far, assumption is that financial buyer sells the company (targer LBO corp) at the same enterprise value to EBITDA multiple that the company was bought for (7.143x). this is a common, conservative approach to deciding whether or not an LBO is feasible to the financial buyer. However, there is a possibility that the financial buyer can sell the company for a higher multiple than what is originally bought for. This can be as a result of operating improvements or a change in the market environment. The company may have also been bought for a very low price. As before, assume that financial sponsor has succeeded in improving margins and has been able to pay down more of the debt than originally thought. Year 5 EBITDA is now improved to USD 155m and net debt in year 5 has been cut down to USD 250m. However, assume that the company can be sold in the open market at a higher *.0x multiple due to a favorable M&A market for that type of company.

Topic 4 Measuring Success for the Financial Buyer Exiting a Private Equity Investment

Understanding how private equity investors measure their investment performance is a key component of analyzing an LBO. In the previous topic, we discussed how a financial buyer attempts to maximize value. Ultimately, the realization of value for the financial buyer comes during an exit event. Exiting a private equity investment usually takes one of the following forms: Sale: Selling the company to a strategic buyer or another financial buyer (M&A event) IPO: Taking the company public through an IPO and selling to the public Special dividend: Relevering the company with new debt and paying out a dividend to the owners

Is there a preferred method of exiting?

It depends. All of the approaches have their benefits and considerations. The advantages of selling the company is that the financial buyer may be able to 'unwind' the entire position (that is, realize the entire value of the investment) at a premium, whereas in taking the company public, the financial buyer cannot sell all of their stock at once in the open market due to price sensitivity and market dynamics. IPO pricing is also typically done at a discount. But in a hot IPO market, the company could get a good valuation. A dividend payment doesn't represent a full exit of a company, but the sponsor can take some money out of the investment and still continue to have a stake. We will focus our discussion on the sale of a company to a strategic buyer or another financial buyer because it represents a complete exit through selling the ownership of a firm.

Measuring Investment Performance Using IRR

In this topic we will calculate returns on an investment using the internal rate of return (IRR) formula and also explore how the concept of leverage significantly increases the potential for higher returns. An important way financial buyers measure returns from an LBO investment is internal rate of return (IRR). The IRR is defined as the necessary discount rate which equates the present value (PV) of an investment's cash inflows to the investment's outflows. Similarly to what we learned in the DCF analysis in the tutorial Discounted Cash Flow (DCF) Analysis, IRR calculations rely on the concept of the time value of money. In a DCF analysis, a present value is calculated when cash flows from various time periods are discounted back to the present based on a predetermined discount rate. Thus, the discount rate is known in a DCF, while the present value is unknown.

In calculating IRRs, however, the present value and the future value (FV) are known (or at least estimated), while the discount rate (r) is unknown and therefore must be 'solved for' using a calculator or spreadsheet.

This can be expressed as the following equality: PV (Inflows) = PV (Outflows) ---------------------------------------------------------------------------

Measuring Investment Performance Using IRR

Viewed another way, the IRR is the discount rate (r) that causes the net present value (NPV) of the investment to equal zero.

To measure investment performance in an LBO, we simply solve for the unknown discount rate (r). In the context of an LBO investment, the outflow is the initial equity investment (CF0) in the company made by the financial buyer and the inflows are the proceeds realized upon exit of the investment. To simplify the analysis, we are going to assume that there are no cash flows received in the interim (for example, no dividends). Therefore, we can simplify the equation as:

Top of Form

Calculating IRR
USD 500m is spent to buy out a company with USD 62.5m in EBITDA. The original contribution from the sponsor is USD 250m. The equity sponsor exits the investment in projected year 3 when the EBITDA is USD 75m, and the net debt is USD 150m. Assuming no multiple expansion, what is the IRR to the sponsor? Input your answer correct to two decimal places.
21.64 qx9=21.64

%
IDAGE3Z

Correct. The buyout multiple is USD 500m/USD 62.5m = 8.0x. Assuming no multiple expansion means that the company will be sold for 8.0x EBITDA in year 5. Therefore the enterprise value is: 8.0 x USD 75m = USD 600m The residual equity value is:

USD 600m - USD 150m = USD 450m With an initial investment of USD 250m, the IRR is: IRR = (USD 450m/USD 250m)1/3 - 1 = 0.2164 (21.64%)
IDAAF3Z

Incorrect. First calculate the enterprise value by multiplying EBITDA by the buyout multiple. Subtract net debt to determine the residual equity value. Then calculate the IRR using the formula:

Click the Back arrow to try again.

Correct. The buyout multiple is USD 500m/USD 62.5m = 8.0x. Assuming no multiple expansion means that the company will be sold for 8.0x EBITDA in year 5. Therefore the enterprise value is: 8.0 x USD 75m = USD 600m The residual equity value is: USD 600m - USD 150m = USD 450m With an initial investment of USD 250m, the IRR is: IRR = (USD 450m/USD 250m)1/3 - 1 = 0.2164 (21.64%)

Bottom of Form

Deleveraging & Leveraged Returns

In the TargetLBO example, the IRR of 24.9% resulted from the increased value of the equity over time. The equity value increased because a significant portion of the debt used to fund the transaction was repaid throughout the five-year period, leaving a greater residual value upon exit of the investment. The deleveraging of the balance sheet and resulting increase in investment returns creates what is known as leveraged returns. The concept is essentially that increased leverage, which reduces the amount of necessary equity capital, can boost IRRs. Imagine the prior example if the buyout of the company remained at USD 1,000m but the lenders put up only 60% of the capital (USD 600m). That means that the financial buyer would have to come up with the remaining capital (USD 400m).

With the same year 5 assumptions of net debt, exit multiple, and EBITDA, the IRR now becomes: IRR = (FV/PV)1/n -1 = (USD 700m/USD 400m)1/5 - 1 = 11.8% This would not be as attractive to the financial buyer because they would have to raise more capital for the same residual value.

Advantages & Disadvantages of Increased Leverage

One of the main advantages of leverage is that the financial buyer can put up less initial capital. Also, in the situations that the company sells for a higher multiple or price, the lenders have a fixed rate of return. They get paid their principal and interest only. The upside goes directly to the equity holders of the firm. The downside to increased leverage is that it puts added stresses on a company and its managers, therefore increasing the company's financial risk, and raises the likelihood of default. High debt levels give the company less financial flexibility in the future should things go wrong with the business operations of the company.