Leveraged Buyout &

Valuation
LBO Overview

A leveraged buyout is the acquisition of a

company, either privately held or publicly
held, as an independent business or from
part of a larger company (a subsidiary), using
a significant amount of borrowed funds to
pay for the purchase price of the company.
LBO Overview

The leveraged buyout transaction is orchestrated

by a private equity firm (also called a financial
sponsor) or group of private equity firms (also
called a private equity group or a consortium),
which will take ownership (own the equity of) the
business after the acquisition has been completed.
About LBO
• A leveraged buyout or LBO is an acquisition of an underperforming company
funded using significant amounts of debt
• The investors (acquires) aim to increase the returns to equity holders and
repay debt from the company’s operational cash flows
• Target companies usually have key characteristics which make them an
attractive investment for investors including stable cash flows, potential for
operational improvements or reduced costs and a clear exit strategy
• There are multiple steps that need to be undertaken to indicate whether a
company is a potential LBO candidate
• A key assumption is that the investor is able to sell the business in order to
understand what they could pay today
Characteristics of Target Companies

Investment strategies of sponsor funds can

differ significantly, but target companies usually
have:
• Stable cash flows and low fixed costs
• Potential for operational improvements
• An attractive valuation upon entry and present a clear exit
strategy
LBO DEAL
• The purchase of the company comes from a combination of equity
capital (contributed by the sponsor/consortium, plus potentially some
tag-along investors, such as management) and debt instruments
(financed through banks and other lenders).
• Generally speaking, the debt will constitute a majority of the
purchase price—after the purchase of the company,
• the debt/equity ratio is typically around 2.0x or 3.0x (i.e., usually the
total debt will be about 60-80% of the purchase price).
Servicing the debt in a LBO deal

In an LBO, the cash flow generated by the acquired company is

used to service (pay interest on) and pay down (pay principal on)
the outstanding debt.

For this reason, while companies of all sizes and industries can be
targets of LBO transactions, companies that generate a high
amount of cash flow are the most attractive (more on this later).
Return to the sponsor
• The overall return for the sponsor or consortium in an LBO is
determined by a number of factors:
• Growth in the operating profit/cash flow of the company (EBIT or
EBITDA) over the life of the investment;
• The exit multiple on EBIT/EBITDA relative to the entry or acquisition
multiple; and
• The amount of debt that is paid off over the time horizon of the
investment.
Key questions for private equity investor
before LBO
• What is the outlook for the company’s industry?
• Does the company operate in a cyclical or seasonal industry?
• What is the outlook for the current state of the domestic and global
economy?
• How was the company affected in past recessions?
• To what degree does the company exhibit operating leverage—i.e.,
how much are profit margins affected by growth or decline in
revenue?
What is LBO Valuation?
• A leveraged buyout (an LBO) is an acquisition by a financial sponsor,
financed using significant amounts of debt.
• Leverage is used to increase the returns to equity holders, and debt is
repaid from the company’s operational cash flows.
• Private equity funds expect to exit the investment within the medium
term to monetize their returns.
• An LBO transaction is evaluated by calculating an internal rate of return
(IRR).
• The IRR compares the equity investment upon exit versus the amount
invested at entry and calculates an annualized return on the investment.
LBO analysis
• Investment bankers typically use LBO analysis to obtain an LBO market value for a
company.
• This can act as a “floor” for company valuation, because it provides a reasonable
amount that financial investors (sponsors) would be willing to pay to own the
company, whereas other investors may be willing to pay more for a variety of
reasons.
• Other typical uses of LBO modeling include:
• Determining the equity returns (through IRR calculations) that can be achieved if a
company is bought privately, improved, and then ultimately sold or taken public
• Determining the effect of recapitalizing the company through issuance of debt to
replace equity
• Determining the debt service limitations of a company based on its cash flows
Forecasting cash flows
• Projected revenue should grow at a rate consistent with past
performance.
• Projected EBITDA margins should be kept flat, or consistent with
results from recent prior years. One way to do this is to use the
average margins from the prior 3 years and use that average in the
forecasted years.
• Working capital requirements should be projected at a constant
percentage of revenue (or cost of sales) relative to recent prior years.
• Capital expenditures should grow at a slow rate, typically consistent
with inflation.
Valuation Key Steps

• Valuing a company as if it were a target for an LBO can provide valuable

insight into the business and give an indication of whether the company is a
potential LBO candidate.
• In order to perform an LBO valuation, the following is required (as a
minimum):
• An operating model, forecasting EBIT and EBITDA
• A debt repayment model forecasting how debt will develop from acquisition
to exit
• An assumption of when and at what multiple the LBO investor can exit
• An assumption about how much debt a buyer could raise to fund the
transaction
Leveraged Buyout Valuation Method

• Financial buyers benefit by keeping the ratio of debt to equity very

high.
• Compared to equity, debt has a lower cost of capital, so it helps to
improve return on investment.
• The financial buyers acquire a company, fix it up, and then sell it.
• Thus, a leveraged buyout is an accepted form of business growth.
• By carrying out an analysis, buyers can determine the maximum
purchase price that should be paid depending on different leverage
levels and associated returns.
Leveraged Buyout Valuation Method

The analysis involves the following steps:

• The sources and uses of the funds for purchasing the firm are
identified in terms of equity and debt;
• The firm's existing balance sheet is modified (pro-forma
balance sheet) to reflect the transaction and the new capital
structure; and
• An integrated cash flow model is created to project the firm's
income and cash flow over a period of time.
Quantum of leverage or debt
• Companies that are very stable and have recurring cash flows can safely
have a very high debt volume, up to 90% or more than the purchase
price.
• However, the normal range would be 40-50% of the purchase price.
When firms do not generate sufficient cash flows to service their debts
(an over-leveraged buyout), a high debt-to-equity ratio may lead to
insolvency or require debt-to-equity swaps, which would amount to
relinquishing control.
• Because of this, steady cash flow (to support the relatively high interest
expense in a highly leveraged buyout) is a very important factor.
Potential Exits and Returns Analysis

• All LBO acquisitions are made with the goal in mind of improving the
company, paying down debt, and selling the company for a handsome
profit.
• Thus it is important, when evaluating a potential LBO, to consider the
exit opportunities that may be available for the company when the
time is right, and an appropriate exit strategy should be developed.
The LBO Model

• Strictly speaking, the LBO model is not a valuation technique. It is

simply a technique that allows a PE firm to assess the impact of
capital structure, purchase price, and various other factors on its
expected return from an investment.
• The LBO model has three main inputs:
• 1. Forecasted cash flows of the target company.
• Cash flows forecasts are provided by the target’s management and
must be carefully scrutinized by the PE firm.
2. Expected return to the providers of financing.
• 3. The amount of financing available for the transaction.
LBO Model
• On the basis of these parameters,
• a PE firm would use the LBO model to determine the maximum price
that it should pay to acquire a company given the returns required by
the providers of financing.
• Analysts also vary the time-of-exit assumption to evaluate its impact
on expected returns.
• The exit value is typically estimated using the market approach (using
the EV-EBITDA multiple of comparable).
Exit value in LBO
• Total exit value can be broken down into the following four
components:
1. This initial amount invested in the company.
2. Earnings growth resulting from operational improvements and
enhanced corporate governance.
3. Multiple expansion from diminishing uncertainty around the company
as it nears a successful exit.
4. Utilizing operating cash flows for debt reduction before exit.
• Exit value = Initial cost + Earnings growth + Multiple expansion + Debt
reduction
Each component of value creation (earnings
growth, multiple expansion and debt reduction)
should be carefully considered and examined
through lengthy due diligence and scenario analysis
to develop a range of estimates for possible value
creation from a private equity investment
Illustration LBO Valuation
• A PE firm is considering the purchase of a company that is valued at $1,500 million.
• The following information is also available:
• The acquisition will be financed with 65% debt and 35% equity.
• The PE firm expects to exit the investment in 4 years at a projected value of 1.60
times the initial cost.
• The equity investment of $525m is composed of:
• $325m in preference shares.
• These shares belong to the PE firm and offer anannual dividend of 12%
(compounded annually and payable upon exit).
• $200 min equity.
• The PE firm holds $175m of equity While management holds the remaining $25m.
• The PE firm will receive 87.5% of the company’s residual value (after
accounting for payments to creditors and preference shareholders) at
exit, while management (as part of the management equity program,
MEP) will receive the remaining 12.5%.
• By exit, the company expects to pay off $500m of the initial $975m in
debt by utilizing operating cash flow.
• Calculate the payoff to the each of the company’s providers of capital.
• Calculate the payoff multiple and IRR for the providers of equity (the
PE firm and management).
• Calculating payoffs to all providers of capital
• First we compute the exit value:
• Exit value = 1,500 * 1.6 = $2,400 million
Then we compute the payoffs to each of the company’s providers of
capital:
• Debt holders receive the amount outstanding after accounting for the
$500m that were paid off using operating cash flows before exit.
• Payment to debt holders = 975m – 500m = $475m
• Preferred shareholders receive the face value of their investment plus
preferred dividends compounded over 4 years at 12%.
• Payment to preferred shareholders = $325m * (1.12)^4 = $511.39m
• Equity holders receive the residual value of the firm after all creditors
and preferred shareholders have been paid off:
• Payments to equity holders:
Private equity firm: (2,400 – 475 – 511.39) * 0.875 = $1,236.91m
Management: (2,400 – 475 – 511.39) * 0.125 = $176.70m
• Calculating the payoff multiple for equity holders:
• The total payoff to the PE firm equals the sum of the payoffs on its
preference shares and equity stake in the company.
• Total payoff for PE firm = 511.39 + 1,236.91 = $1,748.3m Payoff
multiple for PE firm = 1,748.3/(325 + 175) = 3.5 times
• The total payoff to management equals its pro rata share of the
company’s residual value.
• Total payoff for management = 176.70m
Payoff multiple for management = 176.70/25 = 7.07 times
• Calculating IRRs for the equity holders:
• IRR for PE firm:
• PV = -$500; FV = $1,748.3; N =4; 36.75%
• IRR for management:
PV = -$25; FV = $176.7; N =4; 63.05%