Valuation of LBO January 17, 2010
Posted by katyan000 in Mergers & Acquisitions.trackback
Leverage Buy-out
A buy-out firm buys 100% of the target by levering it up and takes it private i.e. shares of LBO no longer trades in the open market. After improving operational efficiency and lowering leverage, the target is brought for IPO or is sold. The buy-out firm usually exits in 3-4 years. A large portion of the buy-out is financed by debt.
Characteristics of good target company
A good target for buy-out would preferably have low debt with high level of “bankable” assets and high growth potential with scope for operational improvement. The target’s cash flow should be stable and sufficient to meet interest and principal payments on the debt and provide adequate working capital. The target’s cash flow should also be protected by patents, strong brand or market leadership.
Though difficult to estimate, the financial distress cost of the target company should be low. When debt is very high suppliers may get concerned about company going bankrupt, stop giving credits and start working with competitors having better chance of survival. For example, if there is a high requirement for after-sales service and the customer think that company may not be able to make spare parts available in future; she would not buy at all – resulting in high financial distress cost for such a company.
The management should be cooperative and receptive for changes required for turn around.
Sources of value in LBO
Usually a buy-out firm, with its experience in monitoring and operating a company with high debt, is skilled in transitioning the acquired company to a more favorable state.
The buy-out firm brings specialists to identify and improve operational efficiency of the acquired company. Since target is taken off the stock market and made private, the compliance cost associated with public company is saved. Increased debt and re-evaluation of assets at current market price result in higher tax benefits. Higher debt brings better discipline in the company. Under the scrutiny of lenders and the risk of collapsing, the employees and management usually are more responsible and serious about their business. High debt also serves as a bonding mechanism within the company by focusing everybody on optimally utilizing all resource, minimizing wastage and facilitating negotiations such as salary re-negotiation, contract with suppliers etc.
Valuation of LBO: Adjusted Present Value Method
The APV method estimates values from investment and financing decisions separately and then adds the two to find the total value of the firm. The total value of the firm is the sum of present value of the firm’s free cash flows to equity investors (as if there is no debt) and the present value of future tax savings discounted at the unlevered cost of equity. Tax savings are subjected to risk since the firm may default on its debt or incur operating losses and fail to use tax saving. Hence unlevered cost of equity is used to discount tax savings.
High debt increases cost of financial distress. So the tax benefit of higher leverage may be partially or entirely offset by the higher probability of default associated with an increase in leverage. The cost of financial distress can have direct cost component such as cost of reorganization in bankruptcy and ultimately liquidation and indirect cost component such as loss of customers (and hence revenue), employee turnover, difficulty in credit from suppliers and higher borrowing cost.
Using APV, value of a LBO firm would be
Present Value(LBO) = Present Value (Unlevered Firm)+ Present Value (Tax Shield) – Present Value (Financial Distress)
Interest payment on debt = (Rate of interest) X (Face value of debt)
Tax shield = (Tax rate) X (Interest payment)
Using perpetuity formula,
Present value of tax shield = (Tax shield) / (Rate of interest)
= (Tax rate) * (Face value of debt)
Use unlevered cost of equity to discount cash flow during the period in which the capital structure is changing. During the firm’s terminal period, the debt-to-equity capital structure is assumed to be stable and free cash flow is projected to grow at a constant rate. The terminal value is calculated using WACC but it is discounted to the present using the unlevered cost of equity. Annual tax saving resulting from tax deductibility of interest is projected and discounted at the firm’s unlevered cost of equity.
When the project’s D/E is known WACC should be used, whereas when level of debt is known (i.e. LBO cases) APV should be used.
There are some problems I faced in this analysis.
1) What should be the unlevered cost of equity. You can use cost of equity from top-down beta or bottom-down beta. But, this firm would become a private company after the LBO. So, how do we account for its inherent illiquidity in the cost of equity. Theoretically, cost of equity in this firm would be higher than in a listed firm.
2) Measuring financial distress is very difficult.
3) The decline in financial flexibility of the firm would lead to lost opportunities in future. It may come across positive NPV projects but reject them due to low debt capacity.
How do we account for the loss of this option?
4) Similar to point 3. Loss of Competitive strength. A competitor can utilize this weakness and use it.
For example, if there is a LBO of Marico, its competitors like Hindustan Unilever could slash prices or increase ad spend. Marico cannot retaliate as it is limited by its budget.
Anup,
I am bit busy with my academics here. I would try to answer your questions soon.
Cheers,
Manish Katyan.
Actually, LBO valuation is slightly different. It depends on Investor’s projections, required returns and debt structure. I will try to explain the process in the following steps:
1. Projections: are based on the current state of operations, using realistic numbers. Estimate the FCF because this will be used to service the debt.
2. Debt Structure: also ability to lever against EBITDA (this is using as much debt as you can to finance the deal)
3 a. Exit strategy: LBO investing is generally for 5 years (investor invests in year 1 and exits in year 5). At the exit what is your estimation of EV (as multiple of EBITDA) that you will get out of selling it? EV – Debt (at the end of Yr 5) = Equity Vale
3 b. Estimate Investor’s Required Rate of Return: Since, short-span, you would use IRR.. generally investors have a range (25% – 40%) depending on business.
4. Based of Equity Value at the Yr 5 and IRR, find the Equity Requirement at the Year 1 that will be added with the debt to fund the deal. Since the idea is to utilize debt, the D/E will be quite high (>1.5).