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 30-

50% 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 pre-
determined 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.

Bottom of Form
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%)

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.