9) LBOs and Go-Private Transactions Flashcards
9 common features of LBO targets
1) Strong and stable cash flows
2) Low capex
3) Strong market position
4) Stable industry
5) Low R&D expense, low rate of technological change
6) Undervaluation in the stock market
7) Proven management
8) No major changes to management or strategy
9) Potential asset sales, divestments
what do the common features of LBO targets align with?
with the LBO target to assume the high levels of debt that the transaction will entail
for LBOs targets, cash flows are important to
pay the interest expense on debt –> want them to be fairly stable
for LBOs targets, minimal expenses are important because:
to ensure no constraints on capacity to pay interest expense
what is promising about the potential for divestments in LBO targets?
potential to raise cash to pay the interest expense
why could stability be important when looking at LBO targets?
if we want management team and their expertise, we need stability there
How do LBOs create value?
arguably result in better operating efficiency + greater governance (more monitoring from debt holders, concentrated shareholding, high insider ownership and alignment of manager owner interest through performance-based compensation
critics of LBO and value creation
argue that value is derived from tax effects –> the high interest expense on debt is used as a tax deduction –> means it’s a form of wealth transfer from public to private sector
issues with equity beta estimation in LBOs
Leverage has an effect on the risk-adjusted returns of the firm. In CAPM analysis the beta estimate captures the systematic risk of the firm’s E w. the market and assumes no financial effects from capital structure.
So, to understand the risk of a firm or investment, it is better to consider the unlevered beta.
Leverage has an effect on
the risk-adjusted returns of the firm.
unlevered beta formula =
= levered B
———————————–
1 + ( 1 - tax rate) x D/E
Unlevered beta (or asset beta) measures
the market risk of the company without the impact of debt.
Unlevering a beta removes
the financial effects of leverage thus isolating the risk due solely to company assets. In other words, how much did the company’s equity contribute to its risk profile.
What’s an alternative way to look at the equity beta estimation in LBOs?
compare betas for highly levered comparable firms (within same industry) with the betas for those firms’ high yield bonds. In valuation analysis, the highly levered beta should be treated as an input with some uncertainty and appropriate sensitivity modelling applied
