LBOs

Question 1

What are the steps of LBO’s

Answer 1

• Fair valuation
• Target selection
• Financing the transaction
• Equity contribution
• Operational Improvements
• Debt repayment
• Exit strategy
• IRR calculation

Question 2

Fair valuation

Answer 2

Conduct a valuation of the target company using methodologies such as discounted cash flow (DCF) or market comparables.

Question 3

Analyse

Answer 3

ability to pay” based on expected debt capacity and equity returns (Kaplan, 1989)

Question 4

Target selection

Answer 4

Choose businesses with strong fundamentals, stable cash flows, and potential for operational improvements.

Question 5

Financing the Transaction

Answer 5

Leverage consists of multiple layers: senior debt, mezzanine financing, and sometimes high-yield bonds (Gompers et al., 2016).

Question 6

Equity Contribution:

Answer 6

Sponsors typically contribute 20-50% of the purchase price to align incentives.

Question 7

Operational Improvements:

Answer 7

Implement cost-cutting measures, streamline operations, and pursue growth strategies. Use management equity incentives to align interests and drive performance improvements.

Question 8

Debt Repayment:

Answer 8

Excess cash flow is prioritized for paying down debt to deleverage the firm over time. Debt repayment reduces interest burden and increases equity value (Jensen, 1986).

Question 9

Exit Strategy:

Answer 9

Common exits include: Initial Public Offering (IPO) to regain public market value. Strategic Sale to another company. Secondary Sale to another private equity firm.

Question 10

IRR Calculation

Answer 10

Investors evaluate returns using Internal Rate of Return (IRR), targeting 20-30% or higher (Acharya et al., 2013).

Question 11

What were the empirical findings of LBOs

Answer 11

Multiple Bid Auctions & Premiums
Insider Trading
LBO Defaults and Distress
Divestitures During Financial Distress

Question 12

Multiple bit auctions and premiums

Answer 12

High premiums (over 50%) were common in multiple bid auctions, compensating shareholders for the added risks of LBO transactions (Hubbard & Palia, 1995).

Question 13

Insider trading

Answer 13

More insider trading occurred before Management Buyouts (MBOs) compared to third-party LBOs, reflecting management’s access to superior private information (Harlow & Howe, 1993).

Question 14

LBO defaults and distress

Answer 14

Of 136 highly leveraged transactions (1980-1989), 31 defaulted by 1996, and 8 others were distressed, illustrating the significant financial risks involved in LBOs (Andrade & Kaplan, 1998).

Question 15

Divestitures during financial distress

Answer 15

Divesting during financial distress led to negative wealth effects for shareholders, suggesting that asset sales in such conditions typically destroy value (Easterwood, 1998).

Question 16

What are the 3 LBO valuation approaches

Answer 16

WACC
CCF
APV

Question 17

Discuss the WACC approach for LBO valuation

Answer 17

Adjusts the cost of capital to include the tax shield

Assumptions: WACC assumes a constant D/V. Works well when the capital structure remains stable over time.

Challenges: In scenarios like LBOs, where D/V changes significantly, WACC must be recalculated for each forecast period, making it less practical (Ruback, 2002).

Key Limitation: Difficult to apply for transactions involving highly leveraged or dynamic capital structures.

Question 18

Discuss the CCF approach

Answer 18

Directly incorporates the tax shield into cash flows

Approach Mechanism: Combines FCF and the tax shield (TS), where TS = actual tax rate × interest expense. CCFs are discounted at the expected return on assets (ka), reflecting the combined risk of assets and tax shields.

Advantages: Simplicity in scenarios with changing debt levels, as the discount rate (ka) is independent of capital structure. Particularly suited for LBOs, where leverage ratios fluctuate.

Key Feature: Assumes tax shields are as risky as the firm’s operations (Damodaran, 2001).

Question 19

Discuss the APV approach

Answer 19

Values the tax shield separately from unleavered cash flows

Mechanism: Separates the valuation of FCF and TS: FCF is discounted at the unlevered cost of equity (ka). TS is discounted at the pre-tax cost of debt (kb).

Advantages: Reflects the specific risk characteristics of the tax shield.

Question 20

What are some sources of gains for LBOs

Answer 20

Tax benefits
Asset step-up
Tax benefits to shareholders
Management incentives and agency costs effects
Wealth transfer effect

Question 21

Tax benefits of LBOs

Answer 21

Debt financing in LBOs provides tax-deductible interest payments, reducing taxable income (Lowenstein, 1985).

Question 22

Asset step-up

Answer 22

In the 1980s, LBOs often involved asset step-ups, allowing a revaluation of assets, which increases depreciation deductions, thereby reducing taxes (Kaplan, 1989).

Question 23

Wealth transfer effect

Answer 23

Shareholder Gains: LBO premiums result in wealth transfer to shareholders, but this can be at the expense of bondholders and preferred stockholders, who may experience losses (Travlos & Cornett, 1993).

Question 24

Management incentives and agency costs effect

Answer 24

Increased Ownership Stake: Managers often receive an increased ownership stake in the firm, aligning their interests with those of shareholders (Lehn & Poulsen, 1988).

Question 25

What are some LBO exit strategies

Answer 25

Sale of LBO
Initial public offering

Question 26

What entails in the sale of an LBO

Answer 26

Description: The private equity firm sells the entire company to another buyer, transferring all ownership. A secondary buyout (SBO) may occur when the company is sold to another PE firm, resembling a sale.

Advantages: Provides a clean and complete exit for the private equity firm. Can fetch high valuations if the company is well-positioned in its market.

Challenges: Dependent on market conditions and buyer interest. Negotiation complexities and potential due diligence risks.
Academic Insights: Kaplan & Strömberg (2009) emphasize sales as the preferred LBO exit strategy due to liquidity and simplicity.

Question 27

Describe IPO’s as an exit strategy

Answer 27

Description: The company goes public, and the PE firm gradually sells its shares in the secondary market. Allows the firm to retain partial ownership initially and realize returns over time.

Advantages: Offers significant upside if the public market assigns a high valuation to the company. Improves company visibility and access to capital.

Challenges: Subject to market volatility; timing is critical for successful pricing (Ritter, 2003). Risk of “money left on the table,” where underpricing leads to wealth transfer to new shareholders.

IPO Statistics: From 1980 to 2001, an average of one company went public daily in the U.S. Peak IPOs occurred in 1996 (621 companies); the minimum was in 1980 (70 companies).
Considerations for Investment

Question 28

What are some different types of risks posed in LBOs

Answer 28

Financial risks
- High leverage
- Debt burden

Operational risks
- Integration challenges
- Performance expectations

Market and economic risks
- Economic downturns
- Industry specific shocks

Question 29

Why is high leverage a risk in LBOs

Answer 29

Substantial debt used for financing creates repayment challenges if the target fails to meet performance expectations (Kaplan & Strömberg, 2009). Excessive leverage increases susceptibility to interest rate fluctuations, particularly for variable-rate debt.

Question 30

Why can the debt burden be a risk in LBOs

Answer 30

Debt can become unsustainable in the face of declining revenues, rising interest costs, or lower-than-expected cash flows (Acharya et al., 2013).

Question 31

Intergration risk in LBOs

Answer 31

Merging new and existing team members, processes, and cultures often leads to disruptions and delays (Jensen, 1986). Poor execution of operational efficiencies may fail to deliver expected cost savings or synergies.

Question 32

Performance expectations

Answer 32

Failure to meet operational benchmarks can magnify financial pressures, particularly when cash flows are insufficient to service debt (Andrade & Kaplan, 1998).

Question 33

What are some risk mitigation strategies

Answer 33

Financial
- strategic debt restructuring

Operational
- Integration planning

Market and economic risk mitigation
- Scenario planning

Question 34

Strategic debt restructuring

Answer 34

Balance debt levels with cash flow projections and revenue forecasts (Kaplan & Strömberg, 2009). Utilize debt with staggered maturities to minimize refinancing risks.

Question 35

Integration planning

Answer 35

Develop detailed plans to integrate acquired and existing operations effectively (Jensen, 1986).

Question 36

Scenario planning

Answer 36

Perform regular scenario analysis to prepare for economic fluctuations or industry-specific shocks

Question 37

What were the different waves of LBOs

Answer 37

1980s Boom: High-yield bonds (junk bonds) financed many LBOs in the US, with significant tax benefits fueling activity.

1990s Resurgence: Following the junk bond collapse, LBOs diversified funding sources, including mezzanine and sponsor equity.

Post-2000 Expansion: Sustained economic growth and innovative deal structures increased activity in Europe and globally.

Question 38

Why the resurgence in 90s

Answer 38

• Sustained economic growth
• Changed financial structure

Question 39

How did sustained economic growth contribute to the LBO resurgence of the 90s

Answer 39

Economic expansion during the 1990s contributed to the growth of mergers and acquisitions (M&As) and the reemergence of LBOs, as more firms sought to restructure and capitalize on favorable market conditions (Jensen, 1997).

Question 40

How did a changed financial structure contribute to the LBO resurgence of the 90s

Answer 40

The price of LBOs dropped from 7-10 times EBITDA (as seen in the late 1980s) to 5-6 times EBITDA (Kaplan, 2000). This made LBOs more financially feasible, as lower leverage ratios reduced risk and made the deals more attractive for buyers.

Question 41

What was the role of junk bonds in LBOs

Answer 41

Junk Bond Market Growth:
In the 1970s, junk bonds represented around 3-4% of the total public straight debt market, primarily from “fallen angels” whose ratings were downgraded.

By 1985, firms began issuing below-investment-grade bonds, which accounted for nearly 20% of new bond issues.

In 1986, Drexel Burnham Lambert dominated the junk bond market with a 45% market share.
Despite setbacks from legislative changes, the junk bond market reached record highs by 1993.

Return on Junk Bonds:
The promised yield spread for junk bonds ranged from 10.5% to 2.8% over 10-year U.S. Treasuries (1978-2001).

The realized return spread was approximately 2%.

Between 1980-1986, around 25% of junk bond proceeds were used for acquisitions, and 75% for internal growth (Yago, 1991).

Question 42

What is a junk bond

Answer 42

Junk bonds are high-yield bonds rated below investment grade (below BBB/Baa3).These bonds allow high-risk firms with lower credit ratings to obtain public financing.