LBOs Flashcards
What are the steps of LBO’s
- Fair valuation
- Target selection
- Financing the transaction
- Equity contribution
- Operational Improvements
- Debt repayment
- Exit strategy
- IRR calculation
Fair valuation
Conduct a valuation of the target company using methodologies such as discounted cash flow (DCF) or market comparables.
Analyse
ability to pay” based on expected debt capacity and equity returns (Kaplan, 1989)
Target selection
Choose businesses with strong fundamentals, stable cash flows, and potential for operational improvements.
Financing the Transaction
Leverage consists of multiple layers: senior debt, mezzanine financing, and sometimes high-yield bonds (Gompers et al., 2016).
Equity Contribution:
Sponsors typically contribute 20-50% of the purchase price to align incentives.
Operational Improvements:
Implement cost-cutting measures, streamline operations, and pursue growth strategies. Use management equity incentives to align interests and drive performance improvements.
Debt Repayment:
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).
Exit Strategy:
Common exits include: Initial Public Offering (IPO) to regain public market value. Strategic Sale to another company. Secondary Sale to another private equity firm.
IRR Calculation
Investors evaluate returns using Internal Rate of Return (IRR), targeting 20-30% or higher (Acharya et al., 2013).
What were the empirical findings of LBOs
Multiple Bid Auctions & Premiums
Insider Trading
LBO Defaults and Distress
Divestitures During Financial Distress
Multiple bit auctions and premiums
High premiums (over 50%) were common in multiple bid auctions, compensating shareholders for the added risks of LBO transactions (Hubbard & Palia, 1995).
Insider trading
More insider trading occurred before Management Buyouts (MBOs) compared to third-party LBOs, reflecting management’s access to superior private information (Harlow & Howe, 1993).
LBO defaults and distress
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).
Divestitures during financial distress
Divesting during financial distress led to negative wealth effects for shareholders, suggesting that asset sales in such conditions typically destroy value (Easterwood, 1998).
What are the 3 LBO valuation approaches
WACC
CCF
APV
Discuss the WACC approach for LBO valuation
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.
Discuss the CCF approach
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).
Discuss the APV approach
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.
What are some sources of gains for LBOs
Tax benefits
Asset step-up
Tax benefits to shareholders
Management incentives and agency costs effects
Wealth transfer effect
Tax benefits of LBOs
Debt financing in LBOs provides tax-deductible interest payments, reducing taxable income (Lowenstein, 1985).
Asset step-up
In the 1980s, LBOs often involved asset step-ups, allowing a revaluation of assets, which increases depreciation deductions, thereby reducing taxes (Kaplan, 1989).
Wealth transfer effect
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).
Management incentives and agency costs effect
Increased Ownership Stake: Managers often receive an increased ownership stake in the firm, aligning their interests with those of shareholders (Lehn & Poulsen, 1988).
What are some LBO exit strategies
Sale of LBO
Initial public offering
What entails in the sale of an LBO
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.
Describe IPO’s as an exit strategy
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
What are some different types of risks posed in LBOs
Financial risks
- High leverage
- Debt burden
Operational risks
- Integration challenges
- Performance expectations
Market and economic risks
- Economic downturns
- Industry specific shocks
Why is high leverage a risk in LBOs
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.
Why can the debt burden be a risk in LBOs
Debt can become unsustainable in the face of declining revenues, rising interest costs, or lower-than-expected cash flows (Acharya et al., 2013).
Intergration risk in LBOs
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.
Performance expectations
Failure to meet operational benchmarks can magnify financial pressures, particularly when cash flows are insufficient to service debt (Andrade & Kaplan, 1998).
What are some risk mitigation strategies
Financial
- strategic debt restructuring
Operational
- Integration planning
Market and economic risk mitigation
- Scenario planning
Strategic debt restructuring
Balance debt levels with cash flow projections and revenue forecasts (Kaplan & Strömberg, 2009). Utilize debt with staggered maturities to minimize refinancing risks.
Integration planning
Develop detailed plans to integrate acquired and existing operations effectively (Jensen, 1986).
Scenario planning
Perform regular scenario analysis to prepare for economic fluctuations or industry-specific shocks
What were the different waves of LBOs
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.
Why the resurgence in 90s
- Sustained economic growth
- Changed financial structure
How did sustained economic growth contribute to the LBO resurgence of the 90s
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).
How did a changed financial structure contribute to the LBO resurgence of the 90s
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.
What was the role of junk bonds in LBOs
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).
What is a junk bond
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.
