pillars of wall street - valuation fundamentals - fundamental valuation - LBO

Question 1

LBO

Answer 1

acquisition of a company in which financial sponsor invests a relatively small amount of equity compared to total purchase price and uses leverage to fund the remainder

valuation yields the maximum price (aka “the willingness to pay”) that financial sponsor would be willing to pay for a business and still achieve its minimum acceptable IRR

Question 2

pros of LBO

Answer 2

helps you realize floor valuation for firm (the max a financial buyer will be willing to pay so therefore the lowest you should expect to get for an asset because strategic buyers routinely pay more than financial ones)

useful in identifying potential LBO opportunities

estimates potential equity returns to the business and provides sensitivity of the returns to growth, leverage and valuation multiple expansion

highlights effects of adding leverage to a business

Question 3

cons of LBO

Answer 3

standalone LBO will underestimate value by ignoring synergies with acquirer (financial buyers tend to pay lower multiples because they are in for a shorter term than strategic buyers)

value obtained is sensitive to projections and operating assumptions

Question 4

IRR

Answer 4

primary metric used to measure attractiveness of LBO

measures total return on equity piece of your investment (will incl. any additional equity contributions made or dividends received)

defined as discount rate which equates to a net present value of zero for all cash inflows and outflows

example: initial investment $100; sell for $200; you doubled your money (100% return); but IRR accounts for time value of money (looks at length of the investment); if it took you 80 years to double your money, then your return is lost to inflation; IRR accounts for this

financial sponsors typically target 20-25% IRR threshold over 3-5 year holding period (although they are rarely getting it nowadays)

IRR = { [ ( terminal equity value ) / ( initial equity investment ) ] ^( 1/n ) } - 1

where n = number of periods

this basic IRR formula does not account for any cash dividends that may have been paid to equity holders prior to exit; in practice, this is rare anyway because debt covenants prohibit dividend payments to equity holders until debtors are paid in full

Question 5

cash-on-cash return

Answer 5

aka multiple-of-money or multiple-of-equity

another popular metric used to measure attractiveness of LBOs in addition to IRR

example: initial equity of $100; exit equity of $300; means 3x return

it ignores time value of money

Question 6

key drivers of value in an LBO

Answer 6

paying down debt

interest tax shield (because LBO means target will be highly levered, there will be lots of interest expense; this reduces the tax burden)

operational improvements (growing revenue, reducing costs, increasing profitability, decreasing OWC)

you cannot assume there will be multiple expansion (increase in EBITDA multiple); this is not a driver of value in an LBO; you must assume that the EBITDA multiple will stay the same over the holding period (even if increases) and that value is created through the interest tax shield, paying down debt/getting better terms on your debt and running the business better