Module 2, Lesson 2.2 LBO Investments and the LBO Model

When the PE firm buyer in a PE transaction acquires from the seller a controlling stake in the equity capital of a target company, it is called a buyout. The generic term “buyout” refers explicitly to the notion of acquiring control. It denotes a wide range of techniques, including but not limited to leveraged buyouts (LBOs), management buyouts (MBOs), management buy-ins (MBIs), and takeovers. In this lesson, we focus on LBOs: using borrowed money to finance a significant portion of the acquisition price.

Attractive Company Characteristics for LBO Targeting

Given their target sector, PE firms look for characteristics that make a company particularly attractive as an LBO target, including the following:

Undervalued/Depressed Stock Price

The PE firm perceives that the company’s intrinsic value exceeds its market price. PE firms are therefore willing to pay a premium to the market price to secure approval for the purchase by the seller’s shareholders. In other circumstances, firms see a chance to make an acquisition cheaply, and the stock prices of out-of-favor public companies may make them attractive.

Willing Management and Shareholders

Company management is looking for a deal. They may have opportunities to increase value, but they lack the resources to make investments in the processes, personnel, equipment, technology, and so on that would drive long-term growth. Company shareholders may have insufficient access to capital and so welcome a PE partner. Family business owners may want to cash out. PE firms can provide the time and capital to expand a company or turn it around.

Inefficient Companies

PE firms seek to generate attractive returns by identifying companies that are inefficiently organized and managed and have the potential to perform well if restructured and/or managed better.

Strong and Sustainable Cash Flows

Companies that generate strong cash flow are attractive because LBO transactions have the target company taking on significant debt. Cash flow is necessary to make interest payments and repay the debt.

Low Leverage

PE firms focus on target companies that have no significant debt on their balance sheets because then it’s easier to use debt to finance a large portion of the purchase price.

Substantial Physical Assets

PE managers like companies that have a significant amount of unencumbered physical assets. These physical assets can be used as security (i.e., collateral), and secured debt is cheaper than unsecured debt.

A typical LBO capital structure might entail 30% equity along with leveraged loans and high-yield bonds to make up the remaining 70% of the purchase price. Leveraged loans are often the source of a larger amount of capital than either equity or high-yield bonds. As an alternative to high-yield bonds, mezzanine financing may be used. Mezzanine financing refers to debt or preferred shares with a relationship to common equity that results from a feature such as attached warrants or conversion options. Being subordinate to both senior and high-yield debt, mezzanine financing typically pays a higher coupon rate. In addition to interest or dividends, this type of financing offers a potential return based on increases in the value of common equity and is generally customized to fit the specific requirements of the transaction in question.

The LBO Model

The LBO model is not a separate valuation technique but, rather, a way of determining the impact of the capital structure, purchase price, and other parameters on the returns expected by the PE firm from the LBO deal.

The LBO model has three main input parameters:

the cash flow forecasts of the target company;
the return that the providers of financing (equity, senior debt, high-yield bonds, mezzanine) are expecting; and
the amount of financing available for the transaction.

The free cash flow forecasts of the target company are generally prepared by its management and are subject to an extensive due diligence process (strategic, commercial, financial, legal, and environmental) to determine their reliability. The forecasts assume an explicit horizon that generally corresponds to the expected holding period (i.e., investment period) of the PE firm.

The exit year is typically considered to determine the expected internal rate of return (IRR) sensitivity of the equity capital around the anticipated exit date. The exit value is determined most frequently by reference to an expected range of exit multiples determined on the basis of a peer group of comparable companies (enterprise value-to-EBITDA ratio).

Given the significant predictability of cash flows in buyout transactions, the income-based approach (discounted cash flows, adjusted present value, target IRR) is frequently used as a primary method to determine the value of equity, considering the expected change in leverage until the time of exit of the investment. The initial high and then declining financial leverage is the main technical valuation issue that needs to be adequately factored into the income approach when applied to a buyout valuation. The value is also frequently corroborated by an analysis of the peer group of comparable publicly traded companies.

On the basis of the input parameters, the LBO model provides the maximum price that can be paid to the seller while satisfying the target returns for the providers of financing. This is why the LBO model is not a valuation methodology per se. It is a negotiation tool that helps develop a range of acceptable prices to conclude the transaction.

The value-creation chart in Exhibit 2 illustrates the sources of the additional value for a portfolio company between the original purchase cost and the exit value. Value creation comes from a combination of factors:

earnings growth arising from operational improvements and enhanced corporate governance;
multiple expansion depending on preidentified potential exits; and
the optimization of financial leverage and repayment of part of the debt with operational cash flows before the exit.

Each component of the value creation chart should be carefully considered and backed by supporting analyses, which frequently come from the lengthy due diligence process (especially commercial, tax, and financial analysis) and also from a strategic review that quantifies the range of plausible value creation.

Exhibit 2: Typical Leveraged Buyout Value-Creation Chart

^{Source: CFA Institute}

Exhibit 3 provides an example of a EUR5,000 (amounts in millions) investment in a PE transaction. The transaction is financed with 50% debt and 50% equity. The EUR2,500 equity investment is further broken into EUR2,400 of preference shares owned by the PE fund, EUR95 of equity owned by the PE fund, and EUR5 of management equity. The preference shares are promised a 12% annual return (paid at exit). The PE fund’s equity is promised 95% of the residual value of the firm after creditors and preference shares are paid, and management equity holders are promised the remaining 5%.

Exhibit 3: Leveraged Buyout Stakeholder Payoffs

^{Source: CFA Institute}

Assume that the exit value, via for example, a trade sale, five years after the investment is made, is 1.6 times the original cost. The initial investment of EUR5,000 million has an exit value of EUR8,000 million. The specific payoffs (in units of millions) for the four claimants are as follows:

Senior debt has been partially retired with operational cash flows, reducing debt from EUR2,500 to EUR1,600. So, at exit debtholders get EUR1,600.
Preference shares are paid a 12% return, compounded annually, for five years, so they receive EUR2,400 × (1.12)⁵ = EUR4,230.
PE fund equity receives 95% of the residual terminal equity value, or 0.95 × [8,000 − (4,230 + 1,600)] = EUR2,061.
Management equity receives 5% of the residual terminal equity value, or 0.05 × [8,000 − (4,230 + 1,600)] = EUR109.

As you can see, preference shares increase in value over time as a result of their preferred dividend being capitalized, and the equity held by the PE fund and by the management is expected to increase significantly depending on the total enterprise value upon exit. Both the equity sold to managers, frequently known as the management equity program (MEP), and the equity held by the PE firm are most sensitive to the level of the exit. The larger the exit multiple, the larger the upside potential for both the MEP and the equity held by the PE firm. In the example, assuming that an exit multiple of 1.6 times the original cost may be achieved at the anticipated exit date (five years from purchase), the management would realize an IRR of 85% per year on its investment, and the PE fund would earn a “blended” IRR of 20% per year, resulting from an IRR of 85% per year from its equity investment and 12% per year on its preference shares.

Click play on the following video to watch Jim Landi, senior content director, explain Exhibit 3.

The Importance of Leverage

This chart also demonstrates the critical importance of leverage in buyout transactions. A reduction in financial leverage over time is instrumental in magnifying the returns available to shareholders. Note that the bulk of financial leverage in LBOs consists of senior debt, much of which will be amortizing. Therefore, the reduction in financial leverage gradually increases over time as a portion of principal is paid back to senior lenders on an annual or semiannual basis depending on the terms of the senior debt. As a result of the gradual repayment of senior debt over time, a larger proportion of operating cash flows becomes available to equity holders. Of course, this mechanism works well as long as no significant adverse economic factors affect the business of the portfolio company and also as long as a successful exit can be secured within the forecasted time frame. Remember that these high levels of debt increase the risks borne by the equity investors significantly. Such risks should be accounted for when comparing the expected returns with alternative investment classes, such as investments in the stock market.

Typically, a series of scenarios with varying levels of cash exit multiples, growth assumptions, and debt levels are engineered with the use of an LBO model, using as inputs the required rate of return from each stakeholder (equity, mezzanine, senior debtholders) to gain a sound understanding of the buyout firm’s flexibility in conducting the deal.