Decoding the LBO Valuation

A Leveraged Buy-Out (LBO) is an acquisition case in which the acquiring company takes a large amount of debt to finance the acquisition. A brief insight is provided as to how the companies do the LBO valuation.

Earnings and Cash flow forecasts
The initial part of the Income statement can be prepared in a usual fashion. The Sales growth can be assumed to be increasing in a stable way, and the expenses can be assumed as a percentage of Sales in a particular year using the data from past years.

The interest expense is different from that of a normal debt interest expense. Suppose, there are two levels of debt- Senior debt paying 10% interest, and Junior debt paying 15% interest. Interest expense is calculated as the sum of interest expense of these two levels of debt.

Pre-tax income, Income taxes and Net Income are calculated in the normal manner. LBO Income taxes are generally lower than the taxes paid by a company with ordinary amounts of debt.

The Cash Flow forecast differs from a normal forecast in that it starts with Net Income, and not with EBIT. The next procedure is the same- add back depreciation and other non-cash expenses, and subtract new capex and change in working capital.

Debt Structure and Cash Sweep
LBO debt contracts generally provide that any excess cash generated by the company in the initial years is used for the repayment of debt, which is known as Cash Sweep.

Generally, in an LBO, there are 5-6 levels of debt, also known as tranches. The more Senior debt is paid first, and then the next level of debt. So, the cash generated in the initial years by the company is used to pay back the Senior debt at 10% (explained earlier).

The LBO Company pays no dividends (prohibited by the debt contracts). The Equity in the company increases by the same amount of Net Income, though the equity holders do not get any cash in their hands.

The LBO starts with a very aggressive capitalization- something like 85% debt and 15% equity. By the end of Cash Sweep period, the capital structure is much more in line with the normal capital structure- something like 50% debt and 50% equity. This is the essence of an LBO plan- take on high amounts of debt initially, then pay back the debt out of the income generated by the business within a reasonable amount of time, and bring back the company to a normal capital structure.

Cashing out horizon and Terminal valuation
The equity holders of the LBO receive no financial returns while Cash Sweep is in effect. The Accounting value of Equity, is increasing because of the reinvestment of Net Income, but the equity holders have no additional cash in their pockets.
The equity holders generally obtain their returns through a Cashing out event. When an LBO is formed, the equity holders anticipate a future liquidation of their holdings, which could occur in 3 ways- 1) via an IPO, 2) via a private sale of the company, 3) via a recapitalization.

The Cashing Out event is assumed to take place in Year 5- this is standard practice. A number of techniques, including Free Cash Flow/ CAPM valuation, P-E multiple, EBIT multiple, and EBITDA multiple can be used to calculate a Terminal value in Year 5.

Translating the Terminal value into a Fundamental Market value of Equity
The purpose of the LBO valuation is to figure out how much the LBO fund and its co-investors can afford to pay for the target enterprise.
Generally, there are 2 methods to convert the terminal value into comparable present values-
– Impose a target Internal Rate of Return;
– Calculate the year-by-year Cost of Equity, \(K_e\) using the CAPM, taking into account the changing capital structure.

Target IRR method of Valuation
The equity holders in an LBO process are expected to take the financial returns after the debt holders get their money back. The equity holders, thus have a higher risk as compared to the debt holders. Hence, it is imperative that the rates of return for the equity holders should be higher than the cost of capital of any of the LBO’s debts.

As a part of the internal governance process, fund managers decide upon a target IRR for LBOs. These target IRRs, also known as hurdle rates, which reflect both the average risk of their investments, and the prevailing market conditions.
Target IRRs for LBOs typically lie in the range of 25%-40%. The maximum investment which fund managers can put in a particular LBO at a target IRR can be calculated as-

\(\text{Present value of Investment} = \frac{\text{Terminal value of Fund equity}}{(1 + \text{Target IRR})^\text{( Cash out horizon)}}\)

Cash out horizon can be assumed to be 5 years.

Changing cost of Equity
This method uses the CAPM to calculate the changing cost of equity for each period.
The CAPM gives the equation for cost of equity as: \(K_i = R_f + B_i (R_m – R_f)\)

\(K_i\): cost of capital of asset I;
\(B_i\) is beta of asset I;
\(R_f\) is risk-free rate;
\((R_m – R_f)\) is market risk premium.

The Method of Backward Induction
Once the terminal value of Equity is calculated at Year 5, we can use the backward induction to figure out the present value of the terminal value of Equity. Six pieces of information are required to perform the same:

– Series of risk-free rates from t=0 to t=cashing-out horizon;
– Market-risk premium for each year;
– Beta of enterprise as a whole;
– Beta of debt of the LBO;
– Terminal value of Equity;
– Value of debt at each valuation time period.

The method of backward induction starts from Year 5, where Terminal value is discounted using the cost of equity from Year 5. The same process happens for Year 4, and continues till the present value is obtained.

Here are some of the formulae which would help in calculating the cost of equity, and the equity value in a particular year.

\( \text{Enterprise Value (T)} = \text{Debt(T)} + \text{Equity Value(T)} \\
\text{% Debt} = \frac{\text{D}}{\text{(D + E)}}\\
\text{% Equity} = \frac{\text{E}}{\text{(D + E)}}\\
\text{Equity Beta, }\beta_e = \frac{[\beta_a – \beta_d\text{(%Debt)}]}{\text{%Equity}}\\
\text{Cost of Equity, }K_e = R_f + \beta_e(R_m – R_i)\\
\text{Equity Value(T-1) } = \frac{\text{Equity Value (T)}}{\text(1+k_e)} \)

This completes our LBO Valuation process.