Leveraged Buyouts

Basic Concept
Business for sale for R10,000,000
ASSETS : R8,000,000

EQUITY: R8,000,000

Stable pretax income per year: R1,250,000

After-tax cash profit: R1,000,000

Would you buy this business?

How can you fund your acquisition?
2

Cash purchase
Pay R10,000,000 cash
Own 100% of assets
FCF to shareholder : R1,000,000

ROI = 1,000,000/10,000,000 = 10.0%

3

Gear the purchase

Obtain R8,000,000 loan at 7%
Own investment: R2,000,000
FCF to shareholder : R1,000,000
Less interest on debt: R560,000
R440,000

ROI = 440,000/2,000,000 = 22.0%

4

Gear the company itself

ASSETS : R10,000,000
R10,000,000

EQUITY: R2,000,000
DEBT : R8,000,000
R10,000,000

PBIT:
R1,250,000
Less interest on debt: -R560,000
R690,000
Less tax (20%):
-R138,000
PAT:
R552,000

ROI = 552,000/2,000,000 = 27.5%

5

Definitions
LBO
Purchase of company using large amount of debt

MBO
LBO where management is the purchaser, or part of
the buying consortium (often of one division or part)

MBI
LBO where outside management is the purchaser, or
part of the buying consortium
Objective is often to gain control so as to unlock value of firm
6
debt is temporary means to do so.

Options if
Company has excess debt capacity

Recapitalise with leverage

Takeover (possibly hostile)
Leveraged buyout
7

Typical parties involved

Buyer

Seller(s)
(Current
shareholders)

LBO

(e.g. other
company, PE
firm)

Management
Financiers
(e.g. banks)

MBO

LBO capital structure

Equity

Ring-fenced
Maximum loss
of sponsor (PE
company)

Debt on target
balance sheet
Collateral for
debt holders

Assets

Often 60-70% of
purchase price

=
Debt

Typically paid
off in 3-7 years
Tax shield benefit,
which reduces over
time

US LBOs (target EBITDA > $50mn)

Source: http://www.leveragedloan.com/lbo-deal-volume-on-pace-to-top-2012-though-activity-remains-slack/

10

Characteristics of good LBO

targets
Debt must be repaid!
Therefore, predictable stable cash
flow is the key requirement
11

Other useful attributes (1)

Attractive price / valuation
Low debt on balance sheet
Low growth
Slow technological change industry
Strong market position
12

Other useful attributes (2)

Good asset base
Divestible assets
Cost reduction opportunities
Good management
Exit options
13

Typical scenarios
Taking a company private
Undervaluation / inefficiencies /chasing
short-term targets

Owner wants to exit

Often MBO

Divestiture of non-core business

Often MBO
14

15

LBO Valuation
(using VC Method)

Depends on:

Objective:
determine value of
deal as EV/EBITDA
multiple

1. Financial statement projections

2. Projections of debt position

3. Exit multiples

4. Required rate of return

Price usually expressed as multiple of EBITDA
16

Step 1 Projections
Grown by
forecasted
growth rates

1. BASE CASE PROJECTION

Revenue
Growth
EBITDA margin
EBITDA

Year 1
80

Free Cash Flow

8%
6.4

Year 2
92
15%
10%
9.2

Year 3
106
15%
12%
12.7

Year 4
116
10%
14%
16.3

Year 5
122
5%
16%
19.6

4.0

6.0

8.0

10.0

13.0
Projections from
full forecast
income
statement

2. DEBT PROJECTION
Beginning Debt
Net Debt

35
35

31.0

25.0

17.0

7.0

Reduced by FCF every year

17
(cash flow sweep)

Step 2 Valuation
3. EXIT MULTIPLE AT YEAR 5
EV/EBITDA Multiple
EBITDA
Enterprise Value
Less Debt
Equity value at exit

Exit year values

8
19.6
156.4
-7.0
149.4

4. PRESENT VALUE AT YEAR 0

Discount Rate

30%

NPV (Equity)
Debt
Value of Enterprise (yr 0)

40.2
35
75.2

EV/EBITDA

Discounted at
30%

11.76
18

Levers of Return
Low entry price
Gearing (incl. tax benefit)
EBITDA expansion
Exit multiple expansion
Dividends
19

IRR of investments (at end)

Scenario 1: pay off debt with CF
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
500
500
1,000

Equity
Debt
EV
Net debt
Free Cash Flow*

-500
100

-400
100

-300
100

-200
100

-100
100

Sell for

0
1,000

* After interest and tax payments

Doubled R500 investment over 5 years

IRR = CAGR = [1,000/500](1/5) -1

= 14.9%

20

IRR of investments (at end)

Purchase 10x EBITDA

Scenario 2: reinvest CF @ 15%

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
500
CF reinvested to grow
500
EBITDA by 15% p.a.
1,000

Equity
Debt
EV
EBITDA
Sell for 12x EBITDA

Net debt
Net proceeds

100

115

132

152

-500

-500

-500

-500

175

201
x12
2,412
-500 -500
1,912

IRR = CAGR = [1,912/500](1/5) -1

= 30.8%
21

Funding structure example

Typical US example:
Funding Source
Secured financing
High yield
(e.g. junk bonds)

Equity

Total Deal

Times EBITDA
3x
2.5 to 3.5 x
1.5 to 2 x

7 to 8 x
22

LBO Funding hierarchy

Source
Bank debt
High yield bonds
(bond market)

Mezzanine finance
(banks, PE)
Equity
(sponsor / buyer)

Collateral
Senior Secured Debt
Senior Unsecured Debt
Senior Subordinate Debt
Subordinated Debt

Preferred Equity
Ordinary Equity
Cost
Risk*
* To provider

23

Mezzanine Debt: Definition

Hybrid (combination) : debt and equity

Sits between secured debt and equity

Provides fixed cash flow

Debt Component
Equity Component
Provides potential upside
24

Typical Mezzanine Structures

Coupons: Cash or Payment
in Kind (PIK)

Debt Component
Equity Kicker

Unsecured
intermediate-term
bond
Share warrants

Fixed dividends

or

Preferred Shares
Conversion rights
to ordinary shares

Allows investor to
buy more shares at
predetermined price

25

Exits

IPO
Trade sale other buyer
Buyout by financial buyer
Leveraged recapitalisation
26

Example of LBO Analysis

is considering Unicorn Technologies as an LBO target.
Unicorn, a listed tyre manufacturer, has 35mn shares in issue,
which are currently trading at R18.50 each.
Current EBITDA is R80mn, and there is R60mn debt and
R15mn free cash on the balance sheet. The target holding
period for s LBO investments is five years at a required IRR
of 30%. Your projections show that with in control Unicorn
can over the next 5 years generate R280mn in free cash, grow
EBITDA at 12% per annum, and be exited at 12x EBITDA .
Generous Bank is willing to finance your acquisition with a
maximum amount of debt equal to 5x Unicorns EBITDA.
Determine whether Unicorn is a viable LBO target, and if so,
how much the maximum amount is that PE company will
be willing to pay for each Unicorn share.