LBO assumptions question
Apologies in advance if this is in the wrong subforum.
I'm learning about LBOs and this one exercise I'm attempting mentions that another PE fund owns a quarter of one of the potential candidates and invested in the company three years ago. What kind of assumptions would you make based on this piece of information or what extra information would you look for knowing this?
The other PE firm owns 1/4 of the target your firm is looking to buyout?
Yes, the question gives each candidate a paragraph detailing one unique characteristic to them, for this company another PE firm owns a quarter, another one had high capex spend in the past years etc.
In an LBO, it doesn't really matter what the current equity make up is. Once the buyout is completed, the new equityholder(s) will dictate what the capital structure looks like.
You can glean a few bits of information from this. First, since they invested three years ago, they'll probably be looking to exit their investment (typically target 3-5 year investment time frames). Based on this, you could back into a minimum purchase price since a PE firm is expected to generate a certain IRR. Say it's 25% IRR in three years, that's about a 2x cash-on-cash multiple. So if you know how much the PE firm paid for the company three years ago, you can account for any debt paydown and then multiply the equity by two to figure out what the expected enterprise value could be.
This is assuming the company has been doing well. If, on the other hand, the company is in the pits, perhaps the company is being sold early due to lenders forcing the PE firm's hand. In which case you'll know that they'll be trying to offload the investment and that it might have trouble taking on a lot of debt, which could affect how your finance your buyout.
EDIT: Forgot to add, an obvious piece of info you would want to know based on what's given is... who owns the other 75% of the company. Your strategy varies a lot if the company is majority owned by founders, another PE fund, public, etc.
Question about underlying theoretical assumptions in a DCF and LBO analysis. (Originally Posted: 03/23/2016)
1) Normally, when projecting revenue in a DCF analysis, you should normally to assume a slower, steadier rate of growth for the later years. 2) In an LBO analysis, you should normally assume that you'll sell the business for the same multiple you bought it for when you exit it several years down the line.
But, if the person crafting the LBO analysis recognizes point "1)" as true and also recognizes as true that, all else equal, slower growth results in a lower multiple, how could that person possibly fail to recognize that he or she'll most likely be forced to sell at a lower multiple (given the company's expected slower growth)?
Several reasons. First of all, the multiple a company sells at doesn't solely reflect its growth prospects. It captures the value of future cash flows and the inherent risk behind those cash flows. So, after a PE firm has held a company for 5 years and it has reached a "mature" stage, that doesn't necessarily make the company less attractive. Essentially, what has happened is that its cash flows are more secure. Take the basic formula for value: V = cf / (r - g). In year 1, your discount rate (r) is high but your growth rate (g) is also high; in year 5, your discount rate decreases and your growth rate decreases. So, in the end, your capitalization rate (r - g) would be similar in both situations. This implies an equivalent firm value from the same amount of cash flow, and thus each would receive the same multiple.
From a less theoretical standpoint, private equity firms create operational improvements that often lead to exiting at a much higher multiple. Additionally, many middle market funds are able to generate proprietary deals with little to no competition, allowing them to enter at relatively low multiples. They make a few improvements, send it to auction after a few years, generate competition among buyers and receive a significantly higher multiple.
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