Why would a Private Equity fund not use WACC as the discount rate when valuing a potential LBO target?
Why would a Private Equity fund not use WACC as the discount rate when valuing a potential LBO target?
Thank you
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I've been on the job 3 months and haven't done a DCF analysis for any project. It's been solely detailed LBO analysis. I would think that the general rule of thumb applies no matter who is doing a DCF exercise (sell-side or buy-side). If you want firm value use WACC on UFCF. If you want equity value use cost of equity LFCF. I believe my shop and everyone else in the space will do DCFs for quarterly portfolio reporting to LPs, but I haven't been responsible for any of that work yet. Hope this is helpful.
The above poster is correct, but to expand:
Its a matter of Enterprise Value, and what cash flows go to whom. The LBO shop owns the equity, and the debt holders hold all the debt. The LBO shop is only entitled to the cash flows of the company after the creditors are paid off. So you only value those cash flows, which are the levered free cash flows, the "The free cash flow that remains after a company has paid its obligations on its debt." (Investopedia)
To discount those, you have to use cost of equity. Using WACC would be wrong, because it partly contains the cost of debt, but the debt lies outside of this matter.
Thank you for the information. I understood that we need to use the Cost of Equity rather than the WACC as we are discounting the Implied Exit equity value rather than the exit EV.
However, PE shops use IRR and not Re I guess if we discount using Re, it might result with a Positve NPV, however, an IRR would result with a NPV =0
So my question in this sense is: How do we interpret the result when we discount using an Re vs discounting using an IRR?
Let say Re =15 % and IRR = 30% Does it say for example, that an investor requires a minimum of 15% rate of return to invest in this project, however, this project has achieved a 30% rate of return to them?
If that's the case, then you can pay more. If its an auction process, someone will likely bid until projected IRR is approximately equal to Re. This is why when you win a deal in an auction, you usually have to have some angle that gets your comfortable you can realize higher equity cash flows than other bidders.
You can absolutely get to equity value using WACC. Get the value of the firm, then subtract whatever you think debt/preferred/NCI is worth. Economics of the business tend to be easier to see using a firm value approach vs. equity value as well imo.
As for why PE firms use LBO's it's probably a combination of: 1) argument to be made you are adding value by forcing the company to run leaner with added debt load, and 2) that's the way it's always been done. There are also some issues with using a constant WACC throughout a forecast period where you're debt/equity breakdown is shifting (by definition), but I think that's more of a minor/academic point.
This question is at the heart of the perpetual question as to whether PE firms add value. The answer btw is "sometimes" (just like for HFs).
Thanks, you are right.
Usually, in a LBO, we calculate backwards to find the the price that would yield a particular IRR. Then we assess if this determined price is higher than the trading price, and whether potentially would be sufficient/convincing enough to acquire the firm.
How does the management determine a suitable IRR for a particular target? I know typically they are between 20-35%. However, whats the rationale behind, for example, asking for 30% IRR rather than 25%. In practice, CAPM is commonly used to determine a Ke.
My guess would be that the management would determine a base Ke (using CAPM, or another method). Then, IRR rate is determined by adding a premium => IRR = Ke+Premium Ultimately, the IRR would be used to evaluate if the target can be bought given the required IRR. (Alongside other typical criteria to what makes a target a good LBO).
Build a simple (or highly complex) lbo model and you'll see that equity returns are extremely sensitive to de-leveraging and re-leveraging. I.e. even if buying the same business with the same initial leverage, three firms will get very different equity IRRs if - first one financed it with bullet payment debt (and free cash goes to dividends every year) - the other one uses all free cash to pay down debt - the third one executed one-off dividend recap in the middle of the holding period But if you used Unlevered FCF and constant WACC you would get the same valuation for all three cases obviously.
So saying the WACC is constant (implicitly assuming that D/E is constant) is very imprecise for leveraged buyouts. It can actually be a good answer to the OP's question.
To add another thought, in unlevered DCF many use the same WACC for both (1) discounting cash flows and (2) identifying Terminal Value via Gordon Growth model. I think (and I managed to get a lot of support around both my firm and external auditors) it is completely wrong for private equity case in most instances - because PE firm often buys into rapid growth / turnaround plan which usualy takes few years to execute and then PE firm exits. Once this rapid growth period has ended, your WACC (both D and E components) change substantially, so does their proportion, so you need to use different (lower) WACC for TV calculation as Gordon Growth TV represents long-term / stable mature company valuation.
P.S. I would never use Gordon Growth to start with, I would always go with multiples (easier to justify, closer to reality) but I know many use GG so wanted to sahre.
Well yeah equity returns obviously are magnified by debt. But guess what? Leverage also adds risk to those returns. There's no free lunch here. Adding leverage to cash flows will make you very wealthy as long as you keep receiving said cash flows.
I agree with your coworkers that using current leverage/WACC would be assinine and I never suggested doing that. Use something close to target D/E.
To be clear, I also agree that you technically shouldn't use a constant WACC if leverage is changing and that in theory you should apply a different WACC to every forecast period. Just don't think it's a needle mover which is why I said it was more of an academic point.
Which of the following would yield the highest IRR and why?
Yes it would typically be higher than cost of equity if you're looking at a public target. Lack of liquidity is main reason for the premium you mention. Can't tell you what makes a 30% IRR vs. 25% beyond (as someone mentioned) if you believe you can run it better than anyone else (or even just existing stakeholders if it's not a competitive process). Beyond that it's going to be solely based on your outlook for the business as a passive investor and whether that outlook is differentiated.
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