Which has the higher expected valuation - LBO or Trading Comps?
LBO models are described to give the "floor valuation" since financial buyers would almost always pay less than what strategic buyers would, and you're backsolving to see what's the highest price the PE firm could pay to achieve its target IRR. But in the case where the target company is public, the PE firm always has to pay a premium above the current stock price of the target in order for the deal to go through. If so, why do LBOs establish the "floor valuation" rather than trading comps?
You're right that in this case trading comps would likely have the lower value, however i think this scenario is an exception, not the rule. The majority of LBO's are done in the private markets (hence 'private equity') where they will generally not have to pay any premium.
Thanks, that makes a lot more sense. If you were to use public comps to value a private company, would that give a higher valuation than an LBO model? Also, how come PE firms don't have to pay control premiums for private companies - is it because the liquidity discount offsets the control premium?
For those giving MS, if I'm wrong please correct me and help us all learn...
I didn’t MS you but did answer ur comment. Let me know your thoughts. I agree to some extent with your comment but think it’s not fully there. Curious to hear your thoughts though
I’m not sure I agree. An LBO could be a precedent in your transaction comps set. Precedent transactions are used to assess the premiums paid for businesses in the past, but the acquirer does not need to be a public company.
I can agree most PE transactions occur in private markets, but that’s not why it’s called private equity. It’s called private equity because the POST transaction companies acquired are not publicly traded, thus the owners are “private” equity holders.
OP, you are right. Sponsors pay a premium over the equity (obviously, if not the current shareholders wouldn’t sell the business) for control, but this is offset by the illiquidity of the investment. So, while they pay a premium for control, the take into account the illiquidity of the investment by running their IRR analysis over a defined time horizon (i.e., they know they won’t be able to exit or monetize the investment for at least a few years).
Generally, you run LBOs not so much to show aN explicit “floor price.” I know that’s what the M&I and similar guides say, but it’s not entirely true. You generally run LBOs to understand what is the price that someone who is just trying to squeeze returns can pay. To make this clear, imagine the following real life scenario:
CEO of, let’s say, Forg Motors communicates to, let’s say, Lizard that they want to sell the business. MD at Lizard is trying to understand and manage expectations of Forg CEO. Lizard MD would ask poor Lizard monkey to run an LBO. Let’s say LBO spits out an implied 20% premium if you target a 25% IRR. Now, Lizard MD can go to Forg motors CEO and say, “listen, even if we go to a sponsor who would just buy you out with leverage, run your business and try to keep it at steady state to then exit in 5 years, we should get a 20% premium. So, when we go to our set of potential buyers, let’s tell them this is a home run even in a no synergy-steady state scenario at 20%. Thus, after having Lizard Monkey do 100 iterations of cost saves analysis, we think you should give us credit for synergies and pay us an ever higher value.”
What I mean is, yes, sure, it sets a “floor price.” But it’s not really a floor price, it’s just more a way to understand what the business would be worth at steady state after financially engineering their capital structure. So any efficiencies you can identify beyond that allow you to argue for a higher price. It’s more a rhetoric tool than an actual number.
Thanks for the thoughtful comment. Why is there a discount for the illiquidity of a private company when the PE firm was going to take it private even if it were a public company in the first place? I thought that the liquidity or illiquidity of an investment was based on whether its shares can be easily traded on the market. But since a PE firm is purchasing all the shares of the private company anyway, why is there this discount?
Isn't that precisely what a floor price means? I think I'm still missing your alternative interpretation of what floor price is...
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