Conceptual Question about LBO vs DCF
I was recently asked what assumptions I would need to make in an LBO to match the EV obtained in a DCF valuation, and vice versa. My response focused primarily on cash flows: I suggested that, in the LBO, one could use the cash flow to the firm and discount it with the WACC instead of the IRR. From the interviewer's reaction, I couldn’t tell what they thought of my answer. Also, I’m unsure if this approach is correct, as it seems that an LBO exit value is essentially like discounting only the terminal value of the DCF without factoring in the intermediate cash flows. Is that accurate?
Furthermore, I was asked why an LBO typically results in lower valuations than a DCF. Again, I wasn’t sure about the interviewer’s opinion on my answer. I explained that the LBO uses an IRR to discount the equity value, then adds net debt. In comparison, a levered DCF would use the cost of equity, which is typically lower than the IRR (often 15-25% in an LBO). I would appreciate if anyone could tell me if this is correct
First question, that's a tough one because I'm not entirely sure what the interviewer is looking for, but I'd start with what you know.
Second question: strategic acquirers can have more synergies and often have lower costs of capital than private equity sponsors.
Generally sounds right to me. I guess the two things I'd look for are:
a) DCF ignores capital structure / utilizes unlevered free cash flows, whereas an LBO needs to factor in debt service
b) That debt drives a higher required return on capital for the equity
This is one of those questions where giving simple answers is usually better. Once you start getting into the minutia, I either lose interest or find errors in your thinking. Just nail the big concepts confidentially and any normal interviewer should move on.
For both questions I first gave those kind of answers, then he said I should explain it "mathematically" so what factors in the calculation lead to a different valuation. I think the question was not about who uses it, so not about why in general PEs as acquirers lead to lower valuations than Strategic Acquirers (like more debt, higher IRR, Synergies...) but he really wanted to explain it with the formula.
Does my given answer make sense here? If not, what is the error with it?
So I said, if you would use an levered DCF and use the IRR from an LBO as the Discount Rate in the DCF, and have no debt repayments in the LBO, then the Exit Value from the LBO would act as the terminal value in the DCF. The only difference now is, that the levered Free Cashflows from the DCF are discounted periodically and in the LBO they are discounted in the end, because if there's no debt paydown in the LBO, the Cash just accumulates until the end. So I am not sure how to handle this difference. But apart from this, is my answer correct or is there some error in the logic? Thak you!
I don't think this works unfortunately. You're talking about discounting levered free cash flows at the LBO IRR, but that means you already have a price.
You want to figure out the right discount rate to use, and then discount that back to get an equity value. What I suspect your interviewer is getting at is that in our lbo version of the model, we're estimating a sponsor's return bogey with some 20 or 25% IRR. That number, when blended with the average cost of financing on the debt, will imply an unlevered discount rate. As mentioned above, that implied unlevered discount rate won't line up with what you calculate in CAPM which I guess is the academic way of determining unlevered discount rates (at least in interviews). Your unlevered discount rate implied by your LBO model is likely going to be higher because of a higher cost of equity than what's in the public markets (cost of debt could be higher too given leverage).
Thanks for taking the time to explain! If I'm understanding correctly, you're saying that the interviewer is getting at the idea of: if you take the targeted IRR and blend that with the avg. Kd, then that's your effective unlevered discount rate, which you can use to discount equity value? If that's correct, are you able to elaborate on why the blended target IRR + avg. Kd = implied unlevered discount rate? Thanks!
yes but in an LBO wouldn't you also have a higher percentage of debt which would in turn lower your WACC. so there are essentially two levers at play one is your cost of equity increasing but also a higher percentage of debt because LBOs usually have a higher D/E
Personally see this as a gearing issue
WACC (in a DCF) assumes Ke * Equity % + Kd * Debt % (post-tax)
LBO derives an equity return that is functionally the same as your Ke (higher in practice due to hurdles/acquisition prices being higher than “market” returns)
A practical bridge between unlevered and levered FCF will generally mean that your rolling gearing (1 - NPV of FCFE / NPV of FCFF in each period) isn’t going to be constant
Therefore LBO valuation =/= DCF valuation less net debt assuming identical discount rate assumptions (if your DCF WACC is based on entry/target leverage)
You could reconcile by setting the DCF WACC to use average gearing over the forecast period (or sculpt amortization to reach a target leverage amount but that’s not the better answer). I would assume this doesn’t bridge perfectly due to time value but think it would be sufficient to answer the question
Good start, this is a valid point.
Not entirely correct, because an LBO would use a multiple to get to enterprise value, and IRR is an output rather than an input, correct? Furthermore, by reducing it to "net debt" we are forgetting about the interim debt repayments.
Ultimately, from a big picture perspective, there are probably two theoretical questions/ key factors of consideration (albeit this is after just 2 minutes of internal hypothesizing):
1. How do relative and absolute valuations of firm value differ? The LBO model leads to an exit price based on multiples valuation, e.g. EV/EBITDA, whereas the DCF is more a "bottom-up" approach based on actual value of projected cash flows + TV.
2. How does an equity-owner perspective differ from a bond-holder perspective in assessing firm value? As mentioned above and hinted by others, an LBO factors in leverage by considering not only debt repayments but also interest payments which reduce cash for equity owners in its projections == essentially we are basing firm value off FCFE. On the contrary, a DCF can be used to figure out the "pure" economic value of the firm to the firm == firm value based off FCFF.
That's how I would frame it and the numerical mechanics of the model (i.e. think all the discussion on WACC vs. cost of equity still apply) are just supporting facts.
What does your point 1 mean?
Is an LBO just a reverse DCF with the only thing that matters being the discount rate? In an LBO the implied valuation is ultimately based on the assumed required rate of return (IRR). A levered IRR will always have a corresponding unlevered IRR. So if you know what your unlevered IRR is you can just set that as your discount rate and get the valuation you are looking for.
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