LBO Question - How is purchase price determined?
When doing an LBO analysis, how is the purchase price determined? In every example training I see online, it starts with "we will pay 8x EBITDA" or something similar. How is the figure actually determined ? Do you value the business first stand-alone (DCF), then determine a reasonable PP, then do the LBO analysis using that figure as your assumption?
So if you're looking at a private company, no cash/debt, and you come up with an EV of x which equates to 8x EBITDA, you say you can pay y which is 6x. Then you make your debt/equity assumptions, project unlevered FCF, debt repayment schedule, etc to get to your IRR.
Am I totally confused? How is the initial purchase price determined in practice?
LBO models can be built to solve for a variety of variables. Solving for returns or PP are probably the most common.
If you are solving for PP, you can build out the model and discount all cash flows by some RoR (~25% maybe) to arrive at a price that you could pay now to earn the sponsor's required rate of return.
That being said, the PP will be what a sponsor is willing to pay for it, so discounting cash flows or EBITDA multiples are useless if a sponsor "says we will pay $100mm or no deal" and they are your only option.
Precedent transactions will usually set the framework for what you believe is a fair purchase price. Once you begin laying out transaction assumptions and applying leverage to the company you will be able to see what the cash flow profile of the business can support and what exit assumptions look like. This allows you to recalibrate your assumptions.
Leveraged Buyouts are often thought of with the perspective of a Sponsor's "Ability to pay" which is why many groups will often look at an LBO as an "Ability to Pay Analysis."
On a separate note... Have you heard of this guy, Armin Van Buuren? He's got us in A State of Trance...
Traditionally, you will determine the value of what you think the market would value the company at using comps (comparing company size, margins, projected growth, capital intensity to other public companies and scaling your multiple off their average multiples accordingly). Then as the others pointed out from there, you run your model and find the returns. This should give you a good idea if a deal can actually get done by a PE firm.
But then most models at the bottom will calculate the minimum purchase price you can pay to still make your return. This is considered more of a baseline assumption of value. (I think this is what non-target was getting at but I will lay it out in a bit clearer steps). You don't need to discount all cash flows, if you have a reasonable expectation of exit multiple (again, comps based) and the working operating model
1) Take your ending year EBITDA and exit multiple to get TEV, and back out your model's ending year net debt to get ending equity value. After making any adjustments you assume (for example, maybe 5% payout to management) you have the ending proceeds that a PE firm would receive 2) Determine a minimum threshold return for the PE firm and discount that ending proceeds number by that amount over the holding period, usually 5 years e.g. (Ending Proceeds) / ((1+Return Threshold)^5). Now you have the amount of equity the PE firm can put in at year 1 3) Use your sources and uses table to solve for the value that can be paid for the company when the PE firm contributes that much equity e.g. Add debt to get total sources, back out any other uses and you have purchase price
Realistically, if the multiples and returns do not work out, then it probably means a financial buyer will not be interested in the company at a price where the seller will transact.
Again, it is an art. If you have a legit LBO model, you have built out an operating model and linked it into the pro formas.
Based on what you expect PE groups to demand for an IRR, you develop a valuation range based on debt level, operating case, etc.
From a practical perspective ...
When you're buying/planning to buy a company, you determine what its worth based on a combination of (a) what you intend to do with the business (i.e., your thesis & projections) and (b) the common valuation methods. You'll consider one or the other methodology more or less based on the particulars of the deal. That gets you to a valuation.
That valuation is the assumption used in your model. Now is where it gets a little (but not very) blurry. Assuming you've come up with a view of the business, you'll be willing to pay a price informed by your valuation and up to a point where you feel the risk-adjusted returns are still compelling.
Maybe you get to an 7x valuation and that results in a 31% IRR. It is however a competitive process and you believe that a 7x bid is not going to clear the market (i.e., won't be the highest bid). So you ramp up your bid to 9x say, which results in a 17% return... which isn't terribly exciting. Capital markets are healthy and you've gotten views that you can get 4.5x of leverage on the business, which you'd be comfortable with. So you max out the leverage in your model at 4.5x, with a 9x purchase price, and your projections you get to 22% returns.
Now you're faced with the following decision... the investment thesis has a certain amount of risk. When you were going to be compensated 31% for that risk, it was a compelling opportunity to you. Then when you dialed up the valuation it increased the risk to your investment further because (a) you're putting in more capital and (b) you're underwriting a higher purchase price and likely expected exit multiple; on top of that you increased the financial leverage which makes the business inherently more risky. So now the question you have to answer is given the new risk profile of the business, is a 22% return adequate to compensate you for that risk?
That's a question that is very specific to the deal at hand and the investors looking at it.
Thank you, Marcus, for your detailed response. I think I always struggle with, as a hypothetical investor, how do I justify the purchase multiple to make sure I do not overpay based on the the sell-side asking price. Your rationale makes much sense to me, but what I still find difficult to wrap my head around is give all the Debt and Capital markets conditions, it sounds like me taking a "leap of faith" nowadays when making a decision whether to buy a business at ##.##x multiple.
Use DCF for LBO Purchase Price? (Originally Posted: 08/22/2013)
See subject line. Other than the usual EV/EBITDA multiple, is a DCF ever used to potentially come up with a purchase price for an LBO? Obviously looking at most of the same line items over the investment horizon, but wasn't sure if an intrinsic valuation is really ever used in a purchase price for a financial buyer vs. a strategic buyer.
An lbo model is used to come up with the purchase price. lbo models are essentially more-detailed DCFs.
PE firms certainly look at DCF-based valuations before making an investment. Both DCF and LBOs are very similar as noted above. The DCF assumes zero debt in the cap structure while the LBO assumes some leverage. Actual sales/ebitda numbers should be the same for both.
While both are relevant, the LBO valuation is more relevant for PE firms as it (if done properly) captures expected tax payments which can vary significantly from just a straight % of taxable income. It also provides guidance for structuring r.e. debt load, covenants, etc.
Keep in mind that all projections are guesses about the future so everything needs to be taken with a grain of salt.
That is not correct. A DCF does assume debt in the capital structure which is reflected in the discount rate / WACC. You do use unlevered FCF's but then your WACC will reflect the company's target capital structure (including debt).
I've never done both a DCF and an LBO for a PE investment. That's redundant as those two should not give you materially different answers unless you're making crazy assumptions about leverage and cost of debt
You generally run a DCF in-line with your lbo model to check what the Board is looking at in terms of fundamental value of the business. The Board will be considering the DCF value + premium for synergies as what could potentially be expected in a strategic deal so if it is way above the LBO value you are bidding, the Board may have a hard time recommending the bid. Obviously you are not sharing your DCF with them - it's just to get their perspective on fundamental value. Also a DCF and LBO are very similar (i.e. the DCF will just link into the LBO) - an LBO model is essentially a DCF model but using FCFE (i.e. FCF to equity) instead of FCFF and layering on incremental acquisition debt.
lbo models will show you a window of affordability to to speak. However, I have seen banks include it in their football fields, which also included DCF, etc. I once had to do both DCF and LBO for one target. I thought it was highly redundant.
Honestly, I'm not sure if any PE firm will ever use an excel model to come up with a purchase price...
For us, purchase price is an input. We have a general idea of what we are willing to pay and look at the implied return.
Yup, I have seen that, too.
double post
That is how our's is setup. Purchase price is an input, but the IRR movement builds out a value range.
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