LBO Valuation
Hi guys,
If you don't mind, could you please help me out with the steps of an LBO valuation. Been searching online, but different sources talk more about LBO Analysis than LBO Valuation. Could someone please walk through the main steps for an LBO valuation.
The intuition behind why an LBO valuation gives a 'floor' valuation is clear because LBOs are used by PE houses, which are financial sponsors rather than strategic buyers is clear due to lack of synergies.
Thank you! :)
Vault Guide.
LBO VALUATION - Question? (Originally Posted: 10/08/2008)
Hey everyone,
I am heading to a superday this coming Friday and was wondering if someone could help me clear up a doubt related to LBO modeling. I had an SA stint this past summer and helped put together DCF models as well as M&A and Pub comp valuations. I did some work with LBOs but not enough to make me feel comfortable discussing all their ins and outs. At a basic level I understand how an LBO works: Small amount of equity down with the rest of the cap structure being made up of debt. Over the years the equity stake grows percentage-wise as the debt gets paid down. There is usually a lot of debt to help firms reach their desired IRR and there are usually several tranches of debt used to accomplish the financing. Obviosuly I get the whole pro-forma modeling thing as well where you change the BS going forward and see if the company can handle the debt, at what price, and assuming a certain exit multiple (typically same as the one the company bought in at) etc etc etc
My question relates more to using a DCF model as a valuation method. I've never actually done this myself but I've seen lbo's on football fields as well as several posts on the site discussing this. After going through them I am still a bit unclear as to how to go about it. Can someone help explain it to me? I just don't get which # in the model you work towards to use as a valuation figure for a football field. I mean, do you discount the debt loaded FCFs in a DCF-like manner, try to back into the buy-in price making assumptions about the PE firm's IRR and the amount for which they will sell the company at a couple of years down the road (and if so, how do you decide what the company will be sold for at that date), etc etc etc...
Thank you so much I apologize if my thoughts are a bit all over the place
they are soooooo 2007...
Haha true.
The value (debt+equity) the buyer can pay for the company that yields an above hurdle IRR in the exit year.
You can go to www.damodaran.com, and he has a spreadsheet for LBO valuation, it's on the valuation entry page.
so its pretty much the PV of the free cash flows modeled on a proforma basis loaded with all the extra heavy int payments cause of the added debt?
While we're on this topic, can someone explain where the entry/exit multiple is usually coming from? Is it the EV/EBITDA multiple, or is it a different metric? And is that metric an industry one or firm specific?
Industry specific multiples
EBITDA is common
Outputs of the model are usually IRR and MOIC along purchase price, exit multiple, and leverage sensitivities.
Your original post was worded in a confusing fashion, but here are my answers to the questions I think you asked:
DCF model - discounted cash flow analysis measures the intrinsic value of a company based on the present value of its projected cash flows
lbo model - helps you assess the returns that a PE firm can get by buying a company in a leveraged transaction. Essentially the purpose of a leveraged transaction is to acquire a company with a large amout of debt but an amount that can still be serviced or paid down via cash flow generation. Over time, debt obligations are paid off which expands equity value (remember that EV = equity + debt - cash), so ultimately the goal is to expand enterprise value and thereby equity value off of a small initial equity commitment. I assume you know this if you made it to the final rounds of a leveraged finance interview. Anyway, lbo models enable PE investors to assess the internal rate of return (IRR) of a prospective investment and how that may vary based on different sensitivities and capital structures, which are things that basic DCF's do not enable you to do.
Entry/exit multiples - your entry multiple is just the EV/EBITDA multiple that you pay for a particular investment. Usually you come up with this number based on comps and precedent transactions. Your exit multiple is just the multiple you think you can sell the company at when you exit. Normally you assume no multiple expansion unless you have some compelling reason otherwise because of industry trends, favorable organic growth or expansion through acquisitions, or just a better market environment overall. Given the current state of the economy, I don't think there is a good reason to bake multiple expansion into your model.
Other things you should know about the current deal environment, just so you aren't completely out of touch with what's happening on Wall Street: you're looking at senior debt with interest upwards of 8-9% (think LIBOR + 450-550 bps) and mezz debt upwards of 15% right now, with many lenders expecting the credit environment to further deterioriate through early 2009. Credit is very hard to come by right now, but there is still some available financing in the middle markets. What'll eventually happen is that as interest rates come down to stimulate the general economy, more lenders will enter the market because they know that they can extend credit at lower rates and still make a killing...so like everything else, things come in cycles and credit will eventually be available again. But right now things are not looking good; credit is very expensive and a lot of PE shops are really focusing on portfolio management rather than new deals from now through year end. Capital structure of a lot of transactions, at least in the middle market (where I work), is usually something like 40% senior debt/20% mezz/40% equity these days. No more 80% debt/20% equity transactions -- not now, and not for a while.
Hope this helps...some of it was hastily written because I want to go to bed, but hopefully it's still all coherent. Good luck with your interview.
A few beginner-esque questions re: valuation/LBOs (Originally Posted: 01/02/2011)
A couple of beginner-esque questions for y'all - and yes, I've already searched, but couldn't find a clear/simple answer to these:
a) What's the point of doing market comps for a public company? As in, if you're just going to use it to value the target based on what the market thinks, why not just take the actual market cap and add debt to find actual enterprise value as determined by the market? Doesn't comparing to other companies just make this slightly less accurate?
b) When you add minority interests in the enterprise value calculation for Company X, does that mean minority interests that Company X holds in other firms, or does it mean minority interests that other firms hold in Company X?
c) I'm not sure I understand why LBOs are so profitable, other than the fact that you can leverage your capital (just like trading on margin). Everything I read seems to say that doing an LBO allows you to pay back debt with earnings and then sell for the full equity value. But if you did a non-leveraged buyout, wouldn't you just be able to pocket the earnings instead of paying back debt? Said another way, is there any reason an LBO is more profitable than a normal buyout other than letting you leverage your capital?
Many thanks,
dublin
a) You want to have an idea of how comparables trade and how that compares to your company and why any differences in multiples exist. This will give you a better picture of what drives valuation than looking at the company alone (i.e. if the multiples are the same, but margins for company X are lower than for comps, you could potentially create a lot of value by improving operating efficiency).
b) Minority interests can get tricky, but they rarely matter, so my memory is a tad hazy on them. Generally speaking though, the value of minority interests in other companies should, in theory, be reflected in the market cap and thus no adjustment is necessary. Other firms can hold stock in company X; but unless you mean a PIPE or preferred or something like that, you don't need to adjust the enterprise value (otherwise just add the market value of the preferred). Usually preferred stocks either get taken out or brought into the new capital structure.
c) Yes, it basically has to do with leveraging up your capital. You are increasing the default risk but increasing potential returns. If you don't lever it up, your rate of return is lower (for example, if you borrow at 10% but earnings on that capital are 15%, you pocket the 5% additional return). At these rates, an unlevered company would earn 15% on equity, but a company levered 50%, would earn 20% on equity, and so on and so forth.
a) when doing comps, you don't just look at enterprise value alone, but rather what multiple that EV is of another metric (EBIT, EBITDA) and based on that, you plot out a range where your company's EV falls. Also when calculating EV you also subtract cash and add in other things as well.
b) Minority interests your company holds in other firms. You add it to EV because that company's revenue and whatnot are included in your company's financial statements, so its value needs to be reflected in your EV.
c) Yes you would be able to pocket the earnings, but where are you going to come up with all the cash to do the transaction in the first place? Leverage magnifies your earnings because you're not out as much out of your own pocket.
^^^I'm a little hazy on minority interest since I never have to deal with it, but isn't the case that the financials of the company in which you have a minority interest are excluded, and only their earnings show up in the "minority interest" line item on the P/L? Also, don't you ignore the minority interest for EV purposes because the value of such stake is already included in the common stock's value (assuming you are taking over the minority interest)? I'm thinking of something like pension liabilities, which often are largely hidden from financial statements but can have large impacts on company valuations if there are funding shortfalls (i.e. the common stock's value will be depressed accordingly - you wouldn't add back the value of these pension liabilities when arriving at enterprise value). Lastly, if anything, shouldn't you subtract the value of the minority interest, instead of add it?
The minority interest you're adding is the part that you don't own (you already own more than 50% of the company). The situation in which you would subtract would be an equity interest where you own less than 50% of the company, as that company's financials are not included in yours.
With pension liabilities, you want to add the only unfunded portion into enterprise value.
Thanks for the responses so far.
Olafenizer, earlier you said "Minority interests your company holds in other firms", but now you're saying "The minority interest you're adding if the part that you don't own".
Seems contradictory... what am I missing?
When there is a "minority interest", this is a bit of a misnomer. It means that you own more than 50% of a company but you don't own all of it. ALL of the company's assets, earnings, etc. get consolidated into your financials. However, because you don't own all of it, the earnings attributable to the other owner(s), get deducted in the P/L. You add the market value of the minority interest (i.e. the value of the stake of the other firms in the subsidiary of company X) because it is a claim on the assets of the firm (all of the subsidiaries assets are on your balance sheet even though you don't fully own them) and the enterprise value is the value of the company free of all claimants (i.e. to buy it "free and clear").
Now, if Company X does not own 50%+ of a company, that company's financials are not incorporated into Company X's, but the income still shows up on the P/L. In this case, you would want to subtract the market value of this stake in calculating enterprise value, because it isn't a part of the company (i.e. it's a not a claimant but an asset, same rationale as cash).
^Yes, you are right on both counts, I was thinking of it wrong, sorry.
A minority interest is where your company owns more than 50% but less than 100% of another company. All of that company's revenues and costs are already included in your company's revenues and costs (and therefore flowing into the cash and retained earnings on your balance sheet), but what isn't being reflected is the value of that majority stake since you don't own 100%, but you're including 100% of the rev and costs. So by adding "Minority Interest" to EV, you are bringing everything in line.
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