LBO valuations -- I really do not understand it

Hello,

I would like to know if someone could provide some information on a couple of questions I have regarding LBOs and valuating them.

I am working on a model which has projections going out 6 years. I am told to assume the terminal value is 10.4 times EBIT on the last year of the projection. What does that actually mean? Do I take the EBIT from the last projected year and multiply it by 10.4, and then what, what does that tell me? I have a figure from the 6 years of cash flows which I have discounted, so I guess I have to compare the two numbers?

Second question is that in the EBIT, do I take out the amount of interest the private equity firm will be paying per year (in my cash flows) to fund this project? There are 5 different loans which will be taken out, and they range from 6 to 10 years, where my projections are only for 6 years, so I do not understand how to spread the longer ones out.

I guess I am just confused, I do not know what the cash flows are telling me. Is the whole point of the leveraged buyout to borrow a lot of money and depend on the cash flows to pay the interest on the debt, and then at a certain point down the road, sell the company for full value once the debt is paid off? Any help, or reference to information would be appreicated.

Thanks,
Mark

Comments (19)

Apr 7, 2009

When you multiply the terminal year EBIT by the multiple you essentially get the terminal value, or the value of the firm in the last year of the model. From there you'd discount it for 6 years at the WACC and add it to the present value of the six years of cash flows, and this will give you the enterprise value as of today. From there you need to subtract net debt (debt-cash) to get the equity value, and then divide by diluted shares outstanding to get a per share value.

You can subtract the interest expenses, but you don't need to worry about interest expenses in latter years if they aren't part of your model.

Apr 7, 2009

Yes that is pretty much the idea. So LBO targets would ideally have low amounts of debt, lots of cash, and non-operational assets that can be liquidated. So if you put up 20% of the equity, and the firm value remains constant, you'll still get very large returns because your equity increases as you pay down the debt.

Apr 7, 2009

Based on your context of your LBO valuation, I suspect that the 10.4x EBIT is really the TV of the deal (to be more precicee the exit price).

Based on this assumed EV, you use the proceeds to pay down the existing debt which you will get from your debt schedule and associated exit costs to calculate the value of the equity.

This equity is what is left over for the PE firm and you will use this to calculate an IRR based on the equity in (and equity that is stripped out during the life of the investment).

depending on the purpose of your exercise, you would probably solve for entry price to hit your target 25% IRR which will give you a ballpark theoretical LBO valuation.

I have never seen a WACC in an LBO model...

Apr 7, 2009
ermen:

Based on your context of your LBO valuation, I suspect that the 10.4x EBIT is really the TV of the deal (to be more precicee the exit price).

Based on this assumed EV, you use the proceeds to pay down the existing debt which you will get from your debt schedule and associated exit costs to calculate the value of the equity.

This equity is what is left over for the PE firm and you will use this to calculate an IRR based on the equity in (and equity that is stripped out during the life of the investment).

depending on the purpose of your exercise, you would probably solve for entry price to hit your target 25% IRR which will give you a ballpark theoretical LBO valuation.

I have never seen a WACC in an LBO model...

Yeah that makes more sense. I thought he was referring to a DCF valuation in his first question. Would you ever use a DCF valuation in an LBO to figure a purchase price, or would you always back it in based upon the IRR?

Apr 8, 2009

Thank you for answering my questions.

The question of the problem is whether the PE place should do the deal or not based on the last year's EBIT times 10.4.

If I have understood all the posts above correctly:

The cash flows I have derived from revenue, costs, depreciation, etc (to get EBIT, net interest, and ultimately capital cash flow (CCF)...I then discount that using a percentage derived from ROA.(this is all according to the CCF method I am supposed to use). I did this for each of the 6 years' projections. If I add all the dicounted cash flows up, the sum should tell me if I am making enough money to repay the debt at the end of the 6 years (my target terminal date). If I can repay the debt after 6 years, as well as have money left over (is there a percentage which is ideal?) then the deal is good. If the cash flows are not generating the money to pay back the debt, then it isn't good.

Someone mentioned something about a debt schedule...should I be listing out each of the debt instruments I will be issuing (in a separate worksheet) and discounting them over the 6 year period to show present value of what I will need to repay investors at the end of the 6 year period?

Finally, say I am borrowing PV 1 billion for the deal, and cash flows show PV of 1.3 billion at end of 6 years....this means that the company at the end of 6 years will have paid the 1 billion in debt back, have 300 million left over, as well as the full value of the equity which they now outright own. Is this the essence of the LBO?

Also, you mentioned before not to worry about interest payments after the 6 year projections. Is it assumed that I can pay the bond back at the end of 6 years, even if the debt issued is for 10? I'm worried about subtracting interest expenses on the debt with each year's cash flow model, because the interest expense is used when solving for the EBIT/Net Income solution when using capital cash flows (CCF).

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Apr 8, 2009

mergerarb, we generally back it based on the expected IRR... that would give you the LBO Analysis (or LBO Valuation, if you will).
ermen is correct.

Apr 8, 2009

Yep, generally you back in based on an expected IRR.

Apr 8, 2009

Yea, there is no need for WACC, IRR is what you use to calculate the return...

Apr 8, 2009

I have to remove the interest expense from my EBIT because I am using the capital cash flow method. There are a few loans that will be taken out. One is a senior term loan for 5 years, with interest rate of 8 percent. The other is a 10 year bond for 9 years at 10.25 percent. I am unsure of how to break the interest down to back out of each year's cash flows. Any suggestions? Do I just take total interest to be paid, divide it by number of years and discount it to PV and then back it out of EBIT?

When it lists the "interest" for the loan, is that typically an annual rate or the interest yield by the end of the loan?

According to my calculations...the debt to be paid back (principal and interest) is more than the cash flow. However, when I take the 2007 ebit and multiply it for terminal value, I come out with a few billion. Is it ok to not have enough in my cash flow to pay the debt back, and therefore have to pull it out of my equity?

Apr 7, 2009

What is the capital cash flow method.. i have never heard of it or either know it by some other name?

Why are you PVing everything? Why don't you build out 5 (or 6 whatever) cashflows to determine what your closing debt balance is at exit? Then calculate implied equity (based on assumed exit EV) and discount that back at target IRR?

Why don't you know how to break down the interest rate? From your info it seems interest payments are as follows:

Bank debt: 8% interest on average balance (use opening to avoid the circulr reference), amortisation total amount of senior divided by 5. So if loan is $1,000 -> 1st year interest is $80, and amort $200, total cash pay $280...

Bond: interest is just your coupons at 9%. Assuming no change in the par value at exit, that's the debt balance you have to pay back.

I think you are thinking of your LBO model like a DCF.. don't think of it that way.. don't PV every single year!

And finally if you don't even have enough EBIT to cover interest payments (ICR < 1.0x), what are you doing with that capital structure in there then?

You seem to be chasing your tail around on this...

Apr 8, 2009

Why are you doing an LBO? Are you trying to sell this business in a couple years?

Apr 8, 2009

Thanks Greg: Yes the intent is to sell the business.

Apr 8, 2009

Best advice would be to go to a small Mid Market/Boutique Bank and let them do the work for you.

Apr 8, 2009

Thanks Abhizzy! Perhaps I was looking in the wrong places- have not found one who would work on success fee for a deal that requires $6M in debt for a $2M Ebitda, $19M revenue, zero asset deal. Any suggestions? How much success fee should I be prepared to spend?

Apr 8, 2009

I will advise you on this deal for a 4.5% fee. I will have my analyst put together a deal list of all deals in the US under $35mm but more than $7mm so that you can compare.

Apr 8, 2009

Thanks George- Basic question-what would advise include? All steps necessary to present, source, close with debt providers? Let me know please.

Apr 8, 2009
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