There is a routine answer to this question – a company with large stable free cash flows and low levels of debt. This is usually followed by:
How Does an LBO Create Value for Financial Sponsors?
Debt paydown/repayment is easy to understand – if an LBO is effected with 75% loan to value for $1 billion of enterprise value, we start off with $750 million in debt and $250 million equity cheque. With $200 million in EBITDA, after 1 year, the company is now still worth $1 billion but there is only $550 million in debt (we are ignoring interest but you get the point). Owing to leverage (you spent $250 million but are getting the cash flows of a $1 billion company), the return on investment if you sold is far higher than if you bought this company with all cash.
EBITDA growth is easy to understand. If you start with $200 million and grow EBITDA by 10% before selling in one year at the same 5x multiple, you get $1.1 billion in enterprise value.
Multiple expansion is also easy to understand. In a robust stock market, the EBITDA multiples trade up from 5x to 6x. So your $1 billion company with $200 million of EBITDA is now worth $6 million just from revaluation.
So ideally, a software company with sticky revenues, a telecommunications company, or a factory that pumps out x amount of widgets every year. Easy, right?
Anyways, it is not that simple. This is so well known and markets are efficient, so while private equity analysts are LBO model jockeys for large periods of time – there is additional analysis that has to be done and plenty more research. Most telecoms are aware of their cash flow position and can get cheap debt from capital markets – they will already be levered. A software company may be generating a lot of cash flows, but will it be a consistent operator under the private equity firm unless they have operational expertise?
And this is why so many private equity companies look for industry professionals and management or strategy consultants. There is a strong operational component in making this LBO a success.
EBITDA growth is easy on paper with a 2% inflation rate or 4% for a few years because of the industry, but execution is paramount. Companies with a lot of debt have much less margin for error as miscalculation and poor execution may drive a company into distress.
Picking the right kind of stable cash flows is also challenging. Newspaper companies may have generated plenty of revenue in the past but they have been completely eroded now by digital technology giants such as Google. Likewise, as we can see with Sears or JC Penney, cash cow department stores have become liquidation stories or threats. Having a well reasoned view and having a plan B for adverse circumstances is key.
Many scenarios will have to be run too – if you purchase an airline and plan on exiting in 5 years, what if there is a recession and your EBITDA drops while multiples contract in a risk off environment? Are you able to stave off bankruptcy in a stressed economy?
Leveraged Buyouts as a Valuation Tool
When asked for some ways to value a company, investment bankers accept the leveraged buyout as one of them.
For the green finance student, this may be confusing because the LBO models that they are tasked with building in school are generally for figuring out an IRR. If the IRR is acceptable – as in it clears what is an acceptable hurdle for the firm – a private equity firm should invest in the opportunity upon conducting the appropriate due diligence.
Basically, an investment banker or private equity analyst will have assumptions on the purchase price/purchase multiple, exit multiple, interest rates for various tranches of debt and allowed leverage to spit out the IRR or return on equity.
However, it is really easy to get a floor valuation for a company by just switching the algebriac equation for what the private equity analyst is solving for.
If we take a minimum acceptable IRR and plug it into the model, we are solving for purchase price.
Investment bankers will do this in an Ability to Pay analysis to see what the floor price is, because any lower and a private equity firm will come in and purchase it.
Leveraged Finance Markets and LBOs
Like other valuation methodologies, the implied LBO valuation is also very market dependent. Leveraged buyouts are associated with high yield bonds and leveraged loans because private equity firms are looking to take on as much debt as lenders will give them provided that the cost of debt is low enough to continue boosting the IRR.
As such, this depends on credit availability and interest rates. If the interest on leveraged loans and high yield bonds are prohibitive, cash flow will not be able to meet interest obligations as easily and accordingly the amount of leverage that could be used to fund the LBO decreases.
This is the all-in interest rate, which may be high because underlying risk free rates are high (government bonds are yielding a high number) or if the credit spread is wide. So how the economy is doing does not necessarily give a read through on the viability of an LBO.
If debt markets are robust and frothy, banks have credit appetite (for institutional term loan Bs) and high yield bond investors are starved for yield, LBOs become far more attractive for private equity firms. However, the market is efficient and this accordingly raises the floor price for purchasing a company.