Valuation Approaches To The Lbo

Determining the value of a leveraged buy-out (LBO) is critical to all parties involved in the transaction. Corporations considering the sale of a subsidiary need to know whether to sell and at what price. Interested buyers must set their bidding limits and strategy.

And lenders need to ensure that operating cash flows and projected asset sales are sufficient to cover future debt obligations.

As Isik Inselbag and Howard Kaufold explain, several different methodologies have been used, ranging from applying multiples to historic cash flows to calculating the equity investors internal rat of return.

Present value methods, of which the weighted average cost of capital is the best known, are increasingly popular but their use is questionable in buy-out environment in which the companys capital structure is changing.

 

Using this hypothetical case study the authors illustrate the advantages of the adjusted present value approach.

A large European multinational has as the result of a strategic review decided to move out of the personal computer business. The managers of the relevant subsidiary are interested in acquiring the business in a buy-out and have received proposals from banks and venture capitalists on methods of funding the deal.

The bankers are interested in providing senior debt funding to the new company while the venture capitalists are willing to provide subordinated financing if the loan terms include an equity stake in the new company.

Management believes it can enhance the subsidiarys performance and eventually find a suitable buyer for it. Scenarios of this kind have occurred around the world as international competitiveness has forced companies to restructure in line with core competencies.

In Europe, the bulk of venture capital financing has been dedicated to funding such buy-out activity. In this article, we will explain the methods investors and companies should use to determine the appropriate values of such highly leveraged transactions.

A leveraged buy-out (LBO) is the acquisition financed primarily with debt by a small group of equity investors of a public or private company. The equity holders service the heavy interest and principal payments of debt with cash from operations and/or asset sales. The shareholders generally hope to reverse the LBO within three to seven years through a public offering or company sale.

A buy-out is therefore likely to be successful only if the organisation generates enough cash to service the debt in the early years and if it is attractive to other buyers as the buy-out matures. Determining the value of an LBO is critical to all parties to the transaction. Pre-buy-out owners, such as corporations evaluating the sale of a subsidiary, want to know the value of assets in order to decide whether or not to sell and to negotiate the highest possible price. Interested buyers must determine the transaction value in order to set their bidding limits and strategy.

The valuation process affects lenders as well. Since debt levels are a significant part of the purchase price, creditors need to ensure operating cash flows and projected asset sales are sufficient to cover future debt obligations.

Most analysts determine buy-out prices by applying multiples from comparable transactions to the target companys historical income or cash flow. Cash flow projections may be used in tandem with the multiples method but less for valuation than for structuring a financing package that meets lender coverage requirements.

Another approach is to calculate the internal rate of return to equity investors as a function of different purchase prices. The maximum bid is then the price that just allows the required equity return to be satisfied.

From a valuation perspective, these practices have several shortcomings. A multiple can serve as a useful benchmark in the valuation process but rarely captures the unique future cash flow features underlying a companys true value.

While it makes sense for equity investors to calculate the internal rate of return on a buy-out, these investors rarely compute their hurdle rate in a rational way. The required return depends on the riskiness of the target businesss underlying cash flows and the repayment schedule for the debt financing.

Most importantly, the required return changes dramatically over the life of an LBO as companies reduce debt and often sell assets.

Recognising these drawbacks, experts in the field have begun using present value methods to appraise future cash flow prospects of highly leveraged transactions. The weighted average cost of capital (WACC) method is the best known of these approaches.

It involves estimating a weighted average of the after-tax costs of debt and equity financing and using this average to discount the after-tax operating cash flows and terminal value.

Although this method is appropriate for valuing transactions where capital structure is expected to remain stable, its use is questionable when the debt-equity mix is changing. Sophisticated users of this approach attempt to adjust the cost of capital over the life of an LBO to account for the effect of the changing capital structure. However, the discount rate correction is complicated and rarely done properly.

We have argued elsewhere that the adjusted present value (APV) method is an easier approach to valuing assets in an environment in which the capital structure is changing.

In this article, we will illustrate the use of this procedure in valuing the hypothetical management buy-out described above.

The formation of HighTech Inc

The management of Multinational Incs personal computer business has put together a bid for the subsidiary of $97m. The newly formed company is to be called HighTech Inc.

Funding is to be provided by a combination of $70m of senior bank debt and Dollars 20m of junior venture capital lending. The venture capitalists have also been promised warrants that provide them with a share of the company in the likely event that the new organisation is sold to the public or another company.

The remaining $7m required to complete the purchase will be equity contributed by the subsidiarys management and private equity contributors.

The buy-out will transfer both the plant and equipment and the working capital from Multinational to HighTech.

Projected sales for HighTech are expected to be $70m for the year ahead. The management believes it can increase sales by 10 per cent per year over the following two years with growth stabilising at the 3 per cent expected rate of inflation indefinitely thereafter. Annual cash costs (materials, labour, selling and general and administrative expenses) are estimated to be 50 per cent of revenues.

Depreciation expense and annual investment in fixed assets are expected to be Dollars 9m in the first year of operation and then to grow in tandem with sales. Working capital levels are expected to be 10 per cent of sales in future years. The required rate of return on assets in the PC business is 18 per cent and the tax rate is 40 per cent.

We now illustrate a framework that can be used to analyse the value of HighTech under its operating projections and proposed financing package. Our approach will be to use a combination of APV and WACC. In the process, we show how the valuation methods reveal value-maximising strategies for Multinationals shareholders.

Valuing the deal

The basis for the APV method is that the current value of a leveraged company (VL) is its value as an all-equity entity (VU), plus the discounted value of the interest tax shields from the debt its assets will support (PVTS)