Streamlining LBO Analysis

Background 

The Corpfin.Net LBO valuation model operates on the five-year financial forecast of a business. The purpose of the model is to estimate the current value of the business to a "financial buyer", based on the businesses' historical and forecasted financial performance. 

 

The already- completed five-year financial forecast, plus a few assumptions, is all that is necessary to create your first draft of two comprehensive LBO valuation cases. The software uses leverage buyout ("LBO") methodology whereby the acquired business's assets are used as collateral for borrowings undertaken by the buyer to fund a portion of the purchase price.

 

The LBO valuation model analyzes the value of the business from the point of view of a "financial buyer" which owns no other company in the businesses' industry and, therefore, expects all of its investment return to result solely from the future operations of the business being purchased. 

 

The LBO valuation model assumes that the buyer has investigated the business and its future plans and believes the business will achieve the financial results forecasted.

 

In general, the LBO valuation represents the minimum current value of the business since buyers who already own similar or complimentary businesses will usually pay more for a given business than will a financial buyer.

 

From a timing standpoint, the LBO valuation model assumes that the financial buyer intends to purchase the business at the beginning of year two (2) of the five-year forecast; and intends to own the business for the ensuing four (4) years and then sell the business.

 

In order to generalize the analyses across a potentially infinite range of "deal" attributes, the model assumes the financial buyer is buying only the assets of the business and is assuming none of its liabilities. Therefore, the seller of the business needs to pay off all of the liabilities of the business (and in all likelihood, the income tax owed as a result of the gain realized on the sale of the assets) from selling price paid by the financial buyer. 

 

If a buyer were to assume any of the liabilities of the seller, the usual adjustment is to reduce the cash amount paid to the seller, dollar-for-dollar, by the amount of the liabilities assumed by the buyer.

 

Developing Each of Two LBO Cases

Step 1.	Review / change the financial forecast on which the LBO valuation is to be based. The LBO valuation is based on the selected, already completed five-year financial forecast. Changes to the financial forecast assumptions (depending on their flow-through to a new owner) may modify the results of previously completed LBO cases.
Step 2.	On the LBO Setup Page, enter the two LBO assumptions that affect all LBO cases. Enter the following two assumptions. These assumptions are default assumptions for all subsequent runs of the LBO analysis:  ·       The estimated auction value of Plant, Property and Equipment. ·       The dollar amount, if any, of operating expenses that will or will not be incurred by the buyer after the buyer purchases the business.    Once this data is entered, the LBO model creates a copy of your designated five-year financial forecast scenario; and two LBO valuation cases, using model-supplied default assumptions.
Step 3.	Complete the "Case 1" LBO valuation. "Case 1" approaches the LBO analysis from the business buyer's standpoint. The model determines the selling price of the business, given the buyer's specific rate of return objective on its equity investment in the business.   Enter four assumptions to create the first draft of Case 1:  ·       The dollar amount of the selling price the seller is willing to finance. ·       The annual rate of return ("ROR") objective of the buyer on its equity investment in the business. ·       The estimated EBITDA multiple to be used determine the selling price of the business at the end of the buyer's four years of ownership. ·       An estimate of interest rates to be paid on senior (bank) debt and subordinated debt.   The default assumptions listed on the setup screen for Case 1 are intended to be reasonable starting points for the analysis. They are not represented to be "correct" and, as such, are not warranted in any way whatsoever by Corpfin.Net
Step 4.	Complete the "Case 2" LBO valuation. "Case 2" approaches the LBO analysis from the business seller's standpoint. The model determines the buyer's rate of return (ROR) on its equity investment in the business, given the seller's specific selling price objective. A selling price objective that results in a low ROR on the equity investment of the buyer implies that the selling price objective may be too high.   Four assumptions are needed to create the first draft of Case 2:  ·       The dollar amount of the selling price the seller is willing to finance. ·       The selling price objective of the seller. ·       The estimated EBITDA multiple to be used determine the selling price of the business at the end of the buyer's four years of ownership. ·       An estimate of interest rates to be paid on senior (bank) debt and subordinated debt.   The default assumptions listed on the setup screen for Case 2 are intended to be reasonable starting points for the analysis. They are not represented to be "correct" and, as such, are not warranted in any way whatsoever by Corpfin.Net.

 

LBO Valuation Reports

 The following reports are available for LBO Cases 1 and 2:                    

·       A multi-page, case-specific narrative report that details the results of the LBO analysis.

·       Estimated LBO Valuation -- Summary. The report contains detailed estimates of:

·       The seller's outcome, including its estimated pretax sales proceeds. 

·       The buyer's outcome, including its sources and uses of funds; the estimated amount and terms of debt financing (including subordinated debt with warrants); the equity investment required; and the return on the equity investment after four years of ownership.

·       Primary financial statements (annual income statements, balance sheets and cash flow statements) showing the businesses' financial performance when owned by the buyer.

·       Several pages of documentation detailing the key assumptions underlying the valuation; and actual and forecasted financial ratio data and statistics.

 

Additional Analyses

The LBO model allows you to run and save as many iterations of your work as desired.

If you wish to analyze how the LBO valuation of the business changes based on changes to the underlying five-year financial forecast of the seller’s business, change the financial forecast assumptions (sales growth, gross margin percent, etc.) for the business and re-run the LBO valuation case(s) based on the revised forecast. 

Private Equity Pricing

Background

Private equity placements are minority (less than majority) investments in the ownership of private businesses that need capital for a variety of reasons, including: to expand operations; to restructure their balance sheets; to enter new markets; or finance major business acquisitions.

 

Generally, businesses that seek private equity funding generate revenue and operating profits but are not able to produce sufficient cash flows to support new initiatives, or to borrow needed funds from senior lenders. 

 

Private equity investments can be in the form of ownership units (common stock, preferred stock, partnership units or LLC units, depending on the legal structure of a business); or in subordinated debt with warrants, also referred to as mezzanine capital, which are loans which require periodic interest payments and allow holders to buy business ownership units in the future for a de minimis price per unit.  

 

Issuing new ownership interests in a business is usually very costly to existing owners in terms of the ownership give up, the likely loss of management’s prerogatives to run the business as they wish, and the potential for additional ownership dilution if the business plan, on which the new equity investment is based, is not accomplished.  

 

On the positive side, additional equity capital allows a business to pursue opportunities it could not otherwise undertake. The important issue for existing owners is to weigh all of the costs and risks associated with the issuance of new equity against the potential increase in their personal wealth resulting from accomplishing the business plan that requires the new equity capital.    

 

Private Equity Analysis

Key metrics in a private equity analysis are the estimated "pre-money" and "post-money" values of a business, and the ownership splits immediately after the equity financing.  

 

The estimated pre-money value is the value of a business (that is, its enterprise value less its liabilities) before the new equity funding is added to a company’s balance sheet.  

 

The estimated post-money value of a business is equal to the sum of the pre-money value, plus the amount of new equity investment, minus issuance expenses.  

 

Subordinated debt with warrants is a hybrid security. The principal amount of the subordinated debt is not added to the post-money value of a company because subordinated debt is a debt obligation. It adds identical and offsetting amounts of assets and liabilities to a company’s balance sheet and therefore provides no net change in the value of a company. While the value of warrants "attached" to subordinated debt are expected to be valuable to subordinated debt investors, their value to a business at the post-money valuation date is immaterial.

 

Estimated pre-money and post-money values are unique amounts that are derived from the interaction of a large number of financial forecast assumptions and investment inputs. Accordingly, changes to assumptions or inputs will result in changes to both values. 

 

Building a Private Equity Model

The amount of equity and/or subordinated debt sought in a private equity placement is usually an amount that bridges the gap between a conservative estimate of the amount senior lenders will lend a company and the total funding a company needs to achieve its long-term financial plan.   

 

We suggest forecasting, by month, the first two years subsequent to the planned private equity placement to determine if the amount of equity capital sought is sufficient to withstand expected monthly variations in net sales and cash flow; and to satisfy intra-year compliance with debt covenants. Funding and compliance that may appear satisfactory on an annual basis may not be so during yearly interim periods.

 

Key assumptions and investment inputs used to create private equity analyses include:

• The sales, profit, asset and liability assumptions contained in a business’ five-year forecast. Because additional equity capital usually supports higher growth rates than can be accomplished without that funding, it is possible that the original five-year forecast (without the new equity capital infusion) should be adjusted to reflect increased business opportunities.  

• The amounts, investment types and pretax annual rates of return (RORs) required by new investors on their equity and subordinated debt investments.

• The EBITDA multiple used at the end of the forecast period to estimate the gross value of a business at that point in time. That gross value, minus the liabilities of a company retained/paid off by the investors at the end of the investors’ ownership period, is a proxy for the pretax value of all investors’ future interests. That residual value is the amount that is divided among the original and new equity investors in accordance with their respective percentage ownership interests.

New investors annual pretax rate of return target on common and preferred stock investments is effected by a number of factors, including: the level of competition among investors for private equity investments; the perceived risk associated with an investee’s industry and the likelihood of achieving the forecast results; the rate of return target for the investor’s private equity fund; and possible dilution in ownership percent due to possible follow-on financing rounds.  

 

Generally, the higher the pretax rate of return required by new investors, the lower the pre-money valuation of a company and the lower the percent of ownership retained by the original equity investors.  

 

Providers of subordinated debt typically want to earn a total rate of return on their investment in the 15-20% range, with that return coming from the combination of quarterly interest payments and a share of the sales proceeds when a business is sold. As such, the higher the coupon rate on subordinated debt, the smaller the share of the sales proceeds paid to subordinated debt holders when the business is sold.  

                  

The EBITDA multiple used to value a business at the end of the five-year forecast period is a key private equity valuation assumption. Like investors’ annual pretax rate of return targets, EBITDA multiples vary over time due to changes is various economic, credit and competitive conditions affecting the market for business investments and acquisitions. 

 

LBO Pricing

Background

A leveraged buyout (LBO) is a type of business acquisition in which a buyer (typically a private equity partnership) acquires a company and uses debt to finance a significant percentage of the purchase price.  

 

The proportions of debt and equity capital used to finance LBO transactions depend on a number of factors, including:

 

• Credit market and general economic conditions. 

• The historical and forecasted operating performance and management expertise of the company to be acquired.

• The ability of the acquired company to meet forecasted interest and principal repayment requirements.
• The market value of the tangible assets to be acquired.
• The buyer’s appetite for financial risk.

 

In an LBO transaction, the assets of the acquired company are pledged as collateral for debt, and the acquired company (or a newly formed company containing the assets of the acquired company) is the borrower. The debt is usually in the form of secured bank loans and, if the acquisition is of sufficient size, subordinated debt provided by investment partnerships.

 

LBO debt is almost always non-recourse to the business buyer, meaning the buyer is not liable if the debt is not repaid by the borrower. If the borrower defaults on the debt, the lender(s) may seize the pledged collateral, and debt recovery is limited to the amount realized from the disposal of the collateral.

 

The LBO form of business acquisition is attractive to business buyers because they need to fund only a fraction of the acquisition purchase price. This funding strategy reduces the buyer’s at-risk equity investment, and enhances his return on investment, if the acquired company performs as expected.  

 

If the acquired company does not perform as expected, the debt service requirements of a leveraged capital structure can range from very challenging, to a situation in which the buyer’s equity investment is worthless.

 

LBO Pricing

LBO pricing uses the financial structure and analyses techniques employed by LBO buyers to estimate the value a business. The valuation presumes the business buyer is a “financial buyer” (for example, a private equity partnership) that owns no other company in the acquired company’s industry and, therefore, expects all of its investment return to result solely from the forecasted performance of the acquired company.    

 

An LBO valuation is typically built on a five-year financial forecast of the acquired company’s operations. The valuation analysis forecasts the operations of acquired company during the forecast period, the debt and other liabilities repaid during the ownership period and contains an assumption about the multiple of earnings a business will be sold for at the end of the ownership period. By targeting pre-tax annual rates of returns on equity and subordinated debt investments consistent with those sought by private investment funds, an LBO valuation estimates the purchase price a financial buyer should be willing to pay for a business to achieve those returns.  

 

In general, an LBO valuation estimates the minimum current value of a business since buyers who already own similar businesses and would benefit from operational synergies with the acquired company, will usually pay more for a given business than will a financial buyer. These synergistic buyers are also known as "industry buyers".  

 

An LBO valuation model can emulate industrial buyer pricing by adjusting the financial forecast of the acquired company to fit its revised ownership - generally by increasing forecasted sales and/or reducing costs and expenses of the acquired company due to its ownership by a complementary enterprise.