Advanced Valuation Lecture 5

Question 1

Which forms of private equity are there?

Answer 1

1. Venture capital
2. Growth capital
3. LBO
4. Distressed capital > the debt is often traded at a discount, and you buy it. The buyer exercises control to get an equity position

Question 2

Remark: the DCF outcome is the pre-money valuation. If you add your investment, you get the post-money valuation.

Answer 2

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Question 3

You have 2 types of IRR definitions

Answer 3

1. Gross IRR = if you buy and sell a company, you make a return on it.
2. Net IRR = returns the investors make, especially the LPs.
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   The difference is the compensation for the PE

Question 4

What kind of equity financing is used in an LBO?

Answer 4

1. Ordinary shares
2. Preferred shares
3. Shareholder loan

Question 5

Note on the purchase price of an LBO:

Answer 5

The purchase price is a proxy for the enterprise value since you also need to refinance the existing debt. Part of the transaction costs is fees for the banks that lend you the money to finance the deal.

Question 6

What is a shareholder loan and why is it used in the financing deal?

Answer 6

It is a loan provided by the PE firm themselves to the target company. This is actually a form of equity, as it is deeply subordinated to senior debt and subordinated debt.
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It is tax-driven, as the interest is tax-deductible. But is now limited.

Question 7

What is a vendor loan?

Answer 7

A vendor loan is a loan provided by the seller to the buyer if other lenders do not want to lend more. In order to meet the target IRR for the PE, a vendor loan is an option to bridge the gap.

Question 8

What is the entry multiple?

Answer 8

Entry multiples exclude transaction costs and are based on last twelve months performance
(purchase price / Normalized LTM EBIT(D)A)

Question 9

How are managers incentivised?

Answer 9

They typically get 10% of the ordinary shares. That way they can invest a relatively low amount of money. But all the value upside is captured by the ordinary shares, as the shareholder loan and the preferred equity have fixed yield. If it’s successful, management will make a lot of money.

Question 10

What does leveraged finance do?

Answer 10

As a bank, you commit to a PE firm to deliver a debt package. And sometimes, you sell this debt to the market afterwards. Sometimes at a discount.

Question 11

What are typical LBO debt instruments?

Answer 11

1. Senior debt = Term A & B / facilities
2. Second lien
3. High yield bonds/notes > additional financing by tapping into public debt markets
4. Mezzanine
5. PIK / PIYC notes
6. Vendor/shareholder loan

Question 12

Characteristics of Term A and B/C financing. And what is a revolving credit facility?

Answer 12

A: often equal amortisation, so equal instalments. Often EURIBOR/LIBOR + spread
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B/C: often bullet loan. Typically 1Y longer tenure than Term A. Often EURIBOR/LIBOR + even bigger spread
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Banks often provide facilities, which is like a credit card. E.g., working capital facility. Draw the facility to fund WC investments, and use the proceeds generated by the WC to pay back the facility.

Question 13

What is second lien?

Answer 13

Second lien debt = subordinated debt. Often bullet loan. Usually EURIBOR/LIBOR + 800bps spread. And with a tenure longer than the senior debt.

Question 14

How is mezzanine financing constructed?

Answer 14

2 interest parts:
- Cash interest = interbank + margin
- PIK interest (rolled-up interest) = interest that accumulates on the liability
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Total interest is the combination of the 2.
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Often it also includes warrants, which they can exercise when the company is sold which gives them equity upside.
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In total, mezzanine financiers target IRR of 15%

Question 15

How are PIK / PIYC notes constructed? Why would a PE accept this structure?

Answer 15

No cash interest, but only rolled-up interest on the liability.
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Typical interest is 18%. But it produces interest tax shields, so on an after tax basis, its yield is roughly 14%. But the PE themselves target, let’s say, 20%. So, it’s much more expensive to finance this with equity than with PIK/PIYC notes. And often there are no covenants involved here!

Question 16

There are 3 types of covenants

Answer 16

1. Financial covenants: financial ratios that you have to meet, such as leverage ratios > DSCR = debt service coverage ratio. If you breach them, typically you’re in default.
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2. Positive covenants: things that you’re obligated to do, such as paying interest in a timely manner.
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3. Negative covenants: things that are forbidden to do, such as issuing new debt, or paying dividends.

Question 17

Give the DSCR formula

Answer 17

FOCF / Debt service.
FOCF = free operating cash flow
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You see if the FOCF is sufficient to pay back the debt and pay interest.
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If this is below 1, you do not generate enough CF to pay back the debt. But this does NOT imply a liquidity shortage. You can still have a huge cash balance to pay off the debt and pay interest.

Question 18

How are the equity instruments structured in a deal?

Answer 18

1. Ordinary shares > subordinated to the debt AND the preferred shares AND shareholder loan. So next to the debt leverage, you also have the equity leverage.
2. Preferred shares > with PIK yield
3. Shareholder loan > with PIK yield
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   This is because the debt providers do not allow for cash interest. Therefore, the interest/yields are rolled-up and are “paid out” at exit.

Question 19

What are typical exits for current PE shareholder?

Answer 19

Available exit routes:
- sale to strategic buyer
- sale to PE investor
- listing on stock exchange > if you sell all your shares, you signal that the equity is overvalued or that you do not believe in the future growth. So, you sell part of the shares and pay off the current debt.
- sale to management
- default/restructuring

Question 20

What is a dividend recapitalization?

Answer 20

Over the life of the company, debt is being paid off, and equity increases. At this point. You can refinance the company by raising new (more than existing) debt, use it to pay off the existing debt, and pay out the residual as a dividend.

Question 20

What are the drawbacks of IRR? Also propose solutions

Answer 20

It’s short term focused and biased to short holding periods due to annualisation of returns > solution: cash multiple is more long term focused, or an absolute return. But cash multiple does not consider time value of money.
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IRR also assumes you reinvest intermediate cash flows back into the business at the Internal Rate of Return. Such as dividends received in the middle of the period. You overestimate the return LPs make in a deal due to this reinvestment assumption, as you assume the dividend also yields a return of 20% > solution is modified IRR. This assumes a different, more realistic, reinvestment rate.
- Compute future value of dividend with a realistic return > add this to the equity proceeds at exit > then do the IRR calculation > you end up with a slightly lower but more realistic IRR.

Question 21

Typically, if you plot IRRs as a function of different exit moment (e.g., years), you see that the IRR first tends to increase, and then tends to decrease. Why is that?

Answer 21

In the first few years, you probably forecast big value creation. And due to the high debt level (high leverage), a small increase in EV boosts equity returns significantly. But as the debt is paid off and growth slows down, the IRR tends to decrease again.