LBOs Flashcards
(43 cards)
What are the steps of LBO’s
- Fair valuation
- Target selection
- Financing the transaction
- Equity contribution
- Operational Improvements
- Debt repayment
- Exit strategy
- IRR calculation
Fair valuation
Conduct a valuation of the target company using methodologies such as discounted cash flow (DCF) or market comparables.
Analyse
ability to pay” based on expected debt capacity and equity returns (Kaplan, 1989)
Target selection
Choose businesses with strong fundamentals, stable cash flows, and potential for operational improvements.
Financing the Transaction
Leverage consists of multiple layers: senior debt, mezzanine financing, and sometimes high-yield bonds (Gompers et al., 2016).
Equity Contribution:
Sponsors typically contribute 20-50% of the purchase price to align incentives.
Operational Improvements:
Implement cost-cutting measures, streamline operations, and pursue growth strategies. Use management equity incentives to align interests and drive performance improvements.
Debt Repayment:
Excess cash flow is prioritized for paying down debt to deleverage the firm over time. Debt repayment reduces interest burden and increases equity value (Jensen, 1986).
Exit Strategy:
Common exits include: Initial Public Offering (IPO) to regain public market value. Strategic Sale to another company. Secondary Sale to another private equity firm.
IRR Calculation
Investors evaluate returns using Internal Rate of Return (IRR), targeting 20-30% or higher (Acharya et al., 2013).
What were the empirical findings of LBOs
Multiple Bid Auctions & Premiums
Insider Trading
LBO Defaults and Distress
Divestitures During Financial Distress
Multiple bit auctions and premiums
High premiums (over 50%) were common in multiple bid auctions, compensating shareholders for the added risks of LBO transactions (Hubbard & Palia, 1995).
Insider trading
More insider trading occurred before Management Buyouts (MBOs) compared to third-party LBOs, reflecting management’s access to superior private information (Harlow & Howe, 1993).
LBO defaults and distress
Of 136 highly leveraged transactions (1980-1989), 31 defaulted by 1996, and 8 others were distressed, illustrating the significant financial risks involved in LBOs (Andrade & Kaplan, 1998).
Divestitures during financial distress
Divesting during financial distress led to negative wealth effects for shareholders, suggesting that asset sales in such conditions typically destroy value (Easterwood, 1998).
What are the 3 LBO valuation approaches
WACC
CCF
APV
Discuss the WACC approach for LBO valuation
Adjusts the cost of capital to include the tax shield
Assumptions: WACC assumes a constant D/V. Works well when the capital structure remains stable over time.
Challenges: In scenarios like LBOs, where D/V changes significantly, WACC must be recalculated for each forecast period, making it less practical (Ruback, 2002).
Key Limitation: Difficult to apply for transactions involving highly leveraged or dynamic capital structures.
Discuss the CCF approach
Directly incorporates the tax shield into cash flows
Approach Mechanism: Combines FCF and the tax shield (TS), where TS = actual tax rate × interest expense. CCFs are discounted at the expected return on assets (ka), reflecting the combined risk of assets and tax shields.
Advantages: Simplicity in scenarios with changing debt levels, as the discount rate (ka) is independent of capital structure. Particularly suited for LBOs, where leverage ratios fluctuate.
Key Feature: Assumes tax shields are as risky as the firm’s operations (Damodaran, 2001).
Discuss the APV approach
Values the tax shield separately from unleavered cash flows
Mechanism: Separates the valuation of FCF and TS: FCF is discounted at the unlevered cost of equity (ka). TS is discounted at the pre-tax cost of debt (kb).
Advantages: Reflects the specific risk characteristics of the tax shield.
What are some sources of gains for LBOs
Tax benefits
Asset step-up
Tax benefits to shareholders
Management incentives and agency costs effects
Wealth transfer effect
Tax benefits of LBOs
Debt financing in LBOs provides tax-deductible interest payments, reducing taxable income (Lowenstein, 1985).
Asset step-up
In the 1980s, LBOs often involved asset step-ups, allowing a revaluation of assets, which increases depreciation deductions, thereby reducing taxes (Kaplan, 1989).
Wealth transfer effect
Shareholder Gains: LBO premiums result in wealth transfer to shareholders, but this can be at the expense of bondholders and preferred stockholders, who may experience losses (Travlos & Cornett, 1993).
Management incentives and agency costs effect
Increased Ownership Stake: Managers often receive an increased ownership stake in the firm, aligning their interests with those of shareholders (Lehn & Poulsen, 1988).
