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Leveraged Buyout
Structures and Valuation

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Learning Objectives

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Primary Learning Objective: To provide students with a knowledge of how

to analyze, structure, and value highly leveraged transactions.

Secondary Learning Objectives: To provide students with a knowledge of

The motivations of and methodologies employed by financial buyers;
Advantages and disadvantages of LBOs as a deal structure;
Alternative LBO models;
The role of junk bonds in financing LBOs;
Pre-LBO returns to target company shareholders;
Post-buyout returns to LBO shareholders, and
Alternative LBO valuation methods
Basic decision rules for determining the attractiveness of LBO
candidates

Financial Buyers

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In a leveraged buyout, all of the stock, or assets, of a public

corporation are bought by a small group of investors
(financial buyers), usually including members of existing
management. Financial buyers:

Focus on ROE rather than ROA.

Use other peoples money.

Succeed through improved operational performance.

Focus on targets having stable cash flow to meet debt service

requirements.
Typical targets are in mature industries (e.g., retailing,
textiles, food processing, apparel, and soft drinks)

LBO Deal Structure

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Advantages include the following:

Management incentives,
Tax savings from interest expense and depreciation from asset writeup,
More efficient decision processes under private ownership,
A potential improvement in operating performance, and
Serving as a takeover defense by eliminating public investors

Disadvantages include the following:

High fixed costs of debt,
Vulnerability to business cycle fluctuations and competitor actions,
Not appropriate for firms with high growth prospects or high business
risk, and
Potential difficulties in raising capital.

Classic LBO Models:

Late 1970s and Early 1980s

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Debt normally 4 to 5 times equity. Debt amortized over no

more than 10 years.

Existing corporate management encouraged to participate.

Complex capital structure: As percent of total funds raised

Senior debt (60%)
Subordinated debt (26%)
Preferred stock (9%)
Common equity (5%)

Firm frequently taken public within seven years as tax benefits

diminish

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Break-Up LBO Model (Late 1980s)

Same as classic LBO but debt serviced from operating

cash flow and asset sales

Changes in tax laws reduced popularity of this approach

Asset sales immediately upon closing of the

transaction no longer deemed tax-free
Previously could buy stock in a company and
sell the assets. Any gain on asset sales was
offset by a mirrored reduction in the value of
the stock.

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Strategic LBO Model (1990s)

Exit strategy is via IPO

D/E ratios lower so as not to depress EPS

Financial buyers provide the expertise to grow earnings

Previously, their expertise focused on capital structure

Deals structured so that debt repayment not required until 10

years after the transaction to reduce pressure on immediate
performance improvement

Buyout firms often purchase a firm as a platform for leveraged

buyouts of other firms in the same industry

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Role of Junk Bonds in Financing LBOs

Junk bonds are non-rated debt.

Bond quality varies widely
Interest rates usually 3-5 percentage points above the prime rate

Bridge or interim financing was obtained in LBO transactions to close the

transaction quickly because of the extended period of time required to
issue junk bonds.
These high yielding bonds represented permanent financing for the
LBO

Junk bond financing for LBOs dried up due to the following:

A series of defaults of over-leveraged firms in the late 1980s
Insider trading and fraud at such companies a Drexel Burnham, the
primary market maker for junk bonds

Junk bond financing is highly cyclical, tapering off as the economy goes
into recession and fears of increasing default rates escalate

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Factors Affecting Pre-Buyout Returns

Premium paid to target firm shareholders consistently

exceeds 40%

These returns reflect the following (in descending order of

importance):
Anticipated improvement in efficiency and tax benefits
Wealth transfer effects
Superior Knowledge
More efficient decision-making

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Factors Determining Post-Buyout Returns

Empirical studies show investors earn abnormal postbuyout returns

Full effect of increased operating efficiency not reflected

in the pre-LBO premium.

Studies may be subject to selection bias, i.e., only LBOs

that are successful are able to undertake secondary public
offerings.

Abnormal returns may also reflect the acquisition of many

LBOs 3 years after taken public.

Valuing LBOs

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A LBO can be evaluated from the perspective of common

equity investors or of all investors and lenders

LBOs make sense from viewpoint of investors and lenders if

present value of free cash flows to the firm is greater than or
equal to the total investment consisting of debt and common
and preferred equity

However, a LBO can make sense to common equity investors

but not to other investors and lenders. The market value of
debt and preferred stock held before the transaction may
decline due to a perceived reduction in the firms ability to
Repay such debt as the firm assumes substantial amounts
of new debt and to
Pay interest and dividends on a timely basis.

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Valuing LBOs: Variable Risk Method

Adjusts for the varying level of risk as the firms total

debt is repaid.

Step 1: Project annual cash flows until

target D/E achieved

Step 2: Project debt-to-equity ratios

Step 3: Calculate terminal value

Step 4: Adjust discount rate to reflect

changing risk

Step 5: Determine if deal makes sense

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Variable Risk Method: Step 1

Project annual cash flows until target D/E ratio achieved

Target D/E is the level of debt relative to equity at which

The firm will have to resume payment of taxes

and
The amount of leverage is likely to be
acceptable to IPO investors or strategic buyers
(often the prevailing industry average)

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Variable Risk Method: Step 2

Project annual debt-to-equity ratios

The decline in D/E reflects

the known debt repayment schedule and
The projected growth in the market value of
the shareholders equity (assumed to grow at
the same rate as net income)

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Variable Risk Method: Step 3

Calculate terminal value of projected cash flow to

equity investors (TVE) at time t, i.e., the year in
which the initial investors choose to exit the
business.

TVE represents the PV of the dollar proceeds

available to the firm through an IPO or sale to a
strategic buyer at time t.

Variable Risk Method: Step 4

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Adjust the discount rate to reflect changing risk.

The firms cost of equity will decline over time as debt is repaid and equity grows, thereby reducing the
leveraged . Estimate the firms as follows:
FL1 = IUL1(1 + (D/E)F1(1-tF))
where FL1
IUL1

= Firms levered beta in period 1

= Industrys unlevered beta in period 1
= IL1/(1+(D/E)I1(1- tI))

IL1

= Industrys levered beta in period 1

(D/E)I1 = Industrys debt-to-equity ratio in period 1

tI

= Industrys marginal tax rate in period 1

(D/E)F1 = Firms debt-to-equity ratio in period 1

tF

= Firms marginal tax rate in period 1

Recalculate each successive periods with the D/E ratio for that period, and using that periods ,
recalculate the firms cost of equity for that period.

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Variable Risk Method: Step 5

Determine if deal makes sense

Does the PV of free cash flows to equity
investors (including the terminal value)
equal or exceed the equity investment
including transaction-related fees?

Evaluating the Variable Risk12 - 19

Method

Advantages:

Adjusts the discount rate to reflect

diminishing risk as the debt-to-total capital
ratio declines
Takes into account that the deal may make
sense for common equity investors but not
for lenders or preferred shareholders

Disadvantage: Calculations more burdensome than

Adjusted Present Value Method

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Value Method (APV)
Separates value of the firm into (a) its value as if it were debt free and (b)
the value of tax savings due to interest expense.

Step 1: Project annual free cash flows to equity investors and interest
tax savings

Step 2: Value target without the effects of debt financing and discount
projected free cash flows at the firms estimated unlevered cost of
equity.

Step 3: Estimate the present value of the firms tax savings discounted
at the firms estimated unlevered cost of equity.

Step 4: Add the present value of the firm without debt and the present
value of tax savings to calculate the present value of the firm including
tax benefits.

Step 5: Determine if the deal makes sense.

APV Method: Step 1

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Project annual free cash flows to equity investors and interest

tax savings for the period during which the firms capital
structure is changing.
Interest tax savings = INT x t, where INT and t are the
firms annual interest expense on new debt and the
marginal tax rate, respectively
During the terminal period, the cash flows are expected to
grow at a constant rate and the capital structure is expected
to remain unchanged

APV Method: Step 2

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Value target without the effects of debt financing and discount

projected cash flows at the firms unlevered cost of equity.
Apply the unlevered cost of equity for the period during
which the capital structure is changing.
Apply the weighted average cost of capital for the terminal
period using the proportions of debt and equity that make
up the firms capital structure in the final year of the period
during which the structure is changing.

APV Method: Step 3

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Estimate the present value of the firms annual

interest tax savings.

Discount the tax savings at the firms

unlevered cost of equity
Calculate PV for annual forecast period
only, excluding a terminal value, since the
firm is sold and any subsequent tax savings
accrue to the new owners.

APV Method: Step 4

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Calculate the present value of the firm including

tax benefits
Add the present value of the firm without debt
and the PV of tax savings

APV Method: Step 5

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Determine if deal makes sense:

Does the PV of free cash flows to equity
investors plus tax benefits equal or exceed
the initial equity investment including
transaction-related fees?

Evaluating the Adjusted Present 12

Value
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Method

Advantage: Simplicity.

Disadvantages:

Ignores the effect of changes in leverage on the

discount rate as debt is repaid,
Implicitly ignores the potential for bankruptcy
of excessively leveraged firms, and
Unclear whether true discount rate should be the
cost of debt, unlevered cost of equity, or
somewhere between the two.

Things to Remember

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LBOs make the most sense for firms having stable cash flows, significant
amounts of unencumbered tangible assets, and strong management teams.

Successful LBOs rely heavily on management incentives to improve

operating performance and a streamlined decision-making process
resulting from taking the firm private.

Tax savings from interest expense and depreciation from writing up assets
enable LBO investors to offer targets substantial premiums over current
market value.

Excessive leverage and the resultant higher level of fixed expenses makes
LBOs vulnerable to business cycle fluctuations and aggressive competitor
actions.

For an LBO to make sense, the PV of cash flows to equity holders must
equal or exceed the value of the initial equity investment in the transaction,
including transaction-related costs.