CHAPTER 8
Leveraged Buyouts Overview
A leveraged buyout is an acquisition of a company using a significant amount of debt to meet the cost of the acquisition. This allows for the acquisition of a business with less equity (out-of-pocket) capital. Think of a mortgage on a house. If you take out a mortgage to fund the purchase of a house, you can buy a larger house with less out-of-pocket cash (your down payment). Over time, your income will be used to make the required principal (and interest) mortgage payments; as you pay down those principal payments, and as the debt balance reduces, your equity in the house increases. Effectively, the debt is being converted to equity. And maybe you can sell the house for a profit and receive a return. This concept, on the surface, is similar to a leveraged buyout (LBO). Although we use a significant amount of borrowed money to buy a business in an LBO, the cash flows produced by the business will hopefully, over time, pay down the debt. Debt will convert to equity, and we can hope to sell the business for a profit.
There are three core components that contribute to the success of a leveraged buyout:
- Cash availability, interest, and debt pay-down
- Operations improvements
- Multiple expansion
CASH AVAILABILITY, INTEREST, AND DEBT PAY-DOWN
This is the concept illustrated in the chapter's first paragraph. The cash being produced by the business will be used to pay down debt and interest. It is the reduction of debt that will be converted into the equity value of the business.
It is for this reason that a company with high and consistent cash flows makes for a good leveraged buyout investment.
OPERATIONS IMPROVEMENTS
Once we own the business, we plan on making some sort of improvements to increase the operating performance of that business. Increasing the operating performance of the business will ultimately increase cash flows, which will pay down debt faster. But, more important, operating improvements will increase the overall value of the business, which means we can then (we hope) sell it at a higher price. Taking the previous mortgage example, we had hoped to make a profit by selling the house after several years. If we make some renovations and improvements to the house, we can hope to sell it for a higher price. For this reason, investors and funds would look for businesses they can improve as good leveraged buyout investments. Often the particular investor or fund team has expertise in the industry. Maybe they have connections to larger sources of revenue or larger access to distribution channels, based on their experience, where they feel they can grow the business faster. Or, maybe the investor or fund team sees major problems with management they know they can fix. Any of these operation improvements could increase the overall value of the business.
MULTIPLE EXPANSION
Multiple expansion is the expectation that the market value of the business will increase. This would result in an increase in the expected multiple one can sell the business for. We will later see, in a business entity, that we will most likely base a purchase and sale on multiples. We will also conservatively assume the exit multiple used to sell the business will be equal to the purchase multiple (the multiple calculated based on the purchase price of the business). This would certainly enhance the business returns.
WHAT MAKES A GOOD LEVERAGED BUYOUT?
In summary, a good leveraged buyout has strong and consistent cash flows that can be expected to pay down a portion of the debt raised and related interest. Further, the investor or fund sees ways to improve the operating performance of the business. It is hoped that the combination of debt converting into equity and the increase in operating performance would significantly increase the value of the business. This results in an increase in returns to the investor or fund. The next pages of this book step through such an analysis in its entirety and are intended to give you the core understanding of how such an analysis can provide not only benefits to a company, but high returns to an investor. This will also indicate pitfalls many investors face and reasons why many LBOs may not work out as planned.
EXIT OPPORTUNITIES
The financial returns from a leveraged buyout are not truly realized until the business is exited, or sold. There are several common ways to exit a business leveraged buyout:
- Strategic sale: The business can be sold to a strategic buyer, a corporation that may find strategic benefits to owning the business.
- Financial sponsor: Although not too common, the business can be sold to another private equity firm, maybe one with a different focus that can help take the business to the next level.
- Initial public offering (IPO): If the company is at the right stage, and if the markets are right, the company can be sold to the public markets—an IPO.
- Dividend recapitalization: Although not necessarily a sale, a dividend recapitalization is a way for a fund to receive liquidity from their business investments. Think of it like refinancing a mortgage or taking out a second mortgage on your home in order to receive cash. The business will raise debt and distribute the cash raised from the debt to business owners or fund management.
LEVERAGED BUYOUT TECHNICAL ANALYSIS
There are three major steps to conducting an LBO analysis:
- Step 1: Obtaining a purchase price
- Step 2: Estimating sources and uses of funds
- Step 3: Calculating investor rate of return (IRR)
PURCHASE PRICE
In order to conduct a leveraged buyout analysis, we first need to obtain a potential purchase price of the entity. Conducting a valuation analysis on the entity will help us arrive at an approximate current value of the entity. The book Financial Modeling and Valuation steps through how to model and value a company. Although a valuation analysis is helpful in providing an indication of what the appropriate value of the entity is today, one will most likely have to consider a control premium. A control premium is the percentage above current market value that one would consider paying to convince the business owner or shareholders to hand over the business or shares.
Public versus Private Company Purchase
It is important to note that for a public company the purchase price is most likely based on a percentage above the current market trading value per share as exemplified in the preceding press release. However, private companies are popular LBO candidates as well. If we are evaluating a private company, we do not have a current market trading value from which to value the business. So, we need to use multiples to establish an estimated purchase price. Multiples of a private company can be based on public company comparables or historical transactions. In other words, to find an appropriate value of a private company, you can look for companies that are similar in product and size to that company: comparable companies. The multiples ranges of these comparable companies can determine the value of the private company. Also, looking at the price paid for historical transactions similar in product and size to the private company as a multiple can help establish an appropriate purchase price.
SOURCES AND USES OF FUNDS
Once a purchase price has been established, we need to determine the amount of funds we actually need raised to complete the acquisition (uses), and we need to know how we will obtain those funds (sources).
Uses of Funds
The uses of funds represent how much funding we need to complete the acquisition. These uses generally fall into three major categories:
- Purchase price
- Net debt
- Transaction fees
Purchase Price
As discussed previously in this chapter, the purchase price is based either on the current market trading value of the business or on some multiple.
Net Debt
As discussed in Chapter 7, in addition to the purchase price, a buyer is responsible for raising additional funds to pay off the target company's outstanding debt obligations. This can also include other liabilities such as capital lease obligations. The need to pay down such obligations is dependent on several factors, including whether the company is public or private.
Transaction Fees
Transaction fees are expenses related to the pursuit and close of the transaction. Lawyers and investment bankers need to get paid for their services in helping the deal come together, for example. The buyer needs to allocate additional funds to pay such fees. The fees can run from a small retainer to a percentage of the transaction size. The amount depends on negotiations and firm-wide policy. See Chapter 7 for more detail on transaction fees.
Let's keep the ShipCo example simple and assume there are no transaction fees. Again, we want to use ShipCo to illustrate the LBO process, so we don't want to complicate the example with distracting details.
Sources of Funds
Now that we know how much we need to raise in total to fund the acquisition, we need to source such funds. Funds are sourced either by raising equity or debt or by using cash on hand. Table 8.1 gives an example of the types of sources one would see in a leveraged buyout. The percentage ranges in the left column represent on average the percentage of total sources raised by each security. The expected returns can vary depending on the market environment. Also note that the expected equity returns of >25% stated in Table 8.1 is the percentage many funds hope to achieve; it is different from what has actually been achieved on average given the recent market environment.
Table 8.1 Example of Leveraged Buyout Capital Structure
| Bank Debt (30% to 50%) |
|
| High Yield Debt (0% to 10%) |
|
| Mezzanine Lending (20% to 30%) |
|
| Equity (20% to 30%) |
|
Debt
A company can raise various types of debts in order to obtain funding for an acquisition. Common debts raised exist in several categories.
Bank Debt
Bank debt or a term loan is the most fundamental type of debt. It usually carries 5 percent to 12 percent interest and can be backed by the core assets of the business. Such debt is also typically amortized over the transaction horizon, five to seven years, for example. Bank debts can come from commercial or investment banks, private funds, or investors. It is also possible, but more difficult, to receive multiple loans from different lenders. However, there is almost always a hierarchy where one is subordinate to another. Subordinated debt would be riskier and warrant a higher interest rate.
Note that the purpose of this book is not to educate on all the various debt instruments. The selection is vast and there are other great books out there that focus solely on debt instruments. This is meant to be a brief overview to better illustrate how various debts are applied to a leveraged buyout analysis.
A private entity can attempt to raise not only standard term debt, but also more aggressive types of debt that would arguably not be doable if the company were public. A public company receiving a significant amount of high-interest debt might send shareholders running. This ability for a private company to access debts that a public market might not allow is key to a leveraged buyout.
High Yield Debt
High yield debt is a more aggressive type of debt borrowed at much higher interest rates to compensate for additional risk of defaulting on such debt. Interest in such debt can be upward of 15 percent, but it varies depending on the situation at hand. We mention in Table 8.1 that 0 percent to 10 percent of high yield debt typically is used in a leveraged buyout transaction because we've seen two schools of thought. Some funds we have spoken to used high yield debt previously but not anymore. Other funds are starting to access high yield debt markets again. If you are the buyer, it really depends on who is willing to lend and at what cost (interest rate).
Seller Notes
Upon purchasing the business, a smart buyer would want to find ways to incentivize the prior owner of the business to help aid in the business transition. In a worst-case scenario, the seller could attempt to build a competing business directly after the sale. To try to prevent such scenarios from happening, and further to encourage the seller of the business to stick around and help transition the business to the new buyer, seller incentives such as a seller note or rollover equity are put in pace. A seller note is a loan from the seller to the buyer paid back in agreed-upon installments. For example, let's say that in the $25 million ShipCo purchase, we agreed on paying the seller $20 million up front and $5 million will be a seller note payable over five years. The seller is now incentivized to help out in the business until he has received his $5 million in full in five years. Such seller notes may or may not incur interest, depending on the agreement between the seller and the buyer. As a side note, sellers often sign “noncompete” agreements, which prevent the seller from starting a new business competitive to the one recently sold. Seller notes are a good way to help enforce such agreements.
Mezzanine
Mezzanine securities are hybrids between debt and equity. Convertible bonds or preferred securities are examples of mezzanine securities. The general concept of a mezzanine security is that it is initially considered debt that will convert to equity after a certain amount of time or after certain hurdles are met. We're being a bit vague here because virtually any combination of debt and equity can be created if there is an investor willing to invest in such a security and if there is a company willing to borrow such a security. As such, convertible markets departments exist in investment banks whose sole purpose is to create unique hybrid structures designed to match a buyer with a seller of a mezzanine security.
The benefit of mezzanine lending to an investor is there is some downside protection (as it is debt for the first specified number of years), but there is upside potential if the security converts into equity. Given the fact that there is an equity component to such securities, and knowing equity is more risky than debt, the effective combined return of a convertible security should be higher than that of debt. In Table 8.1 we suggest that anywhere from 20 percent to 30 percent of the total sources are typically made up of mezzanine securities. Again, this depends on the company and respective markets.
Just a note: Preferred securities can technically be considered equity, although they are also considered mezzanine as they often simulate debt in some form.
Equity
A public company can raise shares in the open market in order to obtain funding for an acquisition. A private entity can attempt to raise equity from funds or investors, or they can use their own funds. Typically, in a leveraged buyout, 20 to 30 percent of equity is raised to meet the total amount needed. That number can change depending on the transaction situation and market environment.
Rollover Equity
In private companies the seller of the business can also invest some funds back into the business and receive a small equity stake. This is helpful in incentivizing the seller to continue to consult with the business, especially as the seller may be tied to clients and important relationships necessary to sustain or further business growth.
Cash
If an entity has adequate cash on hand to meet the total funding needs, raising equity or debt may not be necessary.
The sources of funding are totaled and should match the uses of funding.
IRR ANALYSIS
Once we have our sources and uses of cash, we can now proceed to determine the annualized rate of return for our potential investment (Table 8.2).
Table 8.2 ShipCo Sources and Uses
| Uses | Amount | Sources | Amount | % |
| Purchase price | 24,900.0 | Bank debt | 8,750.0 | 35% |
| Transaction fees | 0.0 | High yield debt | 6,250.0 | 25% |
| Net debt | 100.0 | Equity | 10,000.0 | 40% |
| Total | 25,000.0 | Total | 25,000.0 | 100% |
Initial Assumptions
First, we begin with the following assumptions.
Time Horizon
It is first important to consider a time horizon. How long do we expect to own and hold the business before selling it? This time horizon could be dependent on how long we deem it would take to make adequate improvements, or maybe it is based on the timing of investment funds required to be returned to investors. Often the horizon is five, seven, or ten years.
Exit Value Method
Once we know when we will sell the business, we need to determine the exit value—how much we can expect to sell the business for. Since the company is now private, we would most likely base the sale on a multiple at the time of sale, an exit multiple. Here, comparable companies or precedent transactions can help determine a fair exit multiple. But often, we can conservatively use the same multiple as we paid for the business. In other words, if we paid 10× EBITDA for the company, we would hope in five years to sell the business for at least 10× EBITDA. The idea is that we would have most likely improved business performance and increased EBITDA, so although the multiple remains unchanged, the sale value would have increased. Therefore, it is useful to consider in advance, for the analysis, what method we will use to arrive at the exit value; that is, will it be a multiple of EBIT, EBITDA, or some other method? It is most common to use EBIT or EBITDA, as they are unlevered metrics and better represent performance of the business operations (see Chapter 4 on valuation).
Steps to Investor Return
Once we have the core assumptions—the purchase price, the uses of funds, the sources of funds, time horizon, and exit value method—we can proceed with the analysis.
Step 1: Unlevered Free Cash Flow Projections
Once we have our core assumptions, we would most likely need five-year projections in order to interpret the exit multiple into an actual exit value. Further, once we have an exit value, we note that this exit value, if calculated based on an enterprise value multiple, will produce an enterprise exit value. If so, we need to convert enterprise value into equity value by removing net debt. It is equity value that reflects our actual return. In other words, when selling the business, we will most likely be responsible for paying down the business debts. Again, the company we are selling is private, and if the sale is based on an EBIT or EBITDA multiple, then the sale value is an enterprise value, and therefore includes the value of debt.
However, in order to predict the level of debt in Year 5, for example, we need to understand not only the impact of interest incurred over the five years, but also the cash produced by the business over the five years. The cash produced can be used to pay down debts. Unlevered free cash flow projections contain both EBIT and EBITDA projections, which can be used for our exit value, and also contain cash projections, which can be used to project cash. So, for a simple IRR analysis it is first recommended to build simple unlevered free cash flow projections.
Unlevered Free Cash Flow
Unlevered free cash flow is cash that is available to all capital providers, including equity holders and lenders. In other words, it is a measure of cash flow before equity holders and lenders have been paid. Further, as valuation is a measure of a company's core operating assets of a business, unlevered free cash flow should represent the cash generated or lost based on the core operations of the business. To clarify, let's take a look at a complete cash flow statement.
To get to an unlevered cash flow amount, we want to remove all cash flows related to the capital structure. So we eliminate dividend payouts, noncontrolling interests, share issuances, share buybacks, debt raises, and debt pay-downs; the entire financing activities section is removed. Further, we want a measure of cash that approaches everyday activity, so nonrecurring and extraordinary items such as acquisitions and divestitures will be removed. In the investing activities section, we are left with capital expenditures. (See Table 8.4.)
Simplifying the leftover cash flows gives us:
| Unlevered Free Cash Flow |
| Net income |
| + Depreciation and amortization |
| + Deferred taxes |
| + Other noncash items |
| + Working capital changes |
| − Capital expenditures |
Finally, since we are trying to capture an unlevered measure of cash, we also need to adjust the net income for interest expense. So we need to add one more line item: after-tax net interest expense.
| Unlevered Free Cash Flow |
| Net income |
| + Depreciation and amortization |
| + Deferred taxes |
| + Other noncash items |
| + Working capital changes |
| − Capital expenditures |
| + A/T net interest expense |
| = Total unlevered free cash flow |
Table 8.3 Consolidated Statements of Cash Flows (in US$ millions)
| Actuals | Estimates | |||||||
| Period Ending January 31 | 2010A | 2011A | 2012A | 2013E | 2014E | 2015E | 2016E | 2017E |
| Cash flows from operating activities | ||||||||
| Net income | 14,883.0 | 16,993.0 | 16,387.0 | 17,192.1 | 18,030.3 | 18,665.9 | 19,066.2 | 19,215.5 |
| Loss (income) from discontinued operations to net cash | 79.0 | (1,034.0) | 67.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Depreciation and amortization | 7,157.0 | 7,641.0 | 8,130.0 | 8,591.7 | 9,188.6 | 9,809.4 | 10,448.9 | 11,101.1 |
| Deferred income taxes | (504.0) | 651.0 | 1,050.0 | 715.9 | 1,003.5 | 791.0 | 596.3 | 411.4 |
| Other operating activities | 318.0 | 1,087.0 | 398.0 | 318.0 | 318.0 | 318.0 | 318.0 | 318.0 |
| Changes in operating working capital | ||||||||
| Changes in accounts receivable | (297.0) | (733.0) | (796.0) | 146.5 | (289.5) | (243.2) | (189.7) | (130.3) |
| Changes in inventory | 2,213.0 | (3,205.0) | (3,727.0) | (148.4) | (2,043.1) | (1,716.2) | (1,338.7) | (919.2) |
| Changes in prepaid expenses and other | 0.0 | 0.0 | 0.0 | (773.9) | (122.9) | (103.3) | (80.6) | (55.3) |
| Changes in accounts payable | 1,052.0 | 2,676.0 | 2,687.0 | 701.2 | 1,865.5 | 1,567.0 | 1,222.2 | 839.3 |
| Changes in accrued liabilities | 1,348.0 | (433.0) | 59.0 | 1,425.7 | 979.0 | 822.3 | 641.4 | 440.5 |
| Changes in accrued income taxes | 0.0 | 0.0 | 0.0 | (460.7) | 34.3 | 26.0 | 16.4 | 6.1 |
| Net changes in operating working capital | 4,316.0 | (1,695.0) | (1,777.0) | 890.4 | 423.1 | 352.6 | 271.2 | 181.1 |
| Total cash flows from operating activities | 26,249.0 | 23,643.0 | 24,255.0 | 27,708.1 | 28,963.6 | 29,936.9 | 30,700.5 | 31,227.1 |
| Cash flows from investing activities | ||||||||
| Payments for property and equipment (CAPEX) | (12,184.0) | (12,699.0) | (13,510.0) | (14,213.0) | (14,923.7) | (15,520.6) | (15,986.2) | (16,305.9) |
| CAPEX % of revenue | 3.0% | 3.0% | 3.0% | 3.0% | 3.0% | 3.0% | 3.0% | 3.0% |
| Proceeds from disposal of property and equipment | 1,002.0 | 489.0 | 580.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Investments and business acquisitions, net of cash acquired | 0.0 | (202.0) | (3,548.0) | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Other investing activities | (438.0) | 219.0 | (131.0) | (438.0) | 219.0 | (131.0) | (438.0) | 219.0 |
| Total cash from investing activities | (11,620.0) | (12,193.0) | (16,609.0) | (14,651.0) | (14,704.7) | (15,651.6) | (16,424.2) | (16,086.9) |
| Cash flows from financing activities | ||||||||
| Short-term borrowings (repayments) | (1,033.0) | 503.0 | 3,019.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Long-term borrowings (repayments) | (487.0) | 7,316.0 | 466.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Long-term debt due within one year | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Capital lease obligations due within one year | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Dividends paid | (4,217.0) | (4,437.0) | (5,048.0) | (5,344.7) | (5,187.3) | (5,029.9) | (4,872.5) | (4,715.1) |
| Dividends paid ($/share) | 1.59 | 1.59 | 1.59 | 1.59 | 1.59 | |||
| Purchase of common stock [treasury stock] | (7,276.0) | (14,776.0) | (6,298.0) | (7,318.8) | (7,318.8) | (7,318.8) | (7,318.8) | (7,318.8) |
| Purchase of redeemable noncontrolling interest | (436.0) | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Capital lease obligations | (346.0) | (363.0) | (355.0) | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Other | (396.0) | (271.0) | (242.0) | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Total cash from financing activities | (14,191.0) | (12,028.0) | (8,458.0) | (12,663.5) | (12,506.1) | (12,348.7) | (12,191.3) | (12,033.9) |
| Effect of exchange rate on cash | 194.0 | 66.0 | (33.0) | 194.0 | 66.0 | (33.0) | 194.0 | 66.0 |
| Total change in cash and cash equivalents | 632.0 | (512.0) | (845.0) | 587.6 | 1,818.8 | 1,903.6 | 2,279.0 | 3,172.3 |
| SUPPLEMENTAL DATA: | ||||||||
| Cash flow before debt paydown | 587.6 | 1,818.8 | 1,903.6 | 2,279.0 | 3,172.3 | |||
Table 8.4 Consolidated Statements of Cash Flows—Unlevered and Free
| Actuals | Estimates | |||||||
| Period Ending January 31 | 2010A | 2011A | 2012A | 2013E | 2014E | 2015E | 2016E | 2017E |
| Cash flows from operating activities | ||||||||
| Net income | 14,883.0 | 16,993.0 | 16,387.0 | 17,192.1 | 18,030.3 | 18,665.9 | 19,066.2 | 19,215.5 |
| Loss (income) from discontinued operations to net cash | 79.0 | (1,034.0) | 67.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| Depreciation and amortization | 7,157.0 | 7,641.0 | 8,130.0 | 8,591.7 | 9,188.6 | 9,809.4 | 10,448.9 | 11,101.1 |
| Deferred income taxes | (504.0) | 651.0 | 1,050.0 | 715.9 | 1,003.5 | 791.0 | 596.3 | 411.4 |
| Other operating activities | 318.0 | 1,087.0 | 398.0 | 318.0 | 318.0 | 318.0 | 318.0 | 318.0 |
| Changes in operating working capital | ||||||||
| Changes in accounts receivable | (297.0) | (733.0) | (796.0) | 146.5 | (289.5) | (243.2) | (189.7) | (130.3) |
| Changes in inventory | 2,213.0 | (3,205.0) | (3,727.0) | (148.4) | (2,043.1) | (1,716.2) | (1,338.7) | (919.2) |
| Changes in prepaid expenses and other | 0.0 | 0.0 | 0.0 | (773.9) | (122.9) | (103.3) | (80.6) | (55.3) |
| Changes in accounts payable | 1,052.0 | 2,676.0 | 2,687.0 | 701.2 | 1,865.5 | 1,567.0 | 1,222.2 | 839.3 |
| Changes in accrued liabilities | 1,348.0 | (433.0) | 59.0 | 1,425.7 | 979.0 | 822.3 | 641.4 | 440.5 |
| Changes in accrued income taxes | 0.0 | 0.0 | 0.0 | (460.7) | 34.3 | 26.0 | 16.4 | 6.1 |
| Net changes in operating working capital | 4,316.0 | (1,695.0) | (1,777.0) | 890.4 | 423.1 | 352.6 | 271.2 | 181.1 |
| Total cash flows from operating activities | 26,249.0 | 23,643.0 | 24,255.0 | 27,708.1 | 28,963.6 | 29,936.9 | 30,700.5 | 31,227.1 |
| Cash flows from investing activities | ||||||||
| Payments for property and equipment (CAPEX) | (12,184.0) | (12,699.0) | (13,510.0) | (14,213.0) | (14,923.7) | (15,520.6) | (15,986.2) | (16,305.9) |
| CAPEX % of revenue | 3.0% | 3.0% | 3.0% | 3.0% | 3.0% | 3.0% | 3.0% | 3.0% |
| Total cash from investing activities | (11,620.0) | (12,193.0) | (16,609.0) | (14,651.0) | (14,704.7) | (15,651.6) | (16,424.2) | (16,086.9) |
| Cash flows from financing activities | ||||||||
| Total change in cash and cash equivalents | 632.0 | (512.0) | (845.0) | 587.6 | 1,818.8 | 1,903.6 | 2,279.0 | 3,172.3 |
| SUPPLEMENTAL DATA: | ||||||||
| Cash flow before debt paydown | 587.6 | 1,818.8 | 1,903.6 | 2,279.0 | 3,172.3 | |||
There's often a lot of confusion as to whether these line items should be added or subtracted. The best rule of thumb is to follow how the cash flow statement is making these adjustments. We are trying to replicate a form of cash flow, so if the cash flow statement is adding the item, we should also add it; if the cash flow statement is subtracting the item, we should subtract. According to a standard cash flow statement, the flow should be:
Yes, it is plus working capital changes, because the cash flow statement adds working capital changes to the net income to get to cash from operations. Many textbooks suggest subtracting working capital, but they are actually referring to subtracting the balance sheet working capital changes. In other words, if accounts receivable increased from $0 to $1, 000, or if the balance sheet change is $1,000, then we know the cash flow change is −$1,000, because an increase in an asset reflects a cash outflow. However, if we take the actual working capital number directly from the cash flow statement, which is already represented as a negative (−$1,000), we just add it.
It is crucial to note that there can be items in the investing activities other than capital expenditures (CAPEX) that could arguably be attributable to everyday operations. Although it's not explicitly defined in the unlevered free cash flow formula, the point of the entire analysis is to get to a number that reflects the cash we expect to be generated from the future operations of the business. Further, in the operating activities, there may be other adjustments that are not categorized within the standard unlevered free cash flow definition. It is important to step back and think about how these line items are affecting net income to decide if they should also be adjusted in the unlevered free cash flow. In other words, if these line items are actually noncash items that need to be adjusted to net income in order to get to a closer measure of cash from net income, then they should be included in the analysis. However, if these are truly nonrecurring events, and if we have already pulled them out of net income on the income statement, adjusting them here may not be correct. This is one example of how important it is to understand fully where unlevered free cash flow is coming from and why it is being used as opposed to just taking and using the formula as printed.
Now, the previous definition is not the most standard definition of unlevered free cash flow. Typically, we use EBIT as a starting point, not net income. It is easier to project an income statement from revenue down to EBIT only, rather than all the way down to net income, especially since we are adding back so many items anyway. However, both ways will get you the same results. So if we had EBIT as a starting point, we still have to make the same core adjustments:
| Unlevered Free Cash Flow | Unlevered Free Cash Flow |
| Net income | EBIT |
| + Depreciation and amortization | + Depreciation and amortization |
| + Deferred taxes | + Deferred taxes |
| + Other noncash items | + Other noncash items |
| + Working capital changes | + Working capital changes |
| − Capital expenditures | − Capital expenditures |
| + A/ T net interest expense | |
| = Total unlevered free cash flow |
Note here we have to double-check once again which line items we are (or are not) including as other noncash items, and for a different reason: If the particular noncash item was a net income adjustment for a line item that was below the EBIT line, which we didn't even include anyway, adjusting it here would be incorrect.
We still have to make one more adjustment: taxes. We do not need to adjust for interest expense, as EBIT is already before interest expense. But EBIT is also before taxes. So in order to adjust for taxes, we need to take EBIT × Tax Rate. It is important to note we do not take the taxes figure from the income statement, as that number includes the effects of interest.
| Unlevered Free Cash Flow | Unlevered Free Cash Flow |
| Net income | EBIT |
| + Depreciation and amortization | + Depreciation and amortization |
| + Deferred taxes | + Deferred taxes |
| + Other noncash items | + Other noncash items |
| + Working capital changes | + Working capital changes |
| − Capital expenditures | − Capital expenditures |
| + A/ T net interest expense | − Taxes (EBIT × Tax %) |
| = Total unlevered free cash flow | = Total unlevered free cash flow |
It is important to note here the importance of understanding the derivation of unlevered free cash flow. In this ever-changing market environment with new and evolving business models, the standard textbook definition of unlevered free cash flow may need to be adjusted to be a true measure of value for a particular entity. Understanding the purpose of unlevered free cash flow as a measure of value will help us to create our own adjustments to get to the true value of an entity.
Step 2: Calculation of Exit Enterprise Value
Unlevered free cash flows contain EBIT and EBITDA. So, assuming we have used an EBIT or EBITDA multiple as our exit value method, we can apply that multiple to the exit year metric found in the unlevered free cash flow projections.
Note that this gives us enterprise value. To calculate our return, we need equity value, so we need to remove the effects of debt.
Table 8.5 ShipCo Unlevered Free Cash Flow
| Projected Free Cash Flow | ||||||
| 2012A | 2013E | 2014E | 2015E | 2016E | 2017E | |
| EBIT | 5,000.0 | 5,250.0 | 5,512.5 | 5,788.1 | 6,077.5 | 6,381.4 |
| EBIT growth rate | 5.0% | 5.0% | 5.0% | 5.0% | 5.0% | |
| D&A | 400.0 | 400.0 | 400.0 | 400.0 | 400.0 | 400.0 |
| CAPEX | (1,000.0) | (1,000.0) | (1,000.0) | (1,000.0) | (1,000.0) | (1,000.0) |
| Changes in working capital | (100.0) | (100.0) | (100.0) | (100.0) | (100.0) | (100.0) |
| Taxes (40%) | (2,100.0) | (2,205.0) | (2,315.3) | (2,431.0) | (2,552.6) | |
| Unlevered free cash flow | 2,450.0 | 2,607.5 | 2,772.9 | 2,946.5 | 3,128.8 | |
Step 3: Calculation of Exit Debt
Now that we have an exit value, we need to subtract Year 5 net debt to determine that actual value returned to us as investors. In order to calculate exit year debt, we need to take several things into consideration:
- We always begin with the amount of debt raised upon initial acquisition.
- We need to calculate interest incurred each year we own the business.
- Cash generated (unlevered free cash flow) can be used to pay down debt and interest.
So, the beginning value of debt raised upon initial acquisition (beginning debt) plus the interest incurred each year less cash generated is the exit debt, or:
Total interest can be calculated by applying an interest rate to the amount of debt raised, multiplied by the number of years we have held the business, and multiplied by (1 − Tax %).
Or:
Should the company have more than one type of debt with different interest rates, interest should be calculated for each type of debt, then added together. Note that this is a quick analysis and is not designed to handle the fact that interest expense can be reduced if debt is paid down year after year. We are conservatively assuming the interest expense is held constant. We will see later that the ability to handle a more dynamic debt and interest pay-down schedule is a benefit of a full-scale leveraged buyout analysis.
Total cash is the sum of the unlevered free cash flows for the projected years.
Explanation of Adjusting Interest by (1 − Tax %)
We often get questions on why we multiply the interest expense by (1 − Tax %). Interest is tax deductible. We will clarify with this example.
Net income including interest:
| Interest × (1 − Tax %) | |
| EBIT | $5,000 |
| Interest | 1,000 |
| EBT | 4,000 |
| Tax (40%) | 1,600 |
| Net income | 2,400 |
This demonstrates net income of $2,400 and contains the effects of $1,000 in interest. If we remove $1,000 in interest expense, we also need to adjust taxes.
Net income excluding interest:
| Interest × (1 − Tax %) | |
| EBIT | $5,000 |
| Interest | 0 |
| EBT | 5,000 |
| Tax (40%) | 2,000 |
| Net income | 3,000 |
You can see that once the $1,000 interest is removed, the net income has increased from the $2,400 to $3,000. Notice that the increase was $600, not $1,000. This is because although interest expense is removed, taxes associated with that interest expense are also removed.
In other words, once that interest expense is removed, the EBT has in fact increased by $1,000 (from $4,000 to $5,000). Higher EBT means higher taxes. Consequently, the taxes have increased from $1,600 to $2,000. So, the real changes are: (1) an interest expense reduction of $1,000 and (2) tax expense increase of $400, or $1,000 − $400; this is the $600 net effect to net income.
Now the $1,000 is interest less the $400 (interest times the tax rate). So,
Using algebra, we can pull out interest so the formula will read:
Step 4: Calculation of IRR
Once we have the exit enterprise value and the exit debt, we simply subtract to get exit equity value. This is the value returned to us as investors. With this value, we can calculate the IRR.
where the equity invested is the value of equity the investors originally invested in the business (found in the sources of cash), and the years is the amount of time that we held the business.
That's it! This is the simple version of a leveraged buyout IRR analysis.
Although 22.3 percent is not too bad a yearly return, some funds have minimum return requirements, such as 25 percent.
To strengthen your understanding of such an analysis, it is important to highlight some key variables affecting the IRR:
- Purchase price. Of course the purchase price plays a major role in determining the IRR. The higher the purchase price, the more costly the investment may be to the investor, and therefore the lower the IRR. A couple of exceptions here: We are assuming that a higher purchase price would mean the investor would have to put more equity into the initial investment. Also, a higher purchase price can be offset by a higher sale value, and if so, the IRR may not be affected.
- Sources of cash. The amount of debt that can be raised to make such an investment will also affect the IRR. The more debt we can raise, the less equity we have to put in, and so the higher our expected returns will be.
- Interest rate. A lower interest rate would lower our costs, which would increase our cash, which would allow us to pay down debt faster and increase the IRR.
- Time frame. Typically, a shorter time frame would produce a higher IRR. But be careful not to get fooled, as this is a compounded percentage. In other words, a 25 percent annual return over five years does not give us as high an overall return as 20 percent annually over 10 years. Take a $1,000 investment, for example:
or
Which would you prefer? Although the first example is showing a higher return of 25 percent, the overall exit value is only half of the second example.
- Operations performance (EBITDA projections). The more we can improve EBITDA, the higher our potential sale value, which would increase IRR. Also, a higher EBITDA would improve our cash flow.
- Cash flow (UFCF projections). Improved cash flow performance will allow us to pay down debt faster and will improve our IRR.
- Exit multiple. The higher our exit multiple (exit value), the higher our return.
These are the major variables that affect an IRR analysis. Although such analyses are used as a quick estimate of investor return, there are several major flaws with such a brief analysis:
- Lack of income statement. We have no record of net income, and we may have overlooked some crucial expenses below the EBIT line that could potentially hinder business performance.
- Lack of complete cash flow statement. Although unlevered free cash flow as discussed earlier is a good measure of cash, without a complete cash flow statement we may overlook some other crucial cash flow line items that can hinder cash generation.
- Lack of balance sheet. Without a balance sheet we really don't know how much debt the business can take on. A complete model will help us better determine debt capacity.
- Interest expense. In this example we calculated interest expense by multiplying the interest rate by the amount of debt initially raised. We then multiplied the interest expense by the number of years we owned the business. In doing so, we are assuming the interest expense is held flat each year. However, in reality debt could be paid down each year, thus reducing interest expense. Although keeping the interest expense the same each year can be seen as conservative, the ability to capture interest savings each year by paying down debt is a crucial component to a leveraged buyout analysis.
- Goodwill/intangible assets. We have not assumed benefits of amortizing intangible assets related to paying a premium above book value for the business.
- Synergies. We did not account for the effects of synergies or cost savings. Although we could have done this in the unlevered free cash flow analysis, it is better to project synergies directly in the income statement.
These are some of the many reasons why a full-scale leveraged buyout analysis provides a more accurate estimation of an effective investor return. However, such a quick analysis is helpful in highlighting the major concepts and drivers to a leveraged buyout analysis. In the book Leveraged Buyouts we evaluate a complete analysis as done on Wall Street. However for interview preparation purposes the concepts and the high level LBO analysis discussed herein are key. Let's practice some questions in the next chapter.