FBE 421: Financial

Analysis & Valuation

Leveraged Buyouts (LBOs)

LBOs – Overview
• In a leveraged buyout, a company is acquired by a specialized
investment firm using a relatively small portion of equity and a
relatively large portion of outside debt financing.

• The leveraged buyout investment firms today refer to themselves

(and are generally referred to) as private equity (PE) firms.

• In a typical leveraged buyout transaction, the private equity firm

buys majority control of an existing or mature firm.

• How is this arrangement different from venture capital firms?

• VCs typically invest in young or emerging companies, and typically do
not obtain majority control.
LBOs – Overview
• LBOs represent a business acquisition strategy whereby
an investor group acquires all the equity of a firm and
assumes its debts.

• If the company is publicly traded, the private equity firm

typically pays a premium of 15% to 50% over current
stock price – expect substantial increases in value.

• The investment is predominantly financed with debt

(60% to 90% of the capital structure).
LBOs – Overview
• The debt portion almost always includes a loan portion that is
senior and secured, arranged by a bank or investment bank

• In the 1980s and 1990s banks were also the primary investors
in these loans

• More recently, institutional investors also purchase a large

fraction of senior and secured loans. These investors include
hedge funds and “collateralized loan obligation” managers

• Buyouts also typically include a junior, unsecured portion that

is financed by either high-yield bonds or “mezzanine debt”
LBOs – Overview
• The private equity firm invests funds from its investors to
cover the remaining 10% to 40% of the purchase price

• The new management team of the buyout company (which

may or may not be the same as the pre-buyout management
team) typically also contributes to the new equity

• The management of the buyout company typically holds large

equity stakes
LBOs – Overview
• What role does the leverage play?
• Forces management to run operations at maximum
efficiency to service debt (i.e., debt as tool of discipline)

• What role does high management ownership play?

• High equity shares for management also create strong
incentives for performance.

• These incentives for performance are also reinforced by

the smaller and more active boards of these companies,
and higher managerial turnover.
LBOs - Overview
• These incentives are also tied to specific value-creation
plans
• e.g. cost-cutting, productivity improvements, strategic changes or
repositioning, acquisition opportunities,…

• LBOs (on average) are associated with operating

performance improvements

• Overall, employment grows at firms that experience

LBOs, but at a slower rate than similar firms
• Stereotype of large employment losses is not valid for the
average LBO
LBOs over time
LBOs over time
LBOs over time
• While public-to-private transactions reduced in importance
after the 1980s, the market did not disappear

• The deals just shifted the focus afterwards towards smaller

companies

• Public-to-private transactions gained importance again in the

2000s

• The two large booms are associated with a greater importance

of public-to-private deals (larger deals) and expansionary
credit markets
Valuing LBOs: Southland Case
• Spring of 1987 – Southland corporation, owner of the 7-Eleven
convenience store chain, went through an LBO

• John Thompson, Chairman, along with his brothers Jere

Thompson, president and CEO and Jodie Thompson held
about 9.5% of Southland

• Samuel Belzberg, a Canadian investor who owned 4.9%,

wanted to implement a buyout in a partnership with the
Thompsons

• The deal would acquire the company at $65 dollars/ share

(48,672,840 outstanding shares)
Valuing LBOs: Southland Case
• On June 15, 1987, the day before the market learned
Southland was considering the deal, the closing price was
$55.875/ share.

• Southland’s Board of Directors formed a special committee to

consider the LBO offer. They hired their financial advisors to
value the deal.

• The Thompsons made their offer based on an operating plan

for the company, made together with their investment
bankers.
Valuing an LBO
• The Management Operating Plan focused on Southland’s core
convenience retailing business and anticipated the sale of
many of its other businesses.

• These other businesses included (among others) dairy and

food production, ice manufacturing, and a retailer of
automobile replacement parts and accessories.

• Plan included substantially improved profitability of

convenience stores.
Valuing an LBO
• In addition, both general and administrative expenses and
capital expenditures were planned to be reduced.

• Men constituted 70% of 7-eleven customers – truck drivers,

construction workers and college men were typical customers.

• Southland’s major marketing effort was to attract female and

upscale customers, without alienating its solid customer base.
Valuing an LBO
Projections for Proposed Leverage Buyout 1988-1997 ($ Millions)
1988 1989 1990 1991 1992
EBIT 372 381 436 499 585
Depreciation 217 175 165 162 158
CAPEX 167 62 142 147 153
Asset Sales 1,013 70 171 23 24
ΔNOWC -15 -21 -31 -26 -28

1993 1994 1995 1996 1997

680 795 896 1,005 1,151
163 164 162 161 154
179 156 163 170 177
24 26 27 27 29
-29 -30 -32 -33 -34
Valuing the LBO
• Can we use the WACC for the valuation of the LBO?

Capital Structure for Proposed Leveraged Buyout, 1987-1997 ($ in Millions)

1987 1988 1989 1990 1991 1992
Total Debt 4,430 3,402 3,179 2,881 2,706 2,469

1993 1994 1995 1996 1997

2,213 1,837 1,384 839 160
Valuing the LBO
• Use APV since D/V is expected to substantially change over
time
• Another reason: deal might be associated with substantial
borrowing costs

APV Approach
1. Determine Southland’s unlevered cost of capital kUA
2. Value FCF forecast for 1988-97
3. Terminal value
4. Value debt tax shield
5. Pull it all together

• Additionally: Can also include estimates for borrowing costs

Unlevered Cost of Capital
• In 1986:
• Equity Beta: 1.00
• Book value of debt = $640M
• Interest rate on 10-year Treasury notes (July 1987) = 8.62%
• Historical average for market premium = 8%
• Stock price =$47; Number of shares= 48,094,000

Assume the following un-levering formula, and that βD=0:

 E  ( D / E ) D
UA 
1  (D / E)
Unlevered Cost of Capital
Market value of equity = $2,260

D/E = 0.28

E 1.00
UA    0.78
1 D / E 1.28

kUA  R f  UA ( R f  RM )  8.62%  0.78(8%)  15%

 Projected FCF
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
EBIT 372 381 436 499 585 680 795 896 1,005 1,151
Taxes (36%) 134 137 157 180 211 245 286 323 362 414
EBIT*(1-T) 238 244 279 319 374 435 509 573 643 737
Depreciation 217 175 165 162 158 163 164 162 161 154
CAPEX 167 62 142 147 153 179 156 163 170 177
Asset Sales 1,013 70 171 23 24 24 26 27 27 29
ΔNOWC -15 -21 -31 -26 -28 -29 -30 -32 -33 -34

FCF 1,316 448 504 383 431 472 573 631 694 777

Based on the cost of capital equal to15% (last slide) we get

PV of Unlevered Assets (Planning Period) = 3,263

Important point
Projections rely on substantial efficiency gains:
Assets are projected to drop by $1,878M (Assets in 86 = $3,421M)
EBIT is projected to annually grow by more than 14%
Terminal Value
• Scenario 1: FCF are flat after 1997

FCF97 777
TV97    5,180
kUA 0.15

TV97 5,180
PV _ TV97    1,281
(1  kUA )10
(1.15)10
Terminal Value
• Scenario 2: FCF grows annually by 3% after 1997

FCF97 (1  0.03) 777(1.03)

TV97    6,669
(0.15  0.03) 0.12

TV97 6,669
PV _ TV97    1,649
(1  kUA )10
(1.15)10
Interest Tax Shields

Cost of debt= 12%

Assuming a flat perpetuity after 1997  PV(Tax Shields) = $810M

 Combining it all
Scenario 1 Scenario 2
Unlevered Assets (Planning period) 3,263 3,263
Unlevered Assets (terminal value) 1,281 1,649
Tax Shields 810 810
Enterprise Value (with deal) 5,354 5,722

Cash 175 175

Firm Value (with deal) 5,529 5,897

Debt (before deal) 1,146 1,146

Equity (before deal, but with deal ) 4,383 4,751

# Shares 48,672,840 48,672,840

Price per share 90 98
Combining it all
• We are valuing the equity just before the deal, but under the
assumption that the deal will take place

• We first compute the Enterprise Value with the deal, i.e. under
the assumption that the deal takes place

• We add the cash holdings just before the deal

• This is the value of the firm’s assets just before the deal (with
the deal)

• The value of the equity just before deal (with the deal) is given
by this value of the assets minus the debt just before the deal
Valuation results
• These projections imply that the equity value will increase by
94%-110% (original market value of equity is $2,260M)

Important considerations:

• Projections are very optimistic in terms of performance

improvements. Where will all these improvements come
from?

• The analysis might be ignoring important costs associated with

the heavy use of debt:
(1) Borrowing costs – borrowing rates on new debt raised
might be high
(2) Potential risks of financial distress (assets are riskier)
Borrowing costs
• The borrowing rate on both the debt raised for the deal and
the debt raised afterwards is likely to be higher than the
(market) cost of debt

• In other words, the borrowing rate is likely to be higher than

the rate of return investors would earn if they invested in the
company’s debt (market cost of debt)

• For example, assume:

Market cost of debt=12%; Actual borrowing rate =15%

• How can we take this into account?

 Borrowing costs
• Interest expenses are based on the actual (realized) borrowing rate

• Given interest expenses equal to $15, the market cost of debt

implies that the firm should be paying (approximately) $12.

• This means that the firm is incurring a borrowing cost

(approximately) equal to $3, for each $15 in interest payments –
i.e., borrowing costs represent (approximately) 20% of interest
payments

• We can compute the PV of this cost by looking at the interest

expenses
Borrowing Costs
• For the purposes of our analysis, we want to compute costs
only when there are interest payments to the new debt (debt
raised from the deal on).

• We are measuring the enterprise value from the moment of

the deal onward.
 Borrowing Costs
Based on proposed capital structure ($ in Millions)
1988 1989 1990 1991 1992
Interest Expense 422 363 339 325 303
Ratio of Preexisting Debt/ Total Debt 0.14 0.18 0.18 0.19 0.20
Borrowing cost 73 60 55 52 49
1993 1994 1995 1996 1997
339 307 278 233 152
0.15 0.10 0.05 0.00 0.00
58 55 53 47 30

We should discount this cost using the cost of debt (12%)

If we project this cost as flat after 1997, we have:

PV( borrowing cost) = $396M

Borrowing Costs
• Since we already computed interest tax shields using the
borrowing rate, we should simply subtract this value from our
previous computations.

• This adjustment is relevant but (in this example) does not

change the main conclusion that the equity value increases by
a very large amount.

• Note: We are still not addressing the risk of financial distress.

• What if there is a downturn and the firm needs to borrow
more? Will creditors continue financing the firm?

• Trimming projections was key.

Adjusting Projections
• Scenario 3: earnings stop growing after 1990

• Enterprise value drops to $4,062M

• Scenario 4: earnings stop growing after 1988

• Enterprise value drops to $3,851M

Scenario 3
1988 1989 1990 1991 1992
EBIT 372 381 436 436 436
Taxes (36%) 134 137 157 157 157
EBIT*(1-T) 238 244 279 279 279
Depreciation 217 175 165 162 158
CAPEX 167 62 142 147 153
Asset Sales 1,013 70 171 23 24
ΔNOWC -15 -21 -31 -26 -28

FCF 1,316 448 504 343 336

1993 1994 1995 1996 1997
436 436 436 436 436
157 157 157 157 157
279 279 279 279 279
163 164 162 161 154
179 156 163 170 177
24 26 27 27 29
-29 -30 -32 -33 -34

316 343 337 330 319

Scenario 4
1988 1989 1990 1991 1992
EBIT 372 372 372 372 372
Taxes (36%) 134 134 134 134 134
EBIT*(1-T) 238 238 238 238 238
Depreciation 217 175 165 162 158
CAPEX 167 62 142 147 153
Asset Sales 1,013 70 171 23 24
ΔNOWC -15 -21 -31 -26 -28

FCF 1,316 442 463 302 295

1993 1994 1995 1996 1997
372 372 372 372 372
134 134 134 134 134
238 238 238 238 238
163 164 162 161 154
179 156 163 170 177
24 26 27 27 29
-29 -30 -32 -33 -34

275 302 296 289 278

Adjusting Projections
Scenario 3 Scenario 4
Unlevered Assets (Planning + TV) 3,252 3,041
Tax Shields 810 810
Enterprise Value (with deal) 4,062 3,851

Cash 175 175

Firm Value (with deal) 4,237 4,026

Debt (before deal) 1,146 1,146

Equity (before deal, with the deal ) 3,091 2,880

# Shares 48,672,840 48,672,840

Price per share 64 59
Adjusting Projections
• These projections are still very optimistic about operating
performance improvements

• Earnings do not increase as much, but assets are substantially

contracting

• These adjustments are already enough to imply that the offer

price is too high
Risks?
• The deal took place just before large changes in economic
conditions, leading to an economic recession in the early 90s
After the deal
• Things did not go so well

• Violent crime hurt late night demand + early 90s conditions.

• Operating improvements less than expected:

• Projected: 1988=$589M; in 1989=$556M; 1990=$601M
• Actual: EBIT(1-t) 1988=$474M; in 1989=$476M; in 1990=$312 M
After the deal
• Interest payments much higher than expected

• Company overvalued  Excessive leverage  Distress

• After failed restructuring attempts, filed for Chapter 11 in

10/90.

• Emerged from Chapter 11 in 02/91, owned by Ito-Yokado.

After the deal
• Easy to say that risks were ignored after we know the
outcome

• But projections really did not incorporate these risks

• Best way to include these considerations is by trimming

projections