Hi everyone, I m an avid reader of the forum though I dont have many posts to my credit. I cleared level 1 in this June and have started going through the level 2 material. i seek some clarification on the following, how does a LBO transaction add value to the company being bought if it does. My understanding is that the PE firm borrows huge amount of debt to pay off the existing shareholders, and the interest on this debt is serviced out of the cashflows of the bought out firm. This being the case the bought out firm does not get the additional debt but is taking additional burden of servicing the interest and the principal upon maturity. Is my understanding correct. If not please explain. Thanks in advance
the exit multiple after the debt has been paid down is usually higher than the EBITDA multiple the LBO sponsor first paid. what happens is the company will typically get starved, heads will roll, a higher EBITDA margin will ensue, and assuming multiple expansion, you get a nice IRR 5 years out. the debt is just there so that sponsors put in less and magnify returns. also, debt forces managers to focus on the long term cash flow generation of the business, which is easier when you are private and not prone to short term EPS targets.
^ Usual BS, even done in convincing consultant speak. There are some good reasons for LBO’s and it isn’t hard to find situations in which companies were poorly managed so the LBO created value. In general, I think LBO’s get people involved in businesses they don’t know, with the immediate need to generate cash flow to service excessive debt. Then, of course, lots of people will tell you there is something good about that. Maybe they should all go borrow a bunch of money to buy a Cessna that they can’t fly just to give them more motivation to do well at work.
Joey, I’m for the most part a fan of your posts but was wondering what is driving your thoughts on the evilness of LBOs? If daj is reeling out the “usual BS”, you appear to come across as the usual “down with the asset strippers” anti PE guy.
“you appear to come across as the usual “down with the asset strippers” anti PE guy.” Guilty as charged.
The above responses dont capture the meaning of the LBO. The private equity firms that do LBO’s are interested in increasing the value of their equity investment. As a simple example, say a PE firm buys a company for an Enterprise Value of $150 mm with $100 mm of debt and $50 mm of equity. Over the next five years, the company goes on to pay down some of that debt and at the end of the five years, the company now has only $50 mm of debt, but it is still valued at $150 mm (value is based on EBITDA multiple), meaning the equity is now worth $100 mm. So, over 5 years, without a change in the value of your company, the PE firm’s equity investment of $50 mm is now worth $100 mm. If the company increases its EBITDA over those five years or if the PE firm can sell at a higher EBITDA multiple than it purchased the company at, the investment will also increase in value. But the main source of value behind most LBO’s is the increased equity value created by paying down debt and hence changing the capital structure of the firm.
JoeyDVivre Wrote: ------------------------------------------------------- > ^ Usual BS, even done in convincing consultant > speak. > dont try to sound like a contrarian just cuz its fashionable. you are only jealous b/c i answered the question first, kemosabe. admit it, doggy!
InfiniteMav Wrote: ------------------------------------------------------- > The above responses dont capture the meaning of > the LBO. The private equity firms that do LBO’s > are interested in increasing the value of their > equity investment. > > As a simple example, say a PE firm buys a company > for an Enterprise Value of $150 mm with $100 mm of > debt and $50 mm of equity. Over the next five > years, the company goes on to pay down some of > that debt and at the end of the five years, the > company now has only $50 mm of debt, but it is > still valued at $150 mm (value is based on EBITDA > multiple), meaning the equity is now worth $100 > mm. So, over 5 years, without a change in the > value of your company, the PE firm’s equity > investment of $50 mm is now worth $100 mm. > > If the company increases its EBITDA over those > five years or if the PE firm can sell at a higher > EBITDA multiple than it purchased the company at, > the investment will also increase in value. But > the main source of value behind most LBO’s is the > increased equity value created by paying down debt > and hence changing the capital structure of the > firm. that is exatly what i said but in half as many words.
Daj you are good!
> that is exatly what i said but in half as many words. Except that your answer, while in some parts accurate, isnt really correct. No LBO firm plans to make its money by expecting a higher multiple at the end of the 5 years. They may HOPE to have a higher exit multiple, but the value is created, and the LBO is undertaken, because of the possibility of changing the capital structure.
InfiniteMav Wrote: ------------------------------------------------------- > > > Except that your answer, while in some parts > accurate, isnt really correct. No LBO firm plans > to make its money by expecting a higher multiple > at the end of the 5 years. They may HOPE to have a > higher exit multiple, hence i wrote “assuming multiple expansion” ASSUMING. i never said it was set in stone…but look at PE deals over the last 3 years. these dudes have been selling firms to each other @ higher multiples!!! overall, we all answered the question well. the og poster can now relax and go sip a beer, cuz that is exactly what imma gonna do.
daj224 Wrote: ------------------------------------------------------- > InfiniteMav Wrote: > -------------------------------------------------- > ----- > > > > > > Except that your answer, while in some parts > > accurate, isnt really correct. No LBO firm > plans > > to make its money by expecting a higher > multiple > > at the end of the 5 years. They may HOPE to have > a > > higher exit multiple, > > hence i wrote “assuming multiple expansion” > ASSUMING. i never said it was set in stone…but > look at PE deals over the last 3 years. these > dudes have been selling firms to each other @ > higher multiples!!! overall, we all answered the > question well. the og poster can now relax and go > sip a beer, cuz that is exactly what imma gonna > do. lemme guess… Natty Light?
and no sipping… rather, CRUSHING, JUST CRUSHING the natty lights. lol. sorry, man. it doesn’t get old.
Having my beers… watching Rudy kick some butt over here…
I think the incentive structure for managers of typical widely held firms encourages a bias towards safety: managers value their income/bonuses, and have small enough equity stakes that they don’t receive much of the upside. In addition, they have the reporting problems and need to hit quarterly targets. So, many of them end up acting more like bureaucrats than like entrepreneurs. In an LBO, however, you typically have managers who are much more comfortale with risk (sometimes too comfortable, but that’s another discussion), and have (by definition) much higher equity stakes. So, they lever up, restructure the right hand side of the balance sheet, and strip operations down to the point where they’re in a high-risk, high return profile. Since they have much higher equity stakes (both as a percentage of total firm equity and as a percentage of their total wealth), they get to keep more of the value created. I think that the financial restructuring model worked in the cheap debt world of recent years (just like real estate flippers made money up until a few years ago). But now, the easier money’s played out. So the LBO shops with operational expertise will continue to make money (dealing with the poorly managed firms mentioned by Joey), but the strictly RHS restructuring shops won’t.
Its amazing to see so many posts each one trying to outsmart the other. the concept of LBO is much clearer now thanks to infinitemav, daj and all others… Thanks, Sudeep
sudeep.ellath Wrote: ------------------------------------------------------- > Its amazing to see so many posts each one trying > to outsmart the other. the concept of LBO is much > clearer now thanks to infinitemav, daj and all > others… > > Thanks, > Sudeep that is how we roll, dog.
mpoonan = sock puppet.
Without trying to “outsmart” my colleagues, I will add a little history to the discussion… As Wasserstein wrote in his book (a few years back) there has been a few stages in the LBO history. In a nutshell, the story began as a pure capital structure change. As we all know debt is cheaper than equity. The target company had to be stable and predictable. InfiniteMav’s example works well here… With a few stages since (with minute differences), we are now talking about a different beast. The low hanging fruit is gone, and PE guys are usually looking for companies with some (or all) of the following criterias: can be loaded up with debt, can be broken up into pieces to unlock value, are poorly run, an underutilized brandname, etc. Bell Canada was just bought out at a p-e ratio of about 100. A pure capital structure change cannot turn this deal into a success story. The market will maybe pay 20 times earnings, which means that managment must now quintuble net income in order to break even…