LBO is like buying a home:
you go to the bank
you take out a mortgage (= debt)
you put in a little equity over time
and then you sell your house few years later
but when you sell your house you've paid down the debt
you sell your house you take those proceeds
you pay off the remaining balance of the debt if there is any and then you get to keep the rest
Current date: purchase company XYZ on the last day of 2012
Market cap: $30 x 500 million = $15B (Share price x Shares)
Current net debt = $600M - $100M = $500M (Debt - Cash)
Enterprise value: $15B + $500M = $15.5B (Mkt cap + Net debt)
EV/ EBITDA multiple: $15.5B/ $2.4B = 6.5x (EV/ LTM EBITDA)
Exit (sell off) date: typically 3 to 7 years holding period for most financial sponsors (ex. last date of 2016)
LBO Debt capacity (Net debt/ EBITDA): How much debt can we borrow, also known as a leverage ratio.
This is based on current debt market conditions. We want to borrow as much debt as possible, not so much that we put the company into financial distress. This debt ratio change over time but for this example we assume 6x EBITDA.
Minimum cash balance: must maintain on hand just in case of a rainy day.
EBITDA multiple in exit year = EBITDA multiple in current year = 6.5x (we'll sell the company for 6.5x EBITDA, same that we can buy the company for).
Financial sponsor required equity return: based on the riskiness of this transaction we (the financial sponsor) must earn 25% every year over our holding period. This is our internal rate of return (IRR). It's high because of the higher risk of this transaction when we're borrowing a bunch of debt.
Revenue: Revenue(t=-1) x (1 + growth rate%)
EBITDA Margin: Revenue x EBITDA Margin %
FCF Margin%: FCF after required debt paydown / Revenue
LBO Debt, beginning of period: 6x $2.4B (LBO Debt capacity x LTM EBITDA).
Company can generate $2.4B in EBITDA and we could borrow 6 times that amount.
Optional paydown (after min cash balance): $528M + $100M - $50M = $578M (FCF after required debt paydown + Cash - Min cash bal)
The excess cash can be used to pay down debt. The quicker we pay down debt, the greater our returns will be when we exit the business and realise the profits.
Ending balance
To calculate "debt" add the "LBO debt".
Cash: Beginning cash + Cash generated through the year (FCF after required debt paydown) - Cash being used during the year (Optional paydown)
Questions
1. What is the implied EV in the exit year (in 4 years)?
EBITDA multiple in exit year x Projected EBIT in exit year = 6.5X x $3.51B = $22.69B
2. What is the implied Equity Value at the exit year? (left over amount for financial sponsor after paying down debt)
EV - Projected net debt in exit year = $22.69B - $7.85B = $14.84B
3. What is the maximum amount financial sponsors can invest in this company?
Equity value / (1 + IRR)^exit year = $14.84B / (1+25%)^4 = $6.08B
4. How much do sponsors have to acquire this company and pay off its debt?
Equity from financial sponsor + LBO Debt = $6.08B + $14.4B = $20.48B (nearly EV)
5, What is the highest purchase price the sponsors would be willing to pay for XYZ shares today?
(Question 4 - Current Net Debt)/ Shares outstanding = ($20.48B - $500M)/500 = $39.96
3 Given XYZ's market trading level, is an LBO likely?
Control premium: Highest purchase price / Current share price = $39.96/ $30.00 - 1 = 33%
Possible LBO candidate.
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