This session will provide an introduction to the leveraged buyout industry and begin to provide some insights as to how an LBO analysis is used as a valuation tool. Since its emergence in the M&A world in the 1980s, leveraged buyouts, also known as LBOs, have become an increasingly large part of the transaction market. The basic definition of an LBO is the change of control transaction, meaning more than 50 percent of the ownership changes hands that is led by a financial sponsor, typically a private equity firm or a hedge fund, and involves a significant amount of debt, also known as leverage, as a source of capital to complete the deal. The percentage of debt that is typically involved in an LBO is 60-70 percent of the capital employed to close the deal, with the remainder in the form of some sort of equity. The financial sponsors that lead the LBOs seek to earn higher than weighted average cost of capital returns on their investments, generally in the high teens or low 20 percent range. They are able to achieve such significant returns through the use of leverage and also through their efforts to acquire private companies at attractive prices and then help them grow and improve their profitability over their holding period, typically 3-7 years. By undertaking a process similar to building out a discounted cash flow analysis, we can assess what a financial sponsor can pay for a business and still earn their required rate of return. That is why we consider the LBO analysis to be an important valuation reference point when completing a company valuation. This valuation is typically considered to be a floor or a lower-end valuation as the required rates of return are higher than what we would see in a DCF analysis and the private equity firm is not able to extract synergies post acquisition. There's no incremental amount of purchase price attributed to that as we would expect in a precedent transaction analysis review. This graphic illustrates the size of the US LBO loan market over the last several years, which is a good proxy for the overall size of the market for LBOs. As you can see, this market is enormous; billions of dollars in size and hundreds of transactions. The size of this market varies year-to-year with the overall M&A market and is also affected by the availability and cost of debt that is used to finance these transactions. The key participants in an LBO transaction include, number one, the financial sponsor. Again, this is typically a private equity firm but could also be a hedge fund, a family office, or what is known as a special purpose acquisition corporation or a SPAC. Number two, the provider of the debt financing required to complete the LBO. This could be a traditional commercial bank, a specialized lender that focuses only on leveraged lending, or an institutional investor like an insurance company, pension plan, or hedge fund that invests in high yield bonds that are used to finance the LBO transaction. Number three, company management. The executive team that is running the company that is going through the LBO is a very important part of the equation. Oftentimes, the executive team invests in the transaction to what is known as a rollover of their existing equity interests. Also, they are usually granted new options by the financial sponsors to provide them an incentive to continue to grow the value of the equity. Most importantly, this is the team that the financial sponsor is betting on to help the company continue to succeed. Number four, investment bankers. Investment banking firms can play a number of roles in an LBO. They generally are involved with helping the financial sponsor to arrange the debt financing and can also be an M&A advisor to the financial sponsor or the company that is the subject of the LBO. In any given LBO transaction, there could be more than one investment bank involved in the transaction. As LBO stands for leveraged buyout, the involvement of debt in the transaction is an essential one. The balancing act for a financial sponsor that is leading an LBO is to get as much low-cost debt as possible without putting the company at risk in the event that financial projections and debt covenants are not met. Financial sponsors will seek a variety of debt capital to optimize this risk-reward equation. Generally, the starting point is to see how much senior debt you can raise as part of the LBO transaction, since this debt has the lowest interest rate. This can be provided by a commercial bank or a non-bank lender, which is an institution that operates like a bank on the lending side, but does not take customer deposits. In addition to senior debt, most LBOs are also financed by what is known as junior debt because it sits below senior debt in terms of liquidation priority. That means that if the company did not perform well and needed it to be liquidated, the senior debt providers will get the first amount of liquidity then the junior debt providers, then the equity providers. That is why junior debt instruments like subordinated debt and mezzanine debt carry with it a higher interest rate and oftentimes have equity like features. By this I mean that sometimes the company being financed will issue warrants, usually a few percentage points of the amount loaned to purchase equity in the business at a specific price. Oftentimes at a penny at a certain time in the future. This serves to increase the return to the debt holder if the company is successful down the road. After all the senior debt and junior debt has been arranged, equity will be the final part of the LBO financing equation. This could be a combination of common equity or preferred equity. Although if it is provided by a financial sponsor, it's typically in the form of preferred equity, as the sponsor will expect to have priority to the common shareholders, usually management and earlier stage investors. Once the deal is financed and closed, the financial sponsor and the company's management team will work together to grow the business and make it more profitable. Over time as the company generates cash, it will pay down the debt and the value of the company will grow. As these two things happen, the value of the equity holdings can grow significantly. The best way to understand what I refer to as LBO math is to look at an example. In this situation, a company with $100 million of EBITDA completes an LBO transaction at a $1 billion valuation, which is referred to as a Tenex EBITDA multiple. The financial sponsor finances that transaction through 70 percent debt and 30 percent equity. This is on the lower end of the equity scale, but certainly in the range. Each year, the company generates $50 million of free cashflow and uses that to pay down the debt balance. At the same time, the company's EBITDA is growing at 10 percent per year rate, and market valuation stay constant at that Tenex EBITDA valuation multiple. At the end of 2024, year 5, the company's enterprise value is $1.611 billion, or 10 times EBITDA of 161 million. Assuming the company is sold for 100 percent cash, the first 450 million will pay down the remaining amount of outstanding debt and the rest will go to the equity holders. This results in equity proceeds of 1.16 billion on an initial investment of $300 million. Pretty impressive. As we explored just a second ago, returns are driven by increasing EBITDA, the ability to pay down debt over the holding period of the investment, and high exit values. Companies that generally fit this profile are market leaders in predictable and growing industries generate significant operating cashflow and have low working capital and capital expenditure requirements. These companies are operated by strong management teams that drive their continued steady growth. Beyond strong company growth and performance over the investment holding period. The key factors that drive annual equity investor returns also known as IRR, is the ability to borrow money at a lower interest rate, have more of the purchase price comprised of debt, and a phenomenon called multiple arbitrage. This last point is a fancy way of saying buy low and sell high. For example, if you buy a business and a multiple of seven times the last 12 months EBITDA and are able to exit it a few years later for Tenex. That then trailing 12 months EBITDA, the profit on the transaction is affected not only by the growth in the EBITDA, but also by an increase in the multiple at which the company is valued. Most private equity firms seek to gain liquidity on their LBO investments after a three to seven-year holding period. Although this is not set in stone and can be shorter or longer. It's important to note the difference between exit, and monetization. Exit refers to a transaction that results in the private equity firm getting fully out or close to fully out of an investment. Monetization, on the other hand, refers to a transaction that results in the private equity firm receiving consideration in a liquidity transaction. It could result in them selling all, some, or none of their investment in the portfolio company. Let's explore all of these in turn. Typical exit strategies that private equity firms pursue are sales of the entire company through an initial public offering of the company's common stock or by completing what's known as a dividend recapitalization. A sales strategy is the most typical exit. As these transactions are much more common and result in the private equity firm receiving the lion's share of their proceeds at the time of the sale. The buyers in these types of transactions could either be another private equity firm or a strategic buyer. Historically, sellers would prefer to sell their business to a strategic buyer, because they should theoretically be able to pay more due to the presence of synergies, and a lower cost of capital. However, over the last several years, we have seen financial buyers be increasingly aggressive as they seek to add strong companies to their fund portfolios, and the presence of plentiful low-cost debt has enabled them to pay prices that are competitive with, and sometimes superior to strategic buyers. Another primary monetization strategy is to execute an initial public offering of common stock, also referred to as an IPO. An IPO you are taking the company public, which means that the company stock will be listed on a major stock exchange. In the US, this is typically the NYSD or Nasdaq. This provides a liquid market for the company to raise capital, creates an opportunity for more investors to own your shares, and creates an avenue for the private equity firm, and other private investors to sell their shares on the open market. In an IPO, the company will typically offer new or what is known as primary shares to the public, and will also provide existing shareholders the opportunity to sell a minority of their holdings in the IPO. This allows the private shareholders to get partial liquidity at the time of the IPO but does not provide a full exit. The full exit can happen in follow on public offerings, and an open market sales. But the entire exit process will generally take at least 18 to 24 months. This is one of the major drawbacks for the IPOs, and exit strategy, and must be weighed against the value differential between an IPO, and a sale. The final primary monetization strategy is what is known as a dividend recapitalization. This strategy requires that the company has increased its level of debt capacity than what was originally available at the time of the LBO. Generally, because the company has increased its earnings. In this process, the company taps this incremental debt capacity to issue more debt, and use the proceeds to pay shareholders a one-time cash dividend. The benefits of this strategy is that the company's equity holders are able to get some liquidity on their investments while maintaining their full ownership of the company. However, to the extent that the company's performance declines after the dividend recapitalization, there's a greater chance that it defaults on its debt obligations, and the creditors take over the company. This is the risk-reward equation that must be studied carefully before deciding to embark on this strategy. It is important to note that none of these strategies are mutually exclusive, it is quite common for a private equity firm to complete a dividend recapitalization a few years into a holding period, and then complete an IPO or a sale after a couple of more years, or a company could choose to do an IPO, gains some liquidity, and then choose to pursue a sale at a later time.
