How Private Equities Create Value. LBOs, Expansion deals and the future of PEs - Trends
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1 How Private Equities Create Value LBOs, Expansion deals and the future of PEs - Trends 1
2 Contents - Introduction to Value Creation in PEs - LBOs - Operating Leverage - Financial Leverage - Recent trends and statistics - Expansion Deals - Conclusion 2
3 Contents - Introduction to Value Creation in PEs - LBOs - Operating Leverage - Financial Leverage - Recent trends and statistics - Expansion Deals - Conclusion 3
4 PEs- Family of Drivers Normal Returns The expected return should the sum of a risk-adjusted return (the T.IRR) and an expected abnormal return. In other words, the expected return (E.IRR as an output of a business plan) should be equal or superior to the T.IRR. If the E.IRR is superior to the T.IRR then the excess return is an abnormal return E.IRR = Risk-Adjusted Return + Abnormal Return E.IRR = T.IRR + Jensen s alpha Abnormal Returns 1 Factors that are governed by the traditional finance theory and the CAPM. (CAPM) 2 Factors that are not governed by the traditional finance theory but are rational. (RF) 3 Factors that are not rational but behavioural (IR) 4
5 How Do PE Firms Add-Value? The right private equity partnership provides capital and/or other resources to help address a variety of common growth and business transition challenges. Growth Capital Capital to support expansion initiatives employee hires, working capital, capital investment Knowledge Capital Experience executing key strategic initiatives system integration, geographic expansion, capital decisions Management Depth / Transition Access to management resources required to support next stage of growth Balance Sheet and Financing Solutions Strengthen balance sheet to add stability to operations. Relationships with finance sources Industry Experience & Relationships Macro level industry knowledge access/relationships with key target customers or markets 5
6 HOW PEs Add Value? Other Drivers Acquisitions Cost Cutting / Deleveraging Maximize leverage (only in the case of LBOs) Minimize liabilities purchased Manage transaction costs Improve business operations Maximize tax efficiency Gains in inefficiency Consequences Organic EBITDA growth (Expansion Deals) Optimize exit: Multiple Expansion New Agency Theory 6
7 Minimize Purchase Price Avoid competition Auction process vs. proprietary deal Maintain price discipline Avoid deal fever Look for a niche Where the others don t go Develop a specialization
8 Maximize Leverage (only for LBOs) Maintain competitive process among banks willing to fund the transaction Choose right financing structure Balance of risk, flexibility and interest cost Look at the interest coverage (EBIT / Interests)
9 Minimize Liabilities Purchased Detailed due diligence Legal Financial Accounting Environmental Tough negotiations Warranties
10 Transaction Costs and Taxation Minimize transaction costs Internal costs Aborted deal costs Maximize tax efficiency Increase interest tax shield Increase depreciation Increase tax deductible amortization
11 Improve Business Operations Top line growth New markets, partners Products Good management Margin improvement COGS (cost of goods sold) SG&A (selling, general and administrative expenses)
12 Exit Difficult to predict future business cycles and market conditions Prepare an exit strategy and groom the business for that exit Trade sale or M&A clean cash exit IPO long process, company needs to be above a certain size, lock-up restrictions Secondary buyout selling to another sponsor
13 Contents - Introduction to Value Creation in PEs - LBOs - Operating Leverage - Financial Leverage - Recent trends and statistics - Expansion Deals - Conclusion 13
14 Leveraged Buyouts The purchased company's balance sheet is leveraged to reduce the investor's cash commitment. The LBO firm will seek to exit their investment within 3-6 years Exit strategies are principally M&A sales or IPOs Targeted IRRs are >20% Here are the main characteristics: Motivated and competent management Robust and stable cash flow (Cash Cows) Leveragable balance sheet Low capital expenditures Asset sales and cost cutting Quality assets Low operative, specific and unsystematic risks Low operative leverage 14
15 Impact of Leverage on Returns Firm U Firm L EBIT $3,000 $3,000 Interest 0 1,200 EBT $3,000 $1,800 Taxes (40%) 1, NI $1,800 $1,080 ROIC 9.0% 9.0% ROE (NI/Equity) 9.0% 10.8% 15
16 Pay Down Debt During Holding Period LTM = Last 12 months LBO Objective: Pay Down Debt During Holding Period Initial: Acquired for 8.0x LTM EBITDA of $125.0 Future: Sold for 8.0x LTM EBITDA of $137.5 $1,000 Initial Future $1,100 $350 Equity Equity $725 $650 Debt Debt $375 Source: Training the Street, Inc. 16
17 Creating High IRR From Investment LBO: Three Ways to Create Returns Assume the Target company was acquired for 8.0x LTM EBITDA of $125.0 Sources of Funds 1. Deleveraging 2. Deleverage & Improve Margins 3. Deleverage, Improve Margins & Multiple Expansion Total Debt $650.0 $650.0 $650.0 Total Equity Total $1,000.0 $1,000.0 $1,000.0 Year 5 Assumptions Cumulative Excess Cash to Repay Debt $167.6 $212.3 $212.3 Projected EBITDA Assumed Exit Multiple 8.0x 8.0x 9.0x Transaction Value 1, , , /- Net Debt 1 (482.4) (437.7) (437.7) Equity Value $517.6 $878.2 $1,042.8 IRR Returns (5-YrExit) 8.1% 20.2% 24.4% Note 1: Total Debt - Cumulative Excess Cash to Repay Debt = Net Debt Source: Training the Street, Inc. 17
18 Contents - Introduction to Value Creation in PEs - LBOs - Operating Leverage - Financial Leverage - Recent trends and statistics - Expansion Deals - Conclusion 18
19 What is operating leverage, and how does it affect a firm s business risk? OL is defined as (%change in EBIT)/(%change in sales). Operating leverage is high if the production requires higher fixed costs and low variable costs. The degree of operating leverage (DOL) measures the sensitivity of changes in EBIT to changes in Sales.
20 Effect of operating leverage More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. $ Rev. TC FC $ Rev. } Profit TotalCost FC Q BE Sales Q BE Sales
21 Using operating leverage Probability Low operating leverage High operating leverage EBIT L EBIT H Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.
22 Contents - Introduction to Value Creation in PEs - LBOs - Operating Leverage - Financial Leverage - Recent trends and statistics - Expansion Deals - Conclusion 22
23 Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk Expected EPS (Earnings x share) or ROE and Coefficient of Variation of EPS or ROE
24 Capital Structure Theory: Probability of Bankruptcy Financial Risk
25 MM relationship between Wacc and debt when corporate taxes are considered. Wacc TD Wacc U Wacc L 0 Debt With corporate taxes, the firm s Wacc decreases continuously as more and more debt is used. 25
26 Tax Shield vs. Cost of Financial Distress Wacc Distress Costs Wacc L Optimal Capital Structure Wacc U 0 Tax Shield (Wacc) Debt 26
27 Contents - Introduction to Value Creation in PEs - LBOs - Operating Leverage - Financial Leverage - Recent trends and statistics - Expansion Deals - Conclusion 27
28 Changing Cost of Debt Private Equity Deals Post-Credit Crisis: More Expensive Debt Average Spread of Leverage Buyout Loans (bps over LIBOR) Credit Crisis H Source: Standard & Poor s
29 Recent Investment Situation in EU
30 Amount Raised per type of fund
31 Capital Invested 31
32 Bigger Companies for LBOs 32
33 Current LBO situation in USA 33
34 Investment x Land and GDP 34
35 Big Investments 35
36 The IRR
37 Contents - Introduction to Value Creation in PEs - LBOs - Operating Leverage - Financial Leverage - Recent trends and statistics - Expansion Deals - Conclusion 37
38 Expansion Deal conditions Company high growth potential Innovative products Business expertise (better for specialized funds) Good Management Acquisitions to generate synergies High EBITDA Long term investment (longer than LBOs) (5-7 years) Targeted IRR 25% 38
39 Example of Expansion Deal Year IRR acquisition price and cash flow 45% acquisition price and cash flow 49% acquisition price and cash flow 56% acquisition price and cash flow 66% Wacc 16% Multiple 8,28 10 Exit Value
40 Contents - Introduction to Value Creation in PEs - LBOs - Operating Leverage - Financial Leverage - Recent trends and statistics - Expansion Deals - Conclusion 40
41 What the credit crunch means for private equity Problems arose in higher risk credit markets causing a serious mispricing of risk. Risk Repricing Credit spreads widening Significant amount of loans to be repaid in the short term causing financial distress Fewer buyouts (particularly the larger ones and no money available) Further corporate activity could be stopped until debt is cleared Refinancings limited and exits may take longer than recent times Secondary buyouts limited 41
42 LBOs at extinsion?? The trend The Present Companies are too leveraged Cost of debt too high Financial Crisis High illiquidity risk Value creation is arguable Too many LBOs, Too many competitors, few firms with the right characteristic left. The Future -Expansiton Deals -High growth potential deal: High Tech sector -More equity and less debt -Specialization -More know how in the sector -Managers and GPs with a more industrial profile -Synergies 42
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