Chapter 5: How Much and Who’s Paying For It?
This chapter is concerned with those stages in the analysis where we work out how much a buyout will cost (uses of funds), where the money to pay for this might come from (sources of funds and leverage), and gauging whether a deal offers good value or not. This example is explained from a practitioner’s point of view, using MS Excel – just as it would be created in a professional setting. Templates and example models can be found atwww.fin-models.com.
Uses of Funds
Price
We begin our analysis by entering the ABC Company’s current stock price of $25.00 in cell (F17).
In order to entice the current shareholders of ABC Co. to sell the stock, we assume that there is a transaction premium of 20% (F18) that will be paid.
The rationale here is simple: as the current stock owner you will sell the stock if you think the premium price is above what the stock is really worth. If you think the stock is worth more than what is being offered and for whatever reason it is not being reflected in the market (plus premium) price, you would not accept the offer.
The objective of the would-be purchaser of the stock is to purchase the equity at a price that is less than what the company will later be sold for post restructuring. We can make it more complicated than that, but there’s no need to here.
It is worth mentioning that herein lies the danger of bidding wars. When two separate would-be purchasers of a stock emerge and attempt to outbid each other, each time increasing the price of their offers, each increased bid decreases any future returns and increases any future losses! This is the reason that purchasers must perform rigorous analysis prior to any bids being submitted for consideration.
Our acquisition stock price of $30.00 (F19) can be determined by multiplying the current stock price (F18) by (1+F19), the transaction premium.
Sources and uses of cash
Number of shares
The next item that we should bring into our model is the number of shares outstanding. This number can be found in the company’s 10-K or annual report.
This is a good time to mention the concept of fully diluted shares outstanding. Fully diluted shares outstanding is the number of common shares that would be outstanding if all instruments that can be converted to common equity, such as options, were converted. Fully diluted number of shares is calculated via the Treasury Method, which adds new shares from converted options, less any shares that are assumed to be purchased back by the company in the open market using the proceeds from the converted options. The notion of fully diluted shares outstanding is important because it is the number that any analyst will most likely consider when conducting a valuation analysis on a per-share basis.
For the purposes of this discussion we are solely concerned with the fundamentals of LBO analysis and therefore will not muddy the waters with convertible instruments in this discussion. Instead we will assume that the number of shares outstanding, found in the annual report, is 540,000,000 and there are no equity options or other convertibles securities outstanding.
Let’s take inventory of what we know so far. We know:
- the current stock price
- the premium that we are willing to pay (and hence acquisition price per share)
- the total number of shares outstanding.
Acquisition equity
Now that we know these items, we can figure out how much money is going to be required to purchase the equity of the company. The purchase of the company’s equity will be a major use of funds in the leveraged buyout of the company. In our example, we will refer to this item as acquisition equity (F6). To calculate acquisition equity you multiple the acquisition stock price by the number of shares outstanding.
Net debt
The other major use of funds to consider in your LBO analysis is the purchase of the target company’s net debt (F7). In our example, the net debt is the sum of short-term debt ($50 million) + current portion of long-term debt ($500 million) + long-term debt ($3,960 million) - the cash on the company’s balance sheet ($5,000 million). All of these figures can be found on the target company’s latest balance sheet.
Note: In your calculation of net debt to be refinanced (F7), do not subtract the entire cash balance from total debt outstanding unless you want to have zero cash on the books post-transaction. Instead, decide on the amount of cash you wish the company to carry on its books post-LBO and use that number to decrease your cash component in the calculation of net debt to be refinanced. In our example model, we have assumed a cash figure of $500 million.
Net debt calculation
Transaction costs
The final item that we will consider in our example as a use of funds will be the transaction costs. This cost will include the fees that are paid to the attorneys, advisors, brokers and all other parties that are involved in some way with the transaction.
For our purposes, we will assume that the total costs associated with completing the transaction are $100 million. However, you could approximate these costs by gathering information on previous comparable transactions that were done to get some idea of what it would cost to complete the transaction and then make a reasonable assumption based on the research that was conducted.
Total use of funds
If we sum all the uses of funds that we laid out for the contemplated transaction we see that the leveraged buyout will require approximately $16 billion (F9) to be completed. This figure is the sum of the acquisition equity, the company’s current equity stake plus premium, the net debt to be refinanced, and the total transaction costs. These items combined give us the LBO’s total use of funds.
Sources of Funds
We just figured out how we are going to spend the money – now we need to figure out how we are going to get the money! This is after all an LBO, so why don’t we discuss how we are going to finance the transaction? Another way of saying this is sources of funds.
“Different sources charge different prices for their funds – it comes down to ‘seniority’.”
As you may have guessed, sources of funds are made up of the various types of capital used to complete the transaction. We will also see that different types of source charge varying prices for the use of their capital. This is is largely dependent upon how high or low a source sits in the totem pole of credit seniority.
For the purposes of simplicity and focusing on the fundamentals of how to conduct LBO analysis, let’s assume that the total amount of equity capital that the equity investors are willing to put at risk in this deal is $4,500 million. This number was derived based on the risk appetite of the equity investors and careful consideration of a sensitivity analysis, which we will take a look at later in this book.
Leveraging Up
So far we have determined 1) How much money the transaction is going to cost to complete (F9); and 2) How much equity we are willing to put into the deal (E12). The gap that exists between those two numbers is the amount of someone else’s money that we are going to use to complete the transaction. In other words, we are going to borrow the difference between the total use of funds and the equity source of funds in order to bridge the gap between the money that we have and the money that we need to purchase the target company.
As you may have noticed, when we take a look at our sources of funds, the debt portion is more than double the amount of equity that is being used in the deal. This heavy reliance on debt financing or leverage to acquire the target is the meaning behind the name leveraged buyout.
Transaction Enterprise Value – Measuring Value
Transaction enterprise value (TEV) is the sum of the acquisition equity, which we already calculated in cell (F6), and the existing net debt refinanced (F7). TEV can be thought of as the amount of money that is required purely for the leveraged buyout of the business, without taking into consideration the cost of doing the transaction (i.e. attorneys’ fees, bankers’ fees, etc.). In our example, if we add the acquisition value and the existing net debt refinanced, this gives us a TEV of $16,210 million (F22).
A similar example outside of the LBO world would be the purchase of a house. The amount of money required to purchase a house is not only the price of the house, but also includes closing fees, which are subject to negotiation.
Why do we care about transaction enterprise value? As a standalone number, TEV does not tell us much regarding whether or not the price of the buyout is of good value. In fact, about the only thing that we can determine from this number is whether or not the price is within or out of reach, depending on the financing resources we believe to be available.
In order to better understand the relative value concerning the contemplated transaction we will look at the transaction enterprise value as a multiple of revenue and of EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization. By multiples we mean how many times greater is the TEV than the company’s revenues or EBITDA, as the case may be?
“Why do we care about ‘TEV’? It tells us whether the price of the LBO is within our reach.”
At this point revenue should be a fairly straightforward concept. It is the first line of the income statement, sometimes generically referred to as ‘the top line’ in casual conversation. You may, for example, hear a research analyst on television say, “We expect earnings to be good, but anticipate they will miss on the top line.” Translation: based on our research, we expect the company to have positive net income, perhaps above expectations previously given by the company’s management team, but we do not expect the company’s revenues to meet those same expectations. A statement like this would imply some form of cost cutting is going on at the firm that would mathematically allow it to have lower revenues, but still realize higher net income.
A simplified net income equation explains that if our revenues are lower, but our net income is higher, we must have reduced our costs and/or taxes in order for such a scenario to be possible:
revenues - expenses - tax = net income
EBITDA is sometimes referred to as a proxy for cash flow. What this means is that EBITDA should provide a reasonable sense of the earnings generated by the operations of the firm. This is important because it provides a good indication of how well the company generates earnings for its owners.
For example, if you are the owner of a popular ice cream shop in town and at the end of the summer you take a look at your financial records to see how well you did – are you more interested in your earnings before or after expensing the depreciation on your soft serve machines? Of course, you are more concerned with the earnings before depreciation!
You may be wondering why this is. The reason for this is because, as the owner of the ice cream shop, you do not send money each month to ACME Depreciation Co. as you do to your dairy suppliers and the utility company. Instead, the depreciation figure becomes important when it is time to consider tax because depreciation can affect taxable income – and this is something every shop owner is concerned with!