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Defining the alternative-investment industry is a challenging task, mostly because of the overlapping structure of the main types of alternative investments, but
INTRODUCTION
also for definitional differences across countries. First it is worth separating the industry into two groups: i) private equity and ii) hedge funds.
PRIVATE EQUITY
A rather broad definition of private equity might sounds like this: “a professionally managed pool of money raised for the sole purpose of making actively-managed direct equity
investments in private companies and with a well defined exit strategy (sale or IPO)”.
Within the private equity industry it is possible to further classify three main areas: i) venture capital, ii) buyout, and ii) distress.
The key feature defining VC is excepted rapid “internal growth” of the backed companies: that is proceeds are used to build new business, not to acquire existing
business. As a simple classification the VC industry can be broken down into: early-stage, ii) expansion-stage, and iii) late-stage.
Seed – A small amount of capital provided to prove a concept and to qualify for start-up financing.
Early
Start-up – Completing development, market studies, assembling key management, developing a business plan. Ready to conduct business.
VENTURE
Expansion Fixed and working capital financing, marketing. It may or may not be showing a profit.
CAPITAL (VC)
Late Fairly stable growth is reached. Again, it may or may not be profitable, but the likelihood of profit is higher than in previous stages.
!!! – Truly early stage investment are generally financed by angels (they uses their own money) rather than VC (less than 2% of VC investments).
!!! – In late-stage financing is included the “bridge” financing: this stage is needed at times when the firm plans to go public within six months to a year.
Buyout investing is the largest category of private equity in term of funds under management. Buyout investors pursue a variety of strategies, but the key
feature is that they almost always take the majority of their companies. In contrast VCs usually take minority stakes. In large buyouts of public companies (such
as the purchase of RJR Nabisco by KKR in 1989) investors usually put up an equity stake and borrow the rest form banks and public markets, hence the term
BUYOUT leveraged buyouts (LBO). Most buyouts firms are engaged in purchasing “middle-market” firms.
!!! - Usually buyout firms have stable cash flows and limited potential for internal growth, although this is not always true.
!!! - A related strategy is “buy-and-build”, where a buyout investor acquires a series of firms in a fragmented industry.
DISTRESS Distress investors focus on troubled companies. Because many distress investments are buyouts, this category intersects with the previous one.
HEDGE FUNDS
Hedge funds (HF) are flexible investing vehicles that share many characteristics of private equity funds. The main difference is that hedge funds tend to invest in public securities.
Moreover, in contrast to other pooled investment vehicles, hedge funds make extensive use of short-selling, leverage, and derivatives.
Hedge funds are usually classified according to their investment style. It is possible to group strategies into four major sets.
Directional Market neutral Event-driven Multiple
Long/Short Equity
Fixed income arbitrage Risk (Merger) arbitrage
Dedicated short bias
Convertible arbitrage Distress
Global macro
Equity market neutral Regulation D
Emerging markets Funds of funds
Managed futures Multiple strategies
!!! - These are also known as “arbitrage” or “relative !!! - These are also known as “special situations”. Profit
value” funds. They search for arbitrage to exploit opportunities arise from special occasions in firm’s life, such as
!!! - They try to anticipate market
various price discrepancies. M&As, reorganizations, or bankruptcies.
movements.
The greatest overlap with private equity is on distress investing: while private equity funds tend to gain control of the distressed company, restructure it e resell, hedge funds (event-
driven) usually trade securities of distressed companies with the intention of making a profit by quickly reselling these securities.
!!! – The distinction between hedge funds and private equity funds has grown more blurred. For now, VC investing remains relatively free of hedge-fund involvement.
!!! – Due to the inaccurate nature of the expression “hedge fund”, the European Parliament decided to use the term “Sophisticated Alternative Investment Vehicles”.
Why alternative investments in an investment banking course?
Three reasons for including alternative investments in an investment banking course.
1) Private equity funds and hedge funds are increasingly important clients of investment banks (corporate finance: about 30% (EU) and 20% (US) of M&A fees are generated by
private equity funds, about 50% of IPO are venture-backed (60% among IT firms) and brokerage for hedge funds).
2) Investment banks are increasingly important players of alternative investments: virtually all major investment banks have a private equity fund and/or a hedge fund, Goldman
Sachs has more capital invested in private equity than any other private equity player, and its hedge fund is one of the largest.
3) Some hedge funds strategies are closely linked to investment banking activities (e.g. merger arbitrage)
!!!- For all of these reasons there is an increasing mobility of human resources from investment banking to alternative investment industry. Moreover, being asset management,
alternative investments activities are investment banking.
Example – Consider a fund with committed capital equal to €100 ml. and 2.5% management fee for all the 10 year life of the fund. The lifetime fees are €25 ml.
and the investment capital is €75 ml. The fund needs to earn at least a 33% of lifetime return on its investment just offset the management fee.
!!! – Sometimes the fee schedule is much more complex. For example, “increasing then decreasing” schedules are not unusual, with the logic that fund expenses
often reach their maximum in the middle years.
!!! – An alternative approach - The industry-standard practice is to compute the management fee on committed capital, but there is another method. First, let’s
define the difference between realized and unrealized investments: the former are those investments that have been exited (or those in companies that have
been shut down), while the latter are those investments that have not yet been exited in companies that still exist. The cost basis of an investment is the value of
THE the original investment. The invested capital is the cost basis for the investment capital that as has been deployed. The net invested capital is the invested
AGREEMENT capital minus the cost basis of realized investments. It is common to see the management fee base change from committed to net investment capital after the five-
year investment period is over, thus minimizing the incentive to overinvest in early years.
!!! – Final comments – First, management fee usually do not cover all the operating expenses. Second, we have assumed that exit proceeds cannot be reinvested
into new companies, but most contracts allow reinvestment rights, subject to given requirements (e.g. the original investment has been exited within 1 year). When
reinvestment does occur, the sum of investment capital and lifetime fees would be greater than committed capital.
CARRIED INTEREST (CARRY)
The basic idea is simple: if the committed capital is €100 ml. and total exit proceeds are €200 ml., the total profit is €100 ml. A 20% carried interest would
produce €20 ml. The standard carried interest is indeed 20%, but recently higher carried have been seen (e.g. 25% or even 30%).
The standard measure in PE performance reporting is IRR. However there are some standard practices of IRR calculation which can lead to confusion.
1) IRR is usually computed quarterly (or even monthly). Annualizing versions of monthly or quarterly IRR might be misleading because this explicitly assumes
reinvestment even when such reinvestment has explicitly not occurred. For example, consider a €1 ml. investment that returns €80.000 every month for one year
and then returns €1 ml. at the end of the year. The investment has clearly returned 8% in every month. If we annualize this return we get 151% (the implicit
assumption is that every distribution has been reinvested). A true annual IRR of 151% should be leaving the investors with €2.51 ml. and the end of the year.
2) Standard IRR reporting does not usually make a distinction between realized and unrealized investments (the latter being considered as a positive cash flow in
INTRO the final period). The IRR is then particularly misleading in first few years of a fund. Even for funds that eventually have high IRRs, a plot of the fund IRR will be
negative for the first few years, and then increase rapidly in later years (J-curve or hockey stick).
3) The IRR is an answer to the question “how well did you do with my money while you had it?”. Many investors would like to get an answer to a different question:
“Overall, how much money did you make for me?” The IRR is not able to answer this question. Suppose for example an investment of €1 ml. returning €2 ml.
after 1 year, and a similar investment that returns €32 ml. after 5 years. Both investments have a 100% IRR, but clearly the second one is preferred. This is why
the industry introduced another simple measure: the value multiple (also known as, investment multiple, realization ratio, absolute return, multiple of money,
cash multiple, times money). This measure answers the question: “For every euro I gave you, how much did I get back?”. The value multiple is the sum of the
realized value multiple and unrealized value multiples.
EXAMPLE
The €200 ml. ABC fund is seven years into its ten-year life.
To compute IRR we first need to aggregate the investments, fees, and distributions into a single cash flow to LPs.
The value multiple is the ratio of total distributions to LPs plus the value of unrealized investments to invested capital plus management fees.
!!! – Generally, value multiple is computed on a net basis, with fees and carry already subtracted. In some cases, firms may report value multiples on a gross basis, including at the
numerator the carried interest, and not subtracting at the denominator the management fee. This gross value multiple represent a better measure of pure performance.
Year 1,0 2,0 3,0 4,0 5,0 6,0 7,0 Total
Investments 20,0 30,0 40,0 40,0 30,0 0,0 0,0 160,0
Portfolio value 20,0 56,0 112,8 186,6 188,1 195,7 203,5
Total distributions 0,0 0,0 0,0 65,0 37,6 39,1 40,7
Carried interest 0,0 0,0 0,0 0,0 0,0 0,0 0,0
Distribution to LPs 0,0 0,0 0,0 65,0 37,6 39,2 40,7 182,5
Cumulative distributions to LPs 0,0 0,0 0,0 65,0 102,6 141,8 182,5
Portfolio value after capital returned 20,0 56,0 112,8 121,6 150,5 156,5 162,8
Management fee 4,0 4,0 4,0 4,0 4,0 4,0 4,0 28,0
Cash Flow to LPs -24,0 -34,0 -44,0 21,0 3,6 35,2 199,5
IRR 24%
Value multiple 1,84
Realized value multiple 0,97
Unrealized value multiple 0,87
Conversion
W W W
Slope = 1/3
Sometimes there is cap on liquidation preference of PCPS.
Suppose the Fund accepts to be capped at 2 times its initial investment. With a PCPS, Fund would 3
receive €1.5 ml. plus 1/3 of any remaining proceeds, until this total reaches €3 ml. (2·€1.5 ml). Slope = 1/3
PCPS WITH The cap point is then: 1/3·(W – 1.5) + 1.5 = 3 W = €6 ml. PCPS
CAP Given this cap, the VC will choose to convert the PCPS for a lower value than the one which triggers 1.5
the mandatory conversion (12).
Indeed, the VC will (voluntarily) convert when 1/3·W > € 3ml. W > €9 ml. (that is before the
mandatory conversion at €12 ml.)
W
1.5 6 9
In public companies preferred stock are issued with the promise of cash dividends, but this is not the case in VC. Portfolio companies are usually cash poor and
dividends may further limit the ability to raise capital. Moreover, VCs are capital-gains oriented, and dividends create asymmetry of rewards between the preferred
shareholders (the VC) and the common shareholders (entrepreneur, management, and/or key employees).
DIVIDENDS Nonetheless, in some term sheets you may find something about dividends. In general dividends may be either for cash or stock (payment-in-kind, PIK).
In general it is common to find a dividend preference to PS (that is you cannot pay any dividends to common stock unless you first pay dividends to PS).
!!! – Dividends rights may be cumulative or non-cumulative, the difference being that cumulative dividends accrue even if not paid. Cumulative dividends in turn
can accrue by simple interest or by compound interest.
ANTI-DILUTION PROTECTION
Many CPS contain anti-dilution provisions that automatically adjust the conversion price down if the company sells stock below the share price that VC has paid (known as down
round). The share price of the VC investment is known as original purchase price (OPP). The rationale for these provisions is that the company is presumably selling at a lower
price because of underperformance. By having an automatic adjustment, the VC is less likely to oppose a dilutive financing (when it is most needed).
The adjustment mechanisms is a negotiated term and can range from complete adjustment (full ratchet) to one based on the size of the round and the size of the price decrease
(weighted-average formula). In this latter case we further distinguish between broad-base and narrow-base.
Full ratchet – The adjusted conversion price (CP2) is set to the lowest conversion price of any later stock sale. The price is adjusted regardless the round size and price decrease.
Weighted-average – CP2 = CP1·(A + B)/(A +C) where CP2 is the adjusted conversion price, CP1 is the conversion price in effect prior to new issue, A is the number of shares of
common stock (fully diluted), B is the aggregate consideration received with the new issue divided by CP1 (i.e. the number of new shares that should be issued was the price the
OPP), and C is the number of new share issued in the subject transaction. The price is “more” adjusted the larger the round size and the price decrease. In broad-base A includes
all shares of outstanding common stock and options on an as-converted basis). In narrow-base A includes just the shares of PS on an as-converted basis): in other words, it
considers just the Series A shares, but not the common stock outstanding.
!!! – It is crucial to know the difference between pre-money and post-money valuation (also known as pre-financing and post-financing). The post-money valuation is simply that
value of the company once the initial investment has been made (number of shares times the price per share). Subtracting the amount invested in this round form the post-money
valuation yields to the pre-money valuation.
EXAMPLE
Suppose that Frank Fund makes a €6 ml. Series A investment in Newco for 1 ml. shares at €6 per share (the OPP). Newco underperforms and receives a €6 ml. Series B financing
from another VC (Desperate Inv.) for €6 ml. share at €1 per share. The founders and the employee stock pool (together the “employees”) have claims on 3 ml. shares of common
stock. The employee stock pool contains shares set aside as incentive compensation for employees. Usually computation is done on a fully diluted basis, which assumes that all PS
is converted and that all options are exercised. Consider the following cases.
Series A has no anti-dilution protection Series A has full-ratchet anti-dilution protection
Fund has 1 ml. shares out of a fully diluted share count of 1 ml. + 6 ml. (Series B) + 3 ml The Series A adjusted conversion price would be €1 (the price of Series B), and Fund
(Employees) = 10 ml., thus controlling 10%. Series B investors paid €1 per share, so the would control 6 ml. shares of a fully diluted share count of 6 ml. + 6 ml. (Series B) + 3
post-money valuation would be 10 ml.·€1 = €10 ml., and the pre-money valuation would ml. (Employees) = 15 ml., controlling 40%. The post-money valuation would be 15
be €10 ml. - €6 ml. = €4 ml. ml.·€1 = €15 ml., and the pre-money valuation would be €15 ml. - €6 ml. = €9 ml.
The idea is simple. It holds that an entrepreneur’s stock does not become his or her own until he or she has been with the company for a period of time, or until
some value accretion event occurs (e.g. the sale of the company). Typically vesting is implemented over a time period (step vesting); alternatively, it takes place all
at one time (cliff vesting). Sometime an accelerated vesting in case of acquisition is allowed.
Vesting performs the function of preventing an employee from leaving and taking with him value disproportionate to the time he was employed at the company.
VESTING
Vesting also performs the function of returning shares to the employee stock pool from employees who “haven’t finished the job”.
!!! – Vesting is sometimes also used for founders’ shares at the time of the first venture capital investment, meaning that a founder who previously owned the
whole company must now temporarily hand back his ownership stake and stay for a few years before he gets it back.
Covenants are the most basic way VCs protect their investments. Usually VCs are concerned about changes in control. The contracts may state that founders
cannot sell any of their common stock without approval (or supermajority voting rule for shareholders or board) of the VCs or offering the securities to the VCs
before anyone else (right of first offer) or offering VCs to buy at the price offered by third parties (right of first refusal). The contracts may also allow VCs to sell
together with the founder (take-me-along or tag-along right) or to force the founder to sell their stake at the same price (drag-along right), the latter being
particularly useful to VCs who need to force a sale of the whole firm.
What is the different between the right of first refusal and the right of first offer? – The right of first refusal is the right to make an offer after offers from
COVENANTS
others are considered. In contrast, right of first offer, is the right to make an offer before offers from others are considered.
Right of first refusal - Suppose you are looking to sell your shares and VC has a right of first refusal on them. If a third party now comes along and offers €100 for
the shares, you have to reveal that price to the VC, and if he chooses to execute his right, he can pay $101 and walk away with the shares.
Right of first offer - You are looking to sell your shares and the VC has right of first offer. Step 1: make an offer to your partner to buyout the shares for say €100.
Step 2: if they refuse then you can take it out into the open market and see if you can get €100. If you can't, you can't just sell it for a lower number, you need to
re-run the process and offer your partner another look.
Discount rate
private equity investments and the value added by VCs need to be 30% 1,85 1,49 1,22 1,00 0,83 0,69
THE KEY compensated, but a 50% seems to be far too large. In fact, there is another
ELEMENTS explanation. What if the VC expected a lower terminal value than the 40% 2,67 2,16 1,76 1,45 1,20 1,00
forecasted one? In that case, a huge discount rate would simply incorporate a 50% 3,78 3,05 2,49 2,05 1,69 1,41
“risk of failure”: the problem here is that the terminal value estimate does not
60% 5,21 4,21 3,44 2,82 2,34 1,95
represent the expected terminal value, but the terminal value in case of
success. In other words, if you expect the terminal value to be much lower 70% 7,06 5,71 4,65 3,82 3,17 2,64
than the forecasted one, by increasing the discount rate you take into account
your expectation (without fighting with the entrepreneur about the “real” Example – Suppose the VC requires a 30% return. Applying a 50% discount rate
terminal value). is equivalent to adjusting the forecasted terminal value by halving it.
Indeed, 1.55 = 2.05·1.35
!!! – The “First Chicago” Method – As an alternative it is possible to consider three (or more) possible scenarios, with each scenario weighted according to its
perceived probability, thus estimating an expected terminal value (rather than a forecasted one) and employing a lower discount rate. This method was first
developed at First Chicago Corp.’s venture capital group.
THE VC METHOD ASSUMING FUTURE DILUTION
As new stock is issued to later-round investors the early-round investors suffer dilution, i.e. a loss of ownership due to the issuing of additional shares. Early-round investors will
have to buy a higher ownership percentage in order to achieve a given terminal ownership. If more stock is issued to early investors, the future investors will have to receive more
stock to have a given percent ownership. Thus, to determine the necessary current ownership, the VC must estimate the amount of new stock that will be issued in the future, but
this amount depends in part on the amount of stock that will be issue now. How can the VC solve this circularity problem?
(1) Estimate the size of the future pie
How much will be available to investors and management? The first step is to calculate the terminal value.
The company is expected to earn €2 ml. in year 5 and P/E for comparables is 10. At that point the whole company will be worth 10·€2 ml. = €20 ml.
(2) Carve up the future pie (3) Convert the future pie into the present
Given the ownership levels, one can get the current ownerships, the number of new shares, and the share prices for each round.
Using the basic VC formula the final ownership The ratio of the final percent ownership to the current percent ownership is the retention ratio. To illustrate, an investor’s
required by each investor can be estimated. First retention ratio will be 75%, if a later investor purchases 25% of the company. The retention ratio can be thought of as the
the timing and amount of equity infusions must portion of the final ownership available to the current investor. Thus, because the second-round investor will hold 13.7%, the
be projected. first investor will only retain 1 – (13.7%) = 86.3% of his original holding. The second round investor will retain 100% of his
A total of two financing rounds are expected: €1 investment, since there will be no subsequent investors through years 3, 4, and 5. So, what percent ownership should each
ml. at now, €1 ml. at years 2. A 50% rate is investor purchase at the time of the financing? The current percent ownership is equal the ratio of the final percent ownership
appropriate for year 0, while 30% is appropriate to the retention ratio.
for year 2.
Round 1 Current % = 38.0%/86.3% = 44%
Round 1 Final % = (1.505·€1)/€20 = 38% Round 2 Current % = 13.7%/100% = 13.7%
Round 2 Final % = (1.40 ·€1)/€20 = 13.7%
3
Using the formula presented earlier we can compute the number of shares each investor must purchase (assuming 1 ml. shares
These are the final ownership shares that each outstanding before the first round) and the corresponding price.
investor requires. If the terminal value is not
high enough the sum of required ownership Round 1 New Shares = 1,000,000·44%/(1-44%) = 785,919 Share price = €1 ml./785,919 = €1.3
might be higher than 100%: in this case there Round 2 New Shares = 1,785,919·13.7%/(1-13.7%) = 283,992 Share price = €1 ml./283,992 = €3.5
would not be enough value to justify the
investments needed. !!! – The final year there will be 1,785,919 + 283,992 = 2,069,911 shares outstanding. If the market value is €20 ml., the price
per share will be €20 ml./2,069,911 = €9.6
In a LBO a group of sponsors undertakes the acquisition of a company (or its assets) mainly by borrowing against the Target’s assets or future cash flows. The
sponsors are often private equity funds (buyout funds); a management team (incumbent, external, or both) is usually involved. The sponsors create a Newco,
which purchases all of the Target’s shares. Target is then merged into Newco (KKR method). It is also possible (not so frequently) that Newco acquires just the
Target’s assets (Oppenheimer method). The Newco is financed through 25%-50% equity and 75%-50% debt.
!!! – Going-private transaction – When a listed company is acquired and subsequently delisted, the transaction is referred to as a public-to-private or going-
private transaction. These kinds of transactions (which make extensive use of debt) were originally called LBO (and before “bootstrap” acquisition). In fact, LBOs
comprise not only public-to-private transactions but also private firms.
INTRO
!!! – MBO, MBI, BIMBO, and IBO – Management-led deals (backed by a buyout fund) represent the majority of LBOs. When the incumbent management team
takes over the firm the LBO is called management-buyout (MBO). When an external management team acquires the firm, the term is management-buyin (MBI).
When the sponsor group includes both members of the incumbent management and external managers it is a buyin-management-buyout (BIMBO). Finally, when
the sponsor group includes only private equity funds (i.e. “institutions”) the LBO is termed institutional buyouts (IBO).
!!! – Reverse LBO – A possible exit strategy for buyout funds is an IPO. Such a “secondary” IPO is usually called reverse LBO.
!!! – The Italian case – According to the Italian law (art 2501 bis) only the merger LBO is possible (i.e. the KKR method).
The total amount to be financed is the EV of the Target and the structure of Senior A
the debt is not related to the outstanding debt of the Target. LBO financing is
generally expressed in terms of debt to EBITDA. However, the typical 4x
Senior B
financing structure is about 5 times EBITDA of debt and about 1.5 times 5x
EBITDA of equity for a purchase price of 6.5 times EBITDA. Moreover the EV = 6.5x
debt is usually structured in senior debt (supplied by banks) for about 4 Senior C
FINANCING times EBITDA and high-yield bonds/subordinated debt for about 1 times
EBITDA (up to 3 times during the ‘80s). Mezzanine
STRUCTURE
!!! - The feasible debt structure changes over time depending on the market. Equity
When high-yield debt is not available (either because of the small transaction size or due to the scarce liquidity of the market) the gap is filled by so-called
mezzanine financing, provided by specialized investors, the mezzanine funds. These funds demand higher compensation, which involves warrants or other
equity-linked instruments (the equity “kicker”) in addition to interest (usually below market) on subordinated debt (repaid only after all senior debt is reimbursed).
!!! - LBO debt contract typically provide that any excess cash generated by the business shall be used to repay (senior) debt (“cash sweep”).
There are two possible candidates for a LBO: the “stable cash flow” firm and the “high growth” firm.
Motives
Stable cash flow High growth
Stable cash generation reimburses debt. The EV at The gains result from the company’s growth, i.e.
exit is unchanged: the reduced debt increases the the EV increases over time. It is generally a short There are several sources of wealth gains that may
equity value. It is generally a long term LBO with term LBO with lower leverage (it is more difficult to motivate a LBO. These are the most relevant:
higher leverage (easier to convince the banks). convince banks).
Tax benefit – The increased leverage increases the tax
CANDIDATES
shield. The question is: “Couldn’t the Target obtain the
AND Debt
Debt tax benefit without a LBO?”
MOTIVES
Debt Agency cost – Wealth gains derive from reunification of
EV EV EV ownership and control (the “owner-manager”) and
Debt
Equity increased control quality (due to the buyout fund and
EV Equity to the discipline function of debt).
Equity Equity
Undervaluation – The wealth gains result from
developing an alternative higher-valued use for the
t=0 t=1 t=0 t=1
firm’s assets.
The price to bid for an LBO depends on two factors: i) the debt capacity of the firm and ii) the return required by the sponsor (i.e, the buyout fund).
VALUATION
Debt capacity determines how much is left to sponsors at exit time. The present value of exit equity plus debt capacity is the affordable price for the LBO.
Giuliano Iannotta – IEMIF – Università Bocconi
LBO VALUATION (1): DEBT CAPACITY
Debt capacity is an estimate of how much the company can borrow against its expected cash flow and still permitting full debt service to senior debt and interest payments to
subordinated debt. In practice debt capacity is measured as a multiple of EBITDA. Debt capacity is a function of revenue, costs, and capital expenditure projections: in other words,
estimating debt capacity is an exercise in pro-forma forecasting. Debt capacity is then a function of the growth rate of sales and of the sources and uses of cash, also expressed as
fractions of revenues. Given the inputs, it is easy to compute cash flow and debt amortization, and to determine how long it will take to pay back all the senior debt: if it takes
longer than lenders require, the debt capacity of the firm is lower than initially assumed. With an Excel spreadsheet the problem simply consists in solving for the amount of debt
that would result in senior debt balance at the given year.
g Growth of sales 5,0%
m EBITDA margin 10,0%
dep Depreciation/sales 1,5%
A simpler (albeit “opaque”) analytical solution exists (assuming cash sweep = 100%): onc Other non-cash/sales 0,2%
inv (CAPEX+∆∆WC)/sales 2,0%
Debt capacity = n
[ ]
x2 ⋅ m −1 ⋅ x1n − (1 + g ) n /( x1 − 1 − g )
cash
Rcash
Cash balance/sales
Interest on cash balance
0,2%
4,5%
x1 ⋅ f + (1 − t ) ⋅ Rsub ⋅ (1 − f ) ⋅ (1 − x1n ) /(1 − x1 ) t Tax rate 40,0%
Debt financing:
Rsen (f) Senior @ 35% 8,5%
with
Rsub (1-f) Subordinated @ 65% 10,0%
x1 = 1 + (1 − t ) ⋅ Rsen n Amortization of senior by year 5
sweep Net cash to senior amortization "cash sweep" 100%
x2 = (1 − t ) ⋅ m + t ⋅ dep + onc − inv + (1 − t ) ⋅ Rcash ⋅ cash /(1 + g ) − cash ⋅ g /(1 + g ) First year sales 1.000
First year EBITDA 100
x1 1,05
Debt Capacity 4,39 x2 0,48
Debt Capacity 439,27 4,39
Year
0 1 2 3 4 5 6 7 8 9 10
Sales 1.000,00 1.050,00 1.102,50 1.157,63 1.215,51 1.276,28 1.340,10 1.407,10 1.477,46 1.551,33
EBITDA 100,00 105,00 110,25 115,76 121,55 127,63 134,01 140,71 147,75 155,13
Depreciation 15,00 15,75 16,54 17,36 18,23 19,14 20,10 21,11 22,16 23,27
Interest income 0,09 0,09 0,09 0,10 0,10 0,11 2,10 4,28 6,66 9,26
Senior interest expense 13,07 11,11 8,86 6,27 3,33 0,00 0,00 0,00 0,00 0,00
Subordinated interest expense 28,55 28,55 28,55 28,55 28,55 28,55 28,55 28,55 28,55 28,55
Income before tax 43,46 49,67 56,40 63,67 71,54 80,04 87,45 95,33 103,69 112,57
Provision for tax 17,39 19,87 22,56 25,47 28,62 32,02 34,98 38,13 41,48 45,03
Net income after tax 26,08 29,80 33,84 38,20 42,92 48,02 52,47 57,20 62,22 67,54
Depreciation and oth. non-cash 17,00 17,85 18,74 19,68 20,66 21,70 22,78 23,92 25,12 26,37
(CAPEX+∆∆WC)/sales 20,10 21,10 22,16 23,26 24,43 25,65 -17,14 -64,12 -115,55 -171,71
Cash flow before debt amort. 22,98 26,55 30,43 34,62 39,16 44,07 92,40 145,24 202,88 265,63
Debt amortization:
Senior 22,98 26,55 30,43 34,62 39,16 0,00 0,00 0,00 0,00 0,00
Subordinated 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00
Cash balance: 1,90 2,00 2,10 2,21 2,32 2,43 46,63 95,08 148,06 205,84 268,73
Senior debt 153,75 130,76 104,21 73,78 39,16 0,00 0,00 0,00 0,00 0,00 0,00
Subordinated debt 285,53 285,53 285,53 285,53 285,53 285,53 285,53 285,53 285,53 285,53 285,53
Total debt 439,27 416,29 389,74 359,31 324,69 285,53 285,53 285,53 285,53 285,53 285,53
EBITDA/Net Interest Expense 2,41 2,65 2,95 3,33 3,83 4,49 5,07 5,80 6,75 8,04
Giuliano Iannotta – IEMIF – Università Bocconi
LBO VALUATION (2): AFFORDABLE PRICE
When a cash sweep is in effect, the shareholders do not get any cash. The buyout fund obtains its return through a “cashing out” event (either an IPO or a trade
sale). The effects of cashing out are represented in a “terminal value analysis”. Usually some multiples (such as EV/EBITDA or EV/EBIT) are used to estimate the
INTRO terminal value at the exit year (normally 3/5 years). Using the debt capacity and the terminal EV one can estimate the equity value at the exit year. Given the
required return (i.e. discount rate) of the buyout fund it is easy to compute the present value of exit equity. The present value of exit equity plus debt capacity is
the affordable price for the LBO.
Consider a Target with debt capacity equal to 4 times EBITDA and current EBITDA equal to €100 ml.. In other words, the LBO can borrow €400 ml. Suppose
senior debt represents 25% (€100 ml) of total debt and can be amortized at the end of year 5. At that time only the subordinated debt will be left (€300 ml).
1. Estimate the exit equity value - Assume that the sponsor expects to exit the investment in 5 years at 5 times EBITDA. Since the expected EBITDA for
the 5th year is €120.00 ml. (growth rate 3.7% per annum), the exit EV would be €600 ml. This implies an exit equity value equal to €300 ml.
EXAMPLE 2. Estimate the present value of exit equity value – Assume that the sponsor requires 30% return on its investment. Equity cannot exceed €80.8 ml.
3. Compute the affordable price – The affordable price is then the sum of debt capacity, present value of exit equity (less fees and expenses, here assumed
to be null): €480.8 ml. (= 400 + 80.8), or 4.8 times EBITDA.
!!! – The calculation assumes an exit multiple close to the purchase multiple. It’s a prudent assumption which puts the burden of value creation in improving
operations rather than betting on an increasing multiple. With some simple algebra one can find the exit multiple that equates the affordable entry multiple.
Exit Equity = M X ⋅ EBITDA ⋅ (1 + g ) n − Exit Debt , where M X is the exit multiple and Exit Debt = (1 − f ) ⋅ q ⋅ EBITDA
Exit Equity
+ q ⋅ EBITDA
EV (1 + IRR ) n M ⋅ (1 + g ) n − (1 − f ) ⋅ q
Let ME be the entry multiple. For a required IRR it will be: ME = = = X +q
EBITDA EBITDA (1 + IRR) n
EXAMPLE
g 3,7%
Given the data of the previous slide let’s determine the exit multiple that equates the affordable entry multiple: f 25%
n 5
M=
[(1 + 30%) 5
− (1 − 25%) ⋅ 4 ]
= 4.716 q 4
(1 + 30%) − (1 + 3.7%) 5
5
IRR 30%
M 4,716
Given an expected EBITDA at year-end 5 equal to €120 ml and a multiple equal to 4.716 the expected EV is equal to €566.0 ml, implying an exit equity value of
€266.0. Thus the entry equity value is €71.6 ml. The affordable price is therefore €471.6 ml, or 4.716 times EBITDA.
Hedge funds specialized in risk arbitrage make a living betting on mergers. Once a deal is announced, the “arbs” take position: they go long on the Target’s
INTRO
shares and short on the Bidder’s shares. This position is at the risk of the deal not at the risk of the market.
Suppose a stock deal is announced with exchange ratio (ER) equal to 1. The Bidder and Target stock prices (post-announcement) are €10 and €8 respectively.
The difference between the current Target’s price and the bid price offered by the Bidder is the arbitrage spread: in this case the arbitrage spread is equal to €2.
Because ultimately you can get one Bidder’s share (€10) with a Target’s share (€8) the arbitrage spread is a potential profit. This profit is juts potential because
the arbitrage spread may narrow and/or disappear as the likelihood of the merger increases or due to change in market prices. The arb’s problem is to maintain
the spread until the merger is consummated. The arb sells short one Bidder’s share, getting €10, and buys one (since the ER is 1) Target’s share, paying €8,
thereby indirectly acquiring one Bidder’s share (if the merger succeeds): he now gains €2. What can happen at the closing?
Scenario 1 – The Bidder’s price drops at €7. Since the ER is 1, the price of one Target’s share will be also €7. The arb sells the Target’s share for €7 with a result
equal to -€1 (€7 - €8) and covers the short at €7 gaining €3 (€10 - €7). The net profit per share is then equal to €2.
A SIMPLE
Scenario 2 – The Bidder’s price rises at €13 and the price of a Target’s share will also be €13. The arb sells the Target’s share at €13 gaining €5 (€13 - €8) but
EXAMPLE
covers the short at €13 realizing a loss equal to -€3 (€10 - €13). The net profit per share is then equal to €2.
!!! – At the closing of the merger the profit from the long position is: (p(B) - €8), while the profit from the short position is (€10 – p(B)). The net profit is €2 for any
p(B). Whatever happens to the market prices the arb gets its spread. The arb just bets on the successful consummation of the deal. Suppose the merge of the
previous example fails: this would produce a rise of the Bidder’s price (say to €11) and a drop in the Target’s price (say to €7): a pattern opposite to the one
usually observed at announcement. What’s the result for the arb? He looses -€1 (€7 - €8) from the long position and looses also from the short position -€1 (10€
- €11), for a total loss of -€2. The main risk for the merger arb is that the deal may not go through: this risk is particularly high in hostile tender offer (due to
competing bids of just to the failure of the offer).
!!! – Notice that a merger arbitrage position can be created also in cash deals, simply purchasing the Target’s shares (and thus betting on the deal completion).
Suppose a stock deal is announced with ER equal to 2. The Bidder and Target stock prices (post-announcement) are €5 and €9 respectively. Given these prices,
the arbitrage spread is equal to €1. Indeed, one would think about buying one Target’s share at €9 in order to eventually get 2 Bidder’s share valued at €10 and
ANOTHER make a profit of €1. The arbitrage position is created selling two Bidder’s shares and buying one Target’s share. In general the number of shares to short is the
EXAMPLE hedge ratio times the number of shares held long. The hedge ratio is the exchange ratio. The profit for the arbitrage position is then: (2·p(B) - €9) + (2·(€5 – p(B))).
!!! – A change in the exchange ratio is another risk for the arb, because it would leave a previously hedged position partly at risk.
The arbitrage spread is an indicator of the likelihood of consummation. Indeed, the current stock price can be seen as the probability-weighted average of two
outcomes: i) the deal is consummated and the Target’s shareholders get the bid price and ii) the merger fails and the Target’s price is at its stand-alone level. A
proxy of the stand-alone price level could be the pre-announcement Target’s price (assuming the price does not impound any expected bid). Solving for Prob gives
the market’s view about the likelihood of consummation.
pCurrent (T ) − p Alone (T )
pCurrent (T ) = Pr ob ⋅ pBid (T ) + (1 − Pr ob) ⋅ p Alone (T ) Pr ob =
PBid (T ) − p Alone (T )
INTERPRETING
ARBITRAGE !!! - When arbitrage spreads are negative, the current Target’s share price is above the Bidder’s offer. It means that arbs and other investors expect a higher offer
SPREADS to be announced soon.
Price
The table shows the estimated Bidder Target Arb. Spread Probability
Current Bid Pre-Bid
probabilities of deal closing based on an
analysis of arbitrage spreads. Oracle PeopleSoft 17,82 19,5 15 1,68 62,67%
ArviMeritor Dana 15,54 14,99 11,5 -0,55 115,76% Higher Bid
!!! – Data about four pending deal at July
Berkshire Hathaway Clayton Homes 13,01 12,5 11 -0,51 134,00% Higher Bid
18, 2003
Palm Handspring 0,99 1,45 0,85 0,46 23,33%
26 April 2001 Offer period closes, receive consideration, collapse short position
!!! - XXX