Efficient Capital Structure
The primary way in which value is created in an LBO is through the use of borrowing to finance the acquisition. A financial sponsor utilizes leverage to realize higher returns on the equity it invests. A key driver behind the outsized returns generated in a successful LBO is reducing the weighted-average cost of capital (WACC) by employing more debt, which is cheaper than the cost of the sponsor's equity. As the debt is paid down, the value of the equity increase and healthy returns are generated, as demonstrated below:
A financial sponsor can also create/realize value in an LBO through operational enhancements, such as organic growth, cost cutting, and realization of synergies from add-on acquisitions.
In addition, expansion of market valuation multiples (i.e. buy low, sell high) can create value for the financial sponsor. Note, however, that multiple expansion is market-driven and beyond the control of the company and the sponsor.
When all of these factors work together, the effects can be powerful for the LBO investors:
What If Things Don't Go So Well?
If none of the expected value creation methods occur, the equity returns can be significantly impaired. Moreover, if one or more of the expected value creation drivers goes the opposite way, the effects can be disastrous:
Example 5.5 – Value Creation Via Deleveraging and Operational Improvement
Suppose the debt capacity of the target is determined to be "3.5x leverage", the target's LTM EBITDA is $90mm, and the target has no existing debt.
(A) What is the debt capacity of the target in dollars?
Debt capacity = 3.5 × $90mm = $315mm.
(B) Assuming a 30% equity contribution and 3.5x leverage, what is the maximum purchase price a financial sponsor can pay?
Max. purchase price = $315mm ÷ (1−30%) = $450mm.
(C) The sponsor expects to exit its investment after 5 years at 7.0x Year 5 EBITDA of $120mm, at which point the target is expected to have net debt of $215mm. What is the sponsor's IRR?
The sponsor's initial equity investment is $450mm × 30% = $135mm. In Year 5, the enterprise value is 7.0 × $120 = $840mm. Therefore, the Year 5 equity value is $840mm − $215mm = $625mm. If the sponsor makes an initial equity investment of $135mm, and the investment appreciates in value to $625mm 5 years later, it realizes an IRR of 35.9%.
To calculate the IRR using your HP financial calculator, enter the following inputs:
N = 5, PMT = 0, PV = -135, FV = 625. Then, hit the I%YR button to compute the IRR.
(D) What is the sponsor's cash-on-cash given the information above?
CoC = $625mm ÷ $135mm = 4.6x.