The determinants of leveraged buyout activity

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ФЕДЕРАЛЬНОЕ ГОСУДАРСТВЕННОЕ АВТОНОМНОЕ ОБРАЗОВАТЕЛЬНОЕ УЧРЕЖДЕНИЕ

ВЫСШЕГО ОБРАЗОВАНИЯ

«НАЦИОНАЛЬНЫЙ ИССЛЕДОВАТЕЛЬСКИЙ УНИВЕРСИТЕТ

«ВЫСШАЯ ШКОЛА ЭКОНОМИКИ»

Факультет экономических наук

Образовательная программа

«Стратегическое управление финансами фирмы»

МАГИСТЕРСКАЯ ДИССЕРТАЦИЯ

Детерминанты сделок по выкупу компаний за счет привлечения заемного капитала

(The Determinants of Leveraged Buyout Activity)

Выполнил:

студент группы МСФ142

Рябоконь Юлия Викторовна

Научный руководитель:

профессор, к.э.н. Ивашковская Ирина Васильевна

Рецензент:

к.э.н. Кокорева Мария Сергеевна

Москва 2016



Content

Abstract

Introduction

I. Leveraged buyout transactions: theoretical insights

1.1 Leveraged buyout transactions: definition and core characteristics

1.2 Key participants: role and incentives in leveraged buyout process

1.3 Valuation techniques in leveraged buyout transactions

1.4 Value creation drivers in leveraged buyout deals: growth, leverage, optimal capital structure

II. Determinants of leveraged buyout activity: literature review

2.1 Hypothesis of leveraged buyout activity

2.2 Phases in the public-to-private process

2.3 Determinants of LBO activity: operating, financial and market-wide factors

2.4 Determinants of the degree of leverage employed in LBO transactions

2.5 The emergence of tech LBOs: the role of intellectual assets in value creation

III. Empirical research: sample and data selection, methodology

3.1 Sample selection

3.2 Methodology: cox proportional hazard model

3.3 Data overview

IV. Empirical results

Conclusion

References

Appendix 1

Appendix 2

Appendix 3



Abstract

Rapid growth in allocation of investor's financial resources to Private Equity funds focused on Leverage Buyout activity is one of the most significant shifts in international investment landscape occurred in the first decade of XXI century. Indeed, it was a strong decade for private equity industry as a whole, with a long-run fundraising dynamics, great number of funds closed as well as sound track record of successfully conducted deals. Whereas, private equity, being rather dynamic and flexible industry, adjusts its screening, selection and managerial strategies in accordance with actual business environments, legal infrastructure and macroeconomics conditions on a regular basis. Furthermore, leveraged buyout community was forced to revise its screening strategy: instead of selecting primary big mature businesses with predictable cash flows, excellent market position, significant asset base as well as measurable risk and predictable exit opportunities, managers increasingly began to pay attention on smaller technology firms with less-developed product, valuable intellectual property assets and less stable market position.



Introduction

Rapid growth in allocation of investor's financial resources to Private Equity funds focused on Leverage Buyout activity is one of the most significant shifts in international investment landscape occurred in the first decade of XXI century. Indeed, it was a strong decade for private equity industry as a whole, with a long-run fundraising dynamics, great number of funds closed as well as sound track record of successfully conducted deals. We can trace this tendency in numbers. If in 2010, total capital raised was equal to ~$221bln, in 2015 fundraising achievements of private equity managers reached ~$384bln, CAGR ~ 11.7 %. Appendix№1, Graph 2. Buyout strategies have been constantly gaining popularity during that time, on average accounting for 35% of overall target value. Appendix №1, Graph 3 If we look deeper in leveraged buyout history, we would mention that the total value of leveraged buyout deals closed during the “second LBO wave” (2004-2007) ten times exceeds the achievements of 1996-2003 years. What are the main drivers stimulating such a significant growth in LBO volume?

Undoubtedly, overall macroeconomic conditions, situation on financial markets as well as low interest rates, favorable legal and tax environment fuels stimulates leveraged buyout activity.

Thus, only the market capacity of the LBO granted senior loans for 2004-2007 was nearly four times higher the 1996-2003 indicator, having considerably `heated' the buyout funds' appetites. Appendix №1, Graph 9

Moreover, the leveraged buyout activity driven by a very strong demand from institutional investors. The sound recognition deserved due to private equity's “value creation potential and ability to ride out cycles” Private equity international. Issue 141, December 2015 / January 2016, page 42. Indeed, the majority of pension or insurance funds are targets to achieve actual annual returns around 7-8%, simultaneously, being required (by legal regulations) to make up the primary part of portfolio with low risk and liquid investments like government bonds. While, US Treasury yields hardly exceeds 2%, “Private Equity has beaten S&P by 400 to 600 points over the last 30 years.” Limited Partner Magazine, Q1 2015, page 7 As a result, in conditions of low interest rates, institutional investors, in order to meet their return targets, forced to invest heavily the rest part of their portfolio in illiquid, PE strategies.

Along with positive drivers of leveraged buyout activity, there is a wide range of factors that rise concerns among private equity investors. The surge in global liquidity, caused primarily by near-zero interest rates, has led to extremely high market valuations. Appendix№1, Graph 10 As a result, loaded by tremendous financial sources, private equity managers face the problem to find a satisfactory deal at such “heated” markets. Appendix№1, Graph 7-8 According to Bain research, private equity “dry power”, being equal $1.2trl in 2014, continues to grow.

Whereas, private equity, being rather dynamic and flexible industry, adjusts its screening, selection and managerial strategies in accordance with actual business environments, legal infrastructure and macroeconomics conditions on a regular basis. Classical leveraged strategies leveraged strategy “buy cheap - leverage business - dispose of non-core assets and operations - exit with a high multiple” does not work anymore. For instance, the issue of private equity tax policy became a key element at election campaign among several candidates. Thus, while Jeb Bush plan to eliminate business loans' tax shields, Donald Trump proposes to raise taxes on private equity funds from 20 to 39.6% - the ordinary income tax level in US.

In response to core challenges - extremely market valuations, taxation or regulatory issues, gradually declining returns - wise private equity managers tend to diversify potential LBO value creation sources: instead of focusing primary on financial leverage and corporate governance value drivers, they prefer to emphasize on operational improvements of the target companies.

Furthermore, leveraged buyout community was forced to revise its screening strategy: instead of selecting primary big mature businesses with predictable cash flows, excellent market position, significant asset base as well as measurable risk and predictable exit opportunities, managers increasingly began to pay attention on smaller technology firms with less-developed product, valuable intellectual property assets and less stable market position. Innovative IP collateralization products such as intellectual property-backed loans, royalty securitization and IP license-back deals significantly simplified the access of technology firms to LBO financing.

Leveraged buyout boom increased the interest of academic researchers in analyzing the public-to-private phenomenon. There is no doubt that empirical researches contributed greatly to the comprehensive understanding of what companies are lucrative targets for leveraged buyout transformation and what firms are not. The same time, classical, recognized LBO hypothesis such as “tax benefit hypothesis, free cash flow, control hypothesis, etc” no longer confirmed on practice. Whereas, financial visibility theory as well as hypothesis of poor capital access and unstable stock market becomes more popular in modern corporate finance research.

Current research aims to determine to which extent leveraged buyout activity nowadays is motivated by endogenous and exogenous factors. We suppose that under the circumstances of rapid private equity growth and PE's evolutionary nature, it is vital to test most of existing theories in order to provide an updated list of ideal leveraged buyout candidate characteristics.

The objects of current study are US, Canada and European leveraged buyout targets.

The subject of the research - endogenous and exogenous factors influencing the leveraged buyout activity.

Hypothesis:

Hypothesis 1: there is a clear link between a rich intellectual property profile of a target company and the decision to make leveraged buyout transformation.

Hypothesis 2: Likelihood for a firm to be a LBO target relates to pre-transaction Operating characteristics of this company.

Hypothesis 3: Likelihood for a firm to be a LBO target relates to pre-transaction performance of this company on financial markets.

Hypothesis 4: Leveraged Buyout activity is driven by Economy-Wide factors.

In order to provide an econometric proof of hypothesis examined we construct a complete sample of LBO deals (US and Canada, Developed European Markets) from Capital IQ base. The final buyout sample includes 228 closed deals in which a listed company became a buyout target (LBO, MBO, Going Private) between 2004-2015 years. Moreover, research focuses primarily on targets that went public after January 1, 2003. The comparison sample contains 1435 companies, that carried out a public offering between 01.01.2003 - 31.12.2012 and still stay public without a track record of being targeted in transactions with > 50% acquired stake.

Due to the fact, that the company's decision to make leveraged buyout transformation is a “classical” case for the Cox's proportional hazard model analysis, this sophisticated model was applied. The big advantage of Cox proportional hazard model is the fact, that this model traces the evolution of determinants over company's life cycle (since IPOs to leveraged buyout announcement or censored). The big drawback - the complexity of data collecting process. Explanatory variables are gathered for each period during company's “public life”. In case of companies from private sample - for each year since IPO closed to buyout announcement. In case of firms from control sample - for each year since IPO closed to 31.12.2015. In order to reduce endogeneity problem all explanatory proxies are lagged by one period (year).

The regression result reveals a positive link between rich intellectual property profile of a target company and the decision to make leveraged buyout transformation. Moreover, according to regression results, firms with strong free cash flow position as well as significant fixed asset share are good candidates for leveraged buyout transformation. Indeed, not every IP-intensive company suits for LBO transaction. Financial visibility hypothesis (poor capital access and unstable stock market performance) is also proven on estimated samples.



I. Leveraged buyout transactions: theoretical insights

1.1 Leveraged buyout transactions: definition and core characteristics

Nowadays market of acquisitions and takeovers represents a large piece of a lucrative global corporate finance pie, showing strong growth prospects in terms of the number, size and quality of deals closed. It is worth mentioning, that highly complex M&A world accumulates not only huge financial resources, but also valuable human ones in order to generate high returns on capital employed, enhance profitability, viability and, as a result, value of business units and other participants involved in restructuring. Indeed, according to Bloomberg financial statistics 2015 year became the leading one in terms of mergers and acquisition volume. Strategic and financial buyers from all over the globe invested in M&A activity the sum exceeding 3.8 trillion-dollars mark. http://www.bloomberg.com/news/articles/2016-01-05/2015-was-best-ever-year-for-m-a-this-year-looks-pretty-good-tooAs a side note, the previous M&A record was beaten in the distant past, even before the financial crisis of 2008^th. Owing to the ever - rising influence of restructuring activity on global finance environment, mergers and acquisitions market attracts more and more general public attention as long as motivates best students of top universities to compete for the career in this complex corporate finance sphere. There is no doubt, that «new blood» of highly motivated, intelligent and ambitious professionals will rise M&A activity to new heights in the nearest future.

As it was mentioned earlier, acquisitions and takeovers market is a very complex one. Indeed, corporate finance practice knows several options of making one firm acquired by another deal participant. The most popular ways are follows: merger, consolidation, tender offer, purchase of assets and buyout. Although current research is devoted to precise analysis of leveraged buyout activity under the angle of ideal LBO candidate estimation, the brief overview of basic kinds of acquisitions is also required.

According to Damodaran's Aswath Damodaran. “Investment valuation: second edition”, Wiley Finance - 2002, page 969 working paper, merger is a transaction approved by boards of directors of firms participating in the deal (further shareholders of both players should confirm the terms of agreement). As a result of transaction, the target firm becomes recognized out of exist, usually drops its name and transforms in an operating unit of acquiring company. On the contrary, as a result of consolidation, a new company is established on the equal in rights base of operating units of independent firms involved in transaction. The absence of hierarchical distinction between participants involved in consolidation usually manifested via combination of their brand - names. Moreover, if we look precisely at merger and consolidation process under the angle of trading in stocks of firms involved, we will also see sound differences. In a merger, holdings of target's existing shareholders cease to exist being replaced by shares or cash of acquiring company; while holdings of acquirer's shareholders continue to be unchanged. In a consolidation, stocks of both firms recognized to be out of exist, in return, shareholders receive new shares of the recently incorporated company. Thereby, the common feature of mergers and consolidations is a voluntary nature of decision-making process.

Conversely, if transaction is initiated without managerial approval of a target company, the deal might by classified as a hostile one. Tender offer is one of the most popular ways in conducting hostile takeover. Tender offer deal represents the public announcement appealed to the existing shareholders of target firm urging owners to sell their stakes on certain terms during definite time period. From the time of official announcement, target's longevity fully depends on the minority stockholder's decision as for the tender. It is worth mentioning, that in a hostile tender-offer the risk of transaction failure is much higher than in voluntary mergers. There are plenty financial tricks to be applied by target company's management in order to defense themselves from such a hostile takeover: from poison pill strategy realization to attraction more agreeable company (a white knight) to make a deal on the rather beneficial terms.

The process of acquiring only specified assets of another company through a formal approval by the stockholders of target is another category of acquisitions called purchase of assets.

Besides, one more type of transaction left - the one that does not suit for any of four groups analyzed earlier - called a buyout. As a result of buyouts transaction, target company is acquired by an interested group of investors (or managers) usually by the means of tender offer, loses its publicly traded status and transforms into a private entity. The next part of current analysis will be devoted to precise estimation of buyouts alchemy.

“A leveraged buyout is the acquisition of a company, division, business, or collection of assets (“target”) using debt to finance a large portion of the purchase price” Joshua Rosenbaum, Joshua Pearl. “Investing banking - Valuation, Leveraged buyouts and M&A”, Wiley Finance - 2013, page 137. According to J. Rosenbaum, the purchase price of LBO stake could be funded not only by debt providers (debt finance), but also by financial sponsors (equity contribution). Withal, Cyril Demaria Cyril Demaria. “Introduction to private equity: venture, growth, LBO & turn-around capital”, John Wiley and Sons, Ltd. - 2013, page 152 insists that classical leveraged buyout is just a simple mechanism of ownership transition, as a target company does not receive any additional capital injection. For the cases when LBO financing structure comprise equity contribution as well as debt finance Cyril Demaria figure outs separate class of a deal called “growth capital”. In practice, pure debt finance transactions structures rarely exist, therefore the first approach of identifying leveraged buyout transaction will be more suitable for the current research.

It is worth mentioning, that public companies as long as private firms and their subsidiaries could become a target in leveraged buyout transaction. What is more, LBO evokes significant reallocation of control in target firm, causing new ownership structure to be highly concentrated. Generally, if listed company is concerned, at a result of leveraged buyout, it loses public traded status and becomes private. The case when listed company is acquired and subsequently opts out of public market is called going-private transactions. In fact, it is not so easy to understand what concept “leveraged buyout” or “public-to-private transaction” is wider. As it was mentioned earlier, LBO could target private firms as well as public. Moreover, sometimes a small part of target's shares is not acquired during buyout and continuous to trade. The same time going-private transaction could be financed not only by borrowing heavily on debt market, but also by attracting merely equity sources. However, throughout the current study, the terms «leveraged buyout» and “going-private transactions” usually used interchangeably because we put focus on public-to private transformation via leveraged buyouts.

There are several kinds of buyout activity:

- Institutional buyout (IBO): a transaction in which private equity fund (so-called buyout fund) or institutional investor acquirers the target with a sound portion of debt finance.

- Management buyout (MBO): a transaction in which firm's management team takes over the company (assets and operations) they managed.

- Management buy in (MBI): a transaction in which outside group of managers acquires the target business. MBI differs from MBO in view of the asymmetry of information. Indeed, outside managers do not possess the same level of insider information as incumbent managers do.

- Leveraged Build-UP (LBU): a transaction structured to acquire the target “platform” company - the base for future additional acquisitions (in order to break into new markets, etc.)

Wide range of possible buyout types is not strictly limited to the classification represented above. On the contrary, buyouts are rather flexible in methods and forms depending on the degree and type of investor's involvement in transaction. For instance, BIMBO (buy in management buyout) is a case when current managers attracts outside management group in order to conduct a deal teamwise. Whereas, each type of LBO characterized with different risk level attached.

The next paragraph is devoted to precise overview of the key players involved in leveraged buyout activity. Indeed, there is a wide range of questions concerning organizational aspects of LBO still left uncovered. What constitutes a leveraged buyout fund? Who are the main interested parties pushing LBO activity on such heights in terms of volume and quality? Is there any list of characteristics describing ideal LBO candidate? The last question is the most important one under the angle of current study, but, unfortunately, the competent answer requires deep understanding of issues under the first two questions.

1.2 Key participants: role and incentives in leveraged buyout process

Private Equity Funds

On the one hand, there is a wide range of troubled entrepreneurial companies, loaded down with high portion of intangible assets, deep negative earnings and stock prices volatility, facing sound difficulties with attraction of external financial resources. On the other hand, big institutional investors seek for long-run direct investments on the regular basis. In such a simplified investment model, private equity act as intermediaries between these groups of financial players.

Having generated from a small-scale, niche activity private equity today is an integral part of global financial system. The manifestation of this trend can be traced in Appendix 1. Appendix 1

According to Office of the Federal Register (US) private equity fund is any company that “Is formed for the purpose of and is engaged exclusively in the business if investing in shares, assets, and ownership interest of financial and non-financial companies for resale or other disposition. Is not an operating company”. Code of Federal Regulations, Title 12, “Banks and Banking”, PT. 220-299, Revised as of January 2010 - Office of the Federal register (US), Government Printing Office, 2010

The globe investment practice has shown that the most effective form of private equity foundation is a limited partnership structure. The limited partnership structure requires the agreement between the fund's investors, named limited partners (LPs) and the fund manager, called general partner (GP). The key point of limited partnership agreement is allocation of responsibility between LPs and GPs: while limited partners risk only in limits of amount invested in fund, general partner (being jointly liable for all debts of the fund) has a managerial control over all stages of investment process.

There are two main kinds of operations led by private equity company: raising and managing external financial resources. Indeed, private equity fund recognized to be successfully launched as long as fund size meats its previously announced targets. The more marketing efforts applied during the first phase the faster required funding is drawn. Although, if there is a significant gap between target size of a fund and the closing one, issues about general partner's competence arise. Longevity of premarketing stage depends on wide range of factors and generally takes between one to two years. As soon as all LPs commit their financial contributions in the private equity fund, fund's managers start seeking and analyzing portfolio companies with the aim to invest in. On the average, private equity fund's duration does not exceed ten years. Whereas, in the case when private equity is listed on stock market, duration is considered to be unlimited.

Being a product of tough negotiations between LPs and GPs, limited partnership agreement aims to ensure interest alignment between parties as well as general partner's incentives such as transaction fees or profit share. The most powerful economic terms of standard agreement are:

- Management fees: sum paid to general partner during the lifetime of the fund on annual basis. There is a wide range of schemes according to which this amount is calculated: as a percentage of net asset value, invested capital, etc.

- Transaction fees represent a compensation paid to general partner in exchange for investment banking services provided for a transaction (for instance, leveraged buyout).

- Carried interest is a general partner's share in profits generated by a private equity fund. Typically, according to 20% of profits earned goes to management team (GPs) of the PE fund.

- Ratchet represents a mechanism that establish the rules of equity allocation between private equity managers and portfolio company stockholders. With a help of ratchet management team becomes capable to allocate its equity depending on the firm's actual performance as well as fund's targeted return.

- Hurdle rate is a required rate of return that must be reached by private equity fund before general partner receive the right to carry interest. The aim of hurdle rate implementation is to motivate management team to outperform traditional financial benchmarks, such as S&P index. Thereby, hurdle rate is frequently in the region of 7 to 10 percent.

Relatively high returns of private equity funds are accompanied with sound risk factors:

- Illiquidity: limited partners do not have a chance to exit of investments on a timely basis, as PE fund is closed-end unit with a certain finishing date

- Unquoted investments: securities publicly traded on a regular stock exchange are less risky in comparison with unquoted stakes in private equity funds.

- Tough competition for attracting lucrative investment targets through private equity funds

- Agency risk: no one can guarantee that management team of portfolio companies will run the business according to expectations of private equity investors.

- Government regulations and taxation risk: the principles of capital gains, dividends or limited partnerships taxation may vary over different economic cycles.

Along with general risk factors of private equity activity presented above, there are some additional points: shortage of investment capital, lack of diversification, market risk, etc.

It worth mentioning, that private equity activity is not limited solely to buyout transactions. On the contrary, there is a wide range of strategies to be applied by managers of private equity company: from investing through venture capital or hedge funds to establishing funds or funds or even real estate foundation. Whereas, the focus of current study is on LBO transactions, private equity activity would be analyzed under an angle of buyout deals.

Institutional Investors

Private equity funds rise a significant portion of external investments with the help of institutional investors - long-term view, patient agents controlling huge financial streams. Pension funds (public, corporate), insurance companies, foundations and endowments, sovereign wealth funds as well as family offices tend to accommodate risks of individuals, providing acceptable return rate by investing in the financial markets (including private equity). Indeed, each of us, paying insurance premiums or pension contributions, indirectly become a passive investor in private equity. Moreover, institutional investors push private equity managers to compete for the most lucrative buyout targets in order to obtain returns in accordance with investor's risk aversion.

As a result, risk tolerance of private equity managers, and therefore, their screening strategy primarily depends on the type of investor that commit capital to this buyout fund. A brief overview of institutional investors' profile aims to clarify potential return characteristics of PE funds.

Pension funds, operating in accordance with defined - benefit retirement plan, assumes making payments to employees as soon as retirement period comes. This commitment bases on agreed terms (seniority, average salary) and is offset by employees' contributions funded over a certain period of time. As a result, risk and return tolerance of pension funds depend on depositors' profile (age, time horizon, etc.). For instance, funds with younger portfolio workers needs low liquidity and long time horizon, while funds burdened with older workers has primarily income focus. In general, due to contractually defined liability requirements and tough legal regulation, pension funds tend to follow conservatively diversified investments strategies. On the contrarily, non-profitable and social oriented foundations and endowments can afford aggressive objectives. As a result, investment profile of foundations requires at least five per cent growth as well as moderate to high risk averse.

Investment and Commercial Banks

Other key leveraged buyout players are investment and commercial bank structures.

Investment banks act as a provider of strategic M&A advisory as well as financial sources. Investments banks are engaged in developing an optimal financial structure. Firstly, precise due diligence on leveraged buyout is conducted in order to adjust the target company's business plan with debt financing capacity. Investment bankers need to be sure that the target will be able to serve highly leveraged capital buyout structures. Secondly, as soon as optimal financial structure approved by all parties, investment bankers take a role of financing commitment providers in order to support private equity fund's bid. In other words, investment banker do their best to ensure that required debt portion of the transaction will be funded under acceptable terms and conditions. Frequently, being underwriters of the mezzanine debt or high yield bonds investment bank guarantees, that sufficient funding will be risen and the deal closed even if a bank fails to negotiate entire debt offering to external investors.

Commercial banks as well as finance companies and loan institutions are classical bank debt providers for LBO financing structures. Bank lenders also conduct due diligence procedures, analyze target's projected cash flows and credit statistics, require covenants and collateral coverage in order to mitigate risk of not receiving future principal and interest repayments.

Bond investors are interested parties, usually attracted via roadshow presentations, during which investment merits of the target company presented as well as terms of proposed transactions disclosed. It worth mentioning, that preliminary offering memorandum containing much of the target company's financial information as well as description of bonds and notes issued to support leveraged buyout transaction. After the roadshow as soon as final terms are adjusted in accordance with the requirements of all parties, final document is signed and distributed to bond investors - generally institutional investors.

1.3 Valuation techniques in leveraged buyout transactions

As soon as all LPs commit their financial contributions in the private equity fund, fund's managers start seeking and analyzing portfolio companies with the aim to invest in. On the one hand, private equity managers have to find business in need of external financing. On the other hand, entrepreneurial should also be interested in raising funds merely through leveraged buyout transformation.

Following a decision about general investment strategy - sector, life-cycle stage, geographic location - private equity fund should attract and evaluate definite deals. Private equity companies use two different ways for transaction selection: “passive” attraction and “active” searching. The first approach is more desirable and lucrative one - proprietary deals fall into your lap like golden apples, the second one is more time and energy consuming as it usually implies tough competition. Indeed, capital intensive buyout deal are widely covered at the time following the announcement, than being closed on highly effective auction, leave no opportunities for private equity to gain easy profits. In other words, “active” searching requires “shaking the apple tree”.

Whereas, the fact of attraction a presumably appropriate leveraged buyout candidate is a half of success. The remaining half depends on quality of valuation conducted.

The next part of current study will be devoted to valuation techniques commonly used in private equity transactions.

“Private Equity firms are a rich laboratory for applying the principles of asset and equity valuation”. CFA Institute. “Alternative investment and fixed income”, CFA Program curriculum 2015, level 2, volume 5 - 2014, page 128 Comparable company and precedent transaction analysis as well as discounted cash flow analysis are the main instruments in this laboratory. Moreover, in a private equity deal classical valuation methods go in step with human relationship, trust and respective motives. Therefore, there is a sound difference between the price paid for a stake by private equity fund and the real value of this stake. Nevertheless, the understanding what valuation methodology should be applied in accordance with the definite stage of target's business cycle is a key skill in due diligence process. Accurate valuation aims to: identify appropriate leveraged buyout candidate; settle clear price limits within which negation process hold; determine the size of debt financing a target can take of. A brief overview of valuation techniques under the angle of possible application for private equity presented below.

Participants of booming private equity market have a tendency to focus primary on income approaches to determine target's value. Income approach aims to evaluate the future economic benefits, generated by a firm and normalize them to the required rate of return. Income approach involves the use of either direct capitalization method or the discounted free cash flow technique.

According to direct capitalization method, the value of an operating enterprise considered equal to the ratio of net income compared to the selected rate of capitalization. Methodology assumes that company's profit is constant throughout the interval of observation, being equal to proceeds of: last reporting year, an average figure for last 3-5 years or the first forecast period. Direct capitalization method is almost never used in buyout valuation as cash flows received after leveraged buyout transformation are highly volatile and hardly to predict in one permanent figure.

Discounted free cash flow method is more appropriate for companies expected to have a significant change in future income compared to the current level.

The main stages of business valuation process with the use of DCF mode are:

· choice of cash flow model;

· definition of the length of the forecast period;

· retrospective analysis and forecast of the gross revenue from the sale;

· analysis and forecast of costs;

· analysis and forecast of investments;

· calculation of the amount of cash flow for each year of the forecast period;

· determining the discount rate;

· calculation of value in post-forecast period;

· calculation of current value of future cash flows and value in terminal period;

· final adjustments.

There are two types of cash flows: free cash flow to the firm and free cash flow to the equity.

In order to analyze how much cash company can afford to return to its stockholders, managers could calculate the free cash flow to the equity (FCFE):

FCFE = Net Income - (Capital Expenditures - Depreciation) - (Change in Non-cash Working Capital) + (New Debt Issued - Debt Repayments)

The disadvantage of using of FCFE approach is that cash flows related to debt have to be considered separately. In other words, evaluating new debt issued and debt repaid when leverage is extremely volatile becomes more difficult with each forecast period.

According to the second approach, cash flows to all claim holders of the business (common and preferred stockholders, bondholders) are added together to form free cash flow to the firm: Aswath Damodaran. “Investment valuation: second edition”, Wiley Finance - 2002, page 533.

FCFF = Free Cash Flow to equity + Interest Expense (1-tax rate) + Principle repayments - New Debt Issues + Preferred Dividends

Free cash flow to the firm might be also measured prior to any claims before equity holders and lenders have been paid

:

FCFF = EBIT (1-tax rate) + Depreciation - Capital Expenditures - ?Working Capital

Worth noting, that interest payments should not be deducted from cash flows in order to avoid double counting of a tax shield. All tax benefits are already incorporated in a cost of capital.

In most transactions, private equity manager faces a large flow of information derived from the due diligence procedures as well as complex financial modelling. The understanding of the potential of the upside and downside power of external (macroeconomic conditions, interest and exchange rates) and internal factors (margins, required financing) affecting the business profile is a key element in a free cash flow forecasting. In other words, when building the qualitative FCFF forecast, managers should apply the wide range of scenarios with assigned subjective probabilities.

It worth mentioning, that forecast horizon generally corresponds to the expected holding period of the PE in the target's equity capital.

As soon as the free cash flow to the firm discounted at the weighted average cost of capital, the value of the firm is calculated. Based on assumptions about the company's future growth, different valuation models could be applied.

Stable growth model applies generally the wide spectrum of companies operating at the maturity stage, with a stable growth rate that is less or equal to the economy one.

FCFF₁ - Free Cash Flow to the Firm at the first forecast period

g_n - constant FCFF growth rate (for an unlimited amount of time, forever)

WACC - weighted average cost of capital

R_D - cost of debt, W_D - leverage ratio Debt/(Debt+Equity)

R_e - cost of common equity, W_e - common equity ratio

R_p - cost of equity (preferred shares), W_e - equity ratio (preferred shares)

Given the emphasis on a constant expected growth rate, stable growth model can hardly provide relevant results when applied to firms after leveraged buyout transformation. Indeed, even if a target company had a steady operating history before a transaction, LBO managers would certainly realign business processes in compliance with a new strategy. Indeed, target business would get additional growth drivers as soon as private equity team improves the business's finance, operating processes, management incentives and marketing power.

The general version of FCFF model virtually solves the problem of growth volatility as free cash flows are adjusted for each forecast period according to new post-LBO strategy.

FCFF₁ - Free Cash Flow to the Firm in year t

If a target company is expected to move into maturity stage after n years and afterwards grow at a stable rate g_n, the value of the company can be calculated as:

In practice, forecasts of future cash flows usually are only available for an expected holding period. Therefore, private equity managers should estimate the terminal value of the target company beyond this time horizon. The one way of doing this, is to apply assumption about perpetual growth rate. The alternative way is to forecast the exit multiple using market approach, and apply this exit multiple to the last holding year's expected values.

The main challenge in discounted cash flow technique is the calculation of the discount factor. DCF methodology assumes that debt ratio of a target company is constant in each year of the firm's life and neglects the financial effect resulting from changes in the debt load. Whereas, the financial structure of leveraged buyout firm is rather flexible, starting with high leverage, LBO company gradually repays debts thus harmonize its financial structure with average industry's levels. Therefore, WACC approach is unable to deal with the specific characteristic of LBO candidates: “debt reduction is a function of cash flow realization and, therefore, is uncertain” Enrique R. Arzac “Valuation of Highly Leveraged Firms”, CFA Institute, Financial Analysts Journal - 1996, page 214.

Moreover, inherently high leverage levels associated with an LBO presume the use of a wide range of debt components: bank debt, high yield bonds, mezzanine debt, etc. WACC approach can hardly take into account the cost of all alternative debt instruments.

Changing Cost of Capital Method Tilman E. Pohlhausen. ”Technology Buyouts. Valuation, Market Screening Application, Opportunities in Europe”, Deutscher Universitats-Verlag GmbH, Wiesbaden - 2003, page 32 is an alternative technique in LBO valuation. According to this methodology, discount rate (WACC) is adjusted for each forecast period separately according to the target's leverage, as planned in the approved debt schedule. As soon as the debt ceases to be calculated as a constant fraction of firm's market value and leveraged beta of equity becomes time - varying, WACC starts to be an appropriate factor in LBO discounting.

Whereas, changing cost of capital method is too technically sophisticated, assumption intensive and time-consuming to be widely used among private equity managers.

Another academic technique for leveraged buyout valuation - Mayer's (1974) Adjusted Present Value (APV). According to Brealey Mayers «APV works fine for LBOs». Brealey Meyers. “Principles of Corporate Finance”, The McGraw?Hill Companies - 2003, page 538

APV model, being a practical consequence of the compromise theory, involves dividing the cash flows into two groups: operating cash flows and the number of cash flows related to the project's financial sources (tax benefits on the loan capital, bankruptcy costs). It is worth noting, financial leverage has no impact on operating flows, since the nature of commercial risk is independent from capital structure.

The process of value estimation with a help of APV approach consists of three stages.

Private Equity managers should begin with value estimation of the target company with no leverage (unlevered firm). In other words, managers analyze the company as if it entirely financed with equity, by normalizing its forecasted free cash flow to the firm to unlevered cost of equity.

In classical weighted average cost of capital model, the levered cost of capital is usually calculated with the help of CAPM model:

]

R_f is a risk free rate; (R_{m -} R_f) - expected equity risk premium; в_{i -} leveraged beta

According APV, unlevered beta is used in order to arrive at unlevered cost of equity:

The second phase in APV approach is the calculation of effects caused by target's financial structure. These financial effects include side effects associated with debt financing at standard conditions (interest tax shields, flotation cast tax shield) as well as effects associated with a financing on favorable terms (preferential interest rate shield, preferential taxation shields). Whereas, interest tax shield has a highest impact on company's value.

Value of Tax Benefits at time t = Tax Rate Cost of DebtDebt

Private equity managers have to project the tax shields for each year and then to discount them to the present year. There are two ways of applying the discount rate:

If debt (required for the LBO transaction) is paid in accordance with fixed predetermined schedule, tax shields could be discounted at the cost of debt. Otherwise, if debt payments are a function of cash flow generation, tax shields should be discounted at the cost of equity.

The third step in APV process is to estimate the effect of the certain debt level on the company's default risk. Expected bankruptcy costs as well as financial distress costs calculated as:

PV of bankruptcy cost = (Probability of Bankruptcy) (Present Value of Bankruptcy Cost) Aswath Damodaran. “Investment valuation: second edition”, Wiley Finance - 2002, page 342

As a result, company's value obtained by adding three components of APV model:

Value of the firm (base case) + Present Value of side effects + Present value of bankruptcy costs

Despite the fact, than APV methodology copes with the problem of predetermined leverage changes in post-LBO financial structures, it is rather academic and sophisticated to be used by private equity managers on a regular basis.

Generally, only two cash events occur for investors during leveraged buyout cycle. The first event - cash outflow - the value of equity originally invested in target business by financial sponsors. The second - cash inflow - the exit equity value, sum obtained after implementation of LBO monetization strategy. Indeed, most leveraged buyout investors expect to monetize investments through the sale of business or initial public offering within five-year holding period. Financial sponsors (senior debt, equity, mezzanine, high yield bonds, etc.) hope not only monetize investments but also receive at least a minimum acceptable rate of return. Indeed, expected rate of is a key negotiation factor in pricing the transaction.

IRR methodology is an appropriate technique to estimate the impact of purchase price, target's capital structure and strategic shifts in operations on the expected returns. Taking into account three factors: the exit equity value, acceptable holding period and the expected return from the investment providers, IRR model indicates the maximum price to be paid for an equity stake in the target company. While the second two factors are determined by invertor's risk appetite, the first one depends primarily on target's operational and financial health. The exit value usually is forecasted by reference to an expected multiples calculated on the basis comparable companies. It worth mentioning, that if a target firm has a sophisticated business model, operates in a niche industry, etc. it would be not so easy to find the right comparable companies or precedent transactions. In order to correctly apply the exit multiple (Enterprise Value - EBITDA), managers should wisely forecast cash flows of the target company throughout the entire holding period. Paul Pignataro. “Leveraged buyouts: a practical guide to investment banking and private equity”, Wiley Finance - 2013, page 42

IRR = (Exit Equity Value/Equity Invested)^(1/cash-out horizon)-1

=> Maximum purchase price = Exit Equity Value/(1 + required IRR)^( cash-out horizon)

IRR technique is not a pure valuation methodology, whereas, being simpler than the previously analyzed models, it provides preliminary view on the degree of leveraged buyout candidate's attractiveness. Indeed, a higher purchase price would lower rate of return until it is not compensated by higher exit value. The lower interest rates, the lower costs incurred, which would permit to pay down liabilities faster and stimulate IRR growth. The shorter cash-out horizon, the higher IRR. These simple rules are assumption intensive and far from being theoretically sound, but are widely used during the process of ideal LBO candidate estimation.

1.4 Value creation drivers in leveraged buyout deals: growth, leverage, optimal capital structure

Average financial return on leveraged buyout investments has historically been very sound, explaining much of their popularity among institutional investors. The question of how value is created in private equity transaction rises heated debates inside and outside PE sphere. The following part of theoretical analysis will be devoted to brief overview of value sources in LBO transactions. Indeed, the understanding of key value drivers might shed a light on the algorithm of selecting the ideal candidates for leveraged buyout transformation.

The advantages of target's operating strategy re-engineering is the first value creation factor in leveraged buyout transactions. Highly qualified consulting capabilities, proven ability to execute global buyout deals (a rich track- record) as well as wide net of business contacts facilitate private equity funds to conduct strategic reforms aimed to stimulate target's revenues, margins and manager's incentives. The same time, many listed companies, like Toyota or General Electric, have established growth strategies with no need for superior re-engineering. Such sustainable companies might be driven by other factors in the potential decision to go private via LBO.

The second key ingredient of LBO success is an availability of credit supply on favorable terms. The impact of financial leverage on target's value could be estimated under the angle of Modigliani-Miller theorem. Indeed, Modigliani-Miler's rule as well as other theories concerting optimal capital structure help to discover what types of firms go private via leveraged buyouts. Scientific concept of determining the target's optimal capital structure would be presented below.

Fundamentals of modern capital structure theory were laid in the classical paper “The Cost of Capital, Corporation Finance and the Theory of Investment” published by Nobel laureates Franco Modigliani and Merton H. Miller in 1958 year. Modiliani F., Miller M. The Cost of Capital, Corporation Finance and the Theory of Investment // American Economic Review, 1958. - V. 48(3). The model proves that under certain circumstances, capital structure does not affect the value of the company, which means that financial policy does not have a key role in the process of target's value maximization. According to the first M&M theorem “cake size does not depend on the way it is cut” or there is no difference whether firm is financed by debt or equity. The evidence base for M&M theory is a notion of financial arbitration. In other words, in an environment where financial markets work effectively in order to enable the investor with opportunity to borrow and provide loans on an independent basis, target's corporate financial policy doesn't affect value, however, can cause major changes in the cost of equity and debt separately.