Leveraged Buyouts

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Carl-Johan Strandberg

Leveraged Buyouts

An LBO Valuation Model

Finance

Master’s Thesis

Semester: Spring 2010 Supervisor: Hans Lindqvist

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Abstract

During the eighties a new type of financial transaction started to emerge on an increasing basis. It was the so called “leveraged buyout” also known as the LBO. In the US private equity firms made it to the headlines in financial media from engaging in leveraged buyouts with small equity investments and large amounts of borrowed capital, their targets where large solid multinational corporations.

Much has happened since the eighties. Back then leveraged buyouts where often associated with terms such as “Slash and Burn” or “Buy, Flip and Strip” often meaning hostile takeovers and huge layoffs. Today private equity firms focus more on active ownership, fast decisions without the bureaucracy of the stock market and long term value creation in order to profit from their buyouts.

As private equity firms today invest tremendous amounts of capital through their private equity funds. Leveraged buyouts have become one of the major areas within investment banking. Even though the LBO is a common transaction it is often hard to find models used for valuation of such a deal. Private equity funds and investment banks all have their own valuation models but these are regarded as strictly confidential and seldom revealed to the public. Therefore the creation and publication of an LBO valuation model should be of great interest for everyone aiming at a future career within private equity, corporate finance or investment banking.

This thesis derives a complete LBO valuation model including a framework for finding a suitable LBO target. The LBO valuation model is created in cooperation with the debt capital markets department at one of the leading investment banks in the Nordic region. The framework is based on a qualitative study conducted on seven of the most distinguished private equity firms active in Sweden. In order to show how the LBO valuation model and the framework works, both are applied on the retail company Björn Borg listed on NASDAQ OMX. To verify the accuracy of the framework, calculated return from the model is analyzed and compared to the indications given by the framework.

Keywords: LBO Valuation, Leveraged Buyout, LBO, Private Equity, Investment Banking, Corporate Finance

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Acknowledgements

I would like to direct an acknowledgment to the private equity firms and their professionals that took part in my study. Regrettably their names have to be kept confidential. Without your participation this thesis would not have been possible. Visiting your organizations and discussing the topic with distinguished investors have not only provided me with invaluable insight into the private equity industry, it has also been a source of inspiration through the often long hours spent on this thesis.

My deepest gratitude goes out to you that have provided me with consensus estimates and financial data not available to the public. Without those numbers the result of my calculations would not have been relevant.

Also, I would like to thank Mr. X on the debt capital markets department of bank Y. The information regarding the LBO loan market that you provided me with has been essential for the completion of the valuation model.

Finally I would like to thank my tutor Hans Lindqvist for giving me useful feedback in the process of writing this thesis.

Carl-Johan Strandberg

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1 Introduction

During the eighties a new type of financial transaction started to emerge on an increasing basis. It was the so called “leveraged buyout” also known as the LBO. The general idea behind an LBO is that an investor acquires control of a company without disposing the capital normally required for these types of acquisitions. The essential part of this equation is spelled debt. Leveraged buyout investment firms also called “private equity” firms¹ or “PE” firms made it to the headlines in financial media with their remarkable deals. One after the other private equity firms took on deals that were even more spectacular than the ones before.

Buyout models have shown to be successful in both rising and falling markets this might be one explanation to why these kinds of deals have increased steeply in popularity excluded the last two years. Much has happened since the eighties. Back then leveraged buyouts where often associated with terms such as “Slash and Burn” or “Buy, Flip and Strip” often meaning hostile takeovers and huge layoffs. Today focus is more on active ownership, fast decisions without the bureaucracy of the stock market and long term value creation. This together with the leverage caused by the capital structure in the portfolio companies often means growth rates and earnings that exceed the performance of public noted companies. As a result of this, private equity funds today are being sought after both as buyers of mature companies with solid cash flow but also by investors trying to leverage their investments. Private equity funds are no longer only for institutional investors. This is another explanation to why private equity deals have significantly increased during the last decade.

Today deals are bigger and private investors can now place smaller amounts in a broad variety of funds.

Figure 1: Global private equity transaction volume between 1985 and 2006.

Source: (Kaplan & Strömberg 2009)

1 Private Equity or PE is equity capital not quoted on a public exchange. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity.

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Figure 1 show how both the number of LBO’s and the aggregated equity value of LBO transactions have increased almost exponentially from the mid eighties until 2006. A dip in deals can be seen through the financial downturn during 1999-2001. Since then, the increase in transactions has been steadily growing from 2001 until the most recent economical slump starting in the summer of 2007.

After that restrictive debt markets, lack of companies for sale and macro economical factors has lead to a decrease in LBO’s during the last years.

Even though the last years and specifically the 2009 decrease in the Swedish private equity market has been worse than ever before seen in history, optimism can be heard among professional investors. In an article in Dagens Industri (Mellqvist 2010), the chairman of SEB, Marcus Wallenberg assures that Swedish banks are open to deals. Deals are still done but to lower leverage levels further a stronger focus is made towards core activities in companies today according to him. Even though there are fewer active funds on the PE market today than two years ago and their aggregated value is lower than before the trend is slowly increasing (Mellqvist 2010).

The four big PE firms with strong presence in Sweden Nordic Capital, EQT, Altor and IK Investment Partners have all done few acquisitions during 2009. However investment activity has slowly started to grow recently and many of the big funds have a positive view on the near future. According to calculations made by SvD, these four PE actors have at least 216 billion SEK in investable capital (Neurath 2010). Björn Savén founder of IK Investment Partners states that 2010 will be an active year for IK (Neurath 2010). In the same article Björn Savén reveals his forecast that buyouts of medium sized companies will increase in the near future while deals including bigger firms will probably never reach the top levels seen during 2006/2007. Björn argues, back then the market was driven by extremely cheap financing in relation to risk. This was not sustainable. In the longer run it is more reasonable to believe that the market will establish itself on levels seen during 2000-2005 (Neurath 2010).

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1.1 Purpose and Thesis Question

The purpose of this thesis is to create an LBO valuation model including a framework for finding a suitable LBO target.

With the purpose stated above, this thesis aims to apply the created LBO valuation model and framework on a company in order to show how they both work.

1.2 Limitations

In this thesis a number of limitations are set up in order to define the area of research. These are purpose limitations, empirical evidence limitations and input & assumption limitations.

1.2.1 Purpose Limitations

The aim of this thesis is to apply the created LBO valuation model and framework on one single company. Testing the framework against several companies should increase its validity but in order to limit the work one single company is used for the analysis.

1.2.2 Empirical Evidence Limitations

The qualitative nature of the conducted study has an inherent limitation. Often quantitative research provides stronger evidence for the findings. However as a qualitative approach is somewhat easier to administer and interpret it is deemed sufficient for the purpose of this thesis. The study is realized on a sample group of seven PE firms with presence in Sweden. This is a limitation as extending the sample group both in number of interviews and geographical coverage could increase the validity of the result.

1.2.3 Input & Assumption Limitations

Companies listed on NASDAQ OMX are used as the sample base for finding a suitable LBO target in accordance with the derived framework. This limitation of the sample group assures for the possibility to acquire company specific information required as input to the LBO valuation model.

Further, as most companies traded on the Swedish stock market have SEK as their currency base it is convenient to use NASDAQ OMX as the sample base.

Availability of company related information is a limitation to the input and assumptions used in the LBO valuation model. In order to predict levels of sales and expenditures, historical financial data is used together with predicted sales growth from the selected company’s financial goals. This is a limitation as historical figures might not reflect the future estimates of a company to the fullest extent. In real life, expensive analytical tools such as Capital IQ, FactSet or Thomson ONE banker is used in order to retrieve consensus estimates. In addition to this professional investors conduct a deeper analysis of the company in order to reach credible estimates for the future development of the target.

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1.3 Disposition

This thesis is divided into the following sections Theory, Method, Empirics, The LBO Valuation Model, Input & Assumptions, Analysis, Conclusion, Discussion, Future Research and Reliability & Validity. In the theory section a general description of the private equity setting is done. Here the different aspects of the PE firm’s business model including their management of the PE fund, the LBO, its financing structure and exit strategies are explained. The method chapter describes the approach used to fulfill the purpose. It includes a description of how the qualitative study on Swedish PE firms where conducted. Under empirics respondents of and findings from the study are presented together with the derived framework for choosing an LBO target. The LBO valuation model section is a step by step passage, showing how the LBO valuation model, attached in appendix I is constructed.

In the paragraph input & assumptions all of the inputs to the LBO valuation model are introduced.

The analysis section contains an analysis of Björn Borg’s suitability for an LBO and an analytical approach to the result of the LBO valuation model. Conclusion reveals the findings of the work. Then a discussion around the conclusion and factors impacting the result is held. Future research contains suggestions for future research that would broaden the understanding of the topic. Finally, a discussion around the validity & reliability of the conclusion is held in order to confirm the accuracy of the result.

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2 Theory

2.1 The Private Equity Firm

As private equity is money invested in companies that are not publicly traded on a stock exchange or money invested in a buyout of a publicly traded company in order to make it private. Private equity firms are companies that manage private equity funds investing in private companies or buyouts of public companies. Private equity firms are often categorized as VC² firms or PE firms depending on their investment profile. In general VC firms provide venture capital to companies in their early stage of development while PE firms invest in mature companies. Venture capital is used by new companies with large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. PE capital is used for growing and enhancing existing companies with well proven business models that often have stagnated in development. A VC firm mainly provides capital to their investments for a stake in the company. As PE firms invest they typically acquire control of their targets through a buyout. These buyouts are often associated with a substantial amount of debt or leverage therefore they are referred to as leveraged buyouts. Leveraged buyouts can be done in several ways. In addition to the LBO, where a PE firm steps in as the new owner, management buyouts and club deals are also common. In a management buyout, MBO, the management of the company becomes the new owner through a buyout. In a club deal, several PE firms work together in order to raise capital for buying-out the target company. Even though the owner structure differs between the buyouts they are all valued in the same way. Here the LBO valuation model is used in order to calculate expected return of the deal.

2.2 The Private Equity Fund

A PE firm raises equity capital through a private equity fund also called PE fund. The PE funds are legally organized as limited partnerships, LP’s where the general partners, GP’s manage the fund and the LP’s provide most of the capital.³ However it is common for the GP’s to provide at least 1 percent of the total capital. The typical PE fund are a “closed-end” vehicle which mean that investors commit to provide a certain amount of money to the fund until date of termination.⁴ A PE fund typically has a fixed life between seven to ten years but can be extended for up to three additional years. Invested capital is used for investment in portfolio companies⁵ as well as management fees to the PE firm. The PE firm normally has up to five years to invest the fund’s capital committed for portfolio companies.

After that it has an additional five to eight years to return the capital to its investors. After committing their capital, limited partners have little say in how the general partner deploys the investment funds as long as the basic covenants of the fund agreement are followed. Common covenants include restrictions on how much fund capital that can be invested in one company and types of securities the fund can invest in etc.

2 VC or venture capital is money provided by investors to startup firms with perceived long-term growth potential. This is a very important source of funding for startups that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-average returns.

3 The PE firm serves as the fund’s general partner. Limited partners typically include institutional investors such as corporate and public pension funds, endowments, insurance companies and wealthy individuals.

4 This contrasts with mutual funds which are so called open-end funds where investors can withdraw their invested capital whenever they like.

5 Companies bought and managed by PE funds are referred to as portfolio companies.

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By managing PE funds the PE firm or general partner is compensated in several ways. First the general partner earns an annual management fee, usually a percentage of capital committed. As investments are realized the general partner gets a percentage of capital employed. Also the general partner earns a share of the profits of the fund, a so-called “carried interest” that almost always equals to 20 percent (Kaplan & Strömberg 2009). Finally some general partners charge deals and monitoring fees to the companies in which they invest.

2.3 The Leveraged Buyout

Finding a suitable target for an LBO is very much about finding companies that has unused debt capacity. Here cash flow plays an essential role. In an LBO, free cash flow is used to pay down debt. In theory the value of the equity in the firm will increase as debt is amortized. Also, in the post-LBO firm managements share ownership significantly increases their incentives to work hard in order to maximize their own wealth provided by their equity stake. This is sometimes referred to as a “carrot”

effect on the management. The heavy debt burden also forces managers to run the company efficiently in order to avoid bankruptcy. This is referred to as a “stick”. Both the “carrot” and the

“stick” ensure that management is doing their best in order to run the company as efficient as possible. In addition to this third-party investors such as the PE firm acquire a large equity stake in the target company. This provides these investors incentives to motivate and monitor managers. In order to do this PE firms often hold chairs in the board of the company. Arguments of how these incentives works together and creates value in an LBO are presented by Jensen’ in his studies (Jensen 1986) and (Jensen 1991). Further many studies have provided empirical evidence that supports Jensen’s arguments (LEHN & POULSEN 1989), (Kaplan 1989), (Baker & Wruck 1989), (Smith 1990), (Denis 1994), (Wruck 1994).

Figure 2: The LBO concept.

Source: (Citigroup corporate and investment banking 2006)

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Figure 2 show the LBO concept where the purchase price is primarily financed through different debt instruments that are paid down with future operating cash flows⁶ of the acquired company.

According to the source (Citigroup corporate and investment banking 2006) initial capital structure typically consists of 75% debt and 25% equity. These numbers varies from deal to deal and also depends on macro economical factors and debt issuer’s willingness to take on risk. The same goes for stated IRR⁷ in the figure as it also differs depending on demands from investors. However, an IRR of 25-30% seems likely to be accepted by most PE investors in Sweden as the mean value of cost of capital for Swedish buyout firms is 23% according to a study by the Swedish Venture Capital Association (Svenska Riskkapitalföreningen 2009).

The different debt layers in figure 2 represents the various sources of debt ranging from high cost debt such as High-Yield / PIK note financing in debt layer 1 down to low cost financing such as a revolving credit facility and term loans in layer 5. The “revolver” in layer 5 is typically undrawn at the exit of the deal. However a certain amount of debt is often left after exit due to tax shield benefits.

From time of entry throughout the time until exit, debt is repaid. As the enterprise value remains constant, these transactions result in a considerable equity growth. Equity growth together with value creation activities conducted by management and sponsors are translated to proceeds for investors at the time of exit. In order to keep cash flows maximized during the holding period, no dividends are paid out to share holders.

Further, the key return drivers of an LBO can be categorized as follows (Citigroup corporate and investment banking 2006).

 Leverage on acquisition and subsequent debt pay down. This is done through maximizing of free cash-flow through strict CAPEX, R&D and working capital discipline.

 Increased firm value through EBIDTA growth between time of investment and exit. Possible through sustainable earnings growth, cost control and possibly restructuring upside or synergies with other companies in the portfolio of the financial investor.

 Increased firm value through multiple-expansion between time of investment and exit.

Driven by evolving industry fundamentals (e.g. cyclicality of industry), quality of assets, enhanced organic growth outlook and improved equity capital market conditions.

 Limited duration of investment. Value is created by, buying in weak markets and exit during robust M&A and equity market within a 3-7 years period. Here, tradeoff between time to exit, total proceeds and IRR is important.

6 Operating cash flow, OCF=EBIT+Depreciation-Taxes

7 IRR or Internal Rate of Return is a discount rate often used in capital budgeting. IRR makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project.

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2.4 The LBO Financing Structure

Traditionally in an LBO transaction, debt has typically been around 75% of the financing structure (Citigroup corporate and investment banking 2006). However, today financing with debt levels somewhere close to 50% is more common. Given the high levels of debt included in transactions like this, the ability for PE funds to lend money is crucial. The information regarding the different debt instances provided below is extracted from discussions with the debt capital markets department of a leading Nordic investment bank⁸ and a report written by Citigroup’s corporate and investment banking department (Citigroup corporate and investment banking 2006).

Interest rates for loans issued by investment banks through a syndicate of lenders consist of two parts. The first part is the official interbank offer rate for short term loans in Sweden. The Stockholm Interbank Offer Rate is referred to as STIBOR. STIBOR is the interest rate banks are charged when borrowing from other banks for maturities longer than overnight. The rate is determined by Riksbanken⁹ and fluctuates over time¹⁰. In order to hedge interest rates on loans in an LBO an instrument called Interest Rate SWAP, or just SWAP, is utilized. SWAP instruments are OTC¹¹ contracts provided by investment banks and financial institutions. SWAP rates are fixed during the instruments term and the actual rate differs depending on the term of the contract. Common terms for SWAP instruments are 1, 3, 5 or 10 years.

On top of the SWAP rate banks charge a spread or margin on their loans. This spread/margin is the premium that the bank charges in order to make a profit. Spreads are negotiated for each debt facility and is highly dependable on the current capital market as well as the risk associated with each loan. For example, if the spread is 2.50% for a revolving credit facility and the current SWAP rate is 3.16%, the actual cost of the loan is 2.50%+3.16%=5.66%.

The debt part of the LBO financing structure often includes a broad array of loans, securities or other debt instruments with varying terms and conditions that appeal to different classes of investors. The financing structure is unique for each deal. Each credit facility is negotiated and therefore the cost and size of the different facilities differs from deal to deal. However a similar financing structure is applied to all buyouts. The structure comprises of the following sources of finance.

 Senior debt or first lien secured debt such as a revolving credit facility and term loan facilities. This is the cheapest type of debt.

 Mezzanine debt, ranked between traditional debt and equity.

 High-Yield Bonds, referred to as corporate bonds.

 Equity contribution, the lowest ranked source of finance and therefore the most expensive.

8 No further reference can be done due to the banks confidential policy.

9 Riksbanken is Sweden’s central bank.

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Senior debt is the main financing source in an LBO and typically has a term of 5-10 years. It consists of bank loans with a higher ranking, lower flexibility and lower cost of capital than the other sources of funds. As it ranks higher than other securities in regards to the owner’s claims on assets and income in the event of the issuer becoming insolvent, it has a lower cost than lower ranked debt such as mezzanine, high-yield bonds and equity contribution. Interest rate is SWAP plus a spread of 2-3%

with the credit spread tied to the appraised fair market value of land and buildings, enterprise value as well as the liquidation value of machinery and equipment. Senior debt is somewhat flexible with varying collateral and covenant packages as well as amortization schedules. It often comprises of 25- 50% of the total deal. The debt is used to finance property and equipment as well as other long-lived assets, acquisitions, buyouts and stock repurchases. Main lenders are commercial and investment banks, mutual funds, structured investment funds and finance companies.

A traditional cash flow revolving credit facility also called “revolver” is a senior debt secured by inventory and accounts receivable which is the most liquid operating asset. It is a line of credit extended by a bank or group of banks that permits the borrower to draw varying amounts up to a specified aggregate limit for a specified period of time, often 5 years or more. It is unique in that amounts borrowed can be freely repaid and re-borrowed during the term of the facility. A revolver requires the borrower to maintain a certain credit profile through compliance with financial maintenance covenants contained in a credit agreement. It is common for companies to utilize a revolver or equivalent lending arrangements to provide ongoing liquidity for seasonal working capital needs, capital expenditures, letters of credit and other general corporate purposes. A revolver is most often not used to fund the purchase of the target in an LBO. Also it is usually undrawn at close.

Revolvers are typically arranged by one or more investment banks and then syndicated to a group of commercial banks and finance companies. In order to compensate lenders for making this credit line available to the borrower, a nominal annual commitment fee is charged on the undrawn portion of the facility. The revolver often comprises of 5-15% of the total deal but depends on the fluctuations in working capital. Typical interest rate is SWAP plus a spread of 2.0-2.5% cash interest only, with credit spread tied to value of current assets, financial performance and risk measures.

A term loan, called “leveraged loan” when non-investment grade, is a loan with a specified maturity that requires amortization according to a defined schedule. Like a revolver, a traditional term loan for LBO financing is structured as a first lien debt obligation and requires the borrower to maintain a certain credit profile through compliance with financial maintenance covenants contained in the credit agreement. Unlike the revolver a term loan must be fully funded on the date of closing and once principal is repaid, it cannot be re-borrowed. Term loans are classified by an identifying letter such as A, B or C etc. in accordance with their lender base, amortization schedule and term.

Term loan A, called “TLA”, are commonly referred to as amortizing term loan because it typically require substantial principal repayment throughout the life of the loan. Term loans with significant annual required amortizations are perceived by lenders as less risky than those with a looser repayment schedule. Consequently, term loan A’s are often the lowest priced term loans in the capital structure. Term loan A’s are syndicated to commercial banks and finance companies together with the revolver and are often referred to as “pro rata” tranches because lenders typically commit to equal percentages of the revolver and term loan A during syndication. Term loan A’s in the LBO financing structure often have a term that ends simultaneously with the revolver.

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B term loans, or “TLBs”, are commonly referred to as “institutional term loans” due to the fact that they are sold to institutional investors. Term loan B’s are used to a greater extent than term loan A’s in LBO financings. Typical, term loan B’s are larger in size and has a longer term than term loan A’s. A reason for the longer term is that, bank lenders prefer to have their debt mature before term loan B’s. Term loan B’s are generally amortized at a nominal rate such as 1% per annum. The rest is repaid as a bullet at maturity. Common tenor for term loan B’s is up to seven years. As institutional investors prefer non-amortizing loans with longer maturities and higher coupons, TLBs are more suitable for them to invest in than term loan A’s.

Mezzanine debt is a highly negotiated instrument between the issuer and investors. It is tailored to meet the financing needs of the specific transaction and required investors return. As such it allows for great flexibility in structuring terms. It provides incremental capital at a cost below that of equity, which enables stretching of leverage levels and purchase price when alternative capital sources are inaccessible. Mezzanine debt has embedded equity instruments, usually warrants attached to it.

The issuance of corporate bonds is an additional more expensive source of finance if senior debt is used up. Because of the inherent high leverage levels associated with an LBO, these bonds are usually deemed non-investment grade. This is a rating of “Ba1” or below from Moody’s Investor Service (Moody's 2009) and “BB+” or below when using a rating scale from Standard and Poor’s (Standard & Poor's 2009). Due to this, bonds issued through an LBO are often referred to as “high- yield” or in some cases “Junk” bonds because of the relative high risk associated with this type of investment. Typical term of the bonds is 6-10 years and they mature after the senior debt. Issuance of bonds is a flexible instrument that can be structured as a debt security with fixed equity coupon and equity-linked features such as warrants. High-Yield debt is often structured as 20-40% of total deal cost. It has yearly payments of interest and repayment of principals at maturity. Interest rate is SWAP plus a spread. Size of spread is tied to cash flows and depends on the investment grade of the bond. Main lenders are pension funds, insurance and finance companies, debt and mutual funds, hedge funds or other institutional and private investors. High-Yield debt is usually publicly traded.

Equity stake in an LBO today usually comprises of 50-60% of the total capital. However this figure varies through time and is highly dependable on bank covenants. As dividend and liquidation rights are subordinated to the interest of the debt lenders, equity contribution provides a cushion for lenders and bondholders in the event that the company’s enterprise value deteriorates. Shareholders often receive their invested capital back at the time of exit, typical after 3-7 years. Management often invests in equity with the LBO sponsor. In most buyouts, a PE firm is the LBO sponsor. Sponsors typically seek a 25-30% compounded annual total return over five years. For large LBO’s several sponsors may team up to create a consortium of buyers, thereby reducing the amount of each individual sponsor’s equity contribution. This is known as a “club deal”.

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2.5 Exit Strategies

As stated above most PE funds exit/monetize their investments in a portfolio company within approximately 3-7 years. This is done in order to provide timely returns to their LPs. The primarily exit strategies are:

 Financial sale includes sale to another PE fund, LBO-backed firm or investment company.

 Industrial sale means sale to strategic buyer or sale to management.

 Secondary buyout, recapitalizations of the company in a new LBO.

 IPO, in an Initial Public Offering the PE fund sells a portion of or all its shares in the target to the public. This means bringing the company back to the stock market.

 Dividend Recapitalization, while not a true exit strategy this means issuance of new debt used to pay shareholders a dividend instead of proceeds from a company sale.

 Bankruptcy, this option is not preferred.

Figure 3: Exit strategies used by Swedish PE firms during 2007.

Source: (Swedish Private Equity & Venture Capital Association 2009) 41%

30%

10%

8%

8% 3%

Industrial sale 41%

Other exit 30%

Finansial sale 10%

Sale to other PE firm 8%

IPO 8%

Sale to entrepreneur 3%

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3 Method

To build a relevant framework for finding a suitable LBO candidate a series of interviews with PE firms active on the Nordic market where conducted. The study revealed what distinguished investment professionals look for in a potential target company. It also gave answer to other important questions needed for the creation of the LBO valuation model. Some of those questions discussed demands on expected return, average holding periods, reasonable premiums and suitable exit strategies etc.

Due to the high level of secretes in the PE industry, many of the approached firms were reluctant to participate in the interviews if their identity where revealed. Therefore no firm names are used when presenting the results of the study. Instead a short description of the interviewed firm regarding its size and investment profile assures the reader that the participating firms are among the absolute top tier investors in the Nordic region.

In order to find suitable interview candidates the Swedish PE setting was screened. From the screening procedure a list of twenty-eight interesting companies appeared. The list is presented in appendix II. Each company from the list where sent an envelope containing a personally signed interview inquiry. See appendix III for the complete inquiry letter. As the companies responded to the inquiry a discussion regarding their participation emerged. While some of the approached firms claimed that they were not suitable to participate in the study due to their lack of knowledge regarding LBO’s, others referred to secretes as a reason to decline the offer. Also, after digging deeper into the asked firm’s business models some of the companies where taken of the list due to their lack of experience from LBO’s. As the list narrowed down, only a few firms showed extensive experience from LBO’s and PE investments. From those, seven firms were chosen as interview objects. These seven all has a long history on the Swedish PE market and has participated in numerous well known LBO’s during the last decade. As such, they all provide a solid foundation of knowledge suitable for deriving the framework and LBO model in this thesis.

The qualitative study that this paper is based upon is of a semi-structured character. Each interview was an open discussion but with certain questions guiding the outline. See appendix IV for the complete interview outline. Each respondent had been sent the questions in advance in order for them to think over their answers. This was also a good way to assure for the discussion to flow as smooth as possible. Six of the interviews were conducted face-to-face at the interviewed firm’s offices. Being able to sit down with the interview target and talk over the topic gave the interviews a good depth. The interviewed persons were asked to contribute with their experience regarding the topic. This assured that important aspects of the topic not covered by the outline also where discussed. Each interview where recorded, this was strictly for academic purpose and all recordings where erased after the completion of the thesis. One of the interviews where responded to by email.

In this case the respondent wrote answers to the questions formed in the outline, here no deeper discussion where conducted.

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Companies listed on NASDAQ OMX where used as the sample base for finding a suitable LBO target according to the framework. A thorough analysis indicated that Björn Borg could be appropriate for a buyout. Further an LBO valuation model was created from discussions with debt capital markets at a leading Nordic investment bank. To evaluate validity of the derived framework, the LBO valuation model was applied on Björn Borg and the result was analyzed.

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4 Empirics

4.1 Description of Respondents

Firm A is one of the leading alternative asset managers in the Nordic countries and Russia. They manage funds with approximately €3.6 billion in total capital. Their team comprises 150 people in Helsinki, Stockholm, Copenhagen, Oslo and Moscow. Buyout investments have been a part of firm A’s investment strategy since the company’s foundation in 1989. Their buyout team is working locally in the Nordic countries. The firm’s investment professionals work closely with the management teams to develop their portfolio companies. They are aiming to be an active value adding owner of its portfolio companies. Firm A buyout invests in mid-sized unquoted Nordic companies in various industries. Their team has in-depth expertise in multiple sectors such as manufacturing and engineering, industrial services, retail, outsourcing, and healthcare. Main targets set for portfolio companies are growth, improved profitability and strengthened strategic position. Firm A buyout has currently 27 portfolio companies and invests in businesses with typical net sales of €50-500 million and market cap of €50-250 million.

Firm B is a private equity investor that owns and develops middle sized companies whose revenues range from 400 million to 4 billion SEK. Their target profile is profitable and stable companies with dedicated and ambitious management teams. Firm B currently manages 8.5 billion SEK invested in three funds. Their primary sources of capital commitments come from international pension funds, endowments and insurance companies. In their role as owner they appoint boards of directors, which give tight support to management and foster continued development of the business. They recruit prospective board of directors from their extensive network of industrial advisors. Since its inception, firm B has been introduced to more than 2000 companies across the Nordic region. In total, this has so far led to 30 acquisitions and 71 follow-on acquisitions. The firm aims to double the earnings of portfolio companies they own. Firm B is an active owner, bringing focus, know-how and capital to its portfolio companies. In 1997 firm B launched a 200 million SEK fund. Today the fund is closed and all its capital, including profits, have been returned to investors. An independent evaluator ranked a firm B fund, as one of the world’s most successful funds of its vintage. Their latest fund was launched in 2007 and has aggregated capital commitment of 5.2 billion SEK. Firm B has been generating excellent returns to their investors over the last fifteen years.

Firm C is a leading independent Nordic buyout firm with exclusive focus on middle market transactions where enterprise value typically ranges between €50-200 million. They have an experienced team with demonstrated ability to create investment opportunities. Their team is a complementary combination of investment, operational and consulting expertise. It consists of 17 persons with extensive local and international expertise. Firm B targets companies with a sustainable competitive advantage in the Nordic marketplace. They have a proven track record of building better and more competitive companies. In order to do this firm B engages in intensive partnerships with management to generate tangible operational improvements. The firm has a strategy to deliver returns through organic growth and add-on acquisitions. They act as a provider of equity capital and debt facilities but also a strategic sparring partner with an extensive analytical toolbox. Since 2000, firm C has invested more than €226 million in 39 transactions. Today they manage three funds aggregating over €550 million. Firm C is one of the most experienced Nordic middle market buyout

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Firm D is a private equity firm focused on investing in and developing medium sized companies in the Nordic region. The typical size of their investments is €25-150 million in equity, but selectively they can take on investments with up to €400 million in equity. Firm D provides buyout and growth capital in companies with revenues of €50-500 million. They have an investment team with members presenting every Nordic country. Their members all have international experience in fields such as private equity, consulting, investment banking and various industrial sectors. Leading institutional investors from the Nordic region, the rest of Europe and the US have committed a total of €3.8 billion to firm D in three funds. Their latest fund was closed in 2008 with a committed capital of €2 billion.

Firm D’s investment strategy is to target sustainable performance improvements in order to build the strongest possible business over time. Such fundamental improvements are pursued within all fields including enhanced revenue growth, margin expansion and capital efficiency. Firm D also actively seeks to build and develop businesses in partnerships with the incumbent owners and has achieved such co-ownerships in a majority of its investments to date.

Firm E is a private equity firm focusing primarily on investments in large- and medium-sized companies in the Nordic region and on selected international investment opportunities. Since 1989 firm E’s funds have invested in a large number of Nordic-based companies operating in different sectors. In a dedicated partnership with management of the portfolio company, firm E seeks to create value in its investments through committed ownership and by targeting strategic development and operational improvements. Their model for value creation is characterized by a careful approach to investment selection, a drive for excellence and a committed ownership mindset.

The firms disciplined investing involves multiple deal sourcing channels, careful analysis, thorough due diligence and a clear post acquisition plan. Their overriding aim is to build enduring partnerships and create long-term value, whether by creating new industrial combinations, pursuing a strategic repositioning or exploring internationalization opportunities. Firm E’s investment advisors have extensive experience in private equity investments, mergers, acquisitions and public equity offerings.

Their investment professionals have backgrounds in investment banking, management consulting and industry. In addition, a unique and extensive external network of experienced industrialists and specialists advise them on a situation by situation basis. Firm E is currently investing their latest fund which reached its hard cap in 2008 with €4300 million in committed capital. Well-known international institutional investors including private and public pension funds, insurance companies, endowment funds and funds-of-funds have invested capital in firm E’s funds. They currently have offices in Jersey, Copenhagen, Frankfurt, London, Helsinki, Oslo and Stockholm. In November 2009, Wall Street Journal, together with Dow Jones and Private Equity News/Financial News, published a list of the world’s top 10 private equity firms, where firm E ranks 2^nd place based on performance.

The list is based on academic research providing a view of a private equity firm’s performance relative to its peers during 1996-2005.

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Firm F manages a group of private equity funds focusing on investments in lower mid-market buyout and later-stage expansion capital transactions in the Nordic region. Firm F was founded in 1994.

Since then, they have invested in more than 50 Nordic mid-market companies and successfully realized some 40 of these investments, becoming the undisputed leader in its market segment. Firm F invests in companies where they can serve as a catalyst for change and thereby transforming these companies into Nordic, European or global market leaders by providing for genuine and sustainable improvements within operations and strategic positioning. Since 1994, firm F has managed 6 funds with total commitments exceeding €1 billion, delivering superior returns to its investors. The funds are backed by well-reputed Nordic and international institutions including public and private pension funds, insurance companies, endowment funds and funds-of-funds. Overall, the Nordic region represents 20%, Europe 60%, the US 20% of investments into firm F’s funds. Some 30 institutions from 10 countries make up the investor base. Firm F has a staff of 10 investment professionals with a broad range of industrial and financial experience. Size of investments is €5-50 million in equity investment per transaction, including follow-on investments.

Firm G is a leading Northern European mid-market buy-out firm with a unique regional footprint.

They lead buy-outs within the €50-500 million deal range in the consumer, industrial and services sector. The firm target opportunities for majority stakes in profitable, cash-generative companies headquartered in the Netherlands, Nordic region and the UK. Firm G currently has €1.66 billion of total funds under management. Their transactions are a direct result of their long term strategy based on local presence together with regional sector expertise and intelligent reading of the market.

The investment strategy of their buyout teams are firmly based on local knowledge and a committed partnership with management. Firm G has a team of 25 investment professionals operating from 3 offices in Amsterdam, London and Stockholm. They have a wealth of experience in closing and managing successful deals in the Northern European region. Their network of sector specialists can advise them when originating deals and their trusted external industry specialists help them realize areas of potential value creation and assist management to deliver on the agreed growth strategy.

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4.2 Interview Findings

Even though the seven interviews where of a semi-structured character they all pointed in the same direction. The answers to the questions formed in the interview outline, seen in appendix IV, gave a similar picture from all of the respondents. Small differences in their answers where noted. However these differences seem to reflect the firm’s size, investment profile and industry focus rather than a radical view on the buyout market today. In order to keep the respondents anonymous, their answer to each question is not presented in the thesis. Instead a summary of the interviews is presented below.

4.2.1 Number of Acquisitions during the Last Two Years

A majority of the firms has done fewer acquisitions and less exits during the last two years. Main reasons for this is said to be that the current market condition has made it hard for seller and buyers to agree on reasonable price levels. The current downturn has also led presumptive target companies to focus on other things than selloffs. The higher cost of debt and the unwillingness from banks to lend money has played a secondary role in the decrease of buyouts. Even though it has affected the number of transactions done during the last two years it cannot be claimed to be the main reason for the decrease. However, PE firms have been affected to a higher extent by the increased cost of debt compared to their competitors in a bidding situation, the industrial buyers. PE firms have in general a bit weaker competitive position compared to industrial buyers due to the fact that PE firms often need to lend more money than the industrial buyers. The financial turbulence has also forced some of the PE firms to work a lot with their current portfolio companies in order to fulfill the covenant demands from lenders. Therefore they have not been able to focus on new acquisitions to the same extent as before. As indicated above, the far most important reason for the decrease in transactions is said to be the lack of sellers. This is particularly evident in the answer from one of the respondents. “When the economy fell off, all sellers disappeared and pricing uncertainty emerged.

These factors are far more important than the cost and availability of debt.” One firm also claims that fund technical aspects have been a reason for them to decrease the number of investments. “Our funds are fully invested, so we did not have any room for additional investments.”

Even though the majority of respondents claimed that their buyout activity has stagnated, there were some firms that had done surprisingly many deals during the last year. This is explained as an expression of each opportunity rather than a reflection of the current market condition. Here distressed companies is said to be attractive buyout candidates due to their low market values.

Another firm answered that they have done several acquisitions during the previous years because their analysis showed on possibilities to buy companies to lower multiples during the downturn. This together with the fact that they just started a new fund made them believe that is was a good time to invest. However the same respondent underpins that sellers still value their companies at too high multiples, therefore you need to dig deeper into the market in order to find attractive investments.

Also, the fact that the same firm invests in smaller companies than their peer’s has made them more insensitive to the cost of debt and ability to raise large amounts of debt.

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4.2.2 Impact on EV’s Due to the Downturn

The question regarding the recent downturns impact on enterprise values had similar answers to the previous question.

“There were no companies for sale during the downturn. No one wanted to sell when their companies where low valued. Sellers still had a high price that did not reflect the market. Buyers were not willing to pay more than the market value of the companies. Therefore no deals were done.” Other respondents stated the same thing when they said. “It is true to some extent that the economical slump lowered the EV’s and provided for attractive entry multiples but in most cases sellers still value their companies as before the downturn.” As revenues still have not reached the same levels as before the slump, current multiples tend to be quite unattractive. Also if prices actually dropped willingness among owners to sell decreased. Again distressed companies could be of interest due to the fact that they might have to sell at a low multiple. There will always be an arbitrage if one is able to buy a cyclical company when it has low earnings and is low valued, if it will come back to higher earnings during a reasonable time frame.

4.2.3 Premiums

All of the respondents agreed on the fact that buyout premiums are highly depending on the actual target and how you calculate the premium. Some suggested that it is natural to calculate how large premium the LBO model can motivate. In most buyouts from the stock market there is no bidding procedure. Instead it is more common for a presumptive buyer to place a bid and hope for accept.

Premiums depend on the owner structure of the target company. As small shareholders do not make any threat to the deal price, the important thing is to agree on the price with the largest shareholders. Worst case scenario is if owners with more than 10% of the shares do not accept the bid. Such owners, for instance aggressive hedge funds sitting on these kinds of corner positions could hinder a sale. A situation like that could force the buyer to increase the bid. In a bidding scenario the premium of course depends on other bidders. Today, the market has a tendency not to appreciate bids from PE firms. In general, if a PE firm and an industrial buyer places bids on the same target, owners want to have a bit more in order to go with the PE firm. Here one respondent says that the PE industry needs to be better at communicating their business model in order for target owners to gain increased confidence in the PE funds as owners.

The interviews indicated that a reasonable premium assumption could be somewhere between 20- 30% even though one respondent explained how this number in reality could range between 10- 100%. Premiums are also highly dependable on the major stock holder’s in-price and the development of the stock. If the valuation of the company is low due to temporary causes such as low earnings during a downturn, premiums tend to be higher and vice versa. Therefore in a decreasing stock market premiums are significantly higher, probably around 40-60%. If a stock is traded close to all-time high or over the last three years average lower premiums can be motivated.

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4.2.4 Holding Periods

The study showed that the typical holding period for PE firms today is between 3-7 years. Ten years ago holding periods where a bit shorter, typically 3-5 years. As the PE industry started to emerge in the Nordic region during the 90ies, it was possible to buy cheap and do small changes to the portfolio holdings before you sold them off for a higher price. These multiple arbitrage situations are scarce today. Nowadays it is much harder to buy cheap. Therefore the holding periods tend to be a bit longer. In the current market, a PE firm needs to create value for the portfolio company in order to sell it at a higher price. This is one of the explanations for the longer holding periods seen today. A major part of the respondents stated that they had postponed exists during the last two years due to the lack of buyers on reasonable price levels. In such cases, if it is clear that the company has a steady continuing growth, it could be good to prolong the holding period.

All of the interviewed firms preferred a shorter holding period over a longer one, as long as their demands on IRR and cash return were fulfilled. Most of the funds have an option to hold their investments longer than 7 years, sometimes up to 10 years if the market condition hinders them from making a profitable exit before. However, in LBO calculations, PE firms often apply a 5 years holding period in order to compare different cases to each other. Branch standard applied in calculations were said to be 3-5years.

4.2.5 Exit Strategies

When deciding upon exit strategies, all of the respondents work with “dual track” schemes in order to evaluate the best possible exit strategy. This is often done before the acquisition. In general the PE firm has more than one possible exit strategy. Suitable exit strategies differ from time to time. Here, trends in the economy often decide what strategy is best for the moment.

Historically there have been a lot of financial sales to other PE firms. Portfolio companies were bought from smaller actors and sold onto bigger players. This was how it worked before the downturn and it was partly explained by the fact that PE firms could increase their loans steadily and therefore pay higher prices. This led to steadily increasing prices in the past. At the same time industrial buyers had a hard time motivating the high prices on companies. In the more recent past, during 2009, there have been many industrial exits. This is explained by the fact that industrial buyers today has a greater understanding for how value is created in the targets and therefore can compete with bids from PE actors. Industrial buyers also have a lot of capital and are not that dependant on the credit market conditions. This has given them an advantage during the downturn.

Most respondents prefer when other actors, both industrial and financial, approaches them with an offer. This can in certain cases avoid the negative development in sales price that often occurs if an investment bank tries to push a company onto the market without having a pronounced buyer present.

Some companies are better suited for an IPO than others. Some are too small. For a company to fit on the stock market it needs to be of a certain size and somewhat non-volatile in order to deliver predictable dividends to shareholders. Stable companies are easier to sell at an attractive price level on the stock market. Respondents state that IPO’s are a stronger exit alternative today than a year ago. However, in the case of an IPO timing is often of great importance. In many cases industrial buyers have synergy effects from the acquisition of a company. Therefore they can pay a high premium. This gives industrial- or financial-sales a slight benefit compared to IPO’s where the seller

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receives market price for their company. Another disadvantage of the IPO is that a seller cannot exit 100% of the company at once. Instead they have to keep a certain amount of shares in the company for some additional time in order to create confidence among the new shareholders. The study highlights that the key to exit your holdings with a significant profit is to provide well positioned and professionally managed companies to the market at the right time. Deciding factors for choosing an exit strategy are valuation and smoothness of the process. As an IPO often means a smaller premium and costs a lot of time and money, most of the interviewed firms prefer an industrial- or financial- sale in the form of a recap.

4.2.6 Leverage Levels

During the eighties, but also more recently in 2007 and beginning of 2008, LBO’s with leverage levels up to 80% where not uncommon. The recent financial downturn has lowered the debt/equity ratios significantly. All of the asked firms were of the same opinion when they said that deals today typically comprises of 50% debt and 50% equity. However, the number differs a bit from deal to deal.

Here the financials and character of the target decides how much you can pull from the debt market.

A stable business can have a debt/equity ratio up to 60% today. A high EBITDA makes it possible to have more debt and less equity in the capital structure. Today, banks will lend you up to 3-4X EBITDA in senior debt depending on stability and size of the target. In a more complex debt structure it should be possible to add 1X EBITDA with the use of mezzanine or other subordinated debt. This makes 5X EBITDA the maximum amount of net-debt available for an LBO in the current market according to the study.

When asked about increasing leverage levels in the future, the consensus where that the debt/equity ratios probably will reach the high levels seen during 2007 again. However, it will take a very long time before that happens.

One respondent comments “We will probably see those levels again but it will take a long time. A year ago it was almost impossible to get finance from banks for these kinds of deals. Margins and set up fees where extremely high. The strengthening of the market has been rather fast during the last year, so today, the market looks much better than it did a year ago. Levels seen during 2006-2007 were too high. It was too easy and cheap to borrow money back then.”

Another respondent state, “I don’t believe that we will see debt/equity ratios at 80% in a close future. This is a too high leverage level that can lead to bankruptcy.”

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4.2.7 Value Creating Factors in an LBO

The interviews revealed that the most value creating factor in an LBO is not the financial transaction itself. Optimizing the capital structure and receiving a financial leverage from the tax shield accounts for around 20% of the value creation. Approximately 30% comes from multiple expansion and the rest, 50%, from operational changes, so called soft values.

One of the interviewed companies described the value creation process as following.

“We will create an optimal capital structure for the portfolio company. We seek to improve the company’s competitiveness and profitability by refocusing business unit strategies, operational enhancements to improve margins, balance sheet management and efficient use of capital. We will also pursue add-on acquisitions and divestments, focus on core activities, divest non-core operations and build critical mass to play a leading role in the industry.”

All of the respondents were focused on EBITDA growth. Here management plays an important role in the future development of the portfolio company. Aligning management interests with the PE firm’s interests is essential in making a profitable deal. Most of the participants in the study look at “best practice” actors in the industry in order to benchmark their portfolio companies and try to develop them in the same direction. This often means cutting costs and having a strategic plan for growing market shares etc. Here the financial operations such as capital structure plays a secondary role in the increase of EV/EBITDA multiples. Private equity is good at shrinking the balance sheets by cutting costs. The capital freed by these actions has traditionally not been used for amortizations of debt.

Instead it has been used for growing the company by acquisitions. This increases the revenues for the company. By doing so, you can make a recap after a couple of years and continue to grow the company without investing more capital.

Another firm described the value creating process like this.

“We act as the catalyst in realizing long-term profit enhancement. Setting mutual long-term goals with portfolio company management is a critical factor in successfully creating value. This might include actions that require several years to come to fruition such as strategic add-on acquisitions, aggressive organic growth or establishing an international sales organization. Key elements in a corporate agenda include basic approach to secure competitiveness by reducing complexity, streamlining processes, reducing cost levels and ensuring an appropriate financial structure. Growth and development are encouraged by expansion into new markets, investment in product development and other organic growth initiatives. Combined with resources provided by a unique network of external advisors we can quickly analyze complex investments or strategic situations, support rapid decision making with respect to potential transactions and internal change at the portfolio company level. Our investments are often industry-consolidating buyouts in which two or more related businesses are acquired and combined into a new, stronger entity.”

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4.2.8 IRR & Cash Return

Even though demand on return from investments varies with the risk associated with each deal. The respondents gave similar answers to what return they need in order to take on an investment. The least acceptable IRR is between 20-30% after 4-5 years. Most of the firms answered that a calculated IRR of 20% is the lowest acceptable figure. Some said that the calculated IRR should be over 30% for them to consider the deal. IRR is an important measure for all of the respondents. However, cash return is of greater importance for the PE firms. This became evident as one of the firms said. “You cannot eat an IRR.” This statement highlights the fact that being able to double your money is more important than showing a high IRR. Even though the measures has a certain covariance, showing a high cash multiple is very important. The firms revealed that a cash multiple of 2-3X is the lower limit for their investments. In their calculations, PE firms typically has a cash return of 4X but in attractive cases they can have numbers up to 6X in cash return. All firms needed to see that the demands on return were fulfilled within 4-5 years in their valuation model. In general a PE investor expects a return on 5% over the stock market.

“For us, a good investment can have a cash multiple of 6X and an IRR of 70% when exiting after 5 years.”

4.2.9 Characteristics of a Suitable LBO Target

It became evident that the ability to estimate the company’s future development is a key issue when finding a suitable LBO target. Here PE firms try to find companies with a large prognosticated organic growth. Therefore non-cyclical companies should act as a theoretical group for selection. If a company is cyclical, the investor needs to understand how the cycle behaves in order to make a good assumption of future profits. This is possible to do but in general PE firms prefer non-volatile companies with predictable and stable cash flows. Other factors that the respondents look at are profit margin and CAPEX. CAPEX is important, if your target needs big investments in order to grow, it is not such an interesting investment for the PE firm. Low entry multiples, EV/EBITDA, is needed in order to exit the holdings with a profit. Worst case scenario is if the EV/EBITDA multiple drops during the holding period. This is referred to as a multiple contraction and should by all means be avoided.

Instead sponsors want to see the multiples grow up to the point of an exit. A multiple arbitrage boosts the PE firms return. Therefore companies that trade at low multiples are potential targets.

Here distressed companies could be worth looking into as those often have low earnings and therefore low EV’s.

Specific key ratios tracked in the PE industry are, EV/EBITDA, EV/EBITA, EV/Sales, EV/Cash flow and (EV-CAPEX)/Cash flow.

“A good deal has an EV/EBITDA entry multiple between 6X-10X.”

“We avoid companies with EV/Sales above 2X.”

“EV/Cash flow should not be more than 10X.”

The key ratios are often used as a sanity check of the target. If key ratios are ok, soft factors such as industry, management, business model, market position etc. are often the ones deciding whether to take on the investment or not.

Leveraged Buyouts

Carl-Johan Strandberg