The LBO Value Equation
The strategy can be immensely profitable for the savvy investor. For example, in early 2010, Blackstone Group offered $15 billion for Fidelity National Information Services (NYSE: FIS). On May 5th, FIS closed at $26. When rumors of the offer surfaced on May 6th, FIS shares jumped +10% in a single day to close at $28.68. The following week, FIS traded all the way up to $29.90.
In order to seek out targets before LBOs are announced, we need to know a few things: What makes a company an attractive LBO target? What characteristics can we look for if we want to try frontrunning private equity firms?
LBO Alphabet Soup
An LBO is the investment vehicle a private equity (PE) firm uses to buy and restructure an existing company. A PE firm is different from its cousin, the venture capital (VC) firm; VC firms invest in start-up companies and PE firms invest in more mature companies.
The most famous LBO is still the 1988 takeover of R.J.R. Nabisco by legendary PE firm Kohlberg Kravis Roberts & Co (KKR). The drama and intrigue of the $31.1 billion mega-deal was memorialized in the book and made-for-TV-movie, Barbarians at the Gate, and led Time Magazine to run a cover asking the question, "Has the buyout craze gone too far?"
The question would continue to be asked again and again, as buyouts got bigger and bigger. The largest deal ever done was KKR and Texas Pacific Group's $45 billion buyout of TXU Corp in early 2007 (though interestingly, the Nabisco deal is still the largest LBO in history in inflation-adjusted dollars).
The LBO Value Equation
Before we can look for companies that may become LBO targets, let's first look at what makes an LBO so profitable for a PE firm.
Not surprisingly, leveraged buyouts require massive amounts of leverage. A PE firm borrows as much as the market will allow it to borrow because the byproduct of high leverage is high return on equity (ROE). In the TXU buyout, PE firms put up $8.5 billion and borrowed $36.5 billion, for a debt-to-equity ratio of 430%.
PE firms value targets in an interesting way. Target values are largely based on comparables, so if you pay attention to what is happening in the market, you can probably gather enough information to come pretty close with your own valuation. We can look at the recent Blackstone deal to illustrate the process.
Blackstone decided that it would like to acquire Fidelity. Blackstone looked at the numbers and saw that Fidelity generated $1.4 billion in EBITDA in 2009 and is expected to generate $1.45 billion in 2010.
Blackstone talked to a group of banks, namely Bank of America, Barclays, Citigroup, Credit Suisse, Deutsche Bank, and JP Morgan Chase, to see how much they'd be willing to lend based on $1.4 billion in annual EBITDA. The banks decided they would lend up to $10 billion, or 7x EBITDA.
The banks also told Blackstone that to get the $10 billion in debt financing, Blackstone would have to contribute $5 billion of its own equity. Blackstone ran the numbers to make sure it would get an adequate rate of return on a $5 billion equity investment, and it decided to make an offer for Fidelity of $10 billion + $5 billion = $15 billion.
Ultimately, Fidelity rejected Blackstone's bid, saying the $15 billion offer did not reflect the company's true worth. Blackstone refused to up the price and withdrew its bid. Shares of FIS now trade around $27.
Here are some guidelines for spotting potential LBO candidates:
1) Low leverage: To extract maximum benefits, a PE firm wants to replace expensive equity with cheaper debt.
Let's take a look at a short list of potential LBO targets and their leverage, EBITDA and P/E levels:
Value the Upside
Today, Pactiv is actively being courted by one of its competitors, Georgia-Pacific, as well as two different PE firms, Apollo Global Management and Rank Group.
Let's do a real-time analysis of a potential maximum bid just to see where this deal could be heading. Once you know what comparables to use in estimating an offer price, you can easily back into the implied price per share of an LBO offer.
Pactiv generated EBITDA of $720 million over the previous 12 months. If we multiply EBITDA by the 7x multiple we saw in the Blackstone deal, we come up with $5 billion in debt financing. Assuming that the banks will require the PE firm to maintain a leverage ratio similar to that in the Blackstone deal (200% debt-to-equity) , the PE firm will have to put up $2.5 billion in equity. This gives us a potential takeover price of $7.5 billion.
The takeover price is also known as enterprise value, though in this case it's a theoretical enterprise value.
Market Cap = $7.5 billion - $1.6 billion + $234 million = $6.1 billion
Dividing market cap by the 132.9 million PTV shares outstanding leaves us with a potential final price per share of $46.16.
The Investing Answer: It is important to note that the multiples we used in the analysis are highly sensitive to changes in the financial markets. For example, if banks decided to tighten credit again, they may lower the amount of credit they're willing to extend to something like 5x or 6x EBITDA. Doing a sensitivity analysis of how the valuation reacts to changes can give you a range of values to consider.
Only time will tell if one of the three Pactiv suitors will bid the price up to $7.5 billion, driving PTV to over $46. Regardless of whether you find this particular investment to be compelling, keep an eye on the process so that you can be ready to value the next potential LBO target.
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