Leveraged Buyout – Debt Equity Ratio (19:48)

Question that came in the other day…

“Help! I just got a case study from a private equity firm I’m interviewing with.”

“I have to pick a consumer/retail company, download its filings, complete a leveraged buyout model for the company, and recommend for or against the deal.”

“How can I determine how much debt to use in the deal? They didn’t give me any instructions!”

You can figure this out simply in most cases without wasting a ton of time sifting through company’s filings. Here’s the 3-step process:

Step 1: Estimate the purchase multiple, purchase price, and Debt / EBITDA by looking at comparable buyout deals (NOT publicly traded companies, as they almost always have lower debt levels).

Step 2: Test your assumptions in Excel and see if the company can manage that much debt.

Step 3: Go back and tweak your assumptions as necessary.

The purchase price and Debt / EBITDA are very closely linked – for example, you can’t assume 6x Debt / EBITDA if you’re paying only 5x EV / EBITDA for the entire company.

For most public companies, you need to assume at least a 20-30% share price premium, and then make sure the implied EV / EBITDA multiple is in-line with those of other recent deals in the market.

Let’s say you pick Bed, Bath & Beyond [BBBY] for your LBO candidate.

To find 2-3 comparable LBO deals, you can do Google searches for terms like:

“consumer retail” “leveraged buyouts” [This Year or Last Year]
consumer leveraged buyouts
retail leveraged buyouts

In this case, we find 3 relevant deals: the buyouts of Petco (10x EV / EBITDA and 6x Debt / EBITDA), Life Time Fitness (11x EV / EBITDA and 5.5x Debt / EBITDA), and Belk (7x EV / EBITDA and 5-6x Debt / EBITDA).

So our deal will likely be done at 8-10x EV / EBITDA with 5-6x Debt / EBITDA.

BBBY’s share price has fallen by ~50% in the past year, so we think a 50%, 75%, or even 100% premium would be more reasonable than the standard 20-30%, and would imply a purchase multiple of 6.5x – 8.5x instead.

But can the company support that much debt?

To answer this question, you can create a simple Excel model with revenue growth, EBITDA margins, Cash Flow from Operations as a % of EBITDA, and CapEx as the key drivers.

The after-tax interest will also be subtracted from CFO – CapEx to determine debt repayment capacity.

Then you can evaluate debt repayment, Debt / EBITDA, and EBITDA / Interest over time to see if the debt level is too low, too high, or just about right.

Focus on the downside cases – What happens if revenue, EBITDA, cash flow, etc. decline? Margins and growth HAVE declined historically for BBBY!

Ideally, Debt / EBITDA should decline over time and EBITDA / Interest should rise as the company repays debt.

So if Debt / EBITDA rises instead, or EBITDA / Interest falls, you’ll have to assume a lower debt level.

In this deal, we run into trouble when revenue declines or when we pay closer to a 100% premium for the company because Debt / EBITDA approaches 8x in some later years.

Even if revenue growth stays positive and the premium is only 75%, the credit stats and ratios still don’t look “great.”

So we’d say that 5-6x Debt / EBITDA is a stretch, and 4-5x is more feasible. At a 75% premium, this might be 60% debt (4.5x) and at a 100% premium it might be 50% debt (4.2x).

Once you’ve come up with baseline estimates for these figures, you would continue to build the model, come up with something more complex, and then ultimately make your investment recommendation on the company and present it.

But you can save a lot of time and finish case studies more efficiently if you know how to find and confirm simple figures like these before you do anything more complex.

Video Transcript

Welcome to another tutorial video. This one is actually a redo of last week’s video. In case you missed it, we attempted to explain why private equity firms prefer to acquire companies with low debt balances when they’re completing leveraged buyouts. The problem is that topic doesn’t really lend itself to an Excel based explanation, at least not a simple one, and ours was a little bit confusing. It didn’t highlight the real mathematical reasons for this well enough in part because it’s really hard to do. It’s just a concept you have to accept and understand that if you have less debt, you can put more debt on the company after the buyout takes place.

So instead, here, we’re going to be covering something related, but something that’s also more useful and easy to explain, which is the following. So this is a question that came in the other day, “I just got a case study from a private equity firm I’m interviewing with.” “I have to pick a consumer/retail company, download its filings, complete a leveraged buyout model for the company, and then recommend for or against the deal.” “How can I determine how much debt to use in the deal? They didn’t give me any instructions.”

Now, this is a question that I’ve seen a lot of people waste a lot of time trying to answer. I’ve seen people spend hours and hours coming through companies filings and looking through long documents to try to get at the answer. But really, you can get to the answer by using Google search, Google Finance, and maybe looking through a few filings if you really have to. But the point is, it doesn’t have to be complicated. It’s actually quite simple. In fact, there is a simple three step process that you can follow to do this.

Step one is that you have to estimate the purchase price, multiple and debt to EBITDA ratio by looking at comparable leveraged buyout deals. Now, you don’t want to look at comparable public companies because they’re almost always going to have less debt than what private equity firms could use to acquire companies and leveraged buyouts. Then once you have the rough numbers, you can test your assumptions in Excel. See if the company can actually manage that much debt.

So if the credit stats and ratios do not move in the direction you want, you might have to decrease the amount of debt. If they do move in the direction you want, and even in more pessimistic cases that’s true, maybe you can increase the amount of debt. And then in step three, you go back and tweak your assumptions as necessary to come up with something that is more realistic for this type of deal.

Let’s go into step one and look at the purchase price and the initial guess for the debt to EBITDA ratio. Now, both these assumptions are tied together pretty closely, because you also need to make an assumption for the purchase price in an LBO case study like this. It doesn’t really make sense to assume six times debt to EBITDA if you’re only paying five times enterprise value to EBITDA for the whole company. So the amount of debt you use is closely related to what you’re actually paying for the company, and these assumptions have to make sense together.

Now for most public companies, you have to assume at least a 20 to 30% premium to the company’s share price, otherwise the existing investors have no reason to sell. If you just go in and say, “Hey, we’ll pay you exactly what your shares are worth right now.” They’re not going to sell. Why would they, when they could just get that same price on the open market? So you have to offer some type of premium. It could be a lot higher than this. It could also be lower than this, depending on the deal and the situation.

And then once you’ve figured out what the premium might be, you have to make sure that the implied EBITDA multiple is in-line with recent deal multiples for other deals and companies in this sector. So let’s say you pick Bed Bath & Beyond for your leveraged buyout candidate. This is a consumer retail company and its business is exactly what its name sounds like. In this case, you might do a Google search for consumer retail leveraged buyouts, and then enter this year number or last year’s year number. So 2016, 2015, 2014, something like that. The goal is to find a few recent deals, two to three maybe, in the sector, where you can easily get the purchase multiple, offer premium, and then also the debt/EBITDA ratio that was used to fund the deal.

So here’s what I found just from a simple Google search. I looked up consumer retail leveraged buyouts 2015 and found a bunch of press releases, PDFs, and other documents about recent deals in this sector. And then I searched for a few related terms like retail leveraged buyouts or consumer leveraged buyouts and the year number, or sometimes left out the year number. And then I found three specifically, that would be good to use for this. 

The first is Sycamore Partners and Belk, 2.7 billion leveraged buyout. Then Leonard Green and TPG Capital, and a $4 billion buyout of Life Time Fitness, along with some information on the debt. And then Petco and their $4.6 billion leveraged buyout by CVC and the Canada Pension Plan Investment Board.

So those are three comparables. And just by looking up the press releases and looking at the basic information there, you can get a lot of these numbers. So Petco is done at a 10X enterprise value to EBITDA multiple, and used about six times debt to EBITDA for the financing. Life Time Fitness was around 11 times, and then 5.5 times for the debt financing. And then Belk was a bit lower than the others, seven times enterprise value to EBITDA, and around five to six times debt to EBITDA. It wasn’t clear exactly what was drawn when the deal closed. So I’m listing a range there instead.

Now, these were all pretty easy to find just in press releases. But if you can’t find them in press releases, just go to the edgar.sec.gov site for US based companies. Find some filings from around the time the deal was announced, and then go in and search for terms like debt financing or commitment letter to find what you’re looking for. Here’s an example. This is for the Belk deal. Just by going in and looking for commitment letter, I found the exact amount of debt and equity that were used to fund the deal. 659 million of equity. And then the debt is divided into different tranches, but it’s about 1.8 billion, and then another 600 million, and then another 800 million on top of that. But the bottom line is, all together, it comes out to roughly 2.4 billion if you look at the amount that was actually drawn initially to fund the deal.

If you’re working with non US based companies, you’ll have to look up companies on the equivalent site for the stock exchange in your country and find it there. You can also go to their websites, look under investor relations and see if they have anything on the company and the terms of the deal there.

So going back to those numbers I just showed you, it seems likely that the purchase multiple will be around eight to 10 times EBITDA in this case. And the amount of debt will be around five to six times would be our initial guess for this sector at this point in time. Now Bed Bath & beyond right now has a market cap of around 7.2 billion, cash of 500 to 600 million, debt of 1.5 billion, and EBITDA of 1.8 billion. Now to get these numbers, I didn’t look through their filings. I didn’t do anything complicated. I just went to Google Finance, looked up the company and found everything right there. They give you the recent balance sheet, they give you the recent income statement, cash flow statement, and it’s fairly straightforward to get the rest of the information just from that.

So at its current levels, its enterprise value to EBITDA multiple is around 4.5X. With a 20% to 30% premium, that would go up to a 5.3 to 5.7X purchase multiple. And this may seem reasonable to you, after all, we’ve used exactly what we learned those guidelines to come up with this purchase multiple. But you can’t act so quickly here because there are a couple of problems with this. First off, if you look at Bed Bath & Beyond share price over the past year, it’s fallen by a massive amount. It used to be closer to 70 to $80 per share. Now it’s only around 40 to $45 per share. So shareholders are likely to want a much higher premium in this case. And so it’s probably not reasonable to go with this type of purchase price. They may not demand exactly $80 a share, but they could want more like 60 or 70 or something closer to where the stock price was about a year ago.

The other issue here is that this purchase multiple is much lower than the ones that we saw for those other companies. It’s a lot lower than 10 or 11X, and it’s even lower than the Belk deal for seven times EBITDA. So based on both those, we are probably going to have to assume a higher purchase multiple for this deal. If you go with a 50% premium instead, that takes you to $64 a share, and that’s a 6.5X enterprise value to EBITDA multiple. 75% premium takes you to $75 a share, and that is around a 7.5 times enterprise value to EBITDA multiple.

So we think these multiples are more aligned with other deals in the sector. They seem to be more reasonable, but we don’t know if the math works. We need to go in and see just how much debt the company can support at these levels. So if we pay 7.5 times EBITDA for the company, for example, can they support five or six times EBITDA for the debt level? Should it be less than that? Could they support more than that? That is what we have to check. And the key question is, can the company support this much debt if we assume something in this range for the purchase multiple for the company?

That takes us into step two, which is testing our assumptions in Excel. Now, initially, I recommend keeping this very, very simple. Once again, go to Google Finance, look at the income statement and cash flow statement there, and you’ll get the company’s revenue, operating income, depreciation, and amortization, cashflow from operations and capital expenditures, which are really all you need to do in a very simple initial version of this model. Don’t make it overly complicated. You’re just trying to test out your assumptions.

Here, for example, I have just made assumptions for revenue and revenue growth. Revenue numbers are all historical, the EBITDA margin, I’ve made cashflow from operations a percent of EBITDA, and I’ve made capital expenditures a percent of revenue. And that’s really all there is in our mini cashflow statement model. We do have interest paid on debt. We do have free cashflow and the amount used to repay debt. But those all come in later. The basic operational assumptions we need are all very, very simple and are spelled out right here.

Now, the reason they’re simple is because when you do this, you have to think about what really matters when you’re analyzing debt support in a leveraged buyout. The revenue and revenue growth certainly matter because generally speaking, as a company gets bigger, it can support more debt, assuming that margins stay about the same or at least don’t fall too much. Margins and EBITDA matter because they determine in large part how much cashflow a company actually has to repay debt. And then capital expenditures and interest expense, both reduce that cashflow, so they also matter. A company with less of both these is going to be able to repay more debt and therefore take on more debt in the beginning.

And then to evaluate all this, you can look at debt repayment, you can look at how the debt/EBITDA ratio changes over time, and you can look at how the EBITDA to interest ratio changes over time. Now, looking at our Excel model here, you might understand that a lot of these assumptions just come from the historical numbers. I’m making assumptions for the revenue growth up here at the top. I’m making an assumption for the EBITDA margin and for cashflow from operations as a percent of EBITDA and also for capital expenditures as a percent of revenue.

You know where the purchase price and all these assumptions for the share count and share price and market cap come from, but what about the interest rate? Where am I getting 5.0%, 5% from here? Well, once again, all you have to do is look at other recent deals in this market. One deal, Belk, was done at 450 to 475 basis points over Libor. So 4.5% to 4.75% above Libor. Libor at this time was well below 1%. So this works out to roughly 5% interest rate. This other deal was done at 400 basis points over Libor. And then this other one was done at 300 basis points over Libor. So the overall conclusion from all this is that we think a 5% rate would work pretty well, given the level that other deals in this market use for their debt.

So at this point, now that we have all that, we want to go through our simple model, tweak these figures and then see how the company does with varied debt levels. See, when the company is performing very well, everything looks good. When it’s growing by a lot 5%, 10%, 15% per year, the margins are staying the same or not falling by that much, cashflow is growing by a lot, everything looks rosy. But lenders focus very heavily on the downside cases. What if revenue declines? What if EBITDA declines? What if cashflow declines?

And quite frankly, here, it’s a very legitimate concern because margins and growth have declined historically for the company. Their revenue growth used to be 15%, now it’s only 3%. Their EBITDA margin used to be 18 or 19%, now it’s only 15%. So it’s reasonable to expect, as we have here, that margins will continue to fall by a modest amount in the future, by about 1% per year here. And revenue growth is probably going to be in the low single digits. We’ve said it to 5% initially, but we might change that one as we go through this.

Now ideally, you want the leverage ratio, debt to EBITDA, to decline over time, and you want the coverage ratio, EBITDA to interest, to rise over time because the company should pay off more and more debt and look less and less risky as it does so. So down here, for example, we have both these ratios, and debt to EBITDA declines by a fair amount, 5.6 to 4.4. The coverage ratio goes up from 3.7 to 4.3. So that is exactly what we want to see in this case.

Now, if it does the opposite, if the leverage ratio rises or the coverage ratio falls, you’re going to have to go in and assume a lower debt level. So let’s go in and see what happens here. First off, at the 75% premium, as I said, the numbers look decent in this case. But if our revenue growth is lower, let’s say 3%, let’s see what happens. In this case, it doesn’t look quite as positive. Our leverage ratio still declines, and our coverage ratio still rises, but not by quite as much as it did before. We still repay a decent amount of debt, but it’s certainly lower than it was.

If we take this even lower and say 1%, now our leverage ratio starts rising, our coverage ratio starts falling, which is what we do not want to have happened in this case. And quite frankly, a 1% growth rate isn’t really that outlandish because look at how much their growth rate has declined historically. Is it really such a stretch to expect that it’ll go down to 1% from where it’s at, at 3% right now? We don’t think so. We think this is a very, very plausible outcome.

Now, if we reduce it further and say negative 1%. Now we get into more trouble because our debt to EBITDA goes up above six X, which, at this point in time, seem to be the maximum for most deals. Our coverage ratio also falls down to three X. That’s not as much of an issue. The real problem is the overall level of debt and the leverage ratio. And then further adding to our problems is the purchase premium. If we make this a 100% instead, so we have around 6.4X debt being used. At 75% purchase premium, our debt used was just in the middle of our range, 5.6X. We assume between five and six X. And we’re saying 75% debt here.

But if we increase this purchase premium, now we run into a lot of trouble because our debt to EBITDA goes up closer to eight X. Our coverage ratio falls to around 2.5X. So based on these downside cases, we would say that this amount of debt is probably too high, especially at this 100% purchase premium. We’d say something more like 50% debt might be more appropriate. So our EBITDA multiple here’s 4.2. If you go down and look at it, the numbers look somewhat better. They’re not really improving, but at least they’re not getting worse. Our leverage ratio stays about the same. Our coverage ratio also stays about the same.

Now, if you go up and you change it to a 75% purchase premium, maybe we can have a little bit more debt now, maybe we could see 60%. That takes us to, again, between four and five times EBITDA for the debt. If you go down and look at it, once again, our debt to EBITDA goes up by a little bit, but really stays about the same. And our coverage ratio goes down by a little bit, but stays in a very, very close range.

Now, of course, if you assume more positive growth, even 1%, something as low as that, the numbers here start to look a fair bit better, but we want to really consider all the possible downside cases. So the conclusion from this quick analysis is that the metrics seem reasonable if you have 75% premium, you have low but positive revenue growth and margins decline by about 1% per year. But if revenue declines or we pay more like a 100% premium, it’s not so positive. And if we get both of those together, it is really not so positive.

So instead of five to six times debt to EBITDA, we would say that four to five times is more reasonable. So around 60% debt at a 75% purchase premium. If you assume more like a 100% purchase premium, then 50% debt, 4.2 times debt to EBITDA might be more appropriate in this case. So that is how you go back and actually tweak your assumptions and come up with something that is a little bit more in-line with the market and with what lenders might be concerned with at the end of this exercise.

Let’s do a recap and summary now. To figure out the amount of debt used in an LBO, you need to figure out the purchase multiple and how much you’re paying for the company first. And then the amount of debt will come from that. So you estimate the purchase price and then debt to EBITDA by looking at comparable leveraged buyout deals. You don’t want to look at public companies in most cases because they’re usually going to have a lot less debt than companies that have been taken private.

Once you have the rough estimate and say two to three good companies, you can go into Excel, test your assumptions, see if the company can actually manage that debt, see if its leverage ratio declines and its coverage ratio increases over time, or at least make sure that, in downside cases, they don’t move too much in the opposite direction of what you want. And then you can go back and tweak your assumptions as necessary to get something that is more reasonable.

Now, at this point, you still have to go in and actually build a buyout model, do something more complex, come up with your recommendation and learn more about the market. But by following these steps, you should at least be moving in the right direction and you should be able to finish these types of case studies more easily and more effectively.