The Leveraged buy out (LBO) model of valuation

Prior to the "great" recession of 2008, LBOs were all the rage. Every investor from the most conservative to the most aggressive wanted a piece of the action.

In this article we highlight how their valuation model is necessary to be understood to appreciate the difference between the "fair value" of a traded company on the stock exchange for a non leveraged investor and the "fair value" for an LBO buyer.

The free cash flow (FCF) yield is the same for all investors at a particular price if the deal financing is the same. You take the FCF generated and divid by the current market cap. However, if you are a leveraged investor, you divid the free cash flow generated by the equity you put in. Hence, if 80% of the deal is financed by debt, you can afford to pay a considerably higher price than a non leveraged investor, yet still can achieve a higher return on your equity! This implies that large investors with a good reputation and work closely within a well financed business circle can afford to pay more for assets whilst still achieving higher returns.

As a result, the fair value for a LBO buyer and a small time non leveraged buyer is different! Fair is defined by the financing method applied to the deal, as well as a number of other variables.

Prior to 2008, financing could be achieved with almost 100% debt financing. This made valuations expensive. This is why in a credit expanding phase of the credit cycle valuations of risk assets become richer (the multiple becomes larger). What is also important is the cost of the borrowing. Indeed, for the LBO to be worthwhile the FCF yield must be greater than the cost of borrowing. This is the theoritical maximum a LBO buyer would pay for a business.

As a result, it is intuitive to appreciate that LBOs reduce in number as the cost of borrowing increases, unless equity markets also drop!