LBO Valuation

Early in my career as an investment banking analyst I was introduced to financial modeling for M&A transactions. Building standalone financial models with integrated financial statements, debt schedules, capital expenditure and depreciation schedules, revenue and expense detail, etc. Combining these models into pro forma combined projections with transaction assumptions, to assess what potential buyers could pay. Likewise, we developed “LBO models”, to better understand what a private equity (aka financial buyer) might be able to pay as well given their constraints (i.e. leverage, interest, growth, profitability, etc). Sometimes, we would model in different instruments, say mezzanine, preferred stock, and common stock, to determine how different exit assumptions would impact returns on specific instruments. What is the holding period, what multiple to the company sold for? Are there dividends? A partial recapitalization coupled with a special dividend? All of these things impact returns (IRR in their language).

Then I decided to become a valuation practitioner. In the valuation world, I have never seen an LBO analysis taught or utilized in a valuation. In my mind, oftentimes it is the most superior valuation approach. In essence, the approach is a DCF with a dynamic WACC with an observed market multiple at the terminal date. In a well crafted analysis, cash flows can be discretely segregated to different investors – and securities, allowing for various returns to investors in different instruments. The capital structure changes over the forecast period – as the company repays or borrows according to its cash flows. However, unlike the income approaches – it’s not really an income approach. It’s the same exercise a real, theoretical buyer would go through in developing a purchase price for the company. No sophisticated buyer would ever base his valuation on a capitalized earnings approach, and many would not use a DCF, either. I’m not sure why the approach isn’t taught. I suppose it goes to a deeper issue – every valuation practitioner should be an expert at modeling forecasts with integrated financial statements. With that said, developing an LBO model for use in their analyses should be standard. We use it from time to time, but the honest truth is, it’s not a method that’s supported by any of the valuation credentialing organizations I’m aware of – ASA, NACVA, AICPA, etc. At least I haven’t seen mention of the approach in their standards. Perhaps it is time the valuation professional looks to his brethren in the investment banking and private equity realms for some valuation pointers.

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