Bankers and financial professionals try to measure risk and returns using all kinds of academic and empirical bases - NPVs, IRRs, weighted average cost of capital, etc.
I introduce to you a new way of looking at risk: How much are you willing to lose?
Say you pay $10 to flip a coin. Heads: you get double the amount ($20), Tails: you walk away empty-handed. Now consider that it'll now cost you $1,000,000 to do this. Would you still take the chance?
Mathematical models involving the calculation of risk unfortunately omits the element of human emotion. For many investment decisions in Asia and other emerging markets, emotion is often a huge part of what drives the deal. This is probably the single biggest reason why your complex DCF and bullet-proof-calculated discount rates don't weigh very much in this part of the world.
Mispriced deals exist all the time because the stakeholders can't accept what they possibly could stand to lose.
Consider a scenario in which a business owner will never relinquish a partial stake in the company to an incoming buyer who has plans to break up the assets and change its corporate direction. Or a seller signing off on an under-valued transaction just to close the deal because he/she can't live with the possibility that there might not be another better offer on the table.
All risk models break down when you have everything (or nothing) to lose. Managing it gets easier when you are more diversified and don't go to the negotiating table with an all-or-nothing mentality.
The next time you are presented with an opportunity that offers a certain rate of return, think: what are you prepared to lose?
With so much negativity around closed-up economies, city lockdowns, finding a vaccine, one can't help but wonder why valuations - especially for tech firms - are sky rocketing.
Long term over short term
In any asset pricing exercise, there are two fundamental parameters to look at: future free cash flows and the discount rate.
The future free cash flows of the assets are whatever anyone thinks it to be: three, five or even ten years out. The discount rate addresses the question of "what is my expected return for purchasing a certain stock vs putting my money into a safe haven such as a government bond".
If you look at consensus data over the next 12 months, nearly every analyst on Wall Street is predicting a decline in revenue and earnings, for a good reason - sluggish economic growth, deferred order books, and overall lower discretionary spending. This indirectly tells us that:
The performance of the NASDAQ shows that no one is bothered with what happens over the next 12 months when it comes to valuation.
Because investors are not relying on the near-term outlook for guidance, the pricing of today's tech stocks are driven by one of the two:
Future cash flows over the longer term, or
Just pure hokum.
If you think about it intuitively, valuing businesses based on the data estimates looking out 3 to 5 years becomes a more viable alternative because no one can meaningfully price any business under circumstances today. Times are unprecedented; It is an anomaly, a black swan scenario. Applying the 1-year forward multiple to value a business just does not make any sense. This is similar in 2000 where the surge in prices of technology and Internet firms resulted in many investors rushing in to cash-in on the tremendous growth opportunities offered.
Therefore the pricing observed in the current market is a reflection of investors projecting incomes based on estimates 2 to 3 years out. The DCF models are for 10-years and they are willing to pay even if the earnings today were crappy.
Discount rates reflect opportunity costs
Government bonds have been widely accepted as the basis for pricing assets. It is considered to be default-free and therefore commonly used as the "risk-free" rate in valuation models. All cash flow valuation models that use the discount rate are based off this simple concept. At the peak of the dot com bubble, the 10-year treasury yield - which was the benchmark for a "safe haven" and a default-free investment - hovered at between 5 to 6%.
At some point of time, investors started to doubt the rich valuations of these Internet firms, and decided they were much better off putting their money in either government bonds that gave decent returns of 6.0%, or invest in the broader market, represented by the S&P 500. One thing led to another and the bubble burst.
The key difference between 2000 and now is that treasury yields today are trading at 0.72%. Which means that investors who decide to cash out from their richly valued stocks get effectively next to nothing if they buy bonds or other fixed income instruments. That, in part, is what is keeping the bubble inflated today.
In addition to that, city and country wide lockdowns from the pandemic have posed a serious risk for global trade and growth. Essentially, no trading = no growth. No growth = no inflation. To climb out of this economic rut, governments around the world have committed to keeping the near-to-mid-term interest rates low (read the Fed's recent announcement in August about its inflation rate policy).
So it is against this backdrop of a grim economy, the lack of other options in putting money to work and choice of taking a much longer term view on cash flows, that many investors are dumping money in equities.
As I am writing this, I do realize that there are wide ranging perspectives from different people out there, as well as numerous datasets that when aggregated and analyzed, could also be used to explain the current phenomenon. But the market is irrational, inefficient, unpredictable. And I have never been a good trader. Only time will tell if we are in the early stages of a new age of growth or if bubble will eventually burst.
At the most recent run of my LBO class, someone asked me this question,
"What is the difference doing a DCF using the WACC and a DCF in an LBO model?"
If we consider the same company in both cases i.e. the free cash flows (to firm), FCFF are the same, isn't the DCF like an LBO? In a typical DCF valuation, the weighted average cost of capital (WACC) is usually applied as the discount rate on FCFF. This discount rate comprises two main components - the cost of equity and the cost of debt.
Why does capital come with a cost?
Nothing is free in this world. The people who choose to fund your venture or your business are giving up something - more specifically, the option of being able to put their money elsewhere and getting more than what they had in the beginning.
Some common examples are: interest income earned from putting a cash deposit with a bank, government and corporate bonds, or even just buying a stock that pays dividends. By choosing to invest with you, these people are giving something up, and that lost opportunity comes at a price, which loosely translates to the cost of capital.
Every business is built and funded on either debt or equity. Conventional wisdom tells us that borrowing cash is cheaper than issuing equity because lenders typically get more security over the assets in the business and also priority in repayment from any cash flows generated. Because lenders do not partake in profit sharing of the business, they get no economical upside in the event the company becomes wildly profitable.
Equity holders (or shareholders) on the other hand, have a vested interest in the profits of the company, prorated to their share of capital contribution. They get paid only after the company's borrowings are repaid and therefore take on relatively more significant risk in their investment.
The optimal capital structure
Depending on the nature of the business and its underlying industry dynamics, each company has a "magic" number for debt and equity in order to get the lowest possible cost of financing. This allows them to maximize the business value. This magic number is the optimal capital structure.
In asset heavy industries whereby the companies have fairly resilient cash flows, the optimal capital structure will lean towards a greater proportion of debt - for example, in real estate, this refers to the core and core+ properties. For early stage enterprises, especially technology based startups, the optimal capital structure will consist of largely equity.
In reality, every company will have a different benchmark for what is optimal. A business which has a strong and proven track record of operations may have more debt in its capital structure because of its favourable credit rating and therefore access to cheaper debt, as contrasted to a younger and much less established firm.
We try to generalize an optimal cap structure across companies within the same sector because we expect the revenue dynamics and operating cash flow margins to be fairly similar.
Now, in a DCF model...
The discount rate represented by the WACC is a mix of debt and equity equivalent to the firm's target optimal capital structure. When we do a DCF based on the WACC, the resulting number yields the fair value of the business.
For the layman, fair value means: What the average or "marginal" investor should pay to acquire the business in order to get an appropriate risk-adjusted return had he/she had invested in all the public listed stocks in the target company's home market.
The risk/return-adjustment mechanism here is the beta, which is loosely speaking - calculated from - the correlation between the movement of similar companies' share prices against the broader market index. As we use the broader market index as the basis for justifying risk/returns, any minor deviation of a company's share price from this index is implied as "risk" (for more technical information on beta read this).
Because every investor has a different expectation on the equity returns (or the cost of equity), the output of a DCF using the WACC as the discount rate does not translate to how much an investor should offer to buy a company. The WACC gives you the fair value, but in reality, you can always choose to offer something higher or lower. Whether or not the seller agrees to the valuation is entirely up to negotiations and other qualitative factors influencing the target company.
All things being equal and agreeable...
Let's assume that the fair value is the offer price. The DCF on FCFF of the business results in the enterprise value ("EV") of the company. Loosely translated, this refers to the price of ALL operating assets in the company.
"Why don't we do the DCF on the FCFE (equity cash flows)?"
In theory, you can. But in the case of most buyouts, the incoming investor assumes responsibility for financing the deal i.e. they will assemble the best possible configuration of debt and equity to buy over the shares from the sellers, and repay / re-finance most or all of the legacy debt in the business.
If the buyers are creditworthy, they stand to increase the amount of borrowings obtainable from the banks, allowing the deal to be financed with the lower amount of equity capital.
In an LBO...
The incoming buyer (usually a PE fund) will test and push the limits of the cost of capital (the WACC) to achieve the highest return on equity possible. Discussions around the future cash flows of the business often result in lengthy negotiations between the buyer and lending banks. Some of these conversations entail iterative spreadsheet calculations that ideally would solve for the maximum amount of debt that will support the financing of the deal.
What the buyer is really trying to achieve here is to find the magic number for the debt that will allow for getting the HIGHEST equity return (or equity IRR). In most PE funds, this number is at least 20%, depending company and region.
The simple mechanics.
For example: If the returns for investing in this business is 10 percent, and assuming the investor doesn't borrow any cash to finance the deal, he/she would get a return of 10 percent. This 10 percent is also sometimes called the unlevered IRR. Unlevered means that the acquisition was purely financed with equity money and no bank borrowings were involved - obviously not a very wise and efficient use of money to the seasoned finance professional.
In order for the investor to achieve a higher return, he/she would try and minimize the amount of equity by looking for alternative sources of funds - such as debt. However, this would only make sense if the cost of debt is lower than 10 percent. Anything form of financing which costs more than 10 percent and the investor is better off using his/her own money.
Now, let's assume that approximately half of the total investment was funded with senior secured debt at a rate of 5 percent. The banks which are lending to the buyer at this stage not only have the first right to claim the assets in the event the business goes into distress, they also have priority over the cash flows generated by the company. The risk of this investment is relatively low as compared to pure equity, hence the 5 percent.
Based on the structure above, this would result in an equity return of 15 percent based on:
Unlevered IRR of 10% = (50% x 5%) + (50% x 15%)
Now, 15% may sound like a decent return but most PE funds are also subject to hurdle rates (typically in the ballpark of 8%), leaving them with only 7% after returning principal + hurdle to their LPs. Naturally, one way to overcome this is to try and get more cheap debt to minimize the equity outlay.
Because every financial institution is subject to their own credit risk matrix and lending exposures, the amount of "lend-able" senior secured debt (based on 5.0% interest rate) will be limited.
The hunt for more capital.
At this point, the PE fund tries to source for alternative sources of financing junior to the 5 percent debt. But this will come at a higher cost because the rights /security to assets and first priority to cash flows in the business have already been claimed by senior debt lenders. This alternative sources of financing would be subordinated. In order to entice this pool of subordinated lenders, the buyer has to make the cost of debt more attractive by increasing the interest rate.
For illustrative purposes, let's say this is going to cost 8 percent and the investor is able to syndicate 50% of it. The resulting calculations would give an additional uplift, bringing the equity IRR to 22 percent as compared to the original 15 percent.
15% return = (50% x 8%) + (50% x 22%)
You now get the idea...
Is 22 percent enough you say? Can we find additional sources of capital which are cheaper? This shouldn't be difficult.
But at this point, both the company cash flows and debt capital markets are going to be fully stretched, and it might be even more challenging to find a sufficient pool of investors who are willing to finance the deal at this level of risk. Some alternative sources of capital at this stage would come from either mezzanine investors or bridge loans.
Closing thoughts.
The mathematics outlined above has been done on an illustrative basis to demonstrate how 'cheaper' bank debt and alternative financing sources can allow an investor to maximize the equity IRR in an LBO. While this may look simple, the complexities lies in the following:
FCFF considerations. In engineering the returns above, we have totally ignored the potential volatility in free cash flows, which could significantly influence equity IRR. This is why stable and visible cash flows are important in any LBO deal.
Depth of liquidity. The pool of available capital shrinks dramatically as we move from senior debt to subordinated debt to quasi-equity financing. As such, the term sheet for alternative financing will start looking a lot like equity further down the debt waterfall.
Cultural factors. The size and structure of the debt package is also partly driven by how sophisticated and comfortable debt investors are with the company and the jurisdiction that it operates in, including other factors such as cash repatriation and withholding taxes. This could also explain why many online LBO structures and templates are usually based on transactions done in the US and Europe. While the loan and corporate bond markets are fairly vibrant in Asia, quasi-equity financing structures still lag those in more mature capital markets.