The difference between a DCF and LBO model

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.

The "optimal" capital structure

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.

Calculations for cost of capital

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.

Private equity funds will try to push the limits of debt funding in a buyout.

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.

In an LBO transaction, the investor's cost of equity is usually north of 20%

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.

The unlevered IRR is the investment return of a deal assuming it is purely funded with equity.

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.

A broad schematic of an LBO returns structure.

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.



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