Deal valuation and financing - LBO structures and private eq...

Learning Outcomes

After reading this article, you will be able to evaluate the valuation process for acquisition deals—especially those using leveraged buyout (LBO) and private equity structures. You will be able to describe how LBOs are financed, explain why high gearing is used, assess the risks involved, distinguish between funding layers, and identify the objectives of private equity investors in acquisitions.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand the practical and theoretical features of deal valuation and financing in the context of LBOs and private equity activity. Key revision areas include:

• Explaining and applying business valuation approaches used in acquisitions, including cash flow and market-based models
• Describing the structure, rationale, and risk profile of leveraged buyouts (LBOs)
• Advising on the influence and objectives of private equity in deal structuring and financing
• Comparing senior, mezzanine, and equity finance in acquisition funding and their impact on risk and return
• Evaluating financial and operational risks from high gearing in buyout transactions
• Outlining typical exit routes and success measures for private equity–led deals

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which type of valuation is most commonly used by private equity firms for LBO targets?
   1. Book value
   2. Discounted cash flow
   3. Replacement cost
   4. Dividend yield approach

2. What primary financial risk is increased by using high debt in an LBO?

3. State two differences between senior debt and mezzanine debt in a typical buyout structure.

4. Briefly explain why private equity backers may use heavy gearing in acquisition deals.

Introduction

Valuing and financing the acquisition of a business—particularly through leveraged buyout and private equity structures—is a frequent requirement in advanced financial management. These transactions typically involve purchasing a company using a substantial amount of borrowed money, with a relatively small equity contribution and the aim of maximising future returns for investors. Understanding how to value a business for such deals, why high gearing is used, and how these transactions are funded and managed is essential for ACCA AFM candidates.

Key Term: leveraged buyout (LBO)
The acquisition of a business using a large proportion of debt finance, usually secured on the acquired company's assets and future cash flows, with the equity often supplied by private equity investors.

APPROACHES TO DEAL VALUATION

A realistic and robust business valuation is central to the success of any acquisition—especially in LBOs, where future debt repayments must be serviceable from the company’s cash flows.

Discounted Cash Flow as a Valuation Tool

The main technique for LBO and private equity deals is discounted cash flow valuation. In this approach, the value of the target is calculated as the present value of forecast free cash flows over a specified horizon (the planning period), plus the present value of residual value (terminal value or exit value).

Key Term: discounted cash flow (DCF)
A method of valuing a company by forecasting its expected future free cash flows and discounting them to their present value using an appropriate rate.

Market multiples, such as price/earnings (P/E) or EV/EBITDA ratios from comparable listed companies or previous transactions, are often used as a secondary check on the DCF value.

Practical Valuation Considerations for LBOs

• The cash flows modelled must be those available after all operating costs, tax, capital investment, and working capital needs—i.e., what is available to repay debt and provide a return to equity.
• The discount rate should reflect the post-acquisition risk, including the effect of the new capital structure.
• The planning horizon in LBOs is usually 3–7 years, aligned with the expected period before a planned exit.
• The exit value is often estimated using an appropriate market multiple applied to forecast profits, based on realistic assumptions.

Worked Example 1.1

A private equity fund is considering an LBO of Alpha Ltd. Forecast free cash flows (after interest, tax, and investments) are £7 million per year for 5 years, with an expected sale value in year 5 of £60 million. The appropriate discount rate is 13%. The deal will be financed with £35 million of acquisition debt. What is the equity value?

Answer:
Present value of 5 years of £7m: £7m × annuity factor at 13% for 5 years (3.517) = £24.62m.

PV of £60m exit value: £60m × 0.543 (DF at 13%, 5 years) = £32.58m.

Total firm value: £24.62m + £32.58m = £57.2m.

Equity value = £57.2m – £35m (debt) = £22.2m.

LBO STRUCTURE AND FINANCING

An LBO uses a significant share of acquisition debt and a smaller portion of equity. The cash flows and assets of the acquired company are pledged to secure and repay borrowed funds.

Key Term: gearing
The ratio of debt to equity in a company's capital structure, used to measure financial risk. High gearing indicates a large proportion of debt financing.

The financing package is typically layered as follows:

• Senior debt: High-priority, secured bank loans with lower interest rates; repaid first from cash flows.
• Mezzanine debt: Subordinated loans, often unsecured and with higher interest or performance-related returns; riskier for lenders.
• Equity: Provided by private equity funds, management, or co-investors; at highest risk but with the most potential upside.

Key Term: mezzanine debt
Subordinated debt financing, typically unsecured, sitting between senior debt and equity in terms of claim. Offers higher risk and reward than senior debt.

Rationale for Using High Gearing in LBOs

• Interest on debt is generally tax deductible, reducing the net cost of borrowing and increasing returns to equity.
• If returns on capital invested are greater than the cost of debt (positive financial gearing), equity returns are magnified.
• Debt providers bear fixed returns, leaving residual gains to equity holders if the business performs well.

However, higher gearing amplifies financial risk—including the risk of default if cash flows are insufficient.

Fund Providers and Their Role

Key Term: private equity
Investment in businesses not quoted on public stock exchanges, using funds raised from institutions or individuals. Private equity owners typically seek to improve operations and exit profitably within a set timeframe.

Private equity provides specialist know-how, operational input, and incentives for management. Equity returns are achieved primarily upon exit through sale or flotation. Private equity funds structure deals to maximise potential for their required internal rates of return, often 20% or higher.

Worked Example 1.2

In an LBO, Beta Fund plans to buy Gamma Ltd for £40m, using £32m in senior debt, £3m in mezzanine debt, and £5m in equity. If the net cash flows allow all debt to be repaid in 4 years, and the company is sold for £50m, ignoring interest and taxes, what is the equity return multiple?

Answer:
Initial equity: £5m. Proceeds at exit (after repaying debt): £50m – £0 outstanding = £50m to equity.

Return multiple: £50m / £5m = 10×. (In practice, this would be reduced by interest and the time value of money.)

DEAL RISKS AND CONTROL MEASURES

Financial and Operational Risks

High gearing raises the risk that fixed debt repayments cannot be covered if operating performance misses target. Material risks include:

• Default and insolvency if cash flows fall short.
• Limited financial flexibility due to lender-imposed restrictions.
• Refinancing risk on maturity of debt.

Key Term: covenant
A clause in a loan agreement setting out requirements or restrictions that the borrower must comply with (e.g., minimum interest cover, limits on further debt).

Operationally, the success of LBOs depends on management's ability to improve performance, reduce costs, or grow revenues to support debt service.

Risk Mitigation

• Conservative cash flow forecasts
• Careful assessment of business sustainability and capacity to generate cash
• Staggered debt maturities and negotiation of flexible covenants
• Regular monitoring and engagement from private equity backers

Exam Warning

Heavy dependence on debt in buyout deals may be restricted by local regulations, tax deductibility rules, or specific legal limits. In an exam scenario, identify and consider any statutory constraints on gearing, equity minimums, or lender rights.

PRIVATE EQUITY EXIT ROUTES

The private equity model seeks to realise returns through a defined exit plan, usually within 3–7 years. Typical exit strategies include:

• Sale to a trade buyer (strategic acquirer)
• Secondary buyout (sale to another private equity fund)
• Initial Public Offering (IPO)
• Leveraged recapitalisation or partial sale

Return for equity investors is driven by a combination of debt reduction (deleveraging), business improvement, and achieving a strong exit price multiple.

Worked Example 1.3

Omega Partners acquires Delta Ltd for £90m, investing £20m of their own equity and borrowing £70m. After 6 years, the company has repaid all debt and is sold for £120m. What is their annualised rate of return (approximate, ignoring interim interest)?

Answer:
Gain: £120m – £70m repaid debt = £120m to equity; initial equity = £20m.

Overall gain: £100m over 6 years on £20m invested. Multiple: £120m / £20m = 6x.

Approximate annualised return: [(£120m/£20m)^(1/6)] – 1 ≈ 34% per annum.

MANAGEMENT BUY-OUTS (MBOs), BUY-INS, AND LBO VARIANTS

Buyout structures can take several forms:

• Management Buy-Out (MBO): Acquisition by current management, typically funded mainly by private equity and debt.
• Management Buy-In (MBI): Acquisition led by outside managers, funded similarly to MBOs.

Both are forms of LBO, using high debt levels to finance the acquisition with the expectation that future cash flows can support rapid debt reduction and deliver high equity returns.

Additional LBO Variants

• Leveraged build-ups: Add-on acquisitions following an initial LBO, using the improved capital structure of the acquired company to buy further targets
• Recapitalisations: Use of new debt to pay dividends or distributions to equity holders before a planned exit

Summary

Effective deal valuation in LBO and private equity transactions demands rigorous DCF analysis, prudent forecasting, and a keen understanding of risk and capital structure. LBOs aim to boost equity returns by concentrating on high gearing, debt reduction, operational improvement, and careful exit planning. Private equity plays an active, hands-on role in overseeing performance, structuring funding packages, and selecting the optimal exit to realise returns.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain discounted cash flow and market-based valuation methods in the context of LBOs and private equity deals
• Describe how LBO deals are structured, and identify the typical layers of financing (senior debt, mezzanine debt, equity)
• Explain the rationale, benefits, and risks of high gearing in acquisition finance
• Identify the objectives and typical exit strategies of private equity investors
• Recognise key financial risks and the importance of loan covenants and risk mitigation in LBO structures
• Distinguish between MBOs, MBIs, and other LBO deal variants

Key Terms and Concepts

• leveraged buyout (LBO)
• discounted cash flow (DCF)
• gearing
• mezzanine debt
• private equity
• covenant