Strategies & Analysis
purchasing leverage, facilities consolidation, staff / program redundancies, and
perhaps capital spending avoidance in
existing operations. The following table
contains the results of increasing synergy
to the Strategic base case.
Similarly, the impact of the firm’s
WACC is a significant driver in how different strategic buyers see deal value.
Calculating the firm’s WACC or inter-
nal Hurdle Rate is another topic en-
tirely, but suffice it to say that WACC
is inversely proportional to the strength
of the firm’s balance sheet and firms
with lower hurdle rates or a willingness
to relax hurdle rate requirements can
gain significant advantage at auction.
Mathematically, lowering the WACC
effectively inflates the value of the perpetuity component of the valuation calculation intended to represent all future
cash flows after year 5. In terms of practical consideration, this makes some
sense as the strategic buyer is assumed
to have an infinite hold period.
The PE buyer has a different set of financial considerations. One of the most
critical to long term survival of the PE
firm is meeting or exceeding minimum
investor expectations for ROE, typically
20% or more. In our analysis we have assumed ROE has a floor at 22% to cover
the 20% minimum ROE plus 2% to cover administrative fees and overhead costs
at the PE itself. With project finance, it is
often more informative to consider net
present value (NPV) of the cash flows
instead of IRR as we are looking to determine if we are creating or destroying
equity capital. Thus the sensitivity is to
ROE expectations in excess of 20%, and
the resultant impact on valuation can be
seen in the table.
One approach to mitigating the effect
of high ROE expectations is to increase
the financial leverage used to finance
the deal. This works to the potential
advantage of equity holders (although
at increased risk of loss) by substituting
cheaper debt into the capital structure,
thus lowering the effective overall cost
of capital and potentially improving
equity returns. In today’s more conservative lending environment, leverage
ratios tend toward 50%, and as noted
in the previous article in the series interest rates are at historically low levels.
LBO deals of yesteryear with super high
leverage ratios are rare, but it is informative to quantify the impact of varying
leverage on purchase price and NPV of
the investment.
In our PE analysis of FantasyChem,
we assumed that we could enter and exit
at the same EBITDA multiple. In today’s
seller’s market, this is more and more frequent compared to maybe 5 or 10 years
ago when EBITDA multiple improvement
was a key element of PE value creation. It
may still be possible for a buyer to see an
increase in multiple at exit as a result of
improvements made to the business while
under PE ownership, but a more conservative treatment is to eliminate this upside from initial consideration.
Hopefully this quick and simplified look at some key value drivers and
the sensitivity analysis has shed some
light on the motivations behind buyer
behavior and priorities. In the final installment, we will take a look at the
implications of some these results and
offer some suggestions for buyers and
sellers seeking to make the right deal in
today’s business environment. CW
Value Drivers by Buyer Type
Strategic Buyer: Impact of Synergy on IRR and Purchase Price
Strategic Buyer: Impact of WACC on IRR and Purchase Price
PE Buyer: Impact of Cost of Equity on NPV and Purchase Price
PE Buyer: Impact of Financial Leverage on NPV and Purchase Price
PE Buyer: Impact of Exit Multiple on NPV and Purchase Price
