In the first section, when describing the different types of acquisitions, we pointed out two important differences between mergers and buyouts. The first is that, unlike a merger, a buyout does not involve two firms coming together and creating a consolidated entity. Instead, the target firm is acquired by a group of investors that may include the management of the firm. The second is that the target firm in a buyout usually becomes a private business. Some buyouts in the 1980s also used large proportions of debt, leading to their categorization as leveraged buyouts. Each of these differences does have an effect on how we approach the valuation of buyouts.

The Valuation of a Buyout

The fact that buyouts involve only the target firm and that there is no acquiring firm to consider makes valuation much more straightforward. Clearly, there is no potential for synergy and, therefore no need to value it. However, the fact that the managers of a firm are also the acquirers of the firm does create two issues.

The first is that managers have access to information that investors do not have. This information may allow managers to conclude, with far more certainty than would an external acquirer, that their firm is under valued. This may be one reason for the buyout.

The second is that the management of the firm remains the same after the buyout, but the way in which investment, financing and dividend decisions are made may change. This happens because managers, once they become owners, may become much more concerned about maximizing firm value. The fact that firms that are involved in buyouts become private businesses can also have an effect on value. In chapter 24, we noted that investments in private businesses are much more difficult to liquidate than investments in publicly traded firms. This can create a significant discount on value. One reason this discount may be smaller in the case of buyouts is that many of them are done with the clear intention, once the affairs of the firm have been put in order, of taking the firm public again. If going private is expected to increase managers’ responsiveness to value maximization in the long term –– since they are part owners of the firm –– the way to incorporate this in value is to include it in the cash flows. The increased efficiency can be expected to increase cash flows if it increases operating margins.

The emphasis on longterm value should be visible in investment choices and should lead to a higher return on capital and higher growth. This advantage has to be weighed against the capital rationing the firm might face because of limited access to financial markets, which might reduce future growth and profits. The net effect will determine the change in value.

The empirical evidence on going-private transactions, however, is clear cut. DeAngelo, DeAngelo and Rice (1984) report, for example, an average abnormal return of 30% for 81 firms in their sample that went private. Thus, financial markets, at least, seem to believe that there is value to be gained for some public firms in going private.

Valuing a Leveraged Buyout

We have seen that leveraged buyouts are financed disproportionately with debt. This high leverage is justified in several ways. First, if the target firm initially has too little debt relative to its optimal debt ratio, the increase in debt can be explained partially by the increase in value moving to the optimal ratio provides.

The debt level in most leveraged buyouts exceeds the optimal debt ratio, however, which means that some of the debt will have to be paid off quickly in order for the firm to reduce its cost of capital and its default risk. A second explanation is provided by Michael Jensen, who proposes that managers cannot be trusted to invest free cash flows wisely for their stockholders; they need the discipline of debt payments to maximize cash flows on projects and firm value. A third rationale is that the high debt ratio is temporary and will disappear once the firm liquidates assets and pays off a significant portion of the debt.

The extremely high leverage associated with leveraged buyouts creates two problems in valuation, however. First, it significantly increases the riskiness of the cash flows to equity investors in the firm by increasing the fixed payments to debt holders in the firm. Thus, the cost of equity has to be adjusted to reflect the higher financial risk the firm will face after the leveraged buyout. Second, the expected decrease in this debt over time, as the firm liquidates assets and pays off debt, implies that the cost of equity will also decrease over time.

Since the cost of debt and debt ratio will change over time as well, the cost of capital will also change in each period. In valuing a leveraged buyout, then, we begin with the estimates of free cash flow to the firm, just as we did in traditional valuation. However, instead of discounting these cash flows back at a fixed cost of capital, we discount them back at a cost of capital that will vary from year to year. Once we value the firm, we then can compare the value to the total amount paid for the firm.

Prof. Aswath Damodaran

Next: In Practice 26.7: Valuing A Leveraged Buyout: Congoleum Inc.

Summary: Index