Equity Value and Enterprise Value in Leveraged Buyouts

In this tutorial, you’ll learn how Equity Value and Enterprise Value change in the context of leveraged buyouts, and how it’s possible to earn an acceptable IRR in an LBO even if the company’s core business remains stagnant and its Enterprise Value does not change during the holding period.

Resources:

https://youtube-breakingintowallstree...

https://youtube-breakingintowallstree...

Table of Contents:

0:00 Introduction

1:07 Part 1: The Short Answer About Equity Value

3:07 Part 2: Excel Demonstration

9:54 Part 3: Other Rules and Notes

12:29 Recap and Summary

Lesson Outline:

QUESTION: “You’ve said that it’s possible to earn an acceptable IRR in a leveraged buyout even if the company’s EBITDA and EBITDA multiple stay the same, meaning its Enterprise Value stays the same.

This is because Debt Repayment and Cash Generation are also sources of returns.

But… your lessons on Equity Value and Enterprise Value also say that Debt Repaid with Cash does not change Equity Value…

So… how does this work in an LBO? Does Debt Repayment boost Equity Value there for some reason?”

SHORT ANSWER: The Change in Cash Attributable to Common Shareholders, not Debt Repayment, boosts a company’s Equity Value in a leveraged buyout where its Enterprise Value stays the same

Cash is a non-core Asset, so changes in Cash could affect Equity Value, but not Enterprise Value

If Cash changes, Equity Value will change only if the change in Cash was due to common shareholders

For example, Net Income generated by the business (flows into Equity), Dividends, Stock Issuances and Repurchases are all changes that affect both Cash on the Assets side and Equity Value.

In LBOs, you typically ignore Stock Issuances and Repurchases or set them to 0, so Net Income and Dividends are the main relevant Cash-affecting items.

So, in an LBO, even if a company’s Enterprise Value stays the same, Equity Value keeps increasing as long as the Cash balance keeps increasing due to cash flows from Net Income generated.

It doesn’t matter how the company uses this Cash balance – it could repay Debt, or it could let Cash accumulate on its BS, and Equity Value would keep changing in the same way.

The only restriction is that the company can’t use Cash on core-business Assets, such as PP&E, or Enterprise Value would change.

This rule breaks down if the company’s EBITDA or EV / EBITDA multiple change.

When that happens, the value of the company’s core-business Assets changes, which means that Total Assets change.

Change in Total Assets = Change in Core-Business Assets + Change in Non-Core-Business Assets (primarily Cash).

So, in this scenario, you must factor in both sets of changes to calculate the company’s Equity Value each year.

Change in Equity Value = Change in Core-Business Assets due to Changes in Enterprise Value + Change in Cash Attributable to Common Shareholders (primarily Net Income generated by the business).