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:
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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).

[@nicholasabrams8193]

Oh my god! 11:20 blew my mind!

[@financialmodeling]

Thanks for watching!

[@T3AMKILL]

Great vid as always! Thanks!

[@financialmodeling]

Thanks for watching!

[@prakashgoath9468]

Very useful video, can you please share excel sheet as well with this video?

[@financialmodeling]

Click "Show More" and then click the links.

[@TheSpartan9012]

When you calculate the Cash Flow Attributable to Common Shareholders, you use the Free Cash Flow figure arrived at before (which is the net income adjusted for non-cash items, WC, CapEx). My question is shouldn't the Free Cash Flow figure have the cash used for debt repayments subtracted from it, in order to figure out what cash is available to common shareholders? I understand my thinking must be wrong as the Ending Equity Value and the Equity Proceeds value square up in the end, but I can't wrap my head around this

[@financialmodeling]

No, because the debt repayments do not affect the common shareholders, even though they reduce the amount the company could potentially issue to them as dividends. Think about it like this: If a company issues Debt, its Debt and Cash balances both go up. But Equity Value does not change because Total Assets are higher, and Total Liabilities are also higher by the same amount, so Net Assets stay the same. When Debt is repaid, it's the same idea but in reverse: Total Assets and Total Liabilities both decrease by the same amount, and Equity Value also stays the same. It's the same principle here, but for the Equity Value in a deal rather than in a standalone or fundraising context.

[@TheSpartan9012]

@@financialmodeling great, that's much appreciated - thanks for the help. I think I confused myself by thinking of how free cash flow to equity is the cash flow available to equity investors, and FCFE includes debt repayments/issuance

[@liaoming5177]

Hi biws, just wanted to ask, why is your IRR formula the same as a CAGR formula?

[@financialmodeling]

Because in a simplified model with regular annual timing, an upfront investment, and an exit at the end and no cash flows in between, IRR and CAGR are the same.

[@jonnycleans7809]

Thank you for the great job! But if at the end we say that in this case "only cash generation attributable...increases Eq.V., not debt payment", when and how in the normal cases debt repayment contributes to increase in Eq.V.? I mean that also in a normal case I would expect that cash generation has a positive effect on Eq.V, since it reduces the NFP and could be used to repay that debt (but it is not necessary to repay it, unless we assume that decreasing debt also our interests will decrease). Thank you again, sorry for the lenghty comment!

[@financialmodeling]

Debt Repayment never changes Enterprise Value either way. How could it? Just think about the basic formula for Enterprise Value: Equity Value + Debt - Cash. Debt goes down, but Cash also goes down. How could repaying Debt possibly change Enterprise Value?

[@alexandervalladares2501]

@@financialmodeling Excellent Answer... Please keep up these great Videos.

[@jonnycleans7809]

@@financialmodeling I totally agree in that, thats why I was wondering the presence of "debt paydown and cash generation" in the table where the 3 "return elements" are listed with their values, I would expect not to see "debt paydown"... Am I missing something? Thank you

[@financialmodeling]

@@jonnycleans7809 Because that table is not measuring the Change in Enterprise Value. It's measuring "Returns to Equity Investors," AKA the Change in Equity Value. And capital structure changes do affect Equity Value.

[@jonnycleans7809]

@@financialmodeling that's what I was misinterpretating, my bad! Thank you. So in the case I decide to pay down debt faster I expect to obtain higher equity value and higher IRR, all the rest staying the same

[@JJ-zy3zv]

QQ - Is it always the case that a change in EBITDA affects enterprise value? I'm thinking of situation where revenue increases on IS, which trickles down to EBITDA and net income. But that doesn't affect Net Operating Assets. The excess net income could just flow to retained earnings and cash. Why is it automatic that EBITDA affects Enterprise Value? thanks

[@financialmodeling]

From an accounting perspective, ignoring changes to valuation multiples (i.e., Current Enterprise Value, not Implied), a change in EBITDA and net income in which the company earns extra cash and does nothing with it will not affect TEV because NOA do not change if it stays in cash. But from a valuation perspective (Implied Enterprise Value), TEV will often increase in this case because the market interprets it as a sign of core business growth, i.e., the market value of the company's Net Operating Assets should be higher.