My LBO case was a small light manufacturing company. I should say, actually, it was an assembling company. They had outsourced all their component manufacturing and did only detailed quality assurance and inspection and assembly at their facilities in Northern New England.
I concentrated on three things. First, doing a good discounted cash flow analysis. This shouldn't have been difficult because there weren't a long series of non-recurring charges to pull out of the financials. It was a pretty clean-cut and clear business this way. The problems with my model were more subtle.
The company was only around $100 million in revenue. At first I wasn't going to call it an LBO because it didn't fit the typical model. Boring firm. Lots of machinery or assets on the books to leverage against. Steady cash flow. Undervalued industry. Here we had 5 years of 15% annual growth in revenue, positive, but hardly steady or consistent, a balance sheet with barely $12 million in assets to leverage, and most of these nearing the end of their useful life. It was an expensive deal though. Nearly $20 million in EBITDA and a banker for the seller who wanted 5x-6x EBITDA, or $100 - $120 million in cash. The discounted cash flow I did was cumbersome. How do you pick a beta to determine a discount rate for a small, totally privately held firm with no obvious industry peers? Wild ass guess, that's how. It came out to around $135 million. I shaved that down by applying a "liquidity penalty" rather arbitrarily to the firm of 30%. Nearly $95 million. That was close.
Even at $95 million, an all equity deal would be painful, and it would make returns very difficult. I doubted the firm could maintain 15% growth for another 5 years now that it had $100 million in sales.
I solved my quandary when I remembered a Wall Street Journal article on hedge funds and their increasing domination in the cash flow based leveraged finance business. Large balance sheets weren't critical to an LBO, provided the lender could get comfortable with the cash flow. Such "cash-flow" based leverage made it possible to do significant LBO deals on firms with weak balance sheets, albeit at more severe rates.
I threw myself into the LBO model with On-Demand movies playing in the background to keep me company in the hotel room. Committed to the LBO model, I had to take some guesses as interest rates and how much a hedge fund with a leveraged finance desk, about which I knew quite little, would want to see.
I ended up with $30 million in equity and three "and a half" tiers of debt. The Senior Secured with $40 million (two EBITDA turns) at 400 basis points over LIBOR. The Senior Secured B with $20 million (one EBITDA turn) at 800 basis points over LIBOR. The Senior Secured C with $20 million at 950 basis points over LIBOR and half of the interest payable as "payment in kind." Below this I added some penny warrants so that the total return to the hedge fund was closer to 15% than not, figuring this was the kind of IRR they would need to do the deal. This seemed like a reasonable structure and there was enough EBITDA to go around even with mandatory payments on the debt.
I threw in a very conservative 3 stage growth model, pulling revenue growth in year 5 down to 5%. Even on this conservative model the equity was showing IRRs of nearly 27%. Any decent sales performance would pay off more debt faster and boost those IRRs even higher.
I was confident I had the right answer, and I wasn't sure how any investor could snicker at those returns given how conservative I had been with growth. Even with a rather severe contraction in revenue the debt holders were still made whole in the first several years. Figure in a refinancing in year 4 or 5 and it was a pretty good looking deal.
I put all my arguments together, got a smattering of sleep and pitched the deal the next day. Armin stopped me cold on my sixth slide.
"Your model looks fine, but this deal would never work." I was frozen. "Did you consider the ownership?"
"Well," I was at sea here. "Yes. I felt that this level of payout would convince all the shareholders it was a compelling deal. I left some upside in the model and I think we could add another $10-$15 million in purchase price in order to..."
"No," Armin intoned again. "Think PAST the numbers. The purchase price is just one part of the story." I was stuck. There was a long pause. Armin finally broke it.
"What percentage of the firm are we buying?" I hadn't considered anything other than 100%, figuring that leaving old minority shareholders in was a bad idea and that a clean slate would be better."
"I guess I figured 100%."
"No. Take another guess."
"No. Tell me, what is the motivation of the seller here?" I was stumped. "Did you read about his family?"
"No," I admitted.
"You should have. How old is the owner?" I was about to try and guess when Armin answered for me. "Seventy six. He has five daughters. All about one year apart. What does that tell you?" I was alarmed by this direction of the discussion. The other partners were totally silent on the phone. The silence continued. "It tells you he probably wanted sons. What are his daughters doing?" I didn't know this either. "Well, it doesn't matter, except that none of them want anything to do with the family business." This had been in the materials, but I had ignored it. "He wanted sons, instead he got a lot of minority shareholders, two of which have made a habit of suing him. Do you think he is ready to retire?" Again, I didn't get the chance to answer, "He's got three sailboats, two planes and a house in the islands, he's seventy six and he's still working at the business he built full time. This guy is bored. He isn't going to retire. He wants to relive the glory days. He's selling because the minority shareholders have driven him to madness. He needs a partner again. He needs... heirs."
"I... I see."
"Yes, I think you do now. Let me tell you what really happened with this deal. By hook and by crook we bought out the seven minority shareholders for $20 million in equity. That got us around 30% of the company. We then structured the rest of the deal as an earn out, slowly buying out the owner but letting him run the company and stay on the board. We ended up paying about 80% of what you suggested. If we kicked him out we'd have had to put in a whole new management team. You have to think first about the people. About the parties and their motivations. Why are they selling? How can you give them what they want without just throwing money? Sometimes you can't. This time we could. All he wanted to do was be the big cheese for a few more years. It was the lawyers telling him to sell." I was crestfallen. I had totally blown it. "Your model was excellent. We might even have done this deal as an LBO, but we didn't have to. That was the key. Well, we'll talk and I'll get back to you tomorrow."
That night was the longest of my life.