When it comes to mergers and acquisitions, everyone is very familiar with them; but leveraged buyouts are relatively less familiar. But now that newspapers are also extremely exposed, we can see LBO as a special case of mergers and acquisitions in general. LBO has three basic points: First, it is generally a transaction structure with financial investors (PE) as investors. LBOs are rarely strategic investors, mainly PE money-making models. Second, it is a controlling transaction, merger and acquisition, although it does not require 100%, but also more than 50%, if there is no more than 50%, it will also use other structural means to achieve actual control. Third, the use of borrowing money or debt financing to complete the transaction is an indispensable means.
Three sources of revenue for LBO
When it comes to how LBOs make money, we need to first discuss how PE makes money. For example, how Jiuding makes money is Pre-IPO. Before the listing, I bought with 10 times pe, then I can achieve the listing within half a year, 20 times, 30 times after the listing, even if the company's profits do not grow, the book can achieve two years of double, or triple an IRR growth. This is called valuation multiple growth.
In the second case, you invest in a very powerful enterprise, this enterprise can create 20%-25% of the net profit every year, then the valuation of entry and exit are similar, basically you can also achieve an annualized yield of about 20%-25%. If the valuation is flat, the annualized yield and net profit growth are basically flat. So the second source of investment income is performance growth.
The problem is that PE general investment annualized returns require more than 20% IRR, to achieve a doubling in three years, or to achieve a return of 2.5 times to 3 times in five years. So everyone is thinking, it is not easy for PE to make money in the US market, why? Because the GDP or market GDP of the United States is also 2% to 3%, then the profit growth of enterprises is unlikely to exceed GDP for a long time, and the primary market and secondary market in the United States are relatively not strongly divided, and the arbitrage space of capital is very small, so the word LBO must be an imported product.
Because in the United States, if you want to make a lot of money, you must rely very heavily on banks or securities markets as a financing channel to complete transactions, so borrowing money to increase the IRR has become the third source of income.
In fact, when it comes to borrowing money to make money, everyone is very familiar with it. Everyone who had a mortgage loan in Beijing three or five years ago should have had a very pleasant experience.
For example, 3 years ago you bought a house for 5 million, and now the house is worth 10 million, even if you completely pay your own money, without leverage, you will achieve a doubling return in three years, with an annualized return of about 20% to 25%. But three years ago, if the $5 million house used 60 to 70 percent bank leverage and the annualized interest rate was 8 percent, you could calculate that your IRR was surging a lot, and the annualized rate of return would be 50 percent, basically 4.2 times the return.
Therefore, once you see that the value of a thing will definitely grow, if you can still borrow money cheaply, then you will actively use financial leverage to expand your income, especially when your personal financial resources are relatively small, you want to eat a big snack, snake swallowing elephants, financial leverage is a better choice.
Therefore, if you have the heart, you can make an Excel model to calculate, LBO has an advantage is that even if the company does not have high growth, it can achieve a good return to investors.
I have calculated one, assuming that the operating cash flow of this enterprise increases by 5% per year, if you invest 60% of the money in it is bank financing, even if there is no valuation multiple increase, for example, if you go in 10 times PE, 10 times PE exit, basically you can achieve a yield of 20% IRR, which is also a basic model for making money in the PE community in Europe and the United States.
So, to sum up, a good PE project investment, or LBO trading investment, will have three sources of income: the first is the contribution of financial leverage, the second is the growth of operating performance or profits, and the third is the possibility of valuation multiples. So before I make each investment, I should basically have a spectrum in my head, that is, the IRR of this project, or where the point of making money comes from, which is a pe investment must be carefully thought out. Of course, I think that the middle source of profit, that is, the growth of profits, can be divided into two factors, the first is the growth of revenue, and the second is the growth of profit margins. So this three-factor model can also be derived as a four-factor model.
The four elements of LBO trade execution
The second part is the second part, which is some of the elements of LBO trade execution. The logic of "borrowing money to buy things" is very simple, everyone knows it, but it is more complicated in implementation.
A large LBO transaction contains four elements. The first element is that it is a M&A transaction itself, that is, you use the buyer to acquire the assets of the other party, so you have to reach an M&A transaction contract, valuation and transaction structure with the other party, so the asset acquisition itself is the first element. This involves the comprehensiveness and depth of corporate due diligence, the design of the transaction structure, and the understanding of the specific circumstances of valuation negotiations.
Unlike VC investments, or pre-IPOs, etc., the due diligence of M&A transactions is very cumbersome and meticulous, and it relies heavily on data analysis to speak. You can imagine that like KKR's acquisition of Toys R Us, or Bain's acquisition of TIM, he has to face the number of stores and the economic profit of each store, this workload is very large, you have to spend a lot of time to do data analysis and operational calculations.
In addition, in this element, I put forward a concept in the valuation link, that is, unlike the Chinese market, we pay more attention to the concept of net profit and PE multiple, and in the M&A market, we pay more attention to the concept of EBITA, that is, operating profit plus depreciation and amortization.
Because the net profit will be affected by the capital structure of the enterprise, will be affected by the tax situation, and some one-time loss of income, so the net profit does not truly reflect the true operating level and cash flow of an enterprise without using financial leverage. Therefore, most overseas LBO transactions will be based on EBITA and depreciation amortized EBITDA.
In this case, we analyze the working capital situation and the capital expenditure in the coming years to get a preliminary understanding of the cash flow of the entire enterprise and the situation of the next year. Or to put it another way, LBO deals don't focus on accounting net profits, but on the cash flow in and out of the company's actual operations every year.
The second element of an LBO deal is the case of equity financing. The third element is the case of debt financing. We can put the elements of these two transactions together. If you decide to buy an asset with a sum of money, you have to think about where your money is coming from. For example, if I use 100 yuan to acquire a company, then I will pay 20 yuan for the bank for 80 yuan or I will pay 30 yuan for the bank for 70 yuan, here is a capital structure design problem.
Capital structure design is a core factor in relation to the final return on investment and whether this investment is safe, so it is very critical. Different from our traditional domestic capital structure design, the traditional is a simple 100 yuan of their own out of what percentage, the bank out of how much, which is relatively simple; the real design of the capital structure, or look at the company's cash flow in the next three to five years, such as 100 yuan cash flow, basically according to the multiple of cash flow for capital structure design.
This is a very big difference in the industry. It is reasonable for industrial enterprises to borrow 3 to 5 times the cash flow; consumer companies can borrow 5 to 7 times; enterprises with very small fluctuations such as medical services, medical facilities and medical care can borrow 8 to 9 times; like some infrastructure companies, such as highways, airports, water plants, and power plants, if the cash flow is more stable, they can borrow more than 10 times.
Like the infrastructure construction project done by Mack Bank, 95 yuan of 100 yuan is borrowed, and only 5 yuan is paid by himself. Therefore, how much money can be borrowed in the M&A transaction, the core is the judgment of the stability of the company's cash flow, and the judgment of cash flow growth, and how high the financing cost is, which will not have a devastating and devastating impact on profitability and liquidity in the future.
The third point is to talk about the transaction link of debt financing. In foreign countries, due to the relatively large volume of M&A transactions, such debt financing is basically not something that a debt institution can eat. Therefore, foreign debt financing tends to be divided into three to four layers.
The top layer is bank loan financing. Basically, there is a relatively good mortgage pledge guarantee, because the bank risk is relatively low, the financing cost is the lowest, the term is relatively long, and it will basically borrow for 7 to 9 years. Bank financing is also divided into three layers of ABC. Tier A is 7 years, and the cost of financing is lower; Tier B costs some up, which is 8 years; Tier C is 9 years.
This is very different in the United States and Europe, but it is both a bank financing channel. It should be pointed out that banks provide financing, and in the end, they will not all be placed on the bank balance sheet, and the bank will soon distribute it to other banks or interested investors through sales channels, including some hedge funds, to reduce the impact on the bank's balance sheet. Everyone knows that the product of CDO (Debt Guaranteed Bond) is a product that banks repackage and distribute M&A financing loans.
What if the bank's preferred debt is borrowed and there is not enough money? In terms of subordinated debt after borrowing inferiority, it is generally the bank willing to borrow, but the interest rate will rise a lot, and inferior refers to the preferential debt that will be inferior to the bank in the distribution of the pledge. The second tier was much less in the wake of the 2008 financial crisis, as banks were significantly more risk-conscious.
The third layer, if the money is not enough, it is necessary to borrow from the bond market, that is, to issue bonds in the open market, everyone knows the US bond market, the willingness of public investors to invest in bonds is very strong, which is much stronger than China, so the European and American markets, in this regard, can be issued to the bond market through a high-yield bond, there is no pledge requirement, so the financing cost will increase accordingly.
The last layer of debt structure, if the money is not enough, is a debt called the mezzanine, a kind of financing between the debt and the stock, his yield will be higher, 12% interest cost, but the interest payment flexibility is stronger, you can not pay cash interest, you can roll over to the book, constantly snowballing, until you exit the one-time repayment.
In addition, he can also ask for convertible bonds, so when he exits, the mezzanine investor can also get a small stake to increase his income. The yield of mezzanine investors is not low, generally there will be an annualized yield between 15% and 18%, which is the investment of the last layer.
Therefore, it is understandable that large-scale LBO transactions in Europe and the United States require a lot of interbank debt products and open market debt product support, and these conditions are very immature in China, resulting in many restrictions on Chinese LBO transactions.
Speaking of which, let's talk about the additional benefits of borrowing, the first is to expand the income, which is the same as a mortgage loan. The second is to lend a high-voltage line to the management, there is no excess cash in hand, and the awareness of cost control will be much better, which is an effective means to effectively solve the risk of agents. The third is that if the transaction structure is designed reasonably, interest can be deducted, especially in countries such as the United States, where the company's tax burden is relatively heavy, if it can be deducted, it is also very beneficial to the company.
So going back to the whole LBO deal, the third element is the equity deal. You may think that LBO trading is simple, as long as I put money in it, but there are actually many places to study and discuss. A large LBO transaction even if your leverage is high, in fact, the amount of equity investment itself is still very large. For example, in 2005, Silver Lake Capital led the investment in Jinshida, and the entire transaction volume was $10 billion. Even if $7 billion is borrowed, then there are still $3 billion that PE needs to pay for itself. In order to control the risk, you can think about how to deal with it yourself. Do you eat alone, or do you find a few co-investors to receive 20% each, or do you use other means?
Equity investment ratio control problem, the second thing to consider is whether the equity transaction design is to use a shareholder loan, or a disguised loan, or a preferential debt structure, because the PE cash flow is very fast, you need to make another capital arrangement, so that it is convenient for you to return funds, dividends, and exit, which is more convenient in terms of tax risk and freedom.
Everyone also knows that if all the equity investment is made into a registered capital, you will have to withdraw funds in the future, I don't know how it is abroad, at least in China it is still a very serious legal issue, you can only rely on corporate transactions, but this is not a long-term solution.
So here's the third element. The fourth element is management motivation. PE investment and VC investment of equity investment design is not the same, VC generally give options, PE generally requires management to participate in joint investment, valuation can be lower, but you pay your own money, the bundling effect will be stronger. So free shares, this ratio will be much smaller.
So how much equity ratio and valuation will be given to management, I think every transaction is different. Generally speaking, it is possible between 5% and 15%, if the enterprise is particularly large, then the proportion of equity will be small, if it is a medium-sized enterprise, then the proportion will be relatively large.
So we can think of M&A deals as four sub-deals. The first is an acquisition, the second is debt financing, the third is equity financing, and the fourth transaction is a transaction between PE and management, that is, an incentive arrangement. All four transactions are very important and indispensable. In particular, the design of debt transactions is relatively complex.
Five elements of post-investment management of LBO trading
Third, I will talk about the post-investment management of LBO transactions, PE is paying more and more attention to the post-investment management aspect. As I said, there are two core elements of growth here, one is the growth of revenue and the other is the growth of profit levels. These two can be in the same direction, with income and profit levels growing at the same time, and sometimes it is possible to sacrifice income growth in exchange for profit growth. For example, bain capital acquired Gome, and the first thing it did at that time was to close the stores in large quantities, which was a means of sacrificing income in exchange for profits.
I think the first element of post-investment management is to do your homework on due diligence. Basically, after doing the due diligence, the company must have a good understanding of where there are problems, how to solve them, and where there is potential for improvement. This is also where I think PE due diligence is more careful than VC due diligence and so on. I think due diligence is not only about seeing the problem, but more importantly, seeing where the company has the potential to improve, and both are equally important. Doing finance is purely conservative, and it only meets a basic requirement.
The second element of investment management is the improvement of corporate governance. A good board operation mechanism, there are PE representatives on the board of directors, as well as senior industry external representatives, which is very useful for business management. In my personal experience, as an investor, it is impossible to know everything in a daily life very carefully, and there is a good board mechanism through which you can control the management, which can make you worry a lot in your daily work.
The third tool is an effective management incentive program. If this is designed, management will have a self-motivating way, and without you pushing him, he will do a good job.
The fourth tool is the refinement of financial control, cost control is not mentioned, because there are liabilities, so the conscious awareness of cost control will be very high. However, despite this, through refined management, there are still many places where costs can be compressed, pe has better management means for working capital, compressing the inventory cycle, compressing the accounts receivable period, and dragging out the accounts payable, which are all good methods.
In terms of financial control, I think PE is doing a good job. It can develop a good set of operational core indicators for the financial situation, summarize it on 1 to 2 pages of paper, meet monthly or quarterly, and just look at this page or two, you will have a clear understanding of the core situation of the enterprise. Therefore, under the guidance of PE experience, the analysis and summary tools in this area will greatly improve the enterprise.
Another tool is the benchmarking analysis tool, which is a tool that PE likes to use. Compare and analyze the operation of the enterprise with the level of the industry and the level of the competitive enterprise, and then find the problem. This is also very practical.
So in general, post-investment management is also a physical and delicate work. However, each PE style is also different, such as Bain Capital's management is thinner, Blackstone is more macroscopic, and the style is different. Now the overall trend is that with the reduction of the scale of financing, everyone pays more and more attention to the improvement of operations. Most large funds have established a dedicated operating partner system. The fund employs a professionally experienced operating partner to be responsible for post-investment management of the project, while the PE team focuses more on project execution and project delivery, handing over the work that needs to be gnawed to people who are more good at this line.
There are four exit mechanisms for LBO trading
The fourth point I will talk about the mechanism of LBO transaction exit, that is, how to achieve exit and realize benefits in M&A transactions. The most popular way in China is called IPO, you have to consider choosing the listing location and listing window, when to list in the capital market, so some factors are uncontrollable. But for large mergers and acquisitions, you still need an IPO if you want to exit. For example, the UK IPO market has been very active in the past six months, and many European mergers and acquisitions have been exited through the UK IPO market.
The second way is to sell to strategic buyers. This model accounts for a higher proportion of buyout funds in Europe and the United States, basically reaching 60% to 70%. Because the market likes to eat big and small, PE acquires a medium-sized asset and then sells it to a large asset, which will be much more tolerant of both valuation and risk.
The simple money-making model is that PE is sold to strategic investors with an annualized rate of return of 20% to 22%, and the requirements of strategic investors for annualized yields are only 10% or even 5%, so it is very simple to achieve value appreciation. Many strategic investors may be less concerned about annualized yields for strategic reasons. Therefore, in terms of investment discipline, PE investors are much higher than strategic investors.
This kind of strategic buyer is not only big and small, but also the merger between enterprises of the same size can also be designed. I recently saw a more classic case, which is KKR's exit from Alliance Boots in the UK.
Everyone should have an impression of Boots, there are drugstores everywhere on the streets of the UNITED Kingdom, a large company of FTSE 100, which is also the largest merger and acquisition transaction in the United Kingdom. Boots were too big for a strategic buyer to buy, and eventually swapped shares with Walgreen, a major U.S. cosmeceutical company( the largest U.S. pharmacy chain operator), to get out. This reflects the good thinking of M&A transactions, and there is a good professional quality to cooperate in order to achieve.
The third exit channel, because there are many PE funds in Europe and the United States, the project target is very difficult to find, so the project often reverses between PE, buying for three or five years to make some money to sell to the next fund, which is also very common. I don't know if the ladies here have worn Jimmy Choo women's shoes, have been upside down between PE funds four or five times, and are still in the hands of some PE fund.
The fourth important technical means of exit is called recapitalization, which is an important exit. With an immature IPO, no strategic buyers, and no other buyers, the company's financial leverage has been significantly reduced through three years of operation (generating cash flow every year). In this case, with the help of the debt market for debt financing, the money raised is distributed to the shareholders by means of similar dividends, so that PE does not have to withdraw from the equity, but also can recover the principal invested, once the principal is recovered, the rest is additional income.
Blackstone acquired an important asset, called Ocean World, at a relatively low price from beer company ABI (AB InBev), which was listed last year, but before going public, Blackstone had recovered 70%-80% of its equity investment by issuing high-yield bonds, and then achieved a complete exit through an IPO. This two-step exit method is more comfortable.
Therefore, the four means are quite practical, but the fourth means, because China's bond market is not developed, and China's regulatory requirements for capital management are very high, so the fourth means is not very convenient to use in China. But in reality, many private enterprises also have the situation of withdrawing money in advance, but there is no packaging of professional terms.
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