GROUP 7 MORNING

Topic : Learning PEF through several methods

This page aims to provide students with understanding of the basic PEF and several methods of PEF

Subtopics :

- PEF based on Buyout (Kim, Sun Young)
- PEF based on Venture capital (Bae, Jong Hun)
- PEF based on M&A (Park, Sang Kyoon)


1. PEF based on Buyout

Definition of Buyout
it is very difficult to arrive at a definition of buyout, because it covers so many transaction
According to wikipedia, a buyout is an investment transaction by which an entire company or a controlling part of the stock of a company is sold. A firm "buys out" a company to take control of it.
According to investorwords, a buyout is the purchase of controlling interest in one corporation by another corporation, in order to take over assets and/or operations.

Characteristic of Buyout in private equity transactions
• Large enterprise value, sometimes very large (multi-billion)
• Bank debt almost always used
• Generally mature, established companies
• Profit levels of investee companies crucial (although turnaround situations are considered)
• Technology considerations largely irrelevant
• Control always present in true buyouts, though some practice development capital
• Firm rules of financial theory available with which to calculate valuation (e.g., earnings multiple)

Types of buyout transactions
<MBO>
The classic buyout has always been an MBO or management buyout.
In its purest form, this involves the executive team who are managing a particular business activity buying it out from the parent company.

< MBI>
The Management Buy-In evolved from the MBO. It is similar in just about every way apart from the nature of the team or, viewed another way, apart from the way in which the deal initially comes together.
The key difference is that instead of the management team of a business getting together to buy it, a team is put together to buy another company operating in the same sector. This may be because they have tried to buy their own business and been rebuffed by the parent company, or because they wanted to buy it but it was sold to a trade buyer instead.

< BIMBO>
As the acronym suggests, these deals are a combination of an MBO and an MBI, where outside executives are grafted on to the existing executive team in order to facilitate a buyout. In truth, many buyout transactions probably fall into this category if one applies the definition strictly.

< LBO>
LBO stands for Leveraged Buyout and in a sense all buyouts are LBOs since “leverage” is simply the American word for “gearing”, and all true buyouts will involve the use of some acquisition debt.

Other factors of buyout
• A buyout transaction will always involve an established, profitable business though the latter condition may obviously not apply in the case of a turnaround transaction in respect of a troubled company.
• A buyout will invariably involve the use of debt. Indeed, today’s financial engineering solutions for buyouts will often involve various different layers of debt, ranging from straight senior debt secured on assets of the company to pure cash flow lending with equity kickers.
• Buyout properly so-called will always be control investing. Development capital may be distinguished from buyout on this ground and also because it may be much more difficult, for legal and accounting reasons, to introduce significant acquisition debt.
• Cash flow is key to buyout transactions, since success depends on the ability to service debt, and as much debt as possible.
• Recapitalizations (recaps) offer an alternative to an exit where the exit window may be temporarily closed or where cash flow levels may have exceeded expectations. Recaps can have huge affection buyout returns, a fact which is not widely appreciated.
• The VentureXpert definition of a mid-market fund ($250 M to $500 M) may happily be adopted, since this will make it much easier to work with the available figures, though my own estimation would be a little lower. Even adopting this definition, genuine mid-market funds are becoming rare compared with 10 years ago, particularly in Europe.
• The main sector-specific barrier to entry for a new buyout firm is to break into the deal flow channel, much of which is now largely controlled by a relatively small number of investment banks. This is true even moving down the size scale, though it becomes a less serious problem as the number of intermediaries handling smaller deals becomes larger.

How to analyze PEF based on buyout
• The four drivers of buyout returns are earnings, earnings multiple, debt (leverage or gearing) and time.
• Buyouts are measured both by IRR and by money multiple. Be aware that there is an inherent trade-off between the two overtimes.
• When modeling buyouts, pseudo-cash flow measures such as EBITDA are the closest to what buyout firms themselves will use, but lack of consistency and public availability of such figures will usually drive the modeler back to earnings and PE ratios.
• The ability to grow the earnings of a company is the most highly prized of buyout firm abilities.
• Multiple increases can be thought of as both systemic (like beta) and non-systemic (like alpha). The latter is obviously preferable and, like earnings growth, represents a highly desirable buyout firm expertise.
• Debt plays a key role in the generation of buyout returns, operating as gearing to enhance equity returns. The way in which different layers of debt and mezzanine can be structured into a deal is a complex subject and requires separate study.
• Timing is largely implicit in buyout returns, since they are calculated by a time period-based measure (IRR). However, there are some explicit considerations which will impact on decision-making and returns, such as the stage of a fund’s life cycle, and prevailing market conditions.
• The effects of earnings increase, multiple increase and debt reduction can and should be broken out and analyzed.
• Other key factors to capture and analyze include the gearing ratio, length of holding period, type of deal (MBO, MBI, etc.), deal source (proactive, auction, etc.), country and fund size.
• Given the mathematical complexities introduced by multiple variables, some degree of algebraic simplification is required. However, once the basics are grasped, there is no limit to the complexity of model which may be created.

Buyout Returns
• Historically, European buyout funds have consistently outperformed US buyout funds. In particular, European buyout funds enjoyed a period of significant out-performance in the mid-1990s, with both 1994 and 1995 being stand-out vintage years.
• While no specific underlying data is available, it is likely that earnings growth and multiple expansions were the main drivers of this European out-performance.
• These in turn were facilitated by the existence of market imperfections in Europe, leading to buyout firms being able to buy companies on a proactive and exclusive basis that had largely ceased to be available by the end of the decade. No comparable conditions existed in the USA at any time during the decade.
• The available data strongly suggests that there is a direct inverse relationship between buyout returns by vintage year and both total capital raised and average fund size by vintage year. In other words, if either the total capital raised in any one vintage year, or the average size of the funds raised in any one vintage year is higher than the corresponding total for the year before, then the returns of the funds raised in the vintage year in question are likely to be lower than for the preceding vintage year. Thus a period of steadily increasing fund sizes would seem to signal a period of steadily declining returns.
• Europe was comparatively little affected by the “mega fund effect” during the 1990s, but the European fundraising pattern has changed dramatically in recent years, so that in 2005, for example, mega funds accounted for over 70% of all European buyout capital raised.
• One must be cautious about drawing firm conclusions, since much of the relevant data is young and therefore unreliable, but mega funds appear to have performed significantly better relative to other funds in their market in the USA than they have to date in Europe.
• It seems likely that buyout returns are in long-term decline in Europe, and that this decline is particularly significant for funds of larger size. The decline is probably a downward curve rather than a straight line and is regressing towards both US buyout returns and quoted equity returns.
• For the larger funds, there is likely to be little difference between US and European returns in future years. The IRRs of such funds currently being raised will probably struggle to out perform quoted equities on a cost-adjusted basis by more than about 150 basis points.
• There may well be a small handful of firms who are able to outperform their peers. Logically these will be those who avoid excessive exposure to syndication and seek out deals which can be exclusive to their fund.
• Those who are concerned by the possible low return potential of mega funds should remember that since the beginning of 2001 they have represented less than 6% of global private equity funds, which would leave well over 3000 other funds from which to choose.

Real stories of private equity buyout fund
<Wellbridge Capital launches private equity buyout fund>
ellbridge Capital has created a private equity buyout fund, Wellbridge Capital 1, which aims to capitalize on the growing numbers of baby boomer business owners retiring and deciding what to do with their companies.
'With over 750,000 baby boomer business owners expected to retire in 2009, WC1 represents an historic opportunity for private equity investors like Wellbridge Capital who have the financial know-how to craft smart deals, and the operational experience to capitalize on this opportunity,' says Wellbridge Capital co-founder and principal Randy LeTang.
LeTang says WC1 is a potential win-win for investors and entrepreneurs.

< Are private buyouts good for the economy?>
The new birth of Burger King Corp. this year delivered the beef to the investing public: Under private management, the long-struggling company turned a corner and then made shares available on the New York Stock Exchange.
But the managers kept some major side orders to themselves. They took out a big loan and paid themselves a $367 million dividend and other fees as well. In all, they extracted cash worth about one-sixth of Burger King's market value.
"Private equity is a very big deal. It has moved from the periphery of the capital markets 20 years ago much closer toward the center," says Robert Bruner, dean of the University of Virginia's Darden Graduate Business School.
Private equity is Wall Street jargon for massive funds pools of money from large investors used for owning and managing companies in private, rather than as companies listed on public stock exchanges.
Clearly, the rich are getting richer here. But arguably the economy is also somewhat better off. Analysts see a larger, healthier company than in 2002. Burger King's market value is now more than $2 billion. If the private equity had merely hollowed out the company with its cash extraction, it wouldn't be worth that much today, some experts point out. But if private equity is helping corporate America be more productive, the returns may diminish at some point partly because it's harder to find lucrative deals.

References
http://en.wikipedia.org/wiki/Buyout
http://www.investorwords.com
http://www.privateequitywire.co.uk/articles/detail.jsp
http://mba.tuck.dartmouth.edu/pecenter/news/christian_science_monitor.pdf
Private Equity as an Asset Class, Guy Fraser-Sampson


2. PEF based on Venture capital

Venture Capital (VC), a part of Private Equity Investing
Venture capital is typically provided to early-stage of high-potential, growing companies in the interest of generating a return through an eventual realization event such as Initial Public Offering or Trade Sale of company. Venture capital investments are generally made as cash in exchange for shares in the invested company. It is typical for venture capital investors to identify and back companies in high technology industries such as biotechnology and information & communication technology etc. Venture capital typically comes from institutional investors and individuals and is pooled together by dedicated investment firms. A core skill within VC is the ability to identify technologies that have the potential to generate high commercial returns at an early stage. By definition, VCs also take a role in managing entrepreneurial companies at an early stage, thus adding skills as well as capital thereby differentiating VC from buy out private equity which typically invests in companies with proven revenue, and thereby potentially realizing much higher rates of returns. A venture capitalist is a person or investment firm that makes venture investments, and these venture capitalists are expected to bring managerial and technical expertise as well as capital to their investments. A venture capital fund refers to a pooled investment vehicle that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. Venture capital is also associated with job creation, the knowledge economy and used as a proxy measure of innovation within an economic sector or geography. Venture capital is most attractive for new companies with limited operating history that are too small to raise capital in the public markets and are too immature to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, venture capitalists usually get significant control over company decisions, in addition to a significant portion of the company's ownership. Young companies wishing to raise venture capital require a combination of extremely rare yet sought after qualities, such as innovative technology, potential for rapid growth, well thought through business model and impressive management team. VCs typically reject 98% of opportunities presented to them, reflecting the rarity of this combination.

Structure of Venture Capital Firms
Venture capital firms are typically structured as partnerships, the general partners of which serve as the managers of the firm and will serve as investment advisors to the venture capital funds raised. Venture capital firms in the United States may also be structured as limited liability companies, in which case the firm's managers are known as managing members. Investors in venture capital funds are known as limited partners. This constituency comprises both high net worth individuals and institutions with large amounts of available capital, such as state and private pension funds, university financial endowments, foundations, insurance companies, and pooled investment vehicles, called fund of funds or mutual funds.

Roles of Venture Capital Firms
Within the venture capital industry, the general partners and other investment professionals of the venture capital firm are often referred to as Venture capitalists or VCs. Typical career backgrounds vary, but broadly speaking venture capitalists come from either an operational or a finance background. Venture capitalists with an operational background tend to be former founders or executives of companies similar to those which the partnership finances or will have served as management consultants. Venture capitalists with finance backgrounds tend to have investment banking or other corporate finance experience. Although the titles are not entirely uniform from firm to firm, other positions at venture capital firms include:
Venture partners - Venture partners are expected to source potential investment opportunities and typically are compensated only for those deals with which they are involved.
Entrepreneur-in-residence (EIR) - EIRs are experts in a particular domain and perform due diligence on potential deals. EIRs are engaged by venture capital firms temporarily and are expected to develop and pitch startup ideas to their host firm. Some EIR's move on to executive positions within a portfolio company.
Principal - This is a mid-level investment professional position, and often considered a "partner-track" position. Principals will have been promoted from a senior associate position or who have commensurate experience in another field such as investment banking or management consulting.
Associate - This is typically the most junior apprentice position within a venture capital firm. After a few successful years, an associate may move up to the "senior associate" position and potentially principal and beyond. Associates will often have worked for 1-2 years in another field such as investment banking or management consulting.

Structure of the funds
Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of extensions to allow for private companies still seeking liquidity. The investing cycle for most funds is generally three to five years, after which the focus is managing and making follow-on investments in an existing portfolio. This model was pioneered by successful funds in Silicon Valley through the 1980s to invest in technological trends broadly but only during their period of ascendance, and to cut exposure to management and marketing risks of any individual firm or its product. In such a fund, the investors have a fixed commitment to the fund that is initially unfunded and subsequently "called down" by the venture capital fund over time as the fund makes its investments. There are substantial penalties for a Limited Partner (or investor) that fails to participate in a capital call. It can take anywhere from a month or so to several years for venture capitalists to raise money from limited partners for their fund. At the time when all of the money has been raised, the fund is said to be closed and the 10 year lifetime begins. Some funds have partial closes when one half (or some other amount) of the fund has been raised. "Vintage year" generally refers to the year in which the fund was closed and may serve as a means to stratify VC funds for comparison. This free database of venture capital funds shows the difference between a venture capital fund management company and the venture capital funds managed by them.

Compensation
Venture capitalists are compensated through a combination of management fees and carried interest (often referred to as a "two and 20" arrangement:
Management fees – an annual payment made by the investors in the fund to the fund's manager to pay for the private equity firm's investment operations. In a typical venture capital fund, the general partners receive an annual management fee equal to up to 2% of the committed capital.
Carried interest - a share of the profits of the fund (typically 20%), paid to the private equity fund’s management company as a performance incentive. The remaining 80% of the profits are paid to the fund's investors. Strong Limited Partner interest in top-tier venture firms has led to a general trend toward terms more favorable to the venture partnership, and certain groups are able to command carried interest of 25-30% on their funds.

Because a fund may run out of capital prior to the end of its life, larger venture capital firms usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely-new generation of technologies and people is ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know.

Venture capital funding
Venture capitalists are typically very selective in deciding what to invest in; as a rule of thumb, a fund may invest in one in four hundred opportunities presented to it. Funds are most interested in ventures with exceptionally high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required timeframe (typically 3-7 years) which venture capitalists expect.
Because investments are illiquid and require 3-7 years to harvest, venture capitalists are expected to carry out detailed due diligence prior to investment. Venture capitalists also are expected to nurture the companies in which they invest, in order to increase the likelihood of reaching a IPO stage when valuations are favorable. Venture capitalists typically assist at four stages in the company's development such as Idea generation, Start-up, Ramp up and Exit. There are typically six stages of financing offered in Venture Capital, that roughly correspond to these stages of a company's development.

•Seed Money: Low level financing needed to prove a new idea (Often provided by "angel investors")
•Start-up: Early stage firms that need funding for expenses associated with marketing and product development
•First-Round: Early sales and manufacturing funds
•Second-Round: Working capital for early stage companies that are selling product, but not yet turning a profit
•Third-Round: Also called Mezzanine financing, this is expansion money for a newly profitable company
•Fourth-Round: Also called bridge financing, 4th round is intended to finance the "going public" process

Because there are no public exchanges listing their securities, private companies meet venture capital firms and other private equity investors in several ways, including warm referrals from the investors' trusted sources and other business contacts; investor conferences and symposia; and summits where companies pitch directly to investor groups in face-to-face meetings, including a variant know as "Speed Venturing", which is akin to speed-dating for capital, where the investor decides within 10 minutes whether s/he wants a follow-up meeting.
This need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven. In turn this explains why venture capital is most prevalent in the fast-growing technology and life sciences or biotechnology fields.
If a company does have the qualities venture capitalists seek including a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise venture capital.

Confidential information
Unlike public companies, information regarding an entrepreneur's business is typically confidential and proprietary. As part of the due diligence process, most venture capitalists will require significant detail with respect to a company's business plan. Entrepreneurs must remain vigilant about sharing information with venture capitalists that are investors in their competitors. Most venture capitalists treat information confidentially, however, as a matter of business practice, do not typically enter into Non Disclosure Agreements because of the potential liability issues those agreements entail. Entrepreneurs are typically well-advised to protect truly proprietary intellectual property. Limited partners of venture capital firms typically have access only to limited amounts of information with respect to the individual portfolio companies in which they are invested and are typically bound by confidentiality provisions in the fund's limited partnership agreement.

Venture Capital in South Korea
The Korean public’s formerly negative attitude toward foreign investment has improved considerably in recent years as senior levels of the Korean government continually stress the importance of foreign investment for Korea’s future. At the same time, there has been a gradual shift away from traditional Chaebol-style business models toward other less-traditional ways of doing business. As in other countries, the rapid growth in the numbers of smaller, typically more nimble start-up companies, often high-tech, has helped spur the development of venture capital firms. Recent changes in Korea’s financial laws, including the removal of most restrictions on financial transfers into and out of the country, have encouraged foreign participation in Korea’s venture capital sector. Nonetheless, while South Korea has made considerable progress in fostering a positive environment for venture capital growth, the continued Chaebol domination of the Korean economy causes substantial business problems for many venture capital investors. For example, small and medium Korean companies may be reluctant to deal with foreign firms for fear of jeopardizing a valued chaebol relationship. For smaller firms, obtaining access to credit may be complicated by the privileged relationships the chaebol enjoy with local banks, though regulations limit a bank’s exposure to any single chaebol group to 25% of capital and stipulate that 35% of lending must go to small and medium enterprises. The full development of Korea’s venture capital sector has also been at a disadvantage, as Korea shareholder culture has yet to be fully developed. As a result, venture capital firms take on average about ten years to be listed on the KOSDAQ, challenging the ability of venture capitalists to realize their investment by selling off their shares on the stack market. Yet these challenges notwithstanding, many of Korea’s newer and more innovative companies are increasingly looking to non-traditional sources for financing their growth, thus offering opportunities for venture capital.

For the past two years, developments in the Korean venture capital sector have tracked those of venture sectors elsewhere in much of the world. Many leading venture companies have been loosing substantial money, while many others are almost bankrupt. The Softbank Research Company indicated that Korea's venture capitalists have sharply reduced their investment in new, start-up companies this year, highlighting the sharp decline in investor interest in the high-tech industry. This reduction in investor interest is illustrated by the 50 percent decrease in venture funding during 2001, when compared with 2000. However, although investor interest enthusiasm for high-tech industries and related investment remains weak, there have been some bright spots, most notably the local film industry, which has seen a spurt in venture capital investing this year. Over the next couple of years, it is expected that investment in entertainment and mobile telecom, components will steadily increase, while bio technology, security and the education sectors also should do fairly well.

Recognizing the importance of the venture sector to the country’s future, the Korean government has recently begun to minimize administrative regulations, which had been hampering the ability of venture companies to taking full advantage of their inherent creativity and technological strengths. Changes in its legal code governing business law, including an "Act on Special Measure for Promotion of Venture Business" were implemented to assist venture companies in such areas as start-up production, financing, manpower, technology and plant sites, and additional steps are currently under development. However, some changes remains to be undertaken, as detailed in this chapter, which describes Korea’s venture capital (“VC”) industry and practices employed therein. This section also outlines the current structural strengths as well as outlines structural problems regarding venture capital in Korea, and offers potential suggestions for improving Korea’s venture capital environment.

General Overview and Practices of Korean Venture Capital
•VCs and Assets Deployed to VC Investing

(In US$ million) 1998 1999 2000 2001 2002
Number of Venture Capital Firms 72 71 142 145 135
Assets Under Management (1) 1,970 3,310 3,620 3,530 2,640

Note: (1) these figures are revised numbers for Assets under Management defined as equity capital of VCs and their fund partnerships under management.
2009 numbers of members reduced to 88 companies.
Source: Korea Venture Capital Association. www.kvca.or.kr

•Creation and Classification of VC firms as Non-Bank Financial Institutions with Loose Definition of Investment Scope
Korean VC firms are licensed entities with the primary licensing criteria of KRW 10 billion in paid-in-capital. As of June 2002, there were 135 licensed VC firms in Korea (it is now reduced to approx.90-100 firms in 2008). The companies are considered and classified legally as Non-Bank Financial Institutions and are allowed to perform various financial activities aside from equity (or equity-linked) investments in start-up enterprises. Korean VCs are allowed to make loans to their portfolio companies, make investments in other asset classes aside from private equity investments in start-ups (such as listed company investments) and are solely viewed as providers of capital, not partners who are heavily involved in assisting entrepreneurs build their businesses.

•Korean VC Firms are Structured as Corporations
Given the paid-in-capital requirement, Korean VC firms are registered as corporations with their own balance sheet and shareholders. Some are even listed entities. The VC firms themselves are allowed to borrow against their capital base and operate with considerable operating leverage. While debt levels vary, many VC firms are highly leveraged, with debt/equity levels of on average 150%. Thus, Korean VCs have two forms of capital to invest: (i) their own leveraged capital base and (ii) funds rose via limited partnerships.

•Funding Assistance from Government
The Korean Government, in an effort to promote the VC industry as well as new business creations and an entrepreneurial culture in Korea, provides significant financial assistance by investing as a limited partner in partnerships rose by Korean VCs. The VCs are to contribute their own capital to a fund and the Korean Government will also contribute to the fund after considering their track records and credibility. The amount that the Korean Government contributes can vary significantly. The VCs from both high net-worth individuals and institutional investors raise the remaining funds. The funds operate via an annual management fee and “investment profit-sharing” through “carried interest” - as in the US. The average life of a fund is typically three to five years (some with an option to extend to seven years) and funds have an immediate draw down feature (all of the capital raised is collected at the launch of the fund). Capital not used in VC investing is put in a money-market account. There is also regulation governing the proportion of funds, which must be invested in Korean technology companies over the life of the fund. For example, approximately 30% of the funds should be invested in a Korean venture company by the second anniversary of the fund, etc. The current structure of demanding that the VC contribute its own capital to a fund that it raises and providing government assistance is positive in the development of Korea’s VC industry and Korea’s entrepreneurial start-up culture. VC’s own capital contribution properly aligns incentives of the VCs with those of the limited partners in the fund. Government assistance helps promote private and institutional investors to contribute to the fund partnership. Such incentives are particularly important in Korea as the VC industry, while it traces its origins back to 1974, is essentially a new industry that became significant and recognized only two to three years ago. Moreover, there is a significant need – economically, politically and socially - for Korea to rely less heavily on a large, interlinked chaebol business model, and more on a more independent, entrepreneurial small and medium sized business model.

Channeling government sponsorship via investments in limited partnerships is beneficial. While venture capital and start-ups are receiving a great deal of attention in Korea, it is important to note that total government funding assistance has been reduced by 62 billion won, from 327 billion won (USD 273 million) in 2001 to 265 billion won (USD 221 million) in 2002. This amount is relatively insignificant when compared to Korea’s GDP and its level of industrial activity, or when compared to the amount of funds supported by the Korean government in distressed assets and banking institutions, or when compared to the amount of capital the chaebol are able to access. Continued public support is necessary to promote this industry in Korea.

References
wiki encyclopedia.
Korea Venture Capital Association news letters
Amcham Korea news letters


3. PEF based on M&A

Valuation
Today valuation is the financial analytical skill that general managers want to learn and master more than any other. Rather than rely exclusively on finance specialists, managers want to know how to do it themselves. The reason why so is because that executives who are not finance specialists have to live with the fallout of their companies’ formal capital budgeting systems. Many executives are eager to see those systems improved, even if it means learning more finance. Another reason is that understanding valusation has become a prerequisite for meaningful participation in a company’s resource allocation decisions.

Executives estimate value in many different ways, the past 25 years has seen a clear trend toward methods that are more formal, explicit, and institutionalized. In the 1970s, discounted cash flow analysis emerged as best practice for valuing corporate assets. The main ingredient for DCF is weighted average cost of capital (WACC).

Today WACC based standard is obsolete. This is not because that it no longer works. Managers need to valuate 3 types of objects, operation, opportunity, and ownership claims.

The operation valuation is the most basic problem. Often managers need to estimate the value of an ongoing business or of some part of one – a particular product, market, or line of business. Or purchase of new equipment will be the one to be estimated by this approach. The question is to estimate the future cash flow from the operation. This is the precisely the aim of DCF. The analyst needs to estimate the future cash flow first and then to discount the cash flows to get present value. The discount value can be said to be opportunity cost. The opportunity cost consists partly of time value – the return on a nominally risk-free investment. Opportunity cost also includes a eisk premium – the extra return you can expect commensurate with the risk you are willing to bear. WACC is the most popular measure of it. However, WACC has its own cost, it cannot prevail when issuing cost comes in the valuation or other non-conventional ingredients is involved. Today’s better alternative for valuing a business operation is to apply the basic DCF with individual business and sum them up. This approach is called adjusted present value (APV).

Valuation of opportunity is more like option pricing. For example, how much you invest on R&D will give you the opportunity to invest more in later time. The common approach to evaluate the opportunity is not to value them until they mature. But some says this is myopic idea. Some values them with DCF with special rules. But long-lived opportunities in volatile business such as R&D are so poorly handled by DCF methods so that option-pricing analysis doesn’t have to be very sophisticated to produce some pricing is as a supplement, not a replacement, for the valuation methodology already in use. The extra insight may be enough to change, or least seriously challenge, decisions implied by traditional DCF analysis.

What generalists need is an easy to learn tool that can be used over and over to synthesize and evaluate simple options. Furthermore, because the goal is to complement, not replace, existing methods, managers would like a tool that can share inputs with a DCF analysis, or perhaps use DCF outputs s inputs. Black-Scholes option pricing model is the good and simple one to recommend. An intuitive mapping between Black-Scholes variables and project characteristics is usually feasible. And even though the model contains five variables, there is an intuitive way to combine these five into two parameters. Each with a logical, managerial interpretation. The crucial skills for the generalist are to know how to recognize real options and how to synthesize simple ones to solve complex models.

Valuing claims companies issue agains the value of their operations and opportunities. When a company participates in joint ventures, partnerships, or strategic alliances, or makes large investments using project financing, it shares ownership of the venture with other parties. Managers need to understand not simply the value of the venture as a whole but also the value of their company’s interest in it.

A straightforward way to value the company’s equity is to estimate its share of expected future cash flows and then discount those flows at an opportunity cost that compensates the company for the risk it is bearing. This is referred to as the equity cash flow (ECF) approach. It is also called flows to equity. It is DCF methodology, but both the cash flows and the discount rate are different from those used either in APV or the WACC based approach. The business cash flows must be adjusted for fixed financial claims, and the discount rate must be adjusted for the risk associated with holding a financially leveraged claim.

Handling leverage properly is most important when leverage is high, changing over time, or both. Unfortunately, leverage is most difficult to treat properly precisely when it is high and changing. When leverage is high, equity is like call-option owned by the shareholders on the assets of the company.

It is widely understood that highly levered equity is like a call option because of the risk of default. The reason why option-pricing model is not used for this problem is because the options involved are too complicated. Every time a payment is due to lenders, the borrower has to decide again whether or not to exercise the option. In effect, levered equity is a complex sequence of related options, including options on options. Simple option-pricing models are not good enough, and complicated models are impractical. That is why it’s worthwhile to have ECF as a third basic valuation tool.

The key to using ECF is to begin the analysis at a point in the future beyond the period in which default risk is high. At that point, an analyst can establish a future value for the equity using conventional DCF methods. Then ECF works backward year by year to the present, carefully accounting for yearly cash flows and changes in risk along the way, until it arrives at a present value. The procedure is quite straightforward when built into a spreadsheet.

As companies adopt valuation techniques made more powerful or accessible by desktop computers, the good news is that the tools a generalist needs are not very hard to learn. The time and effort necessary before the techniques pay off naturally will depend on a company’s situation and its current finance capabilities.

The three valuation methods explained so far are as follows :

1. Adjusted present value
2. Option pricing
3. Equity Cash Flow

For most companies, getting from where they are now to this vision of the furue is not a corporate finance problem – the financial theories are ready and waiting – but an organizational development project. Motivated employees trying to do a better job and advance their careers will naturally spend time learning new skills, even financial skills. That is already happening. The next step is to use this broadening base of knowledge as a platform to support an enhanced corporate capability to allocate and manage resources effectively.

An active approach to developing new valuation capabilities – that is, deciding where you want your company to go and how to get there – should allow you to develop those capabilities faster than a passive, laissez-faire approach, and it ought to yield more focused and powerful results. Of course, it’s also probably more expensive. However, the question is not whether it’s cheaper to let nature take its course, but whether the more powerful corporate capability will pay for itself. That is, how much is that capability worth?

Synergy and Restructuring of M&A

It explained how a positive deal NPV leads to the positive CAR (Cumulative Abnormal Return). Investors in general distrust mergers and acquisitions, especially big ones. This implies that the immediate response to the news of M&A leads the downward slip of share price of bidder. However, if the deal creates value and shows the success, then bidders’ share price appreciates at higher level than the usual expected rate of return. This cumulative abnormal return (CAR), will continue until the stock reaches a new equilibrium. The time period between a deal’s announcement and arrival at the new equilibrium price is called the period of resolution of uncertainty. This interval may be short or long depending on that needs to be done to create value in the deal and when the market learns of the results.

The predicted CAR of a deal is the difference between the company’s predicted rate of return if it does the deal and its cost of capital. This, a CAR is always the difference between two rates. For a positive NPV deal, we can use the example of a special deal bank account that will earn a higher than normal interest rate for some period of time. The difference between the special rate and the normal rate is the predicted CAR of the deal.

The predicted CAR of a deal is proportional to the angle between the original price of the stock plus the deal NPV and the original price of the stock. Looking at those angles, you can see that the predicted CAR is positive if the deal NPV is positive, and is negative if the deal NPV is negative. This, a positive deal NPV is the secret to a positive CAR. For the same period of resolution of uncertainty, a higher deal NPV shoes higher predicted CAR. For the same deal NPV, the predicted CAR becomes more positive or more negative as the period of resolution of uncertainty goes down.

In the real world, analysts do not go back to the time the deal was done to measure performance. They measure performance one, two, or three years after the deal and calculate the actual CAR. The actual CAR of a company is simply the difference between the company’s actual rate of return and a benchmark over a given time period.

If the actual CAR is calculated from the date of announcement, then the actual CAR is a proxy measure of the deal NPV. This correspondence holds as long as the company has done no other major deals in the interim. If the company has done other major deals, then the actual CAR reflects all of them.

For stocks with betas close to one, it is often acceptable to compare the actual performance of the stock to a broad index such as the S&P 500.

It is very important for managers to estimate deal NPV using their best available information, which is usually better than the market’s. Managers must also make judgements about what the market’s reaction to the deal is going to be, and how long it will take to resolve the uncertainty. Based on their inside information, managers may choose to “bet against” the market. By doing a positive NPV deal that the market scorns. CEOs who take this bet and win are richl rewarded, but those who lose generally lose their jobs.

When evaluating M&A deals, it pays to think about deal NPV. They are the most reliable way to predict actual CARs. Shareholders will ultimately judge and reward a management team by he CAR they delivered.

M&A deals come in two basic flavors – restructuring and synergy. In a restructuring deal, the target company continues to exist as a separate entity, but the bidder will improve the seller’s financial performance, by putting in new management, changing the strategy, opening up new markets, and so on. The key point is that the seller will continue as a separate business, and will bot be merged into the bidder.

In pure synergy deal, the seller and bidder’s operation are combined, and both companies cease to exist as separate businesses. There are also partial synergy deals, in which the seller and bidder continue to operate as separate businesses.

Most private equity deals are restructuring. So called “strategic deals that consolidate capacity or combine operations are synergy deals. If they are successful, most partial synergy deals become pure synergy deals with the passage of time,.

Deal NPV of buyer is
NPV = -C – W + V(T) + dV
Where C is consideration, which is what the buyer pays for the target. It includes the cost of deal such as transactional cost, which is usually 5 to 10 percent of the value of the deal. W is for work. It is a measure of what the buyer plans to invest in the target after it takes control. If the restructuring is going to be handled by one person, such as a private equity partner. Then W equals the opportunity cost of that person’s time. If the buyer plans to close plants and layoff workers, then those costs are part of W.

V(T) stands for the target value as is. It is the value of the target if the deal does not go through. Often, this is simply the target’s market value before the deal is announced. But in some cases, the target’s pre-deal market value is inflated by market expectation.

dV stands for value created, which is the new value that will be realized as a result of the deal. This is the change in the target’s value brought about the buyer’s ownership and management. This value can be estimated by forecasting the target’s post-deal free cash flows.

Deal NPB of seller is
NPV= C – rC – V(T)

Where r denotes the fraction of consideration accounted for by transaction costs. Things are not quite so simple whenConsideration is in the form of equity.

In a pure synergy deal, the buyer and target are combined to create a new integrated company. Both the target and the buyer disappear as separate companies.

VN : Value of new company, and buyer value as-is VB, plus the target value as-is VT then

VN=VB+VT+S where S for synergy.
S=dV-W

Deal NPV (buyer) = -C + VT + S

The deal NPV for the seller in a synergy deal is exactly the same as in a restructuring deal. The seller gets the consideration and gives up the target value as-is.

Creating value through M&A involves changes to a company’s methods of operation. Such changes may or may not succeed – they are risky. However, the risk of success or failure in a deal is different from the CAPM-based systematic risk that determines the company’s cost of capital. The risk in the deal is whether the buyer’s plan for restructuring or synergy will work. Things may go wrong.

To distinguish the risk that things go wrong from CAPM-related risks, we give it another name ‘fragility risk’. Fragility risk is roughly proportional to the number of changes the buyer plans to make in the target or in its own operations following the deal. The more things that have to be done, the more things can go wrong. In contrast, robust deals involove few changes in either the target’s or the buyer’s ways of doing business.

Fragility risk may differ across buyers. Buyers who are experienced in a particular type of turnaround or consolidation have better plans and procedures than buyers who are inexperienced. Experienced buyers generally have lower fragility risk in the same deal than inexperienced ones or those new to the industry.

Fradile deals must be managed differently from robust deals. In general, they require higher levels of responsiveness and more day-to-day involvement from senior managers. When a deal is fragile, the buyer’s plan cannot be hardwired and then carried out as if on autopilot. Managers can often reduce fragility risk by increasing Work.

Trading off Work against Gragility is a critical element in successful M&A practice. Mastery begins with the recognition that there is a trade-off that Work and Fragility are both partly under the buyer’s control. The key is not to maximize one or minimize the other, but to find the right balance, which leads to the best combination of risk and return for the deal as a whole.

Reference
Evaluating M&A deals – Introduction to the deal NPV – Carliss Baldwin


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