1
The Anatomy of an LBO: Leverage, Control and
Value
Aswath Damodaran
Professor of Finance and David Margolis Teaching Fellow
Leonard N. Stern School of Business, New York University
New York City
In a typical leveraged buyout, there are three components. The acquirers
borrow a significant portion of a publicly traded firm’s value (leverage),
take a key role in the management of the firm (control) and often take it
off public markets (going private). None of these three components is new
to markets and there can clearly be good reasons for each of them.
Starting with traditional corporate finance first principles, we examine
the conditions that are necessary for each component to make sense.
Using the aborted Harman LBO, where KKR and Goldman were lead
players, as a case study, we argue that choosing the wrong target for a
leveraged buyout is a recipe for disaster even for the most reputed
players in the business. In other words, no amount of deal expertise can
overcome poor financial fundamentals. In closing, we argue that the
three components in an LBO are separable and that bundling them
together as essential pieces of every deal is a mistake.
This paper is derived from a presentation made at the AIMR Equity Research and
Valuation Techniques conference held in Los Angeles on 4–5 December 2007.
In September 2007, Kohlberg Kravis Roberts & Co. (KKR) and Goldman
Sachs withdrew from a leveraged buyout (LBO) of Harman International
Industries. My intention is to examine that LBO attempt from the perspectives
of corporate financial theory and valuation first principles to see not only why
the deal failed but to draw general lessons on what needs to happen for a deal
to be successful. In the process, I intend to demonstrate how basic principles of
corporate finance and valuation are sometimes ignored in deals, especially in
boom times, and how such flaws lead predictably to the collapse of many
transactions. My intent in picking on KKR and Goldman, widely regarded
among the elite in the business, is not to showcase their failures but to
illustrate that even smart investors are not immune from mistakes.
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I will first provide a general description of the Harman deal and then
examine it in the context of the three possible components of an LBO: (1)the
disproportionate funding with debt, which leads to a significant increase in
financial leverage, (2) a change in control of the firm, which is the opportunity
to alter the way in which a company is run, and (3) going private, which entails
taking a public company private or quasi-private. Figure 1 captures the three
components:
Figure 1: The Components of a Leveraged Buyout (LBO)
Increase financial leverage/ debt
Leverage
Control
Leveraged Buyout
Take the company
private or quasiprivate
Change the way
the company is
run (often with
existing
managers)
Public/ Private
One of the problems with leveraged buyouts is that these three
components are seen as inextricably linked rather than as components that
can be considered independently of one another. Furthermore, I will argue that
Harman never had the characteristics that would allow investors to take
advantage of any of the three basic components. Harman was not the right
company against which to borrow large amounts, it did not need to be
managed differently, and it was not an appropriate candidate for being taken
private. In addition, the flaws inherent in the Harman deal were representative
of many leveraged buyouts done during 2006 and 2007. In short, many
companies selected for LBOs were unsuited for the transaction in the first
place, and there should be no surprise at how many of these deals have
unraveled since.
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Harman LBO Overview
Harman International Industries is a company known for making highend audio equipment. Before the transaction, Harman was funded
predominantly by equity, with $5.5 billion in publicly traded equity and only
$371 million in debt (mostly leases), which yielded a debt-to-equity ratio of less
than 7%. Goldman Sachs and KKR joined with the managers at Harman to
arrange an LBO with a total value of about $8 billion. Of the funding for the
LBO, $4 billion was to come from debt; $3 billion, from Goldman Sachs, KKR,
and company managers; and $1 billion, from other equity investors. The
principals, therefore, were paying a premium of more than $2 billion to buy out
existing equity investors and leave Harman as a private company with a capital
structure consisting of 50 percent debt and 50 percent equity. Figure 2
captures the changes expected at Harman:
Figure 2: The Proposed Harman LBO
Predeal
Postdeal
Debt
$ 4 billion
Debt (mostly
leases)
$371
Publlicly
traded
equity
$ 5.5 billion
KKR & Goldman would
buy out existing equity
investors
Firm will become a
quasi-private
company with 75%
of the equity held by
KKR, Goldman and
managers.
KKR,
Goldman &
Managers
$3 billion
Public
$ 1 billion
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The questions that are worth examining are the following: (1) Where is the
increase of more than $ 2 billion (from $5.9 billion to $8 billion) in value
coming from? (2) Can Harman carry a mix of roughly equal amounts of debt
and equity? (3) What is the motivation for taking Harman private?
I. Leverage and Value
The question of whether changing the mix of debt and equity can alter
the value of a business has long been debated in finance. When examining the
leverage component of an LBO, it is essential to determine whether changing
the mix of debt and equity in a company can change the value of the company.
But before I can determine that, I must first define what I mean by debt in this
discussion.
Debt Defined. While most analysts use the accounting measure of debt
from the balance sheet, the accounting definition of debt is far too narrow, in
some cases, and far too loose, in others. It is to contest this definition that I will
begin by listing three criteria that I see as central to categorizing financing as
debt.
1.
Debt gives rise to fixed contractual obligations that have to be met in
both good times and bad. Equity, in contrast, is a residual claim,
where cash flows are paid out (example: dividends) only if the firm
feels it can make these payments.
2.
The fixed payments in debt are usually tax deductible. In contrast,
cash flows to equity are not (in most tax jurisdictions)
3.
Failing to meet the fixed commitments can result in loss of control of
the firm.
Using these criteria, a company’s debt will include all interest-bearing
debt, both short term and long term, but not non-interest bearing obligations
such as accounts payable or suppler credit. The latter may carry a cost (in the
firm of higher costs of goods sold), but the absence of an explicit interest
payment weighs against their treatment as debt. In addition, there are some
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items off the balance sheet that should be part of debt. In particular, long term
leases and the commitments that ensue meet all the criteria for debt – fixed
commitments in the form of lease payments that are tax deductible and that
give rise to negative consequences if not met. Therefore, all lease commitments,
both operating and capital, should be considered as debt. For many service
firms, such as retailers and restaurants, lease commitments are the primary
form of debt.
One way to draw a contrast with the accounting balance sheet is to set
up a financial balance sheet. On a financial balance sheet, only two items
appear on the asset side—assets in place (investments already made) and
growth assets (investments expected to be made in the future) and two on the
liability side – debt and equity. Figure 3 illustrates a financial balance sheet:
Figure 3: Financial Balance Sheet
Assets
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments
Liabilities
Assets in Place
Debt
Growth Assets
Equity
Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible
Residual Claim on cash flows
Significant Role in management
Perpetual Lives
For example, Google traded at a $200 billion market capitalization in
late 2007. Of this value, it is possible that $20 billion was for investments
already made, but the remaining $180 billion represented expectations for the
future. The financing of companies should reflect the breakdown of their assets
into assets in place and growth assets. Verizon, which gets the bulk of its value
from assets in place, can afford to use more debt (as a percent of market value)
than Google because the latter’s growth assets do not generate cash flows.
For debt to affect value, therefore, the use of debt must have benefits
and costs relative to the use of equity. Furthermore, if the benefits of using
debt exceed the costs of using debt, the value of the business will increase with
the use of the debt. If the costs of using debt exceed the benefits, the value of
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the business will decrease when debt is increased. Just to complete the circle,
it is also possible that the benefits of debt exactly offset the costs, making debt
a neutral factor in firm valuation.
Benefits and Costs of Debt. Debt has two key benefits, relative to equity,
as a mode of financing. First, the interest paid on debt financing is tax
deductible, whereas cash flows to equity (such as dividends) are generally not.1
Therefore, the higher the tax rate, the greater the tax benefit of using debt. This
is absolutely true in the United States and partially true in most parts of the
world. The second benefit of debt financing is more subtle. The use of debt, it
can be argued, induces managers to be more disciplined in project selection.
That is, the managers of a company funded entirely by equity, and with strong
cash flows, have a tendency to become lazy. For example, if a project turns
sour, the managers can hide evidence of their failure under large operating
cash flows, and few investors notice the effect in the aggregate. But if those
same managers had to use debt to fund projects, then bad projects are less
likely to go unnoticed. Since debt requires the company to make interest
payments, investing in too many bad projects can lead to financial distress or
even bankruptcy, and managers may lose their jobs. In effect, this was Michael
Jensen’s free cash flow justification for debt and the leverage buyout boom of
the 1980s.
Relative to equity, the use of debt has three disadvantages—an expected
bankruptcy cost, an agency cost, and the loss of future financing flexibility.
• The expected bankruptcy cost has two components. One is simply that as
debt increases, so does the probability of bankruptcy. The other component
is the cost of bankruptcy, which can be separated into two parts. One is the
direct cost of going bankrupt, such as legal fees and court costs, which can
eat up to a significant portion of the value of the assets of a bankrupt firm.
1 This is clearly the case in the United States. There are other markets, such as
Brazil, where equity cash flows also provide tax advantages. Even in those
markets, the tax advantages for debt tend to be higher than the tax advantages
for equity.
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The other (and more devastating) cost is the effect on operations of being
perceived as being in financial trouble.. Thus, when customers learn that a
company is in financial trouble, they tend to stop buying the company’s
products. Suppliers stop extending credit, and employees start looking for
more reliable employment elsewhere. Borrowing too much money can create
a downward spiral that ends in bankruptcy.
• Agency costs arise from the different and competing interests of equity
investors and lenders in a firm. Equity investors see more upside from risky
investments than lenders to. Consequently, left to their own devices, equity
investors will tend to take more risk in investments than lenders would
want them to and to alter financing and dividend policies to serve their
interests as well. As lenders become aware of this potential, they alter the
terms of loan agreements to protect themselves in two ways. One is by
adding covenants to these agreements, restricting investing, financing and
dividend policies in the future; these covenants create legal and monitoring
costs. The other is by assuming that there will be some game playing by
equity investors and by charging higher interest rates to compensate for
expected future losses. In both instances, the borrower bears the agency
costs.
• As firms borrow more money today, they lose the capacity to tap this
borrowing capacity in the future. The loss of future financing flexibility
implies that the firm may be unable to make investments that it otherwise
would have liked to make, simply because it will be unable to line up
financing for these investments.
Figure 4 captures the trade off inherent in the use of debt as opposed to equity.
Figure 4: Trade off on Debt versus Equity
Advantages of Debt
Disadvantages of Debt
1. Tax Benefits of Debt: As tax rates
1. Expected Bankruptcy Costs: As
increase, the tax benefits of debt
firms borrow more, the probability of
increase
bankruptcy increases. Multiplying by
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2. Added Discipline: Debt can make
the cost of going bankrupt yields the
managers at all equity-funded firms
expected bankruptcy cost.
with significant cashflows more
2. Agency Costs: As conflicts between
prudent about the investments that
equity investors and lenders increase,
they make.
the costs to borrowers will rise (from
monitoring costs and higher interest
payments)
3. Loss of future financing flexibility:
As firms use their debt capacity today,
they lose the capacity to use that debt
capacity in the future.
In the special case where there are no taxes, no default risk and no agency
issues (between managers and stockholders as well as between stockholders
and bondholders), debt has neither advantages nor disadvantages. This, of
course, is the classic Miller-Modigliant world, where debt has no effect on value.
In the real world, where there are tax benefits, agency problems and default
looms as a problem, there is clearly an optimal mix of debt and equity for a
firm. Firms can borrow too much as well as too little, and both have adverse
effects on value.
Tools for Assessing Debt. I will use three basic tools to determine how
much debt a company can take on: the basic cost of capital approach which
ignores indirect bankruptcy costs, an enhanced cost of capital approach that
tries to incorporate indirect bankruptcy costs, and an adjusted present value
(APV) approach that tries to capture the benefits of debt separately in value.
1. In the cost of capital approach, the optimal debt-to-equity ratio is the one
that minimizes a company’s cost of capital. In effect, we keep operating cash
flows fixed and assume that changing debt changes only the cost of capital.
By minimizing the cost of capital, we are maximizing firm value.
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2. The enhanced cost of capital approach introduces indirect bankruptcy costs
into the analysis. In this case, the optimal debt ratio creates a combination
of cash flows and cost of capital that maximizes a company’s value.
3. In the adjusted present value approach, debt is separated from operations,
and the company is valued as if it had no debt. Then, the positive and
negative value effects of debt are considered as separate components.
1. Cost of capital approach. The cost of capital approach has its roots
in the discounted cash flow model for valuing a firm, where expected cash flows
to the firm (prior to debt payments but after taxes and reinvestment needs) are
discounted back at the cost of capital.
t =∞
Value of firm = ∑
Free cash flow to the firmt
t =1
(1 + Cost of capital )t
.
If a company can keep its cash flows unchanged and lower its cost of capital, it
will increase its present value. Therefore, the optimal debt ratio is the one at
which the cost of capital is minimized.
At first sight, the answer to what will happen to the cost of capital as the
debt ratio is increased seems trivial, given that the cost of debt is almost
always lower than the cost of equity for a business. However, that solution
misses the dynamic effects of introducing debt into a business. To see these
effects, consider the two components that drive the cost of capital— the cost of
equity and cost of debt:




Equity
Debt
Cost of capital = Cost of equity 
 + Pretax cost of debt (1 − Tax rate )
.
Debt
+
Equity
Debt
+
Equity




As the company borrows more money, its equity will become riskier.
Even though it has the same operating assets (and income), it now has to make
interest payments, and financial leverage magnifies the risk in equity earnings.
Thus, the cost of equity will be an increasing function of the debt ratio.
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Furthermore, as borrowing increases, so does default risk, which, in turn,
increases the cost of debt. The trade off on debt’s effect on the cost of capital
can be summarized as follows: replacing equity with debt has the positive effect
of replacing a more expensive mode of funding with a less expensive one but in
the process the increased risk in both debt and equity will push up the costs of
both components, creating a negative effect. Whether the cost of capital
increases or decreases will be a function of which effect dominates. Figure 5
captures the trade off:
Figure 5: Trade off on Cost of Capital and Debt
Bankruptcy costs are built into both the
cost of equity the pre-tax
cost of debt
Tax benefit is
here
Cost of capital = Cost of Equity (Equity/ (Debt + Equity)) + Pre-tax cost of debt (1- tax rate) (Debt/ (Debt + Equity)
As you borrow more, he
equity in the firm will
become more risky as
financial leverage magnifies
business risk. The cost of
equity will increase
As you borrow more,
your default risk as a
firm will increase
pushing up your cost
of debt.
At some level of
borrowing, your tax
benefits may be put
at risk, leading to a
lower tax rate.
To understand the mechanics of the cost of capital approach, we will work
through it in steps.
Step 1: Start with a risk and return model for estimating the cost of equity. For
instance, with the capital asset pricing model
Cost of equity = Rf + Equity Beta (Equity Risk Premium)
In this equation, Rf is the riskfree rate and neither this number nor the equity
risk premium will change as the debt ratio changes, leaving us with only one
input to estimate – the equity beta. To estimate this number, you should start
with an asset or unlevered beta.2 As the company increases borrowing,
2 The simplest way to estimate an unlevered beta is by looking at publicly
traded firms in the business, computing an average regression beta across
these firms and then cleaning up for the debt to equity ratios of these
companies. The process is described in more detail in other papers on my
website.
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recompute the debt-to-equity ratio and compute a levered beta based on this
recomputed ratio:3

 Debt  
Levered beta = Unlevered beta 1 + (1 − t )
 .
Equity



The levered beta is the equity beta and will risk inexorably as the firm borrows
more money. As the equity beta climbs, so will the cost of equity.
Step 2: Now, consider the cost of debt, which is the rate at which you can
borrow money long term today, given the firm’s default risk.
Pretax cost of debt = Rf + Default spread.
As the firm borrows more money, its default risk (and the default spread) will
go up. To get a simple measure of default risk, estimate the interest expense at
each debt level and compute an interest coverage ratio based on expense:
Interest coverage ratio =
Operating income
.
Interest expense
As debt increases, interest expenses will increase; holding the operating income
fixed, this will result in lower interest coverage ratios at higher levels of debt.
Using a look-up table developed by looking at rated firms in the United States, I
estimate a synthetic rating at each level of debt and use the rating to establish
a default spread, which, when added to the risk-free rate, should yield the
pretax cost of debt. Figure 6 captures the essential steps in the process:
3 This is one variation on the levered beta equation. There are others that
assume a beta for debt and still others that ignore the tax effect. Using any of
these approaches consistently yields similar results.
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Figure 6: Cost of capital computation
Cost of Equity = Rf + Beta (Equity Risk Premium)
Pre-tax cost of debt = Rf + Defautl sprread
Start with the beta of the business (asset or
unlevered beta)
Estimate the interest expense at each debt level
As the firm borrows more, recompute the
debt to equity ratio (D/E) .
Compute an interest coverage ratio based on expense
Interest coverage ratio = Operating income/ Interest expense
Compute a levered beta based on this debt to
equity ratio
Levered beta = Unlevered beta (1 + (1-t) (D./E))
Estimate a synthetic rating at each level of debt
Use the rating to come up with a default spread, which when
added to the riskfree rate should yield the pre-tax cost of debt
Estimate the cost of equity based on the levered
beta
This approach is used to derive the costs of debt and equity for Harman
at different debt ratios, with the results summarized in Table 1:
Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Beta
1.45
1.55
1.67
1.83
2.05
2.39
3.06
4.08
6.12
12.98
Cost of Equity
10.30%
10.70%
11.20%
11.84%
12.70%
14.04%
16.74%
20.82%
28.98%
56.40%
Bond Rating
AAA
AAA
A
BB
BCC
C
C
C
D
Interest rate on debt
4.85%
4.85%
5.35%
7.00%
10.50%
14.50%
16.50%
16.50%
16.50%
24.50%
Tax Rate
38.00%
38.00%
38.00%
38.00%
38.00%
35.46%
25.97%
22.26%
19.48%
11.66%
Cost of Debt (after-tax)
3.01%
3.01%
3.32%
4.34%
6.51%
9.36%
12.21%
12.83%
13.29%
21.64%
WACC
10.30%
9.93%
9.62%
9.59%
10.22%
11.70%
14.02%
15.22%
16.42%
25.12%
Firm Value (G)
$5,660
$6,063
$6,443
$6,485
$5,740
$4,507
$3,342
$2,938
$2,616
$1,401
Table 1: Costs of Equity, Debt and Capital: Harman
The unlevered beta is 1.45, which indicates that Harman is already a fairly
risky business. I then estimate its levered beta at 10% increments on the debt
ratio, up to 90 percent debt. . The table also shows the effect of the rising debt
ratio on the company’s bond ratings, interest rate on debt, tax rate, cost of debt,
weighted average cost of capital (WACC), and firm value.
The cost of equity and cost of debt both rise as debt increases, but the
cost of capital drops and the firm value increases, at least initially. The benefits
of debt exceed its costs until the debt reaches 30 percent, at which point, the
cost of capital starts climbing again and the firm value begins to drop. To
minimize the cost of capital for Harman, the optimal debt ratio would be about
30 percent, or $1.8 billion in debt. Before the LBO, Harman was clearly under
levered at a 7% debt ratio. But if the LBO had gone through and achieved its
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goal of a 50 percent debt ratio, Harman would have been overlevered after the
transaction.
As powerful as the cost of capital approach is, it clearly has flaws that
may lead firms to choose the wrong financing mix. In particular, there are three
elements of the analysis that are troublesome.
1.
Indirect bankruptcy costs: One flaw is the assumption that cash flow
can remain fixed even as the debt ratio is increased. Indirect
bankruptcy costs should preclude a company with a rising debt ratio
(and lower bond ratings) from maintaining the operating income at its
existing level.
2.
Static approach in a dynamic world: A second flaw is that the
approach itself is static; it is based on the previous year’s operating
income and prevailing values for interest rates and default spreads.
But conditions change. A recession for a cyclical firm, a loss of a major
contract or increase in competition can all change the optimal debt
ratio for a firm.
3.
Risk Bearing Assumptions: It makes rigid assumptions about the
ways in which market risk and default risk are borne by different
claim holders as a company continues to increase debt. For instance,
the approach that we have used for levering and unlevering betas
assumes that all market risk is borne only by the equity investors.
2. Enhanced cost of capital approach. Through the enhanced cost of
capital approach, I introduce three innovations. First, indirect costs are built
into the expected operating income. As the rating of the company declines, the
operating income is adjusted to reflect the loss in operating income that will
occur when customers, suppliers, and investors react. In this way, I account
for distress costs, such as indirect bankruptcy costs. Second, I can make the
analysis more dynamic. Rather than examining a single, static number for
operating income, I allow for the use of a distribution of operating income, thus
allowing for a range of optimal debt ratios. Third, the levered beta formulations
can be modified to reflect the fact that debt holders sometimes bear market
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risk (the beta of debt is greater than zero). Since the latter two modifications
create little in the optimal debt ratio, we will present just the first modification
in this section.
To quantify the distress costs, I tie operating income to a company’s
bond rating. As shown in Table 2, once a company’s rating drops below A (that
is, below investment grade), distress costs occur in the form of a percentage
decrease in earnings.
Table 2: Operating Income and Bond Rating
Rating
A or higher
ABBB
BB+
BB
B+
B
BCCC
CC
C
D
Drop in EBITDA
No effect
2.00%
5.00%
10.00%
15.00%
20.00%
20.00%
25.00%
40.00%
40.00%
40.00%
50.00%
The result of this enhancement to the cost of capital approach can be seen in
Table 3, where we compute the costs of capital, operating income and firm
valuse at different debt ratios for Harman:
Table 3: Firm Value, Cost of capital and Debt ratios: Enhanced Cost of Capital
Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Beta
1.45
1.55
1.67
1.92
2.33
2.80
3.49
4.66
6.99
13.98
Cost of Equity
10.30%
10.70%
11.20%
12.17%
13.82%
15.68%
18.48%
23.14%
32.46%
60.42%
Bond Rating
AAA
AAA
AC
D
D
D
D
D
D
Interest rate on debt
4.85%
4.85%
5.50%
16.50%
24.50%
24.50%
24.50%
24.50%
24.50%
24.50%
Tax Rate
38.00%
38.00%
38.00%
24.55%
8.94%
7.16%
5.96%
5.11%
4.47%
3.98%
Cost of Debt (after-tax)
3.01%
3.01%
3.41%
12.45%
22.31%
22.75%
23.04%
23.25%
23.40%
23.53%
WACC
10.30%
9.93%
9.64%
12.26%
17.21%
19.21%
21.21%
23.21%
25.21%
27.21%
Firm Value (G)
$5,549
$6,141
$6,480
$1,276
$365
$308
$266
$234
$209
$189
As long as the bond ratings remain investment grade, Harman’s value remains
intact. Its value, in fact, achieves its highest level at an A– rating and a debt
ratio of 20 percent. But as soon as the rating drops below investment grade,
the distress costs begin to take effect, and Harman’s value drops precipitously.
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Thus, the debt ratio of 30 percent that seemed optimal under the unmodified
cost of capital approach now appears to be entirely imprudent. The optimal
debt ratio is now 20 percent, which means that Harman should be leveraged to
about $1.2 billion, not $1.8 billion and certainly not the $4 billion proposed in
the LBO bid of Goldman Sachs and KKR. In fact, at the 50% debt ratio, there is
a very real danger of the firm getting caught up in the whirlwind of indirect
bankruptcy costs.
3. Adjusted present value approach. In the adjusted present value
approach, we explicitly add the value added by the tax benefits from the use of
debt and subtract the value destroyed by higher bankruptcy costs from the
value of the firm with no debt (unlevered firm value).
Firm value = Unlevered firm value + (Tax benefits of debt − Expected bankruptcy costs from debt ).
As in the other two approaches, the optimum debt level is the one that
maximizes the firm’s value.
Three steps are needed for the adjusted present value approach. First,
the value of the unlevered company must be estimated, and this can be done in
two different ways:
(1)
Estimate the unlevered beta, which is the cost of equity based on the
unlevered beta, and value the company using this cost of equity
(which will also be the cost of capital in an unlevered company)
(2)
Start with the current market value of the company, subtract the
current tax benefits of debt, and add the expected bankruptcy costs
from debt. In effect, remove those components of market value that
reflect the influence of the debt that the firm currently has on its
books.
Second, calculate the present value of tax benefits at different levels of debt.
The simplest assumption is that the tax benefits are perpetual, in which case
the following equation applies:
Tax benefits = Dollar debt × Tax rate.
Electronic copy available at: https://ssrn.com/abstract=1162862
16
Note that this equation can be easily adapted to meet more general
descriptions of the debt. The key is that the interest tax savings are being
discounted at the pre-tax cost of debt to arrive at the value of the tax savings.
(In some modifications of the APV approach, the tax benefits are discounted
back at the unlevered cost of equity)
Third, estimate a probability of bankruptcy at each debt level and
multiply that by the cost of bankruptcy (including direct and indirect costs) to
estimate the expected bankruptcy cost. The probability of bankruptcy can
usually be estimated using the synthetic ratings process described earlier in
computing the cost of debt. However, estimating direct and indirect costs of
bankruptcy is the most difficult task in the APV exercise and is often skipped.
But if these costs, which represent the disadvantages of debt, are not estimated,
the optimal debt ratio will be 100 percent, which is the reason that adjusted
present value is the approach preferred by many proponents of high financial
leverage.
Assuming that direct and indirect bankruptcy costs are roughly 25
percent of Harman’s firm value, I developed Table 4.
Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
$ Debt
$0
$563
$1,127
$1,690
$2,253
$2,817
$3,380
$3,943
$4,506
$5,070
Tax Rate
38.00%
38.00%
38.00%
38.00%
38.00%
35.95%
17.73%
15.20%
13.30%
11.82%
Unlevered Firm Value
Tax Benefits
$5,596
$0
$5,596
$214
$5,596
$428
$5,596
$642
$5,596
$856
$5,596
$1,013
$5,596
$599
$5,596
$599
$5,596
$599
$5,596
$599
Bond Rating
AAA
AAA
A
B+
CC
CC
D
D
D
D
Probability of Default
Expected Bankruptcy
ValueCost
of Levered Firm
0.01%
$0
$5,596
0.01%
$0
$5,810
0.53%
$8
$6,016
19.28%
$301
$5,938
65.00%
$1,049
$5,404
65.00%
$1,074
$5,535
100.00%
$1,549
$4,647
100.00%
$1,549
$4,647
100.00%
$1,549
$4,647
100.00%
$1,549
$4,647
Table 4: Adjusted Present Value for Harman
Note that the unlevered firm value stays the same at every debt ratio. Up
to a point, the tax benefits increase as debt increases, but then level off once
the interest expenses exceed the operation income. The expected bankruptcy
costs also increase, as the probability of bankruptcy rises at high debt ratios.
As with the enhanced cost of capital approach, the value of the firm reaches its
Electronic copy available at: https://ssrn.com/abstract=1162862
17
highest point with a 20 percent debt ratio. Therefore, all three approaches give
an optimal debt ratio far below the 50 percent recommended by Goldman
Sachs and KKR.
Debt assessment tool summary. All three of these approaches rely on
sustainable cash flow to determine the optimal debt ratio. They do not rely on
market value or growth prospects, and I believe that is appropriate. The more
stable and predictable a company’s cash flow and the greater the magnitude of
these cash flows—as a percentage of enterprise value—the higher the
company’s optimal debt ratio can be. Furthermore, the most significant benefit
of debt is the tax benefit. Higher tax rates should lead to higher debt ratios.
Based on the insights offered so far, the best candidates for large
amounts of financial leverage will be mature or declining companies that have
large, reliable cash flows. Growth companies—companies with their best days
ahead of them—are not good candidates for LBOs because such companies
have high market values, relative to cash flows, and usually need to plough
these cash flows back into the business (rather than pay interest expenses) to
generate future growth.
Finally, the macro environment has relatively little effect on optimal debt
ratios, and two myths often asserted by market observers need to be dispelled.
The first myth is that optimal debt ratios increase as interest rates decline.
Certainly, it is true that lower interest rates decrease the cost of debt, but they
also decrease the cost of equity and it is the relative costs that determine
financing choices. The second myth is that optimal debt ratios increase as
default spreads decline. It is true that lower default spreads lower the cost of
debt, but periods where default spreads decrease are also usually periods when
equity risk premiums also go down. In other words, the cost of debt and equity
both decline when default spreads and equity risk premiums decline. It is only
when one measure declines while the other remains unchanged that one mode
of financing will dominate the other. The 2003-2007 period was an aberration
in that sense, since default spreads decreased while equity risk premiums
Electronic copy available at: https://ssrn.com/abstract=1162862
18
remained relatively stable. Not surprisingly, this provided an incentive for firms
to borrow more money and for leveraged deals.
Value of Control
Control is the second potential component in an LBO and it is a
key factor in determining the value of a company. Investors targeting a
company for an LBO generally assume that they can run that company
better than it is run right now. In particular, the expected value of
control is the product of two variables: (1) the value achieved by
changing the way a company is operated and (2) the probability that
such a change will occur.
Note, though, that a leveraged buyout is not the only means of
asserting control. Activist boards can force top management to change
its behavior or replace it altogether. Proxy contests and activist investing
can also be used to pressure underachieving managers into modifying
their behavior. Such methods are relatively inexpensive to implement
but require assertive behavior and may not be effective against
entrenched management.
Control Premium. There is significant evidence that investors value
control and are willing to pay to acquire it. For instance, acquiring companies
pay a premium for substantial control. When buying shares in a publicly
traded company, investors often pay a premium for voting shares because of
the control such shares afford. Conversely, when buying a minority stake in a
private company, investors will frequently expect a discount because of the
absence of control. In other words, a 49 percent share in a private business
has a significantly lower value from a 51 percent share in that same business.
In theory, the control premium is the difference between the current
value of a company and its optimal value. Therefore, the premium should be
larger for poorly managed companies and smaller for well-managed companies.
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Because the control premium varies across companies, no simple rule of
thumb applies for all companies. For example, the notion that control is worth
20–30 percent of the value of a company is not valid. Furthermore, the control
premium will vary according to the reasons for a company’s underperformance.
The control premium will be lower when external and uncontrollable factors are
affecting a company’s performance and higher when the poor performance is
being caused by bad management. Finally, the control premium will vary
according to the ease with which management decisions can be made. For
example, if a less than optimal financing mix is the primary flaw in
management decision making, the control premium should be fairly large,
because the problem can be easily and quickly remedied. If the management
flaw is the retention of outdated physical plants that must be modernized, then
the control premium will fall because of the higher costs involved.
Harman Case. To assess the value of control in the case of Harman, I will start
with a conventional discounted cash flow (DCF) valuation of Harman. I will
begin my valuation of Harman by taking Harman as it is and call this valuation
the “status quo” valuation. Figure 7, at the end of the paper, summarizes the
status quo valuation.
Note a few significant figures: Harman earns a 14.56 percent return on
capital, and its cost of capital is 9.91 percent—a spread of just over 4.5
percentage points. That is a healthy number and not at all indicative of a badly
managed company. What, then, would Goldman Sachs and KKR do differently
to improve management? Based on this valuation, the value of this (or any
other) company can be increased in only four ways, related either to either
making operations more efficient or increasing growth value – increase cash
flows from existing assets, increase the expected growth rate during the high
growth period, lengthen the high growth period or reduce the cost of capital.
When I compare Harman’s margins relative to those of other companies
in its sector, I find that Harman’s margins are about 2 percent higher than
those of others, so cost-cutting opportunities do not appear to abound. Perhaps
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Harman can grow faster in the future, but the only two ways my analysis
indicates that Harman can grow faster are by reinvesting more or reinvesting
better. Harman reinvests about 42 percent of its after-tax operating income
back into the business, so perhaps it could reinvest a bit more. But I do not see
much room for improving its current reinvesting. With a 14.56 percent return
on capital against a 9.91 percent cost of capital, Harman is doing much better
than other companies in the sector. In summary, Harman appears to be a fairly
well run company that is probably growing as fast as the market allows.
Another tactic might be to put off being a mature company. In my status quo
valuation, I assumed that Harman had five years of high growth. Beyond that,
perhaps it can identify and capitalize on new comparative advantages or
barriers to entry. It seems unlikely, however, that Goldman Sachs and KKR
could identify new competitive advantages that Harman’s existing managers
have not already considered. The one area that appears to have some potential
for improvement is cost of capital. Certainly, Harman can carry more debt than
6 percent. In fact, the analysis of financial leverage in the last section suggests
that the optimal debt ratio for Harman is between 20 and 30%.
In summary, I revalued Harman with some simple changes in figure 8.
First, I had the company reinvest more of its cash flow. Being a U.S.-centric
company, perhaps it could invest more in emerging markets. Second, I
increased the debt ratio from 6 percent to 25 percent, which is in the range of
the optimal ratio determined earlier. Such changes raise its value from $4.6
billion to $5.3 billion, thus creating $700 million of additional value.
Undoubtedly, this is an improvement, but it is not a dramatic one, and the
reason that the change is so small is that the company is well run. From a
control perspective, Harman is once again a poor target for an LBO because its
managers are already doing a good job.
When a potential target is well managed, the expected value of control is
small. But if the target company is badly managed, the value of control can be
significant. If control is the motive for an acquisition, the target company
should possess the following qualities:
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21
•
Its stock should be underperforming in its sector and in the market in
general.
•
Its margins should be lower than those of comparable firms in its sector
with no offsetting benefits, such as higher turnover ratios.
•
Its returns on equity and returns on capital should lag its costs of equity
and capital.
•
The flaws should originate with the management of the company and
should be repairable.
Harman does not meet these characteristics. Its stock has earned returns
similar to those earned by the rest of its sector. Its operating margin is 11
percent, and the average for its sector is 8 percent, so it is not underperforming
the sector in that respect. Given its healthy excess returns and good reputation,
there is no reason to believe that its managers are incompetent. Harman is not
a badly managed company and does not look like a good target for control.
Public to Private Transition
The final component that drives value is the issue of taking a public
company private. For decades in corporate finance, the assumed normal
sequence of events is for businesses to start as private businesses and then
make the transition to publicly traded companies for at least three reasons:
•
Raise capital. Although private companies today have more sources of
capital (such as private equity and venture capital) than they had years
ago, raising capital in public equity markets still tends to be less
expensive and provide more choices than private equity, and can be done
on a larger scale.
•
Monetize value. Even if a private company is valuable, that value is an
abstraction. Being traded in the public market puts a price on a
company and provides its owners with the capacity to monetize value.
•
Bear risk more efficiently. Much of the risk in any business is company
specific and diversifiable. Private business owners are often invested
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22
primarily in their own businesses, and are exposed to all of this risk. The
investors in a public company are more likely to be diversified and will be
able to eliminate a significant portion of the risk.
The last reason is the most important one. The owners of a private
company must contend with 100 percent of the company’s risk—both market
risk and company-specific risk. But owners of a public company need contend
only with market risk (i.e., the 10-30 percent of risk that is not diversifiable).
Thus, a public company with a beta of 1.2 would, in private hands, probably
expose the private investor to much higher risk – the equivalent of having a
beta of 3 or 4. Applying this understanding to Harman, I can value it as both a
public and a private company. As a public company, Harman has a market
beta of 1.46, a cost of capital of 9.91 percent, and a value of $4.9 billion. To
value Harman as a private company, I must scale up its beta to reflect total
risk. I do this by dividing the market beta by Harman’s correlation with the
market, which is approximately 0.5, which gives a total beta of 2.97 and a
corresponding cost of capital of 15.6 percent. On this basis, the value of
Harman as a private company is $2.4 billion.
Given this huge drop in value from the public to private switch, why
would I want to take Harman private? Listed below are four issues that may
justify this transaction:
•
Agency issues. Because managers of a publicly traded company are
spending stockholders’ money and not their own, they may have little
incentive to do what is best for the company. By making it their private
business, you may increase their incentives to do what is right for the
business.
•
Disclosure costs. Publicly traded companies have to meet far more
disclosure requirements than do private companies. Not only does
disclosure cost money, but compliance with disclosure requirements may
also provide competitors with valuable information on strategies and
products.
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•
Time horizon. To the extent that publicly traded companies are at the
mercy of the short-term whims of analysts and investors, going private
may allow these companies to make better long-term decisions
•
Public pressure. More public pressure (by regulators, the financial press
and investors, for instance) can be placed on a publicly traded company
than on a private business.
As already shown, such arguments must be weighed against the high cost of
going private. In the case of Harman, I have estimated a loss in value of $2.5
billion caused by going private. To minimize privatizing costs, three specific
steps can be taken. First, the acquiring investors, such as KKR, may hold a
portfolio of private companies, thus increasing correlation with the market and
lowering total beta. Second, the company that is going private may do so only
temporarily, in which case the higher cost of capital will apply only until the
company returns to the public market. Third, the private equity investor can go
public (as did the Blackstone Group) and thereby reduce its residual risks.
Based on the discussion so far, the best candidates for going private are
companies that have the following characteristics:
•
Top managers are not significant stockholders in the company.
•
The actions needed to correct the company’s problems are likely to be
painful in the short term, such as lower earnings, layoffs, and factory
shutdowns.
•
Analysts following the company are not giving it credit for long-term
actions and are focusing primarily on earnings in the near term.
Harman does not meet these criteria. The Harman family has a large
stockholding in the company and has been active in its management since it
was founded. The company is run with long-term goals in mind, and any
suitable changes apply primarily to optimizing Harman’s debt, not retooling its
operations. I see little gain from going private.
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24
In conclusion, Harman is not a good candidate for leverage. It is not a
good candidate for control. And it is not a good candidate for going private.
Harman should never have been targeted for a leveraged buyout.
Interactions among the LBO Components
In our discussion of the financial leverage, control and value, we have
treated them as independent components with separate effects on value.
However, there is the possibility that these three components could interact
with each other, in both positive and negative ways, and create secondary
effects on value.
Leverage and Control. Begin by considering an LBO from a lender’s point of
view. On the plus side, a company that is restructuring to fix its operating
problems is likely to become healthier and, therefore, more likely to pay off its
debt obligations. Restructuring in such a case should reduce a company’s
default risk. On the minus side, companies that restructure are also changing
themselves on multiple dimensions—business mix, cash flows, and assets.
Lenders who do not monitor the process may discover that the assets that were
intended to secure their loans have been eliminated with the restructuring,
thus leaving them exposed. Furthermore, the equity investors who now control
the business can direct cash flows (in the form of management fees and other
compensation) into their own pockets. The implication, therefore, is that
lenders in leveraged buyouts need to take an active role in the restructuring
process and should demand an equity stake in the business.
Control and Going Private. After a going-private transaction, the managers of
a privatized business are now the owners. They are likely to become much
more aware of default risk and distress costs, since it is their wealth that is on
the line. Therefore, on the one hand, they are less likely to be overly aggressive
risk takers, which is a positive turn for good management. On the other hand,
if things start going bad and the managers decide that they have little to lose,
they may start taking not just more risks but also imprudent risks. In effect,
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25
their equity positions become options, and more risk makes them more
valuable. Allowing managers/owners to make decisions in their companies can
provide a license to steal. Therefore, lending should be restricted to businesses
with transparent and easily understood operations, and when privatized
companies get into trouble, lenders must be prepared to step in quickly and
aggressively.
Leverage and Going Private. Finally, consider the interaction between
leverage and going private. An advantage is that lenders can make the owners
of the private company personally liable for the loans taken by the company,
which increases lenders’ security and reduces default costs. On the flip side,
the owners and their lawyers may find creative loopholes for hiding cash and
assets. Therefore, lenders should be wary of hot deals for which the borrowers
set the terms of the leverage and protect their personal assets and keep track
of the assets of the business to ensure that they are not being redirected into
the wrong hands.
Conclusion
Each of the three potential components of an LBO—leverage, control, and
privatization—can have either a positive or negative effect on a company’s value.
But the components are separable, and there is no reason not to pick and
choose among them.
For example, some companies may be good candidates for leveraged
recapitalizations, others may be ripe for a hostile acquisition, and still others
may benefit from going private. A few companies may benefit from a
combination of two out of the three components. But the list of companies that
are right for all three components is a very short one.
Electronic copy available at: https://ssrn.com/abstract=1162862
26
Figure 7: Harmon Valuation (Status Quo)
Harman: Status Quo
Reinvestment Rate
42.00%
Current Cashflow to Firm
EBIT(1-t) :
248
- Nt CpX
67
- Chg WC
37
= FCFF
144
Reinvestment Rate = 104/248=42%
Return on Capital
14.56%
Expected Growth
in EBIT (1-t)
.42*.1456=.0613
6.13%
Stable Growth
g = 4%; Beta = 1.00;
Cost of capital = 7.40%
ROC= 12%; Tax rate=38%
Reinvestment Rate=33.33%
Terminal Value5=231(.074-.04) = 6799
Op. Assets
4,886
+ Cash:
106
- Debt
350
=Equity
4,641
-Options
119
Value/Share $69.32
Year
EBIT (1-t)
- Reinvestment
FCFF
1
$263
$111
$152
2
$279
$117
$162
3
$296
$125
$172
4
$314
$132
$182
5
$334
$140
$193
Discount atCost of Capital (WACC) = 10.34% (.94) + 3.01% (0.06) = 9.91%
Cost of Equity
10.34%
Riskfree Rate:
Riskfree rate = 4.5%
Cost of Debt
(4.5%+%+.35%)(1-.38)
=3.01%
+
Beta
1.46
Unlevered Beta for
Sectors: 1.43
Weights
E = 94%% D = 6%
X
Risk Premium
4%
Firmʼs D/E
Ratio: 6%
Mature risk
premium
4%
Country
Equity Prem
0.%
Electronic copy available at: https://ssrn.com/abstract=1162862
Term Yr
346.9
115.6
231.3
27
Figure 8: Harmon Valuation (Restructured)
Harman: Restructured
Reinvestment Rate
70.00%
Current Cashflow to Firm
EBIT(1-t) :
248
- Nt CpX
67
- Chg WC
37
= FCFF
144
Reinvestment Rate = 104/248=42%
Return on Capital
15%
Expected Growth
in EBIT (1-t)
.70*.15=.105
10.5%
Stable Growth
g = 4%; Beta = 1.00;
Cost of capital = 7.48%
ROC= 12%; Tax rate=38%
Reinvestment Rate=33.33%
Terminal Value5=284(.074-.04) = 8155
Op. Assets
5588
+ Cash:
106
- Debt
350
=Equity
5,325
-Options
119
Value/Share $80.22
Year
EBIT (1-t)
- Reinvestment
FCFF
1
$274.7
$192.3
$82.4
2
$303.5
$212.5
$91.1
3
$335.4
$234.8
$100.6
4
$370.6
$259.4
$111.2
5
$409.6
$286.7
$122.9
Discount atCost of Capital (WACC) = 10.90% (.80) + 3.41% (0.20) = 9.40%
Cost of Equity
10.90%
Riskfree Rate:
Riskfree rate = 4.5%
Cost of Debt
(4.5%+%+1%)(1-.38)
=3.41%
+
Beta
1.60
Unlevered Beta for
Sectors: 1.43
Weights
E = 80%% D = 20%
X
Risk Premium
4%
Firmʼs D/E
Ratio: 25%
Mature risk
premium
4%
Electronic copy available at: https://ssrn.com/abstract=1162862
Country
Equity Prem
0.%
Term Yr
425.9
141.9
284.0