Question

Required Rates of Return in MBOs

Leveraged or management buyouts (LBO/MBO) often are financed with 75% or 80% debt. Typically, the rest of the purchase is financed by the buyout or private equity firm (80% to 85% of the remainder) and the new management team (15% to 20% of the remainder). The company is taken private, so the stock is no longer traded on any stock exchange. Once private the new owners usually sell some assets to repay some of the debt. Good buyout candidates have strong stable cash flow and limited growth opportunities. Initially most to all of the company’s cash flow goes to debt reduction. Buyout firms often have a portfolio of dozens of companies, so each company is being added to a somewhat diversified portfolio. To simplify thinking about this question assume that the buyout firm either has a very well-diversified portfolio of companies.

Buyout firms have a very high required rate of return or hurdle rate, 30% to 40%. They evaluate deals assuming that they will exit after about 4 years. Often the exit strategy is to take the company public again through an IPO (Initial Public Offering). If the average asset beta (that is the average beta of an unlevered firm) is about 0.80, can you explain the high hurdle rate buyout firms apply to their deals? To give the problem some structure assume that the historic risk-free rate is about 6.0% and the historic market risk premium is 7.5%.

A.What problems would occur if a buyout firm just picked a number as its required rate?

B. How would you explain the 30% to 40% required rate of return used in buy-outs? Is it theoretically correct?

Answer 1

A. The required return essentially measures the minimum return which will justify undertaking the risk inherent in an investment. It is an easy way to compare various investment options and to segregate them according their respective risks - if there are two investments and one is more risk than the other, then the only way to attract an investor will be to have higher return otherwise a rational investor will always (all other things equal) a less risky investments over a more risky one if the returns are same. Hence the buy out firm has to select the hurdle rate which appropriately incorporates the return which can justify the underlying risk - if the hurdle rate is arbitrary then the buy out fund may end up undertaking either too much risk commensurate to its return or it may reject too many opportunities by have a hurdle rate which is too high compared to the underlying risk.

B. As per CAPM, the expected/required return on equity can be summed by equation :

risk free rate + Beta * (market risk premium); with the given values for an unlevered firm the required return would have been : 6% + 0.8 * 7.5% = 12%

Now this is for an unlevered firm; as the leverage increases the beta will also increase to reflect the higher risks. The formula for levered Beta is = ([D/E * (1- Tax rate)] + 1) * unlevered beta ; where D/E is debt to equity ratio. We are not given tax rate but we assume a 30% marginal tax rate. Since we are told that LBO are financed by almost 80% debt , the D/E would be in the range of 4 (may even be higher in mane cases). With this kind of leverage the levered Beta will be like = [4*(1-30%) + 1] * 0.80 = 3.04

As per CAPM, this will translate into reuqired return of 28.8% which is almost similar to the number used by the buy out funds.