In this blog, we argue that distinguishing between an M&A model and LBO model is patently wrong, as LBO is also essentially an acquisition. The difference between the models are essentially driven by the objective of a strategic and financial buyer.
At Profectus Academy we essentially do not prefer to characterize models based on their purpose but would only like to characterize them based on the approach. However, it is a common financial industry practice to label models based on their purpose. Two such commonly labeled models are M&A models and LBO models.
A mergers and acquisitions model (M&A model) essentially shows the proforma financials of a combined entity after a merger or an acquisition. In other words, it shows how the financials of the entity would look like if the merger/acquisition had already happened. It may look at the past or the future performance or, more often, both. A leveraged buy out model (LBO model) on the other hand focuses on the target company's valuation and how much cash flows it can generate and distribute so that the acquirer can repay the debt involved.
But an LBO is also an acquisition. So, wouldn't the acquirer be interested in looking at proforma performance, too? Before, we answer this we need to understand the two broad categories of acquisition: strategic acquisition and financial acquisition.
Strategic acquisition refers to acquisition of one business by another business. These acquisitions can be bolt-on acquisition or primary acquisition. But that distinction is not critical here. The primary objective of the acquirer here is to combine the business of the acquired company (also referred as 'target') with its own business to realise some synergy or achieve some other strategic goals. Acquisition of Corus Group Plc by Tata Steels or MindTree's acquisition by Larsen & Toubro Limited are examples of a strategic acquisition.
A strategic acquirer may be involved in the same business as the target or can be from any other industry. Similarly, such acquisitions can be either funded through internal accruals or through fresh issue of equity. It can be also be carried out as a leveraged buy out where the acquisition is funded by large amounts of debt. Tata Steel's acquisition of Corus in 2007 and Verizon's acquisition of AllTel in 2008 are examples of strategic acquisitions carried out in the form of leveraged buy out.
Financial acquisition refers to an acquisition where an investor purchases stake in another company with the intention of earning profits through dividends and capital gains from sale of the shares at a future date. So, when SoftBank acquires major stake in OYO or FlipKart, they are financial acquisitions. The investor eventually intends to exit the company at a future date at a significant profit.
Funding and structuring of financial acquisition transactions vary significantly based on the growth curve of the company. For instance, investors who enter at an early stage often use hybrid instruments such as convertible bonds while those entering at a later stage when there is more clarity on a company's value may directly invest in equity shares. Private Equity firms may employ LBO strategy when they acquire mature businesses generating stable cash flows. KKR in a way set a template for this by carrying out acquisition of RJR Nabisco in 1988 through the LBO route.
As you must have understood by now, a strategic acquisition as well as financial acquisition can be carried out as an LBO. Alternatively, both of them may also be funded through equity.
However, the objective of a strategic acquirer is completely distinct from that of a financial acquirer. Therefore, if at all models have to be classified based on their purpose it has to be strategic acquisition models and financial acquisition models.
Financial modelling for strategic acquisitions
If we have to name it, we would call what is commonly referred as M&A models as strategic acquisition models. The purpose of these models is to show how the combined performance of an entity after a merger or an acquisition. It may also be used to redraw past financials imagining what if the acquisition had already taken place.
An acquirer specifically looks out for accretion/dilution in EPS post a merger or acquisition. An acquisition increases the overall size of the income statement. But it may also result in increase in interest expense or share count (depending upon how the acquisition is funded). An accretion/dilution analysis tries to capture the net effect.
It may also be used to quantify or help understand several other things including the following:
What is the maximum consideration that can be offered to the target company without diluting the EPS of the acquirer?
What would be proforma EPS if the expected synergies are realised or otherwise?
In case if the transaction is carried out through LBO, then these are some of other questions it may have to answer:
How much of EPS accretion is on account of increase in financial leverage?
How much dividend can the company distribute so as to help acquirer service the debt?
What is the potential for financial distress?
Financial modelling for financial acquisitions
The core objective of a financial investor is to earn profits by buying cheap and selling dear an investment. Thus, whether it is structured as an LBO or otherwise, the main objective of a financial model here would be to help investors understand the profits or the rate of the returns they would make if they exit the investment at different points in time in future.
These model focus on what would be the valuation that the target company may command in future and what would be the rate of return they may, thus, earn.
However, financial acquisitions often involve far more complicated structures than strategic acquisitions. Therefore, these models would have to take into consideration the impact of these structures on the returns that an investor makes.
For instance, financial investors often rely on company management to run the operations successfully and therefore may put in place ESOPs or sweat equity plans. They also employ share warrants and convertible bonds / preferred shares (converts) that can allow them to increase their stake if things are favorable. Thus, these models also have to address several additional issues including the following:
How much dividend can the company pay?
How much stake may get diluted on account of ESOPs or sweat equity?
How much of warrants / converts may get exercise at different performance levels?
What is likely to be the most suitable time to exit the investment?
If the transaction is carried as an LBO then these additional factors will have to be considered
How much debt can be repaid during the holding period?
What is the potential for financial distress?
As you can see, some of the concerns are common between a financial acquirer and strategic acquirer while some of the concerns are different. Thus, a good financial model should have the objective to address these concerns rather than be driven by nomenclatures such as "LBO model" or "M&A model".