Question

Describe common strategies LBO firms use to exit their investment. Discuss the circumstances under which some methods of “cashing out” are preferred to others.

Answer 1

The most common way of exiting buyouts is through a sale to strategic buyers.The second common method is a sale to another buyout firm. Selling to strategic buyers usually results in the best price as the buyer may be able to generatesignificant synergies by combining the firm with its existing business. If the original buyout firm’s investment fund is coming to an end, the firm may be able to sell the LBO to another buyout firm that is looking for new investment opportunities. This option is best used when the LBO’s management is still enthusiastic about growing the firm rather than cashing out. Consequently, the LBO may be attractive to anotherbuyout firm. An IPO is often less attractive due to the massive amount of public disclosure required, the substantial commitment of management time, the difficulty in timing the market, and the potential for incorrectly valuing the IPO.The original investors also can cash out while management remains in charge of the business through a leveraged recapitalization. This strategy may be employed once the firm has paid down its original debt level. The firm may borrow additional monies to repurchase stock from other shareholders, leaving the firm with a more conventional capital structure. Ideally, an exit strategy enables financial buyers to realize gains on their investments. Exit strategies most commonly include an outright sale of the company to a strategic buyer or another financial sponsor, an IPO, or a recapitalization. The value of a company acquired in an LBO transaction is often value at the time of acquisition using valuation multiples (e.g. EV/EBITDA). While exiting the investment at a multiple higher than the acquisition multiple will help boost a sponsor's IRR, it is difficult to justify a prediction that the exit multiple will be higher than the entry multiple (known as "multiple expansion"). It is important that exit assumptions reflect realistic approaches and multiples (exit multiples should generally equal acquisition multiples) for analytical purposes, and multiple expansion is usually an unjustifiable assumption.

A preponderance of secondary offerings by private equity firms represent the first seasoned equity offering after the IPO of the portfolio firm. The issue of the relation between the pricing of an IPO and subsequent sales of equity has drawn considerable attention in the modelling of the IPO market, although none of this research has been generated within the context of private equity firms. Instead, the relevant theoretical models focus on the case of owner/founders who can influence the pricing of an IPO, taking into account the importance of subsequent equity offerings as a means of cashing out that is an alternative to selling shares in the IPO. Although it is common to think of an IPO as a way for the corporate issuer to raise new external capital, within the realm of the private equity sponsor an IPO may be more accurately viewed as a way for it to gain access to liquidity, because an IPO generates a market valuation of its investment as well as providing a means for the private equity sponsor to eventually cash out. Moreover, in some cases, these two functions can be combined via a joint offering in which shares are sold both by the issuing firm, as well as by existing stockholders (including private equity).