We're going to try more of an explainer topic today rather than talking about a deal in particular.

So can you just explain what is an LBO? Any time we're buying a company and funding a big part of the purchase price with debt, hence the name leveraged buyout.

So we started by investing 500,000 of our own money.

All of a sudden, we've made three times our money with this leverage, otherwise known as financial engineering, really, in this case.

And that increase in the IVST, that is my return as an investor.

Welcome to all of our listeners. Welcome to this week's episode of "What's the Big Deal?" where we take a look under the hood of major deals in the public and private markets and explore finance industry developments.

My name is Deborah Taylor, and I'm going to use my experience from my career in investment banking to bring insights from a public markets perspective.

And I'm Graham Smith. I'm going to use my career in investment banking and private credit to bring the private market perspective here.

Fantastic. And Graham, before we dive in, tell us a little bit about what you've been doing this week.

Ooh, okay. So I'm still in Abu Dhabi.

So I think I mentioned last episode, I'm here for a pretty long training session, actually. So one of the big sovereign wealth managers, this is a five-week program for some of their new recruits.

Let's see. This week we've been doing a lot of financial statement modeling.

There's an assessment tomorrow morning, so trying to make sure everyone's ready for that. So it's been a lot of time in the classroom, which has been a lot of fun. And then we're going to talk about some LBO stuff today.

I think we're going to kick off on some LBO content, I think back end of next week. So we'll get a little bit of live run through of some of the stuff that we do in the classroom.

But otherwise, can't complain. It's hot here.

It's probably, I think in Fahrenheit, so it's probably in the 90s right now. So it's not- Ooh ... it's not too crazy. I'm coming back here in June, July, and everyone's like, "Get ready for that." So we'll see how that goes. But for now, pretty good. It's all good. How about you? Yeah, good. And likewise, I'm still doing lots of teaching.

I've been delivering more Spring Insights training this week.

And also, I've done a little bit of forensic accounting.

I know I kind of hide it very well, but deep down, I am a bit of a nerd, and I do quite enjoy rolling my sleeves up and doing a bit of forensic accounting work. So I've been having lots of fun with that this week as well.

I don't even try to hide it. I'm fully a nerd over here.

And I like- Flag it on ... but what I don't tell everyone, though, is I actually did an accounting degree in college, and I did an internship my junior year at one of the big four accounting firms.

And everyone in school said, "Audit's way more exciting than people give it credit for.

Just give it a try." And I was drinking the Kool-Aid.

So, I did this summer internship. I show up at the job, and literally the first day I'm on the client site, the guy who's right above me, who's, I don't know, first year, whatever you call first-year accountant, opens up the little plastic box with colored pencils and a ruler, and I'm like ," Oh, my God, I signed up for the wrong thing.

This is not me." So I finished the internship- That's not fun times, Graham ... and then... Yeah.

I had a fun summer. I just didn't have a fun summer in the work part of it. So that's when I decided, I'm like, "No, I'm going to recruit for investment banking," and then went into M&A, which I think suited my interest and personality a little bit more.

So I'll take your red pencils and raise you to the fact that my first audit client when I was training as an accountant was Enron, and within the first few weeks- ... I was told to leave the building because they were going to lock the doors. So actually, my start off in accountancy was actually quite thrilling. And to be honest, it was all a bit dull in comparison.

But yeah, so great that we've both got that background.

I think that level of technical expertise has been really useful. It's definitely for me in my career, and I'm sure the same for you, Graham.

Yeah. Well, hey, and I was at Lehman Brothers. You worked on Enron.

So we were both in or around places that just spectacularly blew up. So we got that as well. So yeah, I love it.

Excellent. Right, so let's dive in then.

Let's talk about what we're going to discuss this week.

What is the big deal, Graham? Hey, so big deal, we're going to try something a little bit new, aren't we, Debs? We're going to try more of an explainer topic today rather than talking about a deal in particular.

We actually are going to use Electronic Arts and Hologic as a couple of kind of template LBO examples to talk through. I really wanted to have a discussion around high level, how to think about an LBO. We're going to run through just the, really when both of us teach these kind of topics in the classroom, really the very first intro into this topic, kind of looking at sources, uses, just some high level entry, exit assumptions, and kind of what that means for returns, and just the high level nuts and bolts of how an LBO comes together.

Because I think there are a lot of YouTube videos, there's a lot of content on here's how you build an LBO model, but sometimes a bit less about actually, if you take a step back, here's what's actually happening. Here's why we build the LBO model.

So we're going to kick off with the high level, and then maybe in another session, we'll do some of the more nuts-and-bolts, in-depth stuff.

Absolutely. Graham, this is definitely your wheelhouse, so you're going to be front and center this week. I'm going to sit back and just ask the questions.

In terms of what we'll cover, we will start off with a quick primer, as you say.

We'll answer the question, what is an LBO? We're then going to look at two deals, as you said, two live deals.

And they are great case studies to help explain some of the real important elements of an LBO.

We're going to look at Hologic, whichMaybe a lot of people haven't heard of.

It's a US med tech company and is a textbook example of an LBO.

And then we'll touch on Electronic Arts, which I think most people will have heard of, and is a really interesting case study because it's a record-breaking deal.

In fact, it's the largest LBO in history at $50 billion. And then hopefully we'll- I think the biggest financing as well, right? So $27 billion of debt. $27 billion of debt financing. Yeah. Yeah. Crazy.

And we'll ask the question, why is that so important in an LBO? Indeed.

And then finally, we're going to talk about the current LBO market.

Where is it at right now? So let's kick off with you, Graham.

Giving us a bit of a walkthrough of the LBO mechanics and almost a 101 on LBOs, if you like.

So can you just explain what is an LBO? It's a leveraged buyout, Debs.

Oh, great. Thank you. Bit more color maybe.

It's funny because I don't know about you, whenever I ask these questions in the classroom, like what's an LBO, what's EBITDA? The first response I always get is earnings before interest tax.

I'm like, "Guys, that is not the answer I'm looking for." I'm like, "What is it?" Not what does it stand for. So really, an LBO is really any time we're buying a company and funding a big part of the purchase price with debt, hence the name leveraged buyout.

I think, and again, one of the ways I talk about this a lot when I'm teaching is think about this like a house purchase.

Like really similar kind of frameworks.

Let's say you've got a house you buy with 100% equity.

You buy that house for, to make the math easy, you buy that house for a million dollars. You roll forward the clock five years, whatever the case may be.

You sell it for $1.5 million. If you think about your returns there, we'll talk a little bit about some of the high-level return metrics we look at in this space.

But cash on cash money multiple, MOIC, you've got $1.5 million that you sell it for, a million that you bought it for.

You've made one and a half times your money.

Then let's- So Graham, you said multiple of money and multiple of invested capital, MOIC. Are those different? And why are we talking about that? All we're really talking about with...

In finance, we love to have a bunch of different terms and words that all really mean the same thing, and what these all are really saying is what was my initial equity value? And this is important because it's not necessarily purchase price.

Right.

In this first example where we say purchase price equals equity value.

When we talk about money multiple, we're just talking about of that initial purchase price, what multiple on that initial equity investment did I make when I sell? So if I buy for a million, sell for 1.5 million, it's 1.5 over one. I've made one and a half times my money.

Got it.

Let's just make up another example here where we buy that same million-dollar house and instead of a million dollars all equity, we buy it for a million dollars purchase price. Think purchase price here being enterprise value. But we split it, say, 50/50 debt equity, so half a million dollars of equity and a half a million dollars of debt.

Now, let's say we've got a great job, we're making a bunch of money in that job, and we, in the time that we own this house, are paying down that mortgage.

Then when we go to sell that house for $1.5 million, now let's think about what our returns are and what's our numerator and what's our denominator, Debs, in that equation.

Yeah, absolutely. So basically, we've invested 500,000 and, or half a million, and we've got one and a half million at exit.

So that's basically three times.

Yeah. Right. Exactly.

Amazing. I'm in.

Right. Nothing has changed. Right. Yeah, 100% right.

And nothing has changed in terms of the actual value of the house, right? We buy it purchase price, AKA, in this case, enterprise value. Buy for a million, sell for 1.5.

But instead of doing one and a half times our money with all equity, all of a sudden we've made three times our money with this leverage, otherwise known as financial engineering, really, in this case.

And one of the things we'll talk about when we start looking at these deals is just when we think about some of the assumptions we're going to flex here, we don't have that many at the end of the day, right? We have what are we buying for, what are we selling for, how much leverage, i.e. how much of a mortgage are we putting on this company at entry? And then how much of that mortgage can we pay off between entry and exit? Okay.

And it's that difference between the exit enterprise value and we'll talk a lot about net debt, right? Enterprise value less net debt equals equity value.

The more net debt we can pay off, so the lower that number is, the higher our exit equity value is, and therefore the higher our returns are going to be.

So a big part of LBO modeling and LBO analysis is really just, it's really just cash flow modeling, right? It's like in that house example of our job that's paying us however much money every year to pay off this $500,000 mortgage, how realistic are those assumptions? Can we pay off all $500,000? Is that assumption aggressive? That's kind of the main point of the whole LBO model is just let's take this company, let's model out what we think it's going to do, right, in terms of revenue down to EBITDA, how much of that EBITDA is going to convert to cash, how much of that cash are we going to use to repay debt? And at the end of the day, we basically add it all up and say, "Okay, what's our ending equity value?" Compare that to our entry equity value, and that's what we're going to do in terms of our return.

So it's kind of the whistle stop tour.

Okay, so basically we're buying assets, a group of assets like a business.

We're using loads of leverage.We plan to sell it on at some point in the future for a higher valuation.

Whilst we've owned it, we've paid down some of the debt, and therefore that means when we sell it, the equity, that's basically what's left over after selling the asset and paying off all the debt, that's gone up massively because both we've increased the value of the asset and we've paid down the debt. And that increase in the value of the equity, that is my return as an investor. Am I right? Exactly that.

Fantastic.

Exactly that. And it can be all these things at the same time. One of the teaching examples I use a lot in the classroom is looking at really a hypothetical LBO where you buy and sell for the same enterprise value. There's no EBITDA growth, there's no multiple expansion. The main assumption we make is that we pay down all the debt in the five years that we're looking at for our returns horizon, and it's like a 3X return on your money just because you have financed so much of the day one purchase price with debt, and you've paid off all that debt by the time you exit.

It's these assumptions, though, that make all the difference in the LBO model and trying to figure out how conservative or aggressive they are. So we're going to talk high level today.

We'll talk through a couple examples, and then we can also spend a few minutes talking about, okay, in the real world, when you do the job and when you're actually modeling this stuff, what are the things you think about, and what are you ultimately working toward? Okay. I have got a few questions for you, Graham.

So first of all, in the example you gave with the house purchase, it was 50% debt, 50% equity. Is that what we also see when it comes to leveraged buyouts, that mix of debt and equity? It's a mix of debt and equity. It very much depends on the company, the industry, and also the competitive market or competitive landscape at that point in time.

This has changed a lot over the years.

You go back to the original LBO days, way back in, let's say, early '90s, and we are seeing the ratio of, or the composition of the capital structure is comprised of debt versus enterprise value really high, 80, 90%.

People worked out it's obviously that's a ton of risk on the debt investment, and over the years, things have been pulled back to a much more modest level. So I'd say real world, anywhere between, say, 50% to two-thirds the enterprise value is financed with leverage.

And we think about that in this term called loan to value. So if you think about- Mm ... again, the value of the business or value of the house being the enterprise value, the amount of debt that you place on that house or on that business relative to value is your loan to value. The higher that ratio is, the more debt you're placing on it, the more risky it is fundamentally from, say, a creditor's perspective. The lower the amount of debt, the safer it is from a creditor's perspective. And in some ways, an equity owner's perspective, because the more contractual obligations you place on a business, the more riskier it is for everyone, realistically.

Okay. And then secondly, we use the example of buying a house, but in reality, we're talking about leveraged buyouts of businesses.

Yeah. What sorts of businesses are usually involved in leveraged buyouts? Is it basically you could pretty much do this with any type of company, or are there specific characteristics that make it more attractive almost to do a leveraged buyout? Yeah. In theory, it can work with anything. But ultimately, when we're talking leveraged buyout, we're talking companies that can support a degree, if not a large degree of leverage. So if you think about what kind of companies are leverageable, companies where you have some kind of stable, predictable cash flow.

The more stability, the more predictability, the more you can get a view on the recurring nature of cash flows, the better a candidate that company is for a leveraged buyout.

Because when we're talking, say, levered lending or leveraged finance, high yields, all these kind of terms to go beyond just, say, pure investment grade, a lot of times what we're talking about is our security that we're going to take as lenders is really around future expected cash flows of a business. It goes well beyond the value of, say, the hard assets of a company. And we're talking about taking security over, ultimately, the enterprise value of this business, and the enterprise value being comprised of, let's talk about the old discounted cash flow analysis, where the value of this company is the value of the future cash flows. So we're looking for companies where we've got some kind of visibility on these cash flows.

And the more visibility we have, let's say, the higher cash conversion we have. We'll talk about this a little bit today, but a thing we think about a lot in this world is cash conversion.

In my mind, I think of cash conversion as really a bridge from EBITDA to cash flow. So for every dollar of EBITDA, how much of that dollar converts into actual cash? A lot of companies are below that. Some companies convert more than 100% of every dollar of EBITDA to cash flow.

So again, when we think about businesses that have recurring contracts, generate cash through their working capital cycles, these are businesses that are really oftentimes highly levered and make good LBO candidates.

But in theory, it can be anything. You can make the argument there's a right purchase price and there's a right level of leverage for almost any business.

Okay. But then you also said that it's really important that we, as part of the LBO, that there is an expectation that the valuation of the business will grow, and some of that's going to be through growth in EBITDA.

So are we just looking for businesses where we have an organic expectation of EBITDA growth, or is there something else driving up that EBITDA and therefore the increase in the value of the company? Can be a bunch of factors. So we can think about this purely from a financial engineering perspective, where ultimately we might not need a whole lot of EBITDA growth to generate financial returns.

Most of that financial return is coming through the use of leverage, right? The less equity we can put in as an owner day one, the more that we can take on with debt.

If we can use the operations and the cash flows of that business to pay down debt, then we will have generated perhaps a pretty interesting equity return, even if we don't do that much from an operational perspective.

I'd say the holy grail of private equity investing is really trying to do a bunch of these things all at the same time, right? Buying a business that might be undervalued, financing a decent chunk of that purchase price with debt, really pushing through operational improvements. So identifying companies that are not only leverageable day one, but hey, I think I can double, I can triple EBITDA because I've got some real sector-focused knowledge in a particular space, and I just know how to increase value because I've, say, done it a bunch of times before.

Also got the concept of, say, a buy and build or a platform opportunity. This has been a really interesting value creation opportunity for private equity in recent years or decades really, where you find a platform, you bolt on acquisitions.

You're often buying companies for a much lower multiple than your group is valued at. Think about you've got, let's say, take any old business that's valued at, I don't know, 12, 13 times EBITDA.

Say, it's a retailer of some sort, whatever the case may be, it doesn't really matter. You then go and buy some single-site business that it's not a big business, it's not part of a brand.

You manage to buy that for a much lower multiple just because, generally speaking, small businesses are just valued at lower multiples. They're riskier. They don't have the stability.

They don't have the big infrastructure that a big platform does.

So let's say you buy something for eight times and you bolt it onto your platform. Before you've even extracted any kind of synergies, the eight times EBITDA you've paid for that business is immediately worth the 13 times that your platform is valued at today. So if you can pull all these levers at the same time, that's when you see these three, five, 10X return private equity deals.

You can really do all this stuff together.

Okay. And you have referred to the return on the equity in terms of multiple of money.

Is that all we're focused on then, in terms of the sort of the targets when we're structuring a deal? Certainly not the only thing we're focused on.

We've got money multiple, which, I think money multiple is kind of the metric that people focus on, I'd say the most in this world, but money multiple and IRR together are really the things that we look at. Because, of course, money multiple, we just talked through the calculation. There's no time component to this.

So if I buy something today and I generate three times my money, that's an amazing deal if I generate three times my money in the span of two years. It looks a little bit less amazing if I generate a three times return over 30 years.

Mm.

Right? So money multiple and IRR together really give us a good feel of just how successful a private equity deal has been.

And when you're talking about IRR, so that's internal rate of return, isn't it? So that's kind of the annualized return that we're generating.

I know if I invest- Yeah ... in the stock market, I can expect a return of around, I don't know, 9, 10% on US equities, let's say.

What kind of return are we talking about for private equity? This really runs a spectrum. I'd say you also have to look at the different types of private equity, and I say different types.

You've got your kind of small cap, mid cap, large cap.

Generally speaking, it's harder to make the kind of really, really high IRR money multiples when you're talking the mega large cap private equity. But let's say, I don't know, your base case hurdle rate, you really need and want to clear at least say 15%. You're really targeting more like 20, 25.

And then you've got the really successful private equity deals that are 30, 40, 50% IRR, right? So generally speaking- Wow ... you've got this huge range, but let's say we're in this overall world of, I don't know, about 20%, something like that.

Okay. Well, I guess because also you know that if you're buying a private company or taking a company private, you're buying a public company and taking it private, you take on quite a lot of risk, aren't you? Because you're locking your money away.

You've then got- Yeah ... potentially operation improvements that you've got to execute on.

So that's actually quite a lot of risk.

So definitely you'd want more of a return than you get in the public markets, for sure.

100%. And you're also getting really involved.

Think about your role as a private equity investor.

It's not like one of us just investing in shares in the public market where you buy a share of stock and then you don't really do anything, right? Sit back. Let the returns roll in.

You let it sit there and see what happens.

Yeah.

Maybe you submit a proxy vote every once in a while if you really care about it.

If you're a private equity investor, to your point, you're investing for control.

You own the business, so you got to do the work, right? Mm. Yeah.

You are now the owner. You buy the whole company, and you're usually buying it because you think you can do something better or different than, say, the person who owned it before.

So you don't buy it and just sit back.

Before you buy it, you've already got a plan, right? We'll talk, I'm sure, in future episodes about the whole...

diligence process that you go into before you even execute a transaction like this. But you don't just buy it.

You've got to do a bunch of work and say, "Okay, I'm interested in this sector overall. I'm interested in this company because of X, Y, and Z.

I've done, say, six months of diligence, really identifying areas of, say, operational improvement of, say, new business lines that I can open up, acquisitions I want to make.

Before I even buy this thing, I've got a really good idea of what I want to do." And then you buy it, and you got to do it.

So you got to roll up your sleeves and do the work, and that takes some time to pull together.

Most of the time when we're looking at deals in this space, we're also not talking about a quick flip.

It's not that never happens or hasn't happened before, but generally speaking, we're buying to hold, we're buying to roll up our sleeves, do a bunch of work, make these improvements, and then sell five, seven years down the line.

Okay. So we've talked through the mechanics.

I think we're now ready to dip into a couple of real deals.

Let's start off- Yeah. Let's do it ... with our first one, Hologic, which I introduced it as kind of the classic or textbook leverage buyout.

I think I mentioned a lot of people won't necessarily have heard of this company.

They are a med tech business. They're focused on women's health.

They sell diagnostic tools and systems.

Lots of R&D behind their products, lots of proprietary technology, which does give it a big competitive advantage.

This was quite a big deal, wasn't it? About $18 billion purchase price.

Talk us through the numbers. What do we know? This is in that mega, mega large cap deal kind of space. This is a big one.

By the way, if you're listening on a platform that's not YouTube, if you're listening rather than watching, we're going to do a quick screen share. If you have time later, maybe just give the YouTube video a watch. The YouTube is going to have a couple of files linked to it so you can play around with some of these numbers yourself as well.

But really what I've got on my screen here is just the most basic private equity analysis.

So when I'm teaching, we call this the napkin LBO, you can do on the back of a cocktail napkin, where all you're basically saying is, "Okay, I know what I'm buying, I know how I'm financing it, so I'm going to back solve into how much equity I need to buy it, and then I'm going to make some assumptions about my exit valuation." So here, because we're talking a public LBO, a P2P, we've got a buyout price per share, number of shares outstanding, and that gives us our entry equity value. Now, most of the time when we're talking valuation for, say, private companies, mid-market LBOs, we're usually talking enterprise value. But in a public LBO, when we've got an offer value, that's the equity value.

So we know what we're buying.

Mm-hmm.

Our uses of funds here, they're really simple in this analysis. We're basically saying what we've got to fund is the purchase price of the equity.

We need to refinance the debt, and then we got to pay the fees.

And what does that mean, refinance the target's debt? Why is that important? So let's talk some high-level numbers first, and then we'll talk about why.

Okay.

Well, we can talk about the numbers now.

Let's say we've got an equity purchase price of $18 billion.

Hologic had $2.5 billion of debt on their balance sheet at the time of this deal, and we're going to assume transaction fees of $370 million. If you're one of the financing parties here, the bankers, that's a pretty healthy fee check. So we know what our total uses are. Now, thinking about this refinancing of the target debt. Ultimately, when we're buying a business, when we are a financial sponsor, and we are undertaking a leverage buyout, one of the things we're doing is we're going to banks, we're going to credit funds, and we're sourcing new leverage for this business.

So in this case, on our source of funds, we've got a $9.5 billion term loan, a $2 billion term loan, and we've got an RCF, a revolving credit facility, of 750 million. Now, Debs, I don't know if we know, more of a detail point, it's not going to make a huge difference for the returns here. I don't know if this revolver was drawn or undrawn at close, if this is really part of the transaction funding here. Talk about that in a second. But let's just look at the term debt here.

So we've got $11.5 billion of term debt that we're bringing with us as the new owners. We're buying this business.

Now, put yourself in the shoes of one of the lenders of this $2.5 billion bank loan, I assume, which is what Hologic had outstanding at that point in time.

You're one of the lenders there. You're happy with your position.

So if we're talking LTM, EBITDA is $1.4 billion. So you are sitting at 1.8 times leverage.

Less than that-- That's gross leverage, by the way, because they've got $2.2 billion of cash on the balance sheet.

So you're basically at zero times net leverage. So your risk profile is just incredibly safe from that perspective.

All of a sudden, someone comes along and says, "Hey, I'm going to put $11.5 billion more debt on this business."Your risk profile changes materially. So you're unlikely to say, "Yeah, okay, just put it on." So usually what happens in the real world is you've got all kinds of change in control provisions, which mean if the equity changes hands, the debt that's outstanding on the existing business just needs to get repaid.

Because if you're sitting in that facility, you're zero times net leverage, and then all of a sudden new owners come along and they're saying, "Oh, actually, if we just look at this from a term debt perspective, I think we've got, what, 9.4 times debt to EBITDA. Let's say the RCF wasn't drawn at close. So we're looking at our $11.5 billion of debt over our EBITDA of 1.4 times. We're now 8.6 times levered.

We've gone from zero to 8.6. That's a pretty big change overnight." Mm.

So you basically say, "No, you got to take me out." Okay. So is it pretty normal, therefore, that when you're doing an LBO, you wipe the slate clean, you basically clear out the capital structure before loading up with absolutely loads of debt? That sounds like a big number.

100%.

Eight times EBITDA.

Okay, great. So we've got our sources and use of funds there for the deal. Okay, what's the next thing we need to sort of walk through then, Graham? Yeah. Well, one thing that I also think is useful to point out really quick is just the fact that we've got the existing cash of this company as a source of funds, because I think sometimes, especially, I don't know about you, especially when I'm kind of teaching this in the classroom, people always say, "Wait, hang on a second. Why can we...

That 2.2 billion of existing cash, that's Hologic's, right? So why can we use that as a source of transaction funding?" And that really comes down to the relationship between enterprise value and equity value. If you think about enterprise value being equity value plus net debt, you really flip that around and you're like, "Okay, my equity value is my enterprise value less net debt." So baked into the value of Hologic's equity is also the value of the cash, right? So as soon as you buy it, you get access to that cash.

And actually going back to that house example, one way I find is really useful to just understand this really quickly is we've got these two houses. They're both, let's say, not two houses, not the one house we bought before. We're looking to buy a house.

We've got two houses that are both valued at a million dollars enterprise value.

It's the value of the actual house, right? In our diligence of the house, we find that one of the houses has a half a million dollars of cash sitting on its kitchen counter.

And when you buy these houses, you get everything in it. So if you're buying the house that's got half a million dollars of cash sitting on the kitchen counter, how much do you think you got to pay for it? I'm definitely going to pay a half a million dollars more.

Right. You got to buy the cash, in essence, right? So the offer value and the purchase price of the equity and the sources and uses has already got the value of that cash included. So the second we take the keys to the business, we can use that as a source of transaction funding.

Okay.

And really, on the last step on our sources and uses really is just back-solving into what we think the, not what we think, what the equity check is going to be based on what we think we can raise in terms of debt.

I was going to say, I can see that the equity number in that table, for those of you who are listening, it's not a blue number, it's a black font in there, which means it's a calculated number.

So that must mean it's basically a plug, is how I would refer to it. It's basically- Yeah ... you need a certain amount- All we do is, yeah ... cash to do, or funding to do the deal.

Yeah, exactly. We know the way that we're doing this, we know what our uses of funds are, we know the equity that we've got to buy, we know the debt we've got to refinance, and then we know what we're bringing with us, as in what the debt we're raising for this transaction is. And then the balancing item is just the equity that we got to raise or put into our pocket, raise from our LPs or call from our LPs rather. It's kind of the balancing figure.

Now, I think realistically, if we want to be intellectually honest with ourselves, we should probably delete this 750 on the RCF.

I don't know if this was drawn at close or not.

So Debs, what's a revolving credit facility? So I like to think of it as like an overdraft for a company.

It's something you can dip into when you need a bit of extra cash for things like inventory purchases or to pay off some of your suppliers, for example. Am I right? Yeah, 100%. I kind of think of it as like a corporate credit card almost, and one of the, to your point, you pay suppliers and whatnot.

It's also called a working capital facility, kind of gets you through working capital swings. Really common in European RCFs, or at least it was anyway, where you have what's called a clean down provision, which means for a certain amount of time every year, it's actually got to be paid down to zero just to prove that it's really a temporary source of funds.

Yeah.

So usually in a transaction like this, they're undrawn at close.

Sometimes part of it is drawn to fund the transaction, but it's not really supposed to be that way. So let's delete the RCF from the source of funds here. What does that mean our equity check is going to do, Debs? We're going to have to put in more equity.

You have to put in more equity. So all else equal, our returns are going to go down. So yeah, our equity's gone from, what, 6-point, 6-something to 7.2 billion now. So let's run with this for the time being.

Okay, so Debs, what's next? I don't know. You tell me. You're teaching me.

Okay.

All right. So one of the examples that I tend to run through in the classroom is, it's actually not a hypothetical company, it's a hypothetical example of a real LBO where we enter and exit at the same multiple. So we're now going to look at this on a multiple of enterprise value to EBITDA, kind of how we tend to think about valuation in this world. We're going to say, okay, we backed into our entry multiple. We're saying that's 14 times. We've got our enterprise value, which is our equity value plus net debt, in this case.

Our entry enterprise value, by the way, when we're talking equity value, we know our equity value.

The net debt that we're going to calculate is the entry net debt.

Broadly speaking, because we're basically zero net debt, enterprise value and equity value are basically the same for this company on entry.

We've got LTM EBITDA of 1.4 billion, so we think our entry enterprise value multiple is 13.7 times.

On a base case. Base case in this world, we're usually going to assume no multiple expansion. Multiple expansion just means your multiple goes up. What you really want is both EBITDA and multiple expansion, right? Grow EBITDA and sell at a higher multiple.

So in our really base case analysis here, we're just going to assume no multiple expansion. We exit at the same value.

In this base case example, we also assume no EBITDA growth. Highly not a realistic assumption for this business, and we'll talk about why. You would never do this deal with zero EBITDA growth.

So then work out our exit EV, which lo and behold, is the same as our entry EV, and then we assume some kind of net debt position at exit. So we buy this business with $11.5 billion of term debt. As we talked about that mortgage example where we have a job, we have a salary, we use that salary to pay down the mortgage. Here, we basically do the same thing.

We're just using the cash flow from this company to pay off its debt. Now, a big part, the main part of an actual LBO model is basically just to model the cash flows of a company, make some assumptions for what you think revenue, EBITDA is going to be.

You have some assumptions for cash conversion.

What's your CapEx, your working capital, whatever else? How much cash are you ultimately going to generate, and how much of that cash can you use to repay debt? The more debt that you can repay, the more you grow your exit equity value, and the more you grow your exit equity value, the higher your return's going to be. That's kind of it.

So with a company like this, now Debs, I actually don't know the company very well. I haven't looked at their actual financials.

But if I go back to my-- Let's go back to our base case example that we always talk through in the classroom where we say we pay down to $0 net debt. One of the things I like to kind of tee the class up and talk about is how reasonable of an assumption is that for a business like this? And what do you think, Debs? We've got $1.4 billion of EBITDA at entry. We've got $11.5 billion of term debt on this business, and we're saying we're going to exit in five years.

So in five years, do you think we can pay down $11.5 billion of term debt with this kind of EBITDA profile? And what information are we lacking, and what do we need to really figure this out? Because we don't know everything right now.

So I say no way, but I think we would probably want to know a little bit more information about how EBITDA converts to cash, because it could be no way, or it could be no way, Jose, if it is very low cash conversion.

Yeah. And look, again, I don't know too much about this business, but medical devices, I'm thinking big CapEx bill, probably a big maintenance CapEx cycle.

Right.

This might be a business that you tend to look at on instead of an EV to EBITDA basis, an EV to EBITDA less maintenance CapEx basis.

Really typical for businesses that have a big kind of regular maintenance CapEx cycle. Because ultimately, by the way, when we're talking EBITDA, we're talking some kind of proxy for cash flow.

At the end of the day, things come down to actual cold, hard cash, right? So we're really looking at things on a multiple of actual cash flow.

So I kind of think about this as, all right, we've got five years to generate enough cash to pay off $11.5 billion.

We'd have to convert a lot of this $1.4 billion of EBITDA to cash to get anywhere close to that.

And what about interest, Graham? Because we're ignoring the fact that you're going to have to pay not just the debt- 100% ... but what about the interest on it? 100%. Yeah. Right. So let's just think about this really, really high level, right? So we've got our $11.5 billion of debt.

So let's just... I know I'm going to...

Not great Excel modeling practice, but we're going to make some notes here as we go. This is our just total debt. We'll make some assumptions for interest. What do you think the blended interest rate across these two facilities is? I'm going to go for about 8%.

That's kind of what I was going to go.

Yeah.

I don't really know. It's going to be close enough.

So we're going to say, okay, of this $11.5 billion, we're going to pay 8% interest per year for five years.

Five years, that's $4.6 billion of interest.

That's a lot. Right? SoIn our five-year holds, if we want to get this down to debt-free, cash-free, we've got to come up with $16 billion of cash, and our entry EBITDA is $1.4 billion. I think that's probably a stretch.

Okay.

But it's not that we have to pay this all the way down to zero to make the returns work. It's highly unlikely that this would ever happen.

Most LBOs don't pay all their debt down to zero at exit in order to make things work. What are some things that could make this interesting, Debs? What do you think is on the owner's mind here? Well, I don't know Hologic as a business very well, but I would expect that there would be some operation improvements in there.

We've very conservatively assumed no change to EBITDA, but I reckon that they are banking on EBITDA improvements and therefore, as you mentioned earlier, some multiple expansion.

There has to be, right? Let's say more conservatively, I don't know, let's say 100% of this EBITDA converts to cash flow, which I think is pretty unlikely, right? I think it's probably likely to be a lot less than that.

So you say 100% of this EBITDA converts to cash flow. That's what? Almost $7 billion of cumulative cash flow over this five-year period.

But let's ignore the fact that we are going to repay, pay down potentially, not equally, but in some fashion, that's not just all at the end of this projection period here. But let's say, okay, we've got $6.7 billion of cumulative free cash flow.

We've paid $4.6 billion in total interest.

So we've got $2 billion left to make actual principal repayments on our debt. We started off with $11.5 billion of debt. We paid down $2 billion. So let's be generous and say we found some extra cash and we paid our debt balance down to $9 billion from $11.5.

All of a sudden, if I plug in $9 billion of debt at exit, then my returns just don't make any sense, like negative 46% IRR, zero times cash on cash.

You just would not do this deal. So you absolutely have to be assuming that you've got some real operational plans for this business.

By the way, there's a good argument to say that the EBITDA that everyone was backing when they bought this business and when they financed this business was actually quite a bit higher than this $1.4 billion anyway.

Mm-hmm.

Because when you do your diligence on the way into one of these transactions, you're not just bidding and buying off of LTM EBITDAs or modeling here. You're saying, "Okay, based on everything that I know about this company, based on all the stuff I'm going to do really quickly, potentially based on some of the operational improvements that I can do basically overnight, I think my true entry EBITDA is probably quite a bit higher than that.

So I think I've got a higher entry EBITDA than I'm reporting here, and I've probably got some pretty interesting growth plans for this business," which means there's no way they're going to exit still at $1.4 billion EBITDA.

So the whole point, by the way, of the actual LBO model is to model this out and say, "Okay, in this five-year period, I think I can get EBITDA to X." I'm going to do the actual cash flow model and say, "I think of this EBITDA, so much is going to convert to cash flow." Again, add it all up, figure out how much debt you can repay, solve for your equity value at the end, and that's at the highest, most basic level.

That's kind of the LBO model. That's basically it.

Awesome.

So I feel like we've kind of explored the Hologic example there. Should we look at another example? We could sort of just touch very lightly, I think, on our second one.

Yeah, let's do it quick.

Yeah.

We always say we're going to do these episodes in 10 minutes, and then they wind up being 45 minutes long.

Yeah. So really, really quickly on EA, we've got the same setup.

So we've got, again, biggest LBO basically in history at 50, call it $55 billion equity value.

The debt that was brought with this business is what, kind of adding all this up, what basically close to $20 billion of debt to finance this buyout. Now, if you look at these base case returns, again, acknowledging these returns for a high growth business just don't make any sense like this. These really, really don't make sense, right? Because you look at the enterprise value here of $55 billion.

If we think LTM EBITDA really was $1.8 billion, that's a 30 times entry multiple.

That just seems kind of nuts. I'm sure that on the way into this deal, there was a lot of analysis done to really bolster that EBITDA number and support something quite a bit higher to bring down that effective entry multiple. But if we just take the numbers as given and say, okay, $55 billion EV, $1.8 billion LTM EBITDA, 30 times purchase price.

Roll that 30 times purchase price forward, assume you can sell for 30 times. That's a pretty aggressive assumption.

Again, we've got this base case assumption here that we've paid down to $0 net debt.

Again, highly unlikely, right? We've got both principal and interest repayments, again, $1.8 billion of EBITDA over five years.

We're not going to get close to paying anywhere near that much debt down.But even if we do, even if we make this assumption that somehow we find the cash to pay down this much debt... And by the way, I have to assume EA is a lot more cash generative than a medical devices company, but still, it's crazy.

We're at an 8% IRR and a one and a half times money multiple. There's obviously a lot more going on here that is not reflected in the numbers you read in the press release.

So obviously people are backing a much higher EBITDA.

This is a high-growth business. There's some kind of assumption that we can sell that maybe our exit multiple isn't 30 times, maybe it's, I don't know, 18 times, but we're going to sell it doing $10 billion of EBITDA, something like that. Now we're at, oh, yeah, we're at five times our money. And again, there's no way we're going to pay down that much debt at this point. Maybe if we do get EBITDA to $10 billion, but it's probably not going to happen in five years. So I don't know.

This one requires a little bit more thought and analysis because just based off the headline numbers, it's hard to see... Well, no one's backing, just going to Control Z and undo, no one's really backing this deal at an 8% return or a one and a half times money multiple. I just don't feel right.

No, for sure. I mean, as I said at the beginning, you can get more in the stock market. I think- Exactly ... a couple of things that make me a little bit surprised about this being a leveraged buyout. We've got the debt-to-equity mix here, 20 billion of debt versus a market cap around $50 billion, $55 billion. That's not that leveraged.

As you said, it's a really high acquisition multiple, so you're buying a business on about 30 times its EBITDA. Whereas when we think about leveraged buyouts, I often think about quite cheap businesses, where leverage is much more effective if you're buying a company on maybe 10 times its EBITDA and the debt- Yeah ... is six times its EBITDA. That kind of sounds a little bit more like a traditional kind of LBO. So what do you think is going on here? I know it was a consortium of financiers. We've got Saudi's Public Investment Fund, Silver Lake, and Affinity Partners all acting as a consortium. So this doesn't feel like a traditional LBO. So what is going on? Yeah, I agree.

What is this deal all about, do you think? I mean, the honest answer is I don't know 100%. I think you're right.

When you look at the investor base here, it's not a traditional, just normal kind of regular buyout. So, maybe I can see the overall return hurdle here being a little bit lower on the basis. Again, it's not your traditional buyout where you're using a lot more leverage. I mean, even though the numbers are big, to your point, in terms of the total capital structure, the leverage here isn't crazy.

Well, we say eight times cash EBITDA, which is still crazy in my world, right? But when you're looking at loan-to-value and your valuation is 30 times EBITDA, it doesn't feel that crazy.

I don't know. I actually need to do a little bit more digging into some of the financials to the extent you can, they're even available here, and see if we can get- Hmm ... a better view on what's going on.

But yeah, I think maybe you've got to have probably a much longer-term investment horizon here than you do for a standard buyout.

Probably a lower return threshold because, yeah, it's a leveraged buyout in the sense the absolute leverage number is big. But in terms of the rest of the characteristics that we think about for a traditional LBO, it doesn't quite feel like the normal kind of transaction.

Hmm. And so I've been reading about the fact that sovereign wealth funds have been increasingly participating in this kind of deal through co-investing, and you know you're teaching at the moment in Abu Dhabi.

So what is driving, do you think, that kind of increased participation from wealth funds in this type of deal? Certainly if you think about the kind of reason for some of these investors to co-invest rather than just make commitments to the actual funds, a few different reasons. One, a deal this big just needs a bunch of capital.

So you're going to need to find pockets of capital that sit outside just the traditional kind of commingled GP, LP style funds.

I think a lot of co-investors also like these kind of arrangements because they tend to be a little bit more advantageous in terms of economics and fees.

If you're investing straight in the deal, you're not paying all the same fees you would if you were investing through the actual private equity fund. So it's kind of a combination of factors.

Also, what we're finding now is, I think if you look at how a lot of these big sovereign wealth managers have developed over the last really couple decades, they've got much more built-out infrastructure in terms of their own investment teams.

They have- Mm-hmm ... the people, the knowledge to be able to make the direct investments, whereas probably didn't have as many resources on the kind of human capital side 10, 20 years ago.

So I think a bunch of different reasons for this being a lot more common, and it's certainly not just EA.

You find this a lot in the private equity space these days.

Yeah, and we've certainly been hearing about fewer deals in total, but more big deals, these kind of mega deals, and this is certainly an example of that.

And maybe this kind of investment reflects that search for-... more large-scale deals in the private equity space.

Maybe so. And definitely, to the point we've been talking about the last few weeks, this does seem to be the year of the mega deal, the quarter of the mega deal.

Right.

So more of this to come, quite possibly.

I don't have a crystal ball and know exactly what's coming down the pipe for the other mega private equity deals. But will we see more stuff that looks like this? Quite possibly.

And what about the exits from these transactions? We've talked about the fact that you can generate a really nice return after five, seven years, but you actually have to be able to exit.

And we've certainly heard some news flow around exits becoming a little bit more challenging, certainly if you want to exit through the public markets. And so now we're increasingly seeing exits to other strategic buyers, that's other corporates, or even to- Yeah ... other financial sponsors. So can you talk us through a little bit about kind of what's going on there? Yeah. And here it very much depends as well on what part of the market we're talking about, mid-cap, large-cap. It's interesting.

I worked in mid-cap private equity in Europe for a long time, and what you actually tended to find there was the same companies that kept getting passed around and around the market.

Yeah.

And what the general kind of philosophy was, you have an owner that extracts some value and then tries to sell it to a new financial sponsor with something, some kind of carrot to say, "Oh, there's this other stuff we haven't done yet, so if you buy this from us, there's a lot more value to extract, create still." So that's certainly one aspect of this world that I've seen a lot of firsthand. To your point around some public exits becoming a little bit more tricky, obviously with public listings, you've got the IPO market and whether that's open, shut to deal with. But certainly for companies that are, say, this big, you can make the argument both Hologic and certainly EA, I don't know how many strategic buyers you're going to find to- Yeah ... to undertake a transaction of this size.

Maybe.

We've been talking a lot about Warner Brothers, Paramount, Skydance, all this kind of stuff. There are some mega strategic deals.

But when EA ultimately comes to list, will it be strategic or IPO? I'd kind of guess one of those two rather than a sale to another private equity shop or consortium.

But who knows? We'll see.

Hmm. Okay. And then I guess my final question about the current market.

We talked about some of the ways that you can drive value in this kind of deal in terms of debt paydown, increasing the valuation through operation improvements, through multiple expansion.

How has that kind of evolved over time? I know that historically or in the early days of leveraged buyouts, there's accusations of asset stripping. That's where you sell off the assets to pay down debt. And there was definitely that in the early days.

But do you think the private equity market has really moved on from that approach, that we're much more focused on things like operational improvements? Yeah. I would say in terms of things like comparing, say, asset stripping for debt paydown versus real operational improvement value creation, if you look at how a lot of the private equity world is structured these days, you find far fewer, say, true generalist private equity firms.

Hmm.

Roll back the clock, I don't know, 20 years, you can find private equity firms that just did private equity. You can just buy any old company, finance with a lot of debt, and that was what you did.

I think right now, one, you've got a lot of capital competing for the same assets.

I forget the-- I think we've talked about it in previous episodes, just the amount of dry powder that's out in the private equity world right now, I want to say is what? About $1 trillion? Trillion. About 900 billion.

Making numbers up.

It has come down a little bit, but it is a huge amount that's just sitting idle- It's- ... waiting for deals.

And ultimately, think about the way these funds are structured.

You have to invest this money. You can't sit on it forever.

You can sit on it for a period of time, but ultimately, your investors are backing you because they think you're going to go out and invest this money and earn a return. So you've got all of this dry powder sitting out in the market right now chasing a finite number of deals.

What does that do? You've got an abundance of capital and a scarcity of companies that's going to drive up your purchase price multiples.

So if your purchase price multiple is getting driven up, you really need to be able to do something interesting on the operational side- Hmm ... in order to generate those same private equity style returns.

It used to be a lot easier 15, 20 years ago. So if you look at the overall space right now, I think it's fair to say you find a lot more specialist private equity these days than you do generalists.

You find people that focus on healthcare, tech, software, services, manufacturing, whatever the case may be.

People who've got real operational and sector experience and know what they're doing in a particular industry, and know how to create value in a particular company.

Hmm.

Much different. I think it's harder, I think, to do private equity well.

Probably more interesting because you're really kind of performing some interesting not just turnarounds, but operational improvements. You're doing some cool stuff at a lot of these portfolio companies. But it's also not easy.

You can't just buy it, put a bunch of debt on, and then go home and chill and expect to make a 3X to your money deal in five years. That's just not going to happen.

And I think these deals are great examples of that.Right.

It's actually interesting, the teaching example that I use a lot for the buy and sell for the same price, pay your debt down where it almost pencils out, I think that was from 2012. Right? Look at what's happening now.

It just does not work the same way.

And I think that's a really important point that private equity has moved on, and it isn't just about having financial smarts, the ability to use just kind of the financial engineering just to create value, that you need to have those operational smarts, the ability to improve a business, and you therefore need that kind of industry expertise. You need that playbook of how you can go in and improve that particular type of business.

100%.

And as we said, that is a huge amount of risk as well that you need to be able to have confidence that you can go in and execute those improvements.

It's not just a plan. You've got to be able to execute that plan.

Exactly.

Interesting. Well, I think it- Exactly ... sounds like it's an interesting space.

Definitely, we're seeing, as I said, some very big deals coming through. We'll keep tracking.

Now we've got basic knowledge of how to do those calculations, so hopefully we can reuse that in further episodes when we're talking about LBO deals.

There's so much more we can talk about.

I've just got this running list of kind of episode ideas as we get a bit farther down the line. So, I think we've probably been chewing each other's ears off for long enough, so we'll save some of that for future episodes.

But there's a ton we can talk about in this space. So yeah.

More to come, so stay tuned.

Okay. Well, thanks so much, and that's it for this week's episode of "What's the Big Deal?" If you enjoyed our dive into the world of leverage buyouts, including Hologic and Electronic Arts, then please do follow us and leave a rating. And if you're watching us on YouTube, please do like, subscribe, and of course, leave us a comment.

So until next week, where we're going to look at a new deal with some fresh insights. Thanks so much from myself, and also, thanks from Graham.