The "ISS A/S: The Buyout" case study offers the opportunity to value a leveraged buy-out and also to examine the character and extent of a company's duties to its bondholders. The case study describes a "going private" transaction in Europe, where the financing plan called for the addition to the company's balance sheet of a high amount of new debt and a change of the capital structure. While leveraged buyouts were nothing new in Europe, this was most probably the first LBO done with an enterprise that had publicly traded investment grade debt outstanding.
Clayton Rose, Lucy White, Carsten Bienz
Harvard Business School (214715-XLS-ENG)
Feb 12, 2014
Case questions answered:
We have uploaded two case solutions, which both answer the following questions:
- What is ISS’s fundamental value? Use both an APV and an ECF approach.
- Construct the ISS capitalization (debt) table. Assume that (senior & junior) bank debt will comprise about 45% of ISS capital, while high-yield debt will comprise about 25-30%, the rest being equity.
- Could ISS offer to redeem the outstanding debt?
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ISS A/S: The Buyout Case Answers
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ISS fundamental value
ISS is a facility services company with headquarters in Denmark. In the event of a bid from EQT and Goldman Sachs, we are asked to analyze the proposed LBO. We have done this by using the ECF method and APV method.
In our ECF calculation, we found the equity value to be DKK 7 billion, and with the APV, we found an equity value of DKK 37.5 billion. There are several reasons for this big difference, one of them being that the APV method does not account for the potential bankruptcy cost and risk that is involved with the high leverage ratio because the discount rate in the APV is a static return of assets.
In contrast to the ECF method, where the leverage ratio is accounted for, and the discount rate is implicitly calculated continuously as the ratio changes. This gives us a high cost of equity and, therefore, a lower value.
Cash flow and forecasts for ISS
EQT and GSCP are satisfied with ISS’s current strategy regarding the main driver of growth being through acquisition. We, therefore, predict growth in revenues of 12% in 2005 and 10% in the following years, see exhibit 1, and after this, a terminal growth of 3%. In other words, we assume that ISS will only grow organically after 2009.
In regards to the margins, we believe that the low barriers of entry, in addition to the fact that customers can change suppliers at a relatively low cost, will push the margins down. However, ISS will be able to increase its bargaining power towards its suppliers as they keep growing. As mentioned in the case text, EQT considers itself to be an active owner and seeks to work in close cooperation with the management.
We, therefore, believe that they will be able to develop and implement value-enhancing strategies to increase the margins for ISS. Since the information regarding cost savings and margin improvements is limited in this case, we have chosen a conservative approach to ISS´s operational forecasts. That is, we used similar cost percentages with respect to revenues relative to ISS´s historical data.
However, as often pointed out in financial literature, debt is a sword, while equity is a pillow. In other words, a high level of debt has a disciplining effect on management, incentivizing them to push down costs and enhance margins. We, therefore, concluded with an initial EBITDA margin of 9% in 2005 and a 10% margin in the following years.
We calculated the Capex for 2003 and 2004 to be respectively 547 and 941(IB – UB (planet and equipment) + depreciation), which is 1.5% and 2.3% of the revenue. We believe that they will continue to have a 2.3% Capex in the following years because they will probably need to maintain a certain level of reinvestments as a result of their current strategy. This will also contribute to an increased depreciation percentage, which we forecast to be 2% of revenue, up from 1.5%.
Based on their acquisition strategy, the amortization of goodwill will probably increase as well, but since we do not have any information regarding this and the fact that ISS historically has had a low tax benefit from this (5%). We, therefore, decided to use a static value of 1217.
Further on, we calculated the working capital (Current assets – current liabilities) to be -839, 587, and 1687 for the period 2002-2004, which gives a percentage of -2.2%, 1.6%, and 4.2% of revenue. Based on the previous conclusion that our bargaining power will increase towards the suppliers, we believe that the WC will stabilize around 4% of revenue, which will give us the basis for the change in working capital. (Shown in Exhibit 2)
Discount rate APV
We found the discount rate to be 7.64 %, using a market premium of 6%, a risk-free rate of 3.8%, and an asset beta of 0.64. The beta was found by running a regression analysis between the percentage return in MCSI and the percentage return in ISS for the past 2 years, excluding the last week recorded, as this represents the market`s reaction to the offer. The regression gave us an equity beta of 0.90, and we unlevered it to find ISS´s asset beta.
The APV model separates the value of operations into two components: the values of operations as if the company was all-equity financed and the value of tax shields that arise from debt financing. When we built the APV-based valuation model, we valued ISS as if the company was all-equity financed. To do this, we discount free cash flow by the unlevered cost of equity, i.e., what the cost of equity would be if the company had no debt. The APV valuation model follows directly from the teachings of M&M, i.e., no financial distress costs.
However, in practice, taxes play a role in determining the capital structure. Since interest is tax-deductible, profitable companies can lower taxes by raising debt. Nevertheless, as we learned in corporate finance, if the company relies too heavily on debt, the company’s customers and suppliers may fear bankruptcy and walk away, restricting future cash flow (distress costs).
As mentioned earlier, the equity value we found with the APV is DKK 37.5 bn. To estimate the terminal value, we used a growth rate of 3%. Further on, we calculated the present value of the tax shield, given the new debt and repayment schedule. The tax shields were discounted by 9.2%, which was estimated from the average cost of debt in 2005 after we had levered up the company. As the debt was raised in March, we had to adjust the estimate so we could get a yearly debt rate. As we repay the high-yield debt, the cost of debt will decrease.
However, we simplified a little bit and decided to use a static cost of debt. Adding up the present value of the FCF, terminal value for the FCF, tax shields, and terminal value of tax shields, we got an enterprise value of DKK 68.7 bn. We then subtracted the net debt in March 2005 of 31.2 bn and ended up with an equity value of 37.5 bn, All this can be found in exhibit 3a and b.
We also estimated an IRR for the investment. This was found to be 55 %, which is a good IRR for a PE company such as EQT and GS. We estimated this IRR by calculating a terminal value for EV in the year 2009 less than the 2009-debt. This gave us an Equity Value of 61.89 bn, assuming that the debt amount is kept steady from 2009.
We based our ECF valuation on the same revenue forecasts as previously discussed. We further assumed that they would use all net cash flow as debt repayment up to and including 2009. As of 2010, the amount of debt will be kept steady, and the resulting cash flows will go to the equity holders.
In order to get the cash flow effects from the buyout itself, we calculated the 2005 cash flow as if the company…
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