Who benefits from the leverage in LBOs? - Said Business School ...

3.2. Methodology for calculating the tax benefits from LBOs
The first main objective is to determine the expected NPV of future incremental tax shields
resulting from higher interest payments. As mentioned before, this is not straightforward in
the case of LBOs involving a number of debt tranches, with different terms and conditions,
and finite holding periods.
The significant increase in a company’s debt and, therefore, the value of higher tax
shields is not permanent. Private equity investors aim – and are required by their lenders –
to free up cash and pay back LBO debt to reduce the default risk of a portfolio company.
Therefore, the traditional permanent debt approach – whereby the leverage used at the time
of the acquisition is assumed to persist into the future – would exaggerate the value of debt
tax shields. Instead, we create a model that determines each company’s debt and tax
positions for every year following the LBO, and produce various scenarios for future
incremental tax savings and their risk-adjusted NPVs. With respect to the holding period of
a company, we follow a conservative estimation by modeling any incremental tax shields
for 10 years following the LBO. A decade is the maximum term of any LBO’s junior debt
tranche, although in practice lenders would expect the level of indebtedness to return to
more normal levels well before the maximum term of the loans, depending in part on the
performance of the company (and therefore the extent of any cash sweep).
The most important variable in our model is the EBITDA of each company and its
future development. As a basis for future scenarios we take the normalized LTM EBITDA
of a company. Since PE investors are generally interested in companies with the potential
to grow EBITDA we assume different growth rates for the following years. This growth
can be either achieved by increasing sales and revenues (ideally without additional capital
expenditures), or by margin improvements. The normalized LTM Capex level serves as a
basis for future Capex estimations. In some of our scenarios we incorporate reductions in
Capex as this is often the case after an LBO. To estimate future depreciation and
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