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

different underlying assumptions regarding the future excess cash flows of our sample
companies and the portion of this cash used to repay debt principal.
The assumptions of scenario one result in amounts of excess cash flows at the
higher end of what might be possible. All cash is then used in every year to repay debt
principal. Hence, the amount of outstanding debt and implied interest expenses in future
years decrease relatively quickly and the additional tax shields become comparably smaller.
At the other extreme, in scenario eight we use assumptions resulting in lower excess cash
flows in future years. Only the minimum of these amounts is then used to repay debt
principal. Hence, the companies under this scenario have higher interest expenses, resulting
in comparably higher additional tax shields. However, such a slow pace of debt repayment
would likely result in covenant breaches of debt-to-EBITDA ratios in credit agreements,
and PE sponsors would face substantial problems selling a company that remained so
highly leveraged. Scenarios one and eight therefore put bounds on the reasonable estimates
for the anticipated tax savings associated with the LBO.
The most likely scenarios, that approximate LBO sponsors’ expectations, are
probably towards the middle of our range of scenarios. In Figure IV we show the evolution
of debt principal and the ratio of debt to EV (estimated as projected EBITDA times the
EV/EBITDA multiple observed at entry) for scenarios 1, 4 and 8. In our regression analysis
we focus on scenario 4, which assumes a 5% expected growth rate for EBITDA, no change
in capex relative to pre-LBO levels, a full sweep of excess cash to repay debt, and no
interest payments on any PIK notes. Although we estimate the incremental tax savings for
up to 10 years – which is clearly longer than the intended holding period for PE sponsors –
under scenario 4 by year 6 the ratio of debt to enterprise value has fallen to around 40%,
and so the bulk of the NPV of the incremental tax savings will have accrued by this stage.
Over the first two to three years the amounts of outstanding debt principal do not
differ very much. In later years higher differences in interest payments are partly offset due
to stronger capitalization effects. Thus, the numbers in Table IX vary in a limited range
throughout all scenarios (this is visualized in Figure V). For the median company in our
sample the present value of the additional tax shields is in the range of 42.3% to 59.3% of
the one-day premium (in cash terms). Between 12% and 21% of the companies have new
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