Investment Banking: The Power of Cash Flow in a Leveraged Buyout
We've all heard the phrase Cash is king, and this really applies to LBOs in investment banking. The ability to generate sufficient cash flow to make the required interest payments and to pay down the principal on the debt is of paramount importance to the success of any LBO.
When prospective investors, prospective lenders and analysts alike scrutinize LBO deals they look at the expected return in cash flow terms on the investment. In addition, private equity sponsors focus on the rate of return (the percentage return) they expect to receive on their investment, as well as the rate of return the limited partners of their funds expect to earn.
Although accounting profit (or net income) is certainly important to companies and investors alike, cash flow is a more important concept. Accounting profit is the firm's total earnings calculated using the rules of accounting and takes into account all the firm's expenses. Accounting profit is used to figure out a company's tax bill and is useful for comparing the returns of companies.
Quite simply put, however, you can't pay your suppliers, employees, or bondholders, or provide dividends to your shareholders, with accounting profits — but you can with cash. The concept of cash flow recognizes that certain noncash expense items (like depreciation and amortization) are deducted in computing net income but don't actually involve any outlay of cash.
For example, firms are able to deduct a portion of the cost of a machine each year as depreciation, but no one writes a check for depreciation or has to pay someone for that charge. Consequently, a firm with a great deal of depreciation will have a substantially higher cash flow than accounting profit.
There are almost as many variations for computing cash flow as there are analysts out there, but the basic methodology is that you simply take a company's net income and add back all non-cash expenses. An important variation of cash flow is free cash flow. Free cash flow is simply cash flow minus any required capital expenditures to maintain the firm's operations at the current level.
Capital expenditures include things such as the purchase of new machines to replace machines that are worn out. Investment bankers often calculate the value of the firm as the present value of all future free cash flows to the firm.
Lenders often use multiples of a measure of cash flow to determine how much in total debt they are willing to provide to an LBO deal. The most common cash flow measure in this context is earnings before interest, taxes, depreciation, and amortization (EBITDA).
Lenders generally gauge how much they're willing to lend as some multiple of EBITDA — for instance, five or six times EBITDA. The exact multiple of EBITDA varies over time. When LBOs are more popular and lenders have a more favorable view of equity markets, the multiple will increase.