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IRRs and the Structure of LBO Models

In Part I, we have argued that the fundamental value of each investment is the present value of its expected, future cash flows discounted at an appropriate risk-adjusted rate. Discounted cash flow models are based on the premise that a company will employ its assets to generate cash flows and will continue its operations. The going concern assumption does not hold if a company is bought and restructured by a strategic or financial investor. Financial investors usually pay a “control premium” to gain control of a target company. After the acquisition, they typically establish new management, restructure operations, divest non-core assets and undertake a variety of other measures to increase the efficiency of the acquired company.

LBO models try to capture the effects of a potential recapitalization and a subsequent operational restructuring of a company. Deutsche Bank, UBS, Goldman Sachs, Credit Suisse and Morgan Stanley have made the frameworks of and the assumptions behind their LBO models more or less transparent to investors.1 The structure of their models is very similar. The purpose of LBO models is to identify potential LBO candidates. In all of these models, the attractiveness of a potential LBO candidate is quantified by its internal rate of return (IRR). Financial analysts at Goldman Sachs, for example, advise their clients explicitly to buy shares of potential LBO candidates: “Equity investors can profit by buying shares of companies ...

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