The LBO of ISS
Prof Ian Giddy
New York University
In early 2005 the Danish management team of the world's largest cleaning services company, ISS, was considering a leveraged buyout of their company. For several months they had worked closely with a Swedish private equity firm, Permira, on analyzing the possibilities. At last they had come up with some numbers to show the banks and potential equity investors. The idea was that the equity partners would form a new company, PurusCo, to buy ISS.
The new company would issue debt secured by the shares of ISS. Once PurusCo had accumulated a controlling stake in ISS, the two companies would be merged and ISS would be delisted. The proposed purchase price was EUR3.1 billion. In addition the new company would assume EUR1000 million of the existing 4.5%, 10-year bonds issued by ISS the previous year. Fees were expected to run at 2% of the purchase price. Expected restructuring costs were estimated at EUR40 million up front. After these investments, capital expenditures were expected to continue at a rate of about 1.5% of sales.
The challenge was financing the buyout. Recent LBOs had been financed at a level of up to 6xEBITDA. For ISS, discussions with banks suggested that for this kind of business it might be difficult to syndicate an acquisition loan unless EBIT interest coverage was at least 1.8. At this level, the cost of funds would be quite high, but the prospective owners hoped to be able to repay the loans within 4-5 years. Ideally the equity partners would have liked to fund as much as possible with debt, but they knew that the more ISS borrowed, the more expensive would be the average cost of debt funding. The table below gives a rough indication of the tradeoff between the EBIT/interest cost ratio, and the spread over government bonds that the company would face. At the time, the German government bond rate was 3.1%.
The company’s managers, who would continue to run the company, have managed to raise EUR15 million among themselves to invest in PurusCo. The remaining equity must be raised by the private equity firm, whose investors generally look for a 25%-35% return and an exit plan, possibly an IPO, after about 5 years.
The partners have pledged that no dividends will be paid for the first 5 years. Similar companies (with little or no debt) have been able to go public at a multiple of 8xEBITDA minus net debt. (This group was hoping for more, but not counting on it).
Table 1: EBIT interest coverage ratios
For large firms
If interest coverage ratio is
(a) What is the total cost of the deal?
(b) What is the company's debt capacity, and how much additional private equity financing is needed?
(c) How long do you estimate it will take for PurusCo to pay down its debt?
(d) What approximate rate of return can the private equity investors expect to make if the predictions work out?
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Today, we’re going to (finally) wrap up that Dell LBO case study that began months ago.
But more importantly, I’m also going to give you a private equity case study interview presentation template you can copy, paste, and re-use.
You’re also going to learn why you cannot believe much of what the mainstream media says when it comes to deal analysis and finance-related topics.
With this Dell deal, for example, 95% of the commentary in the media focused on the decline in the desktop / laptop markets, the unusual deal structure, Michael Dell’s sweet deal to claim ~75% of the company post-buyout, and so on.
However, those factors – particularly the market declines – make much less of a difference in this deal compared to points that few other people were even talking about.
It’s a classic example of everyone thinking one way about a deal or company when something else altogether mattered more.
Recapping This Case Study
In Part 1, we went through how to find data on the deal and set up the basic model.
Part 2 was about making revenue and expense projections, Part 3 was about how to set up the debt schedules, and Part 4 was about how to model post-buyout add-on acquisitions.
You can understand this article and tutorial without having read any of those, but you’ll get more of it if you’ve been through the first 4 parts.
The Deal is Done!
The main update since last time is that shareholders (amazingly) approved the deal in September.
Many firms already lost so much on Dell that they figured it was probably better to cut their losses at this stage.
Carl Icahn, of course, was pissed, but that always seems to be the case.
The Presentation, the Template, and the Video Tutorial
Here you go:
And here are all the files you’ll need:
I highly recommend full-screening this video in 720p so you can see everything better.
If you’re reading this via email, click here to view the video and this post.
Table of Contents
- 0:00:Introduction & Case Study Structure Overview
- 4:47: Overview of Private Equity Case Study Template Presentation
- 5:48:Executive Summary
- 7:47:Market Overview and Qualitative Factor Slides
- 11:09: Discussion of Operating Scenarios
- 13:09:LBO Model Output and Sensitivities
- 17:10:What If We’re Wrong? What Factors Could Make the Deal Work?
- 20:07: Conclusions and Summary
Previously in Private Equity Interviews…
You may have seen previous articles here on private equity interviews and case studies – this one is different for 3 big reasons:
- I’ve changed my mind about the most effective way to make case study presentations over the years.
- The recommendations I’ve given before are fine for relatively short/simple case studies, but they would not work as well for something as complex as this one.
- Oh yeah, and this is a real example + a template you can use and re-use.
My Recommended Structure
If you have a 20-slide presentation, you might divide it as follows:
Slide 1 – Executive Summary / Investment Recommendation
Slides 2 – 6 – Qualitative Factors That Support Your Conclusion
- The Market
- Growth Opportunities
- Deal/Company-Specific Factors
Slides 7 – 16 – The Numbers
- Valuation vs. Asking Price and/or Current Market Value
- Revenue, Expenses, and the Scenarios You’ve Built
- LBO Model Output
- Commentary on the Numbers – Which cases are most / least likely? Why?
- The Downside Scenario(s) – VERY important for buy-side modeling and analysis because you will lose your money if you’re wrong
Slides 17 – 19 – The Counter-Factual – Would anything cause your opinion to change? What could cause your recommendation to be incorrect? How can you hedge yourself?
Slide 20 – Conclusions – Similar to the first slide, but now you can reference more of the numbers and specifics you highlighted in the preceding slides.
You can see an example of this structure in the blank presentation template file right here.
If you only have 10 slides or 5 slides or some other smaller number, you could compress this and cut down on the number of slides in each section.
In this case study, we’re skipping over the valuation aspect because we’re analyzing a real deal that actually happened and we’ve been asked to offer our thoughts on it as-is.
You would have to do more work on that in case studies based on potential deals.
The Crux of the Deal: Who Cares About Market Growth – Got Margins?
In a “Base Case” scenario, this deal looks reasonable. We get fairly high IRRs with our baseline assumptions, ranging from 20% all the way up to 50% in the mid-range of the table:
But the “Base Case” scenario here is very rosy since we assume that the Operating Margin increases by almost 2% over 5 years… and that’s starting from a 3.5% margin, so 2% is an increase of over 50%.
The deal looks worse in other cases, including one where margins stay the same and one where margins decline by 1.5% instead:
And then things get really fun in both our own “Downside” case and the Street Consensus Downside case:
In contrast to margins, the decline of the PC and laptop markets barely makes a difference (see the Excel files and presentation for more on that).
This is not surprising: for a company with margins in the ~5% range, you would expect margin changes to make much more of a difference.
So this deal comes down to a very simple question: how certain are we that Dell will maintain its margins?
The answer is “not very” since 1) Margins have fallen in the most recent fiscal year, 2) It’s under a lot of pricing pressure in all markets, and 3) Even its acquisitions have traditionally had < 5% yields. There is very, very little evidence to support margins staying the same or increasing and a lot of evidence to support the opposite case.
As a result, we recommend against buying the company because those Downside cases represent too much risk, the company provides limited information on margins by segment, and there is almost no way to hedge against a risk like pricing pressure in the company’s core markets.
Slide 1: Executive Summary
Keep this simple – 5-6 bullets at the most. State a clear recommendation in the first bullet, followed by a few supporting factors (the numbers work / don’t work, the market is growing / shrinking and the company is well-positioned / not well-positioned, etc.).
Slides 2 – 6: Qualitative Factors That Support Your Conclusion
In these slides, you can focus on the overall market, the company’s competitors, potential growth opportunities, and deal/company-specific factors.
Here, we point out how Dell is in many different markets, each of which has different profile:
- PCs and Laptops: Flat to negative growth, with a declining market share for Dell.
- Servers & Networking: Growing modestly and Dell’s share is increasing.
- Services: Unclear how big the market is, but Dell’s backlog is growing at a good clip and this has been an area of focus for them, especially overseas.
- Software & Peripherals: Flat growth due to falling hardware sales but rising software sales.
- Storage: Very small, but also essentially flat growth.
Dell has performed well against the competition in services and software, but it’s unclear how well it will do as an end-to-end IT provider against the likes of IBM and HP. And, of course, it’s a bit of a disaster against lower-priced desktop/laptop competitors and premium competitors (e.g. Apple).
Dell’s best growth opportunities are to increase its Servers/Networking market share, grow indirect sales (i.e. products sold via distributors rather than sales reps), increase Services revenue via bundling, and make large, solid acquisitions.
The biggest “deal” factor here is how Michael Dell’s ownership increases from ~15% to over 75%, invoking the rage of shareholders everywhere.
It’s also unclear exactly why Dell “needs” to go private to turn itself around, given that IBM and HP both did this as public companies.
Slides 7 – 16: The Numbers
The biggest problem here is that Dell doesn’t disclose much information on margins by business segment. Some older investor presentations have numbers, but there’s nothing very recent / helpful.
The most likely outcome is that their performance will be somewhere between the “Street Consensus” case and our “Base Case” – in other words, revenue will decline modestly and margins will also decline.
If Dell really earns very little Operating Income from its declining business segments, we might be more confident of its ability to maintain its margins over 3-5 years.
As it stands, though, the data is ambiguous at best.
Interestingly, the numbers “work” at first glance because:
- The company still generates $3.0 billion+ of Free Cash Flow each year, even in more pessimistic scenarios.
- It traded at an EV / EBITDA of 3.9x before the deal was announced, meaning it was very cheap for a tech company.
- Dell is repatriating close to $10 billion of overseas cash to fund the deal.
- Michael Dell is rolling over his equity.
- And as a result of all that, Silver Lake barely contributes any of its own equity – $1.3 billion on a total deal size of $24 billion. It gets over 2x that equity contribution in FCF in just the first year!
Of course, the “Downside” cases here don’t look too pretty, which is the main reason we’re recommending against investing.
Yes, on a bright sunny day when leprechauns are dancing in the forest every deal looks great… but some deals fall apart in the Downside cases, while others hold up better.
This one falls apart even with very modest market share and margin declines.
Slides 17 – 19: The Counter-Factual
If we were making an “INVEST” recommendation, we might look at the risk factors in more detail here, explain why we might lose money on the deal, and how we could hedge against those risks.
Since we’re arguing against the deal, though, we list several factors that might make it work instead:
- If we were more certain of margins in future years;
- If we found out for sure that desktops/laptops contributed very little to the company’s margins;
- If it were a simpler company with a clear buyer (we might have to sell off business lines separately here, which adds to the exit risk);
- If there were other viable acquisition candidates with higher yields (15-20%) that weren’t incredibly expensive.
So it’s possible that our recommendation might be wrong – and you want to show interviewers and firms that you’ve thought through that possibility.
Slide 20: Conclusions
This slide restates the Executive Summary slide slightly differently.
We point out the crux of the deal: everyone was worried about the PC and laptop markets, when margins and margin contributions by business segment matter a lot more.
Without further insight into those, and more clarity around how its older acquisitions are now performing, this is a tough deal to recommend.
Download all the documents above, including the template I gave you, and get to work picking this presentation apart and using it in your own case studies. The “blank template” file will also come in handy.
Oh, and subscribe to our YouTube channel to get even more tutorials and videos.
Between now and the end of the year, I’m going to add more shorter 5-10 minute clips for quick review of key topics.
That’s All For Now
With that, we’re done with this case study. The full 24-part case study that goes into more granular detail is already available on BIWS if you’ve signed up for one of the modeling courses there.
We’re gradually adding more YouTube videos to the M&I / BIWS channel, and I may do another case study like this one next year.
But it’s really up to you: articles/tutorials like this one tend to get a poor response rate since they’re so dense and packed with information.
Do you want to see more case studies? Shorter and simpler videos and examples? Or do you prefer to read about non-technical topics on this site?
Let me know when you have a chance.
The Rest of the Series:
About the Author
Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys memorizing obscure Excel functions, editing resumes, obsessing over TV shows, traveling like a drug dealer, and defeating Sauron.