Leverage

To determine the amount of debt that a PE firm is able to obtain in the LBO of A&F, we have been estimating it using a Debt/EBITDA multiple. This multiple has been chosen since it is the most common multiple used when determining the total debt for a LBO, but also because it is highly connected to the conversion into cash flows (Greisen, 2017). Due to this, banks are often using EBITDA values, since it comprises a good estimate of the company’s ability to service the debt. In order to enable us to determine a proper Debt/EBITDA multiple, we have collected global historical data for the Debt/EBITDA multiples from 1Q 2012 to 1Q 2017, which are shown in figure 21 below.

Figure 21 - Compiled by the authors with data from PitchBook

As seen from the graph above, the level of Debt/EBITDA that PE buyouts have been able to acquire has been fairly volatile during the period, ranging from 3x EBITDA to 4x EBITDA (PitchBook, 2017). During the last years, banks’ willingness to lend to PE buyouts has been reduced and they are now requiring a higher equity contribution from PE firms whom wish to borrow. The debt level as a percentage of the total value has reached record low levels with PE firms, during 2016, paying 40-60% of the total purchase price out of their own pocket on a more regular basis. Furthermore, banks are also becoming more selective in which LBO deals they choose to finance. This is a result of the highly competitive environment between strategic- and PE buyers, who are both competing for the best financing deals (Schwarzberg and Deo, 2016). There are also clear differences between the European and the US loan market. According to Tommy Greisen, associate director at Danske Bank Leveraged Finance, a very distinct difference between the two markets,

3.7x 3.4x 3.2x 3.5x 3.1x 3.5x

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2012 2013 2014 2015 2016 2017

Global median EBITDA buyout multiples

Debt/EBITDA Equity/EBITDA EV/EBITDA

87 is the fact that the US market use a lot more corporate bonds. As a result, US bank loans are not the go to for financing is needed, and banks has thus come to act as a revolving credit facility rather than as senior lenders in a LBO transition. There are also some structural differences between the two markets, as the US market is operating in a more covenant light environment. This is a result of the preference of bonds over bank loans, resulting in less amortization and fewer covenants needed. However, bank loans are still used in the US, but with a higher proportion of a bullet payment structure, where no amortization is needed (Greisen, 2017).

Evaluating the individual risk profile of the target company is very important when determining the debt level that a PE firm is able to acquire and it is one of the first things that a bank does when presented with a new LBO case (Greisen, 2017). To determine the Debt/EBITDA multiple applied for the buyout of A&F, we will assess both the industry as well as company specific factors in the next section, incorporating the most relevant factors discussed in our strategic and financial analysis.

As discussed in our strategic analysis, A&F is, through its global operations, exposed to exchange rate and interest rate risks, where fluctuations in foreign currency and interest rates has the potential to adversely impact their financial performance. Even though A&F, to the best of their ability, are hedging their exposures, these fluctuations still propose a risky element, which is why it will be reflected in their individual risk profile.

Another factor is the political risk that A&F is exposed to through its operations. More specifically, the minimum wages set by the different states in the US. According to A&F, the majority of A&F’s labor force is located in the US, which exposes them to the risk of potential increases in the minimum wage, which in turn will affect their financial result and should therefore be part of their risk profile. Furthermore, as discussed in our PESTEL analysis, the commodities needed to produce clothes, such as cotton, has experienced huge fluctuations in recent years, which has the potential to affect the financial performance and should also be considered.

Moreover, the apparel industry is largely affected by changes in customer preferences, with a larger preference of purchasing online and get your purchases delivered to you already next day, which has given rise to an increased competition within the industry. As a result, the direct to consumer business has become an important part of apparel companies’ survival. Thus, this factor is considered to highly affect A&F’s individual risk profile due to its inability to, in later years, adequately adapt to such changes.

Other risks facing the apparel industry is the intensified competition within the US and European markets, where fast fashion companies such as H&M and Zara are increasing their presence. A vast majority of

88 A&F’s revenue is attributable to the US market, and as a result, the risk associated with the increased competition in the US is considered moderate. The increased competition is introducing a new and more agile business models, such as fast fashion, which forces apparel companies to become more agile and respond quicker to changing customer preferences.

The apparel industry is a very cyclical industry with a significant amount of the sales occurring during the fourth quarter, in relation to Christmas. Furthermore, extreme weather conditions and changes in weather patterns can seriously affect customer purchase patterns, store traffic and the profitability of the business, as failure to sell certain weather dependent apparel might lead to severe markdowns. As a result of these two factors, we asses A&F’s business to be fairly dependent on both seasonality and more sudden changes to the weather, as was observed during fiscal 2016, when sales fell due to a disappointing Christmas campaign. This must therefore be reflected in A&Fs risk profile.

In addition to the above discussion it also possible to evaluate A&F’s risk by evaluating its Beta, to get an indication of its current and historical volatility in relation to an appropriate market portfolio. To ensure that individual occurrences don’t affect our Beta estimate, we have measured A&F’s Beta during a period of between 1-10 years. Furthermore, we have chosen to look at 1, 3, 5 and 10-year Beta’s in order to see how A&F’s volatility, in relation to the apparel industry, has changed during different time periods. A&F has been evaluated against the S&P 500 Apparel Retail Index in order to evaluate its riskiness, compared to the industry. This index has been chosen as we in collaboration with Tommy Greisen, have established that a normal leverage is around 50% for the apparel industry. We are therefore interested in seeing if A&F would be more or less risky in comparison to the industry they operate in. As seen in appendix 6, A&F’s beta against the aforementioned index for a 3-10 years’ period ranges between 1,176-1,275, while its one-year beta is remarkably higher at 1,563. In order to understand what beta is the most accurate it is important to understand that the apparel industry has been going through major changes the last 2-3 years, and that many “traditional” retail companies are now struggling. As described in our company presentation, A&F is currently struggling to adapt to these changes, which is why a higher beta might not be temporary and might reflect its true riskiness, compared to its industry. After dialogue with Tommy Greisen, we have decided that a realistic estimate must lie between the 3-10 years and 1 year betas.

All the betas for A&F lie above 1, which gives us an indication of that they are more volatile than the overall apparel industry, as well as the overall market. This since the apparel industry as a whole has a beta of 1 compared to the world market index (Stern, 2017). This finding, together with the above mentioned factors gives us an indication that A&F is more sensitive to changes in the market, and as a result more cyclical than its peers and should be associated with a higher risk profile.

89 Another very important factor, which cannot be left out when evaluating A&F’s risk profile, is its weak financial performance during the last 5 years. With failed cost saving programs and failure in attracting millennial customers to its stores, A&F has experienced a constant decline in its like for like sales, thus affecting its margins, among other things due to increased price reductions, and consequently also its bottom line result. More importantly, is A&F’s FCF, which although has been positive, has been very volatile and unpredictable. A factor which in the end is one of the most important factors in determining how much leverage a PE fund will be able to obtain from a bank for the acquisition of A&F (Greisen, 2017).

As can be seen in figure 22, debt is now constituting just below 50% of the total deal multiple, and the Debt/EBITDA multiple is currently at a level of 3,5x. However, this number only gives us an indication of the median multiple given to companies, which all has different risk profiles. Given the information discussed above, we are assessing A&F to have a riskier profile than its peers and thus, it is assumed that a PE firm will be able to obtain a lower leverage level than this. As discussed with Tommy Greisen, it is further assumed that only senior debt will be raised, due to the fact that lower tranches has been both more expensive and difficult to obtain, and as figure 22 shows, the senior tranche only amounts to 2,7x EBITDA. Based on the above given information about median leverage multiples together with the individual risk profile of A&F, a Debt/EBITDA multiple of 2,21x has been established for the acquisition of A&F, which amounts to a leverage percentage of 40% of the EV.

Figure 22 - Compiled by the authors with data from PitchBook 1.6x

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2012 2013 2014 2015 2016 2017

Senior and Non-Senior debt multiples

Senior Debt Non-Senior Debt Debt/EBITDA

90 When determining the debt level, there are multiple factors that has to be taken into consideration, as seen above, which makes the estimated of debt level exposed to uncertainties. As a result of this, and due to the fact that the leverage set for an LBO has a significant impact on the final return, a sensitivity analysis will be made in section 15, to evaluate the set debt levels impact on the IRR.