Potential Buyer: Financial Investor

In general, financial buyers (also known as financial sponsors) are referred to as private equity (PE) firm, venture capital firms, and other investment funds or vehicles (Pearl & Rosenbaum, 2013). This group of investors can be classified as investors interested in the return they can realize through buying a business.

By nature, the pursuit of return opportunities translates into investing in undervalued companies, provides financial supports, and exits the investment for a profit in within the next 10 years (PwC, 2013; Barber &

93 Goold, 2007). In this thesis, if a financial buyer is identified, the transaction will be measured in the form of an LBO valuation. This will be applied as it is an approach that is used by financial sponsors (primarily PE firms) to acquire a range of businesses, including both public and private companies²⁹ (Pearl &

Rosenbaum, 2013). The foundation for an LBO candidate provides a solid foundation of the investment rationale and investment decision for financial buyers. Consequently, it is therefore assumed that the theoretical attractiveness of an LBO candidate is applicable to all potential financial buyers.

Theoretical Investment Rationale

In short, the key feature of a LBO is the use of debt to finance (leverage) a large portion of the purchase price, where the financial sponsor funds the remaining share with an equity contribution. As such, the ability to leverage the relatively small equity investment is imperative for financial buyers to realize satisfactory returns (Pearl & Rosenbaum, 2013). As a result, a requirement of this approach is the company’s capacity to carry leverage, which corresponds to certain features of a company to service and repay debt.

Pearl & Rosenbaum (2013) presents the key characteristics of a strong LBO candidate as:

▪ Low CAPEX requirements

▪ A strong asset base

▪ Leading and defensible market position

▪ Growth opportunities

▪ Efficiency enhancement opportunities

▪ Proven management team

These characteristics reflect different aspects of an attractive LBO investment. Strong asset base and cash flow generation as well as factors that support cash flow generation (such as low CAPEX requirements, growth in top-line, competitive advantages) represent the company’s ability to support larger quantities of debt (service periodic interest rate payment and debt reduction over time). Others, such as proven management team and efficiency enhancement opportunities, refer to the capability to operate under a highly-leveraged capital structure and a strong fundamental business model (if not, sponsors seek to improve operations and thereby generate cost savings) (Pearl & Rosenbaum, 2013). In aggregate, the higher the company “score” in these categories, the greater opportunity to handle leverage and less need to reduce organisational slack, thus increased attractiveness as a LBO candidate.

Moreover, Kaplan and Ströberg (2009) identify three different classes of internal value increasing actions that financial sponsors tend to focus on: financial engineering, governance engineering and operational engineering. In common, these actions share the features of either untapped growth potential or vast organisational inefficiencies that can be solved by bigger incentives, pressure from leverage, active corporate

29 This is by no means an exclusive valuation method. Financial buyers are involved in a variety of other deal structures as well. Further, the mechanics of the LBO valuation method will be elaborated upon if applied.

94 governance or by adding industry and operating expertise. Research on what private equity investors look for show that most focus is placed on the company’s business model, the competitive position in the market and they see the management team, the investors ability to add value the valuation of the company of approximately equal important (Gompers, Kaplan and Mukharlyamov, 2015). In terms of value creation, Gompers et al., (2015) identify the most important source as increasing revenue, while reducing costs is identified as a secondary source in 36% of the deals before investment.

Volvo – The Case

Based on the investment rationale outlined above, this section will evaluate whether Volvo make an attractive LBO candidate.

Volvo is currently transitioning out of the most investment intense phase in its history, with a CAPEX to NOPLAT ratio averaging at approximately 5:1 over the past three years. Further, the automotive industry is very capital intensive, especially with regards to R&D. Consequently, and as recognised in the forecasts, though CAPEX is expected to some extent level out, continued investments is required to keep up with competitors. However, noteworthy is that, during the same period the top-line grow substantially, profitability increased and positive cash flows were generated. Yet, the growth in operating profit corresponds to a two-year CAGR of 86%, so even though the development is positive, cash-flow volatility is high. Going forward, it is estimated that Volvo’s ability to generate positive cash flows increase, with the caveat of the uncertainty regarding heavy investments.

A contributing factor to the volatility of cash flows is the company’s relatively small market share. With just over half a million cars sold in 2016 compared to the total sales of 62 million, the company appears insignificant. Yet, the company possess qualities, such as recognized brands, products, and product innovations, that likely both retain and attract new customers. These features are one the company’s competitive advantages that potentially increases the stability, or the predictability, of cash flows. However, as financial sponsors are seeking a target with a secure market position, this is arguably an unlikely conclusion in this case. Nevertheless, as a manufacturing company, the book value of PP&E makes about one third of total assets. The feature of a solid asset base benefits investors as it could be pledged as collateral against a loan.

Since the company was acquired by Geely and Li Shufu, a strategic plan has been formed and executed yielding a significant improvement of the company’s overall performance. As such, the management team has arguably proven itself competent and very likely capable of handling a high leverage. Further, the company has recently appointed several new members to their board of directors that are external to the majority owner. The newly appointed members bring key expertise in international business operations and

95 technological development ³⁰. Thus, the benefits to increased corporate governance and expertise contribution from a financial buyer is limited, if not, redundant.

In terms of efficiency enhancement opportunities and lowering costs, the company is still in an expansionary stage of their strategy, thus stepping in as an owner to decrease organisational slack is arguably the wrong focus and might harm the company’s future prospects. With respect to recent and future growth, the transition into the premium segment fit the current consumer trends well. Increasing demand for larger and more secure vehicles, at the same time as environmental issues and concerns is very present, the company’s product portfolio display promising signs.

In conclusion, financial buyers value the business based on the current and future expectations of cash flows of the company, as they perceive it at the time of an acquisition. Critical is the ability to heavily leverage the business. With a standard practice of buying businesses, which is then steered through a transition that aim to rapidly improve performance and sold within a short to medium-term period, there is is likely more to wish for. Volvo’s volatility in cash flow and uncertain market position, as well as large investment needs, decreases the attractiveness of leveraging the firm even though it operates in an otherwise and mature industry. Additionally, there are limited operational benefits to a transaction. As a result, Volvo is not considered an attractive LBO candidate, thus, a financial buyer is deemed an unlikely exit strategy and will not be developed further.