Furthermore, it has a stable revenue history that has had an extraordinary amount of consecutive growth. Additionally, Hertz has built a great deal of brand equity worldwide; especially in regards to the airport services they provide. All of this makes Hertz an ideal candidate for a leveraged buyout. The interesting aspect to this case is how the dual-track process was structured. Ford must have known that their subsidiary would have been a prime target for a leveraged buyout and gained enough confidence to put the pressure of the IPO option as an incentive for potential investors to move quickly.
However, even if no investors emerged to acquire Hertz, it is also reasonable to suspect that Hertz would have fared well in the IPO. Yet, in the event that Hertz was sold through an IPO, there is a substantial amount of risk involved. Ford would have been subjected to whatever the market deemed the appropriate price for the stock was. Therefore, from their perspective, they had to juggle potential LBO offers with their prediction of what the company would have commanded in the marketplace. Hertz was a prime buyout target for a LBO because the company meets many of the classic criteria for a successful LBO target.
It has an extremely strong brand name which consumer markets all over the world have come to know. It was actually listed among Business Week’s top 100 most valuable brands in 2005. Additionally it is one of the top three competitors in the rental car (RAC) market and commands a fair amount of market share. It dominates the airport rental segment and is estimated to hold roughly eighty percent of this market place. Hertz has relatively low existing debt obligations and has a long history of stable growth. This is one of the most important considerations for a successful LBO.
It wouldn’t make sense for a company to accept large amounts of risk due to the lack of a stable financial history given the specific set of challenges that are present in a LBO purchase. If a company makes an acquisition through an LBO and the company isn’t successful then this makes for a horrific and complicated bankruptcy filing. However, given the financial stability that Hertz was described as having in the case it is reasonable to suspect that the company is a prime LBO target. In fact the bidding companies were predicting an IRR of 41. 09% .
Such an IRR would easily double the market average and therefore Hertz represents a rather safe and profitable acquisition. The bidding group was willing to pay $2. 3 billion for Hertz. We used this offer price to calculate an IRR on the deal of 41. 09% as seen in Exhibit 2. In calculating the terminal value, we used the exit multiple approach due to the fact that this deal is an LBO. The sponsor of an LBO usually will sell the target in about five years, so it is more common to use the exit multiple approach than to use the perpetuity growth approach in calculating the terminal growth for an LBO.
We found the terminal growth by taking an average of comparable Enterprise Value/EBITDA multiples for both the car rental business and the equipment rental business, then multiplied the Gross EBITDA in 2010 (the final year) for each by these average multiples to find a terminal value of each, and then combined the two to find a total terminal enterprise value of $27. 35 billion. We then subtracted the long term debt in 2010 from this value to find the equity terminal value, which would be the selling price after five years. The terminal value calculation can be found in Exhibit 3.
We then used the equity terminal value and the estimated unlevered cash flows to capital to find the IRR. If the Carlyle Group was seeking a return of 20%, they could actually offer more money for Hertz – they could offer about $5. 2 billion and still achieve a return of 20%. In calculating IRR, we also calculated an estimated WACC for Hertz. We did not use WACC and the perpetuity growth approach because calculating WACC was based on too many estimates due to the fact that Hertz did not trade publicly as its own entity, and therefore the exit multiple approach was more reliable.
Our estimate of WACC, as shown in Exhibit 4, was calculated to be 8. 10%. In calculating the required rate of return on equity, we had to consider what to use for the market return, the risk-free rate, and beta. We estimated the market return by using the S&P 500 market return at the time of the valuation in August 2005 of 12. 56%. Our risk-free rate was based on the 5-year treasury bond rate, which we felt was appropriate for a five year project. Finally we used the unlevered average beta of comparables of 0. 6, and relevered the beta at Hertz’s projected leverage, which resulted in a beta 3. 8.
This is an extremely high beta, but the LBO would make Hertz highly leveraged, therefore subjecting it to much higher risk. The required rate of return on equity was calculated to be 30. 98%. The return on debt was estimated using the corporate rate on BBB bonds of 5. 98%. As Hertz was not publically trading shares, it was hard to estimate a market value of equity. We used the equity value from 2005 on the pro forma balance sheet of $2. 3 billion as this is the price the Carlyle Group was willing to pay for equity, and we felt this was a fair estimation of the market value of equity.
The book value of debt was taken to be the total long-term debt on the pro forma balance sheet. All these assumptions computed a WACC of 8. 10%. Because our estimations were not very solid, we felt it was more reliable to use the exit multiple approach in calculating the terminal value. There was several possible value enhancing opportunities that were identified. One such possibility deals with the equipment rental market. This subsidiary of Hertz primary operations has many unique possibilities. For example, Hertz is mentioned to be the third largest player in the equipment rental business already.
Therefore, it could use its brand power to continue to try to exploit this particular market segment. Thus, Hertz could focus on the airport RAC market for stability while continuing to develop market share in this segment. The nature of the equipment rental market is highly fragmented and as a result there may be opportunity to gobble up smaller competitors and dominate this market as well. However, on the other hand, the equipment rental business could also be spun off and sold to help finance the LBO if needed.
Therefore there seems to be a lot of potential in the equipment sector that could be used for a variety of goals. In valuating Hertz, the bidding group had to make several assumptions in preparing the pro forma financial statements. One of these assumptions was a projected transaction of 6. 9% in 2005. This assumption is reasonable because the market trend seems to be favorable in the near future as air travel was finally rebounding post-9/11. Another assumption made is that it was possible to achieve $400 to $600 million in annual EBITDA savings by 2009.
These assumptions were based off the facts that current adjusted EBITDA margins were below 2000 levels and below those of Avis, meaning that there is potential to improve EBITDA margins. Additionally, Hertz RAC could reduce its non fleet capital expenditures as a percentage of sales, reduce Europe RAC’s SG&A expenses, and improve its return on assets. All of these support the assumption that there were significant cost savings potential for Hertz. They also assumed a 4. 5% terminal growth rate for car-rentals, while equipment rentals were assumed to stabilize at 3%.
It would be reasonable to assume a lower terminal growth rate for equipment rental as the market is more volatile than that for car rentals. Ultimately, assumptions for increase in sales and cost savings are the ones most likely to affect returns because returns are heavily driven by EBITDA. The case also mentions that Ford’s management style in regards to Hertz was rather lax and hands-off. Therefore there seems to be other opportunities for value creation in the operations of the company. Compared with other firms in the same industry such as Avis, Hertz seems to have substantial opportunities to increase margins.
It was stated that Hertz’s expenses grew at a rate that greatly exceeded its revenue generation. Also, Hertz’s assets lagged some of its major competitors which would indicate an insufficient use of capital. It seems evident that Ford’s hands off approach to Hertz would offer new management several opportunities to create both efficiencies and higher margins. The primary difference in selling a subsidiary to a private equity firm as opposed to taking the company to the market through an IPO is that when selling to a private equity firm the seller will have more control and more security over the negotiations and the terms of the deal.
Yet, at the same time, it is likely that both parties have some estimation of what the company would bring through the market offering that they would use as a baseline for part of their bargaining position. In this case both options were present which undoubtedly made for a complicated negotiating environment. For example, if the Bidding Group wasn’t content with Ford’s offers, then it could pull back and let Ford go to the market. However, Ford would presumably like to avoid going to the market which would add an incentive for them to try to negotiate.
Furthermore, with the presence of other potential buyers, this only adds to complicate the dynamic. Form Ford’s position though, they have a good estimation of what the company would bring in the market. This gives them a point of reference in the negotiations in which they can attempt to increase their value through a sale to a private equity firm. Furthermore, this direction would also add significant amounts of security and reduce risks since the terms of the deal would be completely transparent. Ford’s decision to use the dual-track process definitely makes for an interesting negotiating environment.
To be able to get an enterprise value, we must first determine the segment value individually as there are two division of the company, car and equipment segment. In order to do so, we started to find the multiples by taking an average of the Enterprise/EBITDA multiples of the Hertz competitor. The multiple for the Car rentals (RAC) is 7. 04 and equipment rental (HERC) is 6. 55. As shown in exhibit 1; The RAC operating value is simply the adjusted EBITDA multiplied by RAC multiple which gives us a value of $6,008 million ($853. 4 * 7. 04).
The RAC Fleet value is determine by subtracting the Required Fleet Equity which is $10,868 million from the Fleet book value which is 13% of its book value which give us a RAC Fleet value of $9,455 billion ($10,868 billion - $1,413 billion). We used 13% as the fleet equity requirement was assume to have an average of 13% of the book value fleet. We then sum the RAC operating value with the net book value of fleet to give us the total RAC segment value of $15,463 billion. The HERC segment value is determine by multiplying the HERC gross EBITDA and its multiple which gives a value of $5,302 billion ($809. billion x 6. 55).
From this we can derive Hertz enterprise value by summing up the two segments, which gives us a value of $20,765 billion. It is clear that Hertz has much potential value and would provide positive synergies if the bidding group was able to achieve the estimated EBITDA savings and create more value for Hertz. Its current offer price of $2. 3 billion is somewhat low, and the Carlyle Group should increase their offer to $5. 2 billion in order to provide a more attractive offer to Hertz, which could revert to an LBO if the offer price is not high enough, while still achieving a 20% return.