02. LBO

Question 1

What is private equity?

Answer 1

In general, private equity is equity capital that is not quoted on a public exchange.

• Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity
• Capital for private equity is raised from retail and institutional investors, and can be used to (1) fund new technologies, (2) expand working capital within an owned company, (3) make acquisitions, (4) or to strengthen a balance sheet.

Question 2

What is a LBO fund? What are its characteristics?

Answer 2

A financial buyer that raises capital from investors to purchase companies with a small amount of equity and uses a significant amount of borrowed money (loans and bonds) to fund the remainder of the acquisition cost in order to boost IRR

(1) Short-term investment (intend to exit 3-7 years)
(2) High level of debt
(3) Assets of the target company are used as collateral for loans
(4) Delever (pay down) with target company’s cash flow
(5) Exit the investment ideally with little or no debt leftover; LBO fund collects higher percentage of exit sale price and/or uses the excess cash flow to pay themselves a dividend

Question 3

What does a PE firm do?

Answer 3

(1) Create fund
(2) Find target
(3) Structure deal
(4) Obtain financing
(5) Unlock value
(6) Exit the investment

Question 4

Why lever up a firm?

Answer 4

(1) By using leverage to help finance the purchase price, private equity fund reduces the amount of money that must be contributed, which can substantially boost returns upon exit
(2) Frees up remaining capital to be used to make other investments
(3) Interest payments on debt are tax deductible - can substantially reduce effective tax rate

Question 5

Strategic acquirers tend to prefer to pay for acquisitions with cash. If that is the case, why would a private equity fund want to use debt in a LBO?

Answer 5

These are two different scenarios because:

(1) Private equity funds do not intend to hold the company for the long-term and thus, are less concerned with the “expense” of cash versus debt. They are more concerned with using leverage to boost its returns by reducing the amount of capital it has to contribute up front
(2) In a LBO, the “debt” is owned by the company so they assume the majority of the risk (i.e. the target company’s assets are used as collateral). In a strategic acquisition, the buyer owns the debt so it is more risky for them

Question 6

What is a hedge fund?

Answer 6

An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

Question 7

What are the main differences between private equity and hedge funds?

Answer 7

Both private equity funds and hedge funds are lightly regulated, generally private firms targeting high net worth and institutional investors. Both types of funds are paid an annual management fee (~2%) as well as a performance fee (~20% of gains).

(1) Time horizon. Private equity firms typically invest in longer-term, illiquid assets with the intent to buy, grow and exit these portfolio companies in three to seven years. Hedge fund investments are typically much more liquid and shorter in duration, lasting anywhere from milliseconds to years.
(2) Control. Private equity funds typically make highly concentrated investments by purchasing whole companies. Hedge funds typically make a broader set of short-term investments by purchasing minority stakes in securities (e.g. equities, bonds, derivatives, futures, commodities, foreign exchange, swaps, etc)
(3) Strategy. Private equity funds generally work closely with management to improve operations in order to make the company more valuable. Although hedge funds use many different strategies (long/short equity, credit, macro, arbitrage, etc), many hedge funds prefer to stay in relatively liquid securities so that they can trade out at any point in time in order to lock in their profits
(4) Fee structure. The main difference is that hedge funds tend to take out their performance fees every quarter or every year, whereas private equity funds do not get paid until their investments are exited. This can mean that no performance fees are taken for 5 years or more

Question 8

What is IRR? What is the formula for calculating the IRR of a LBO?

Answer 8

IRR is the discount rate that makes the net present value of all cash flows from a particular project equal to zero. IRR is a measure of the return on a fund’s invested equity.

Generally speaking, the higher a project’s IRR, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.

CAGR = [(end equity / beg equity) ^ (1 / years)] – 1

Question 9

What is the hurdle rate?

Answer 9

Minimum required IRR. Historically, the hurdle rate for most private equity funds was around 30% but it may be as low as 15% to 20% in adverse economic conditions

*Note that larger deals tend to have lower hurdle rates

Question 10

Run me through the changes between the existing balance sheet and the pro forma balance sheet in an LBO model.

Answer 10

(1) Deduct cash used in transaction
(2) PP&E Step-up
(3) Newly Identified Intangibles
(4) New Goodwill
(5) Capitalized financing fees
(6) New debt + repayment of old debt if any
(7) Deferred tax liability
(8) New common equity

Question 11

Walk me through an LBO analysis.**

Answer 11

(1) Transaction assumptions (sources and uses)
- Entry multiple and purchase price
- Financing (leverage levels / cap structure)
- Interest rates on debt tranches
- Equity contribution (uses less other sources of financing)

(2) Pro-forma target balance sheet to reflect transaction and new cap structure
- Add new debt, wipe out shareholders’ equity
- Replace with equity contribution
- Adjust cash
- Capitalize financing fees
- Plug goodwill / intangibles

(3) Integrated cash flow model
- Operating assumptions (e.g. revenue growth, margins)
- Pro-forma income statement, balance sheet, statement of cash flows
- Projected available FCF per year
- Required debt repayment each year

(4) Exit assumptions
- Time horizon of investment
- EBITDA exit multiple
- Dividend recapitalization
- Calculate equity returns
- Sensitize results

*Absent dividends or additional equity infusions, the IRR equals the average annual compounded rate at which the PE firm’s original equity investment grows (to its value at the exit).

Question 12

Let’s say you run an LBO analysis and the private equity firm’s return is too low.
What drivers to the model will increase the return?**

Answer 12

Some of the key ways to increase the PE firm’s return (in theory, at least) include:

(1) EBITDA/Earnings Growth – links to value creation by creating a higher implied exit price and higher cash flow, which can lead to higher dividends and quicker debt repayment
- Organic revenue growth
- Acquisitive revenue growth
- Cost cutting (thus, improved margins)
- Reduced taxation
- Reduce operating leverage (lower fixed costs, higher variable costs)

(2) FCF Generation / Debt Paydown – quick debt paydown with excess cash decreases risk and increases proceeds to equity holders
* Note: operational improvements (e.g. working capital management) increases cash flow available for debt repayment

(3) Multiple uplift – simple arbitrage between the purchase multiple and sale multiple
- Negotiate lower entry multiple
- Increase exit multiple (even with the same earnings, if market conditions become favorable and/or risk decreases, a higher sale price results from a higher multiple)

(4) Increased Gearing – increase in interest-bearing debt, which can amplify the gains (and losses) to equity holders
- Conservative leverage reduces equity contribution and boosts returns

*Note: increased gearing also increases the amount of financial stress on the company being acquired and increases bankruptcy risk

Question 13

What are ways to increase the exit multiple?

Answer 13

While we cannot always rely on multiple expansion because it is difficult to control the market, decreased risk results from

(1) Reaching a greater size
(2) Reducing debt
(3) Diversifying the offering
(4) Increasing customer/supplier fragmentation
(5) Implementing exclusive arrangements and contracts
6) Anything else that may lead to more stable earnings.

Question 14

What are the three ways to create equity value?**

Answer 14

1) EBITDA/earnings growth, 2) FCF generation/debt paydown, and 3) multiple expansion.

Question 15

What are the potential investment exit strategies for an LBO fund?**

Answer 15

(1) Sale (to strategic or another financial buyer)
(2) IPO
(3) Recapitalization (releveraging by replacing equity with more debt in order to extract cash from the company)

Question 16

Advantages of LBO financing?**

Answer 16

(1) As the debt ratio increases, equity portion shrinks to a level where one can acquire a company by only putting up 20 to 40 percent of the total purchase price.
(2) Interest payments on debt are tax deductible.
(3) By having management investing, the firm guarantees the management team’s incentives will be aligned with their own.

Question 16

What are some characteristics of a company that is a good LBO candidate?**

Answer 16

The most important characteristic is steady cash flows, because sponsors need to be able to pay off the relatively high interest expense each year.

(1) Strong/predictable CFs – used to pay down acquisition debt
(2) Profitability and limited business risk (e.g. mature, steady, non-cyclical industry; strong, defensible market position w/ high barriers to entry to make cash flows less risky)
(3) Strong management team
(4) Clean balance sheet with low gearing
(5) Low ongoing investments (e.g. capex and R&D requirements)
(6) Limited working capital requirements
(7) Synergies and potential for cost structure reductions
(8) Strong tangible asset that can be used as collateral to raise more debt
(9) Undervalued
(10) Viable exit strategy
(11) Divestible assets

*Note: PE is all about backing a great management team and helping to drive a great business to abnormally high value

Question 17

What is a good framework for an investment memorandum?

Answer 17

(1) Investment thesis / recommendation (make a decision either way)
(2) Investment positives / major risks
- Five major points
- Mitigating factors
(3) Industry analysis
(4) Company analysis
(5) Key model drivers
(6) Financial summary
- Deal structure
- FCF
- Credit stats
- Multiples
- Returns
- Sensitivities
(7) Areas for further due diligence

Question 18

What is an offering memorandum?

Answer 18

Legal document stating objectives, risks and terms of investment involved with private placement

Includes: financial statements, management biographies, detailed business description

Question 19

If I handed you an offering memorandum, what are some of the things you’d think about?**

Answer 19

(1) Industry analysis: You’d examine at the industry, look for growth opportunities and question whether the sponsor and/or management could capitalize on those opportunities.
(2) Company analysis: You’d try to understand the business as much as possible, especially in operational points like capex, working capital needs, margins, customers, etc.
(3) Valuation: You would think about how you would value the company; areas to unlock value?
(4) Good investment? You would consider if the target meets your criteria for a good LBO candidate
(5) Deal structure: You would wonder what would be appropriate capital structure, and whether it is achievable in the current markets.
(6) Most importantly, you’d think about all the potential risks.

Question 20

Walk me through S&U?**

Answer 20

Uses: amount of money required to effectuate the transaction

• Purchase of the company, either of the assets or shares
• Purchase of the target’s options
• Refinancing debt
• Financing fees and transaction costs (banker and lawyer fees)

Sources: from where the money is coming

• Excess cash used in transaction
• Tranches of debt (revolver, bank debt, mezzanine preferred stock, subordinated notes, mezzanine debt, seller notes, preferred stock)
• Proceeds from options exercised at the target
• Sponsor equity (uses less all other forms of financing)

*Note: amount of debt issued is dependent on state of capital markets and other factors

Question 21

What is a revolving credit facility and what are its characteristics?

Answer 21

• Unfunded Revolver = form of senior bank debt that acts like a credit card for companies and is generally used to help fund a company’s working capital needs
• A company will “draw down” the revolver up to the credit limit when it needs cash, and repays -the revolver when excess cash is available (there is no repayment penalty).
• Offers companies flexibility with respect to their capital needs, allowing companies access to cash without having to seek additional debt or equity financing.

Costs:

(1) Interest rate charged on the revolver’s drawn balance
- LIBOR plus a premium that depends on the credit characteristics of the borrowing company.

(2) Undrawn commitment fee
- Compensates the bank for committing to lend up to the revolver’s limit
- Usually calculated as a fixed rate multiplied by the difference between the revolver’s limit and any drawn amount

Question 22

What is bank debt and what are its characteristics?

Answer 22

Bank debt is a lower cost-of-capital (lower interest rates) security than subordinated debt, but it has more onerous covenants and limitations.

(1) Typically 30-50% of cap structure
(2) Based on asset value as well as cash flow
(3) LIBOR based (i.e. floating rate) term loan depending on credit characteristics of borrower
(4) 5-8 year payback or maturity with annual amortization often in excess of that which is required (4-5 years)
(5) 2x – 3x LTM EBITDA (varies w/ industry, ratings, and economic conditions)
(6) Secured by all assets and pledge of stock
(7) Maintenance and incurrence covenants

• Note: existing bank debt of a target must typically be refinanced with new bank debt due to change-of-control covenants
• Note: depending on the credit terms, bank debt may or may not be repaid early without penalty
• Note: generally no minimum size requirement
• Use if company is concerned about meeting interest payments and wants to lower cost option
• Use if company is planning major expansion / capex and does not want to be restricted by incurrence covenants

Question 23

What forms does bank debt usually take?

Answer 23

(1) Revolver
(2) Term Loan A – shorter term (5-7years), higher amortization
(3) Term Loan B – longer term 95-8years), nominal amortization, bullet payment
- Allows borrowers to defer repayment of a large portion of the loan, but is more costly to borrowers than Term Loan A.

Question 24

What are incurrence and maintenance covenants?

Answer 24

• Incurrence: Covenants generally restrict a company’s flexibility to make further acquisitions, raise additional debt, and make payments (e.g. dividends) to equity holders.
• Maintenance: financial maintenance covenants, which are quarterly performance tests, and is generally secured by the assets of the borrower.

Question 25

What is high-yield debt (sub notes or junk bonds) and what are its characteristics?

Answer 25

High-yield debt is so named because of its characteristic high interest rate (or large discount to par) that compensates investors for their risk in holding such debt. This layer of debt is often necessary to increase leverage levels beyond that which banks and other senior investors are willing to provide, and will likely be refinanced when the borrower can raise new debt more cheaply.

(1) Typically 20-30% of cap structure
(2) Generally unsecured
(3) Fixed coupon may be either cash-pay, payment-in-kind (“PIK”), or a combination of both
(4) May be classified as senior, senior subordinated, or junior subordinated
(5) Longer maturity than bank debt (7-10 years), with no amortization and a bullet payment
(6) Incurrence covenants

Question 26

What are the advantages of subordinated debt?

Answer 26

(1) A company retains greater financial and operating flexibility with high-yield debt through incurrence, as opposed to maintenance, covenants and
(2) Greater flexibility due to a bullet (all-at-once) repayment of the debt at maturity.
(3) Early payment options typically exist (usually after about 4 and 5 years for 7- and 10-year high-yield securities, respectively), but require repayment at a premium to face value.

Question 27

What is cash-pay vs PIK?

Answer 27

Cash-pay means that coupon is paid in cash, like the interest on bank debt.

PIK means that the issuer can pay interest in the form of additional high-yield debt, so as to increase the face value of the debt that must ultimately be repaid.

*Note: Sometimes, high-yield debt is structured so that the issuer may choose between cash-pay and PIK (the PIK option is usually more attractive to the issuer). Also, the mezzanine debt may be structured so that the PIK option is available for the first few years of the debt’s life, after which cash-pay becomes mandatory.

Question 28

What is the minimum high-yield debt amount?

Answer 28

Public and 144A high yield offerings are generally $150mm or larger; for offerings below this size, assume mezzanine debt. In some case, it may be appropriate to include warrants such that the expected IRR is 17-19% to the bondholder

Question 29

What is mezzanine debt and what are its characteristics?

Answer 29

The mezzanine ranks last in the hierarchy of a company’s outstanding debt, and is often financed by private equity investors and hedge funds. Mezzanine debt often takes the form of high-yield debt coupled with warrants (options to purchase stock at a predetermined price), known as an “equity kicker”, to boost investor returns to acceptable levels commensurate with risk.

(1) Can be preferred stock or debt
(2) Convertible into equity
(3) IRRs in the high teens to low twenties on 3-5 year holding period

The debt component has characteristics similar to those of other junior debt instruments, such as bullet payments, PIK, and early repayment options, but is structurally subordinate in priority of payment and claim on collateral to other forms of debt. Like subordinated notes, mezzanine debt may be required to attain leverage levels not possible with senior debt and equity alone.

*Note: For example, regular subordinated debt might have an interest rate of 10%, while a hedge fund investor expects a return (IRR) in the range of 18-25%. To bridge this gap and attract investment by the hedge fund investor, the borrower could attach warrants to the subordinated debt issue. The warrants increase the investor’s returns beyond what it can achieve with interest payments alone through appreciation in the equity value of the borrower.

Question 30

What are seller notes and what are their characteristics?

Answer 30

A portion of the purchase price in an LBO may be financed by a seller’s note.

In this case, the buyer issues a promissory note to the seller that it agrees to repay (amortize) over fixed period of time. The seller’s note is attractive to the financial buyer because it is generally cheaper than other forms of junior debt and easier to negotiate terms with the seller than a bank or other investors. Also, the acceptance of a seller’s note by the seller signals the seller’s faith and confidence in the business being sold.

However, seller financing may be unattractive to the seller because the seller retains the risks associated with the business without having any control over it. Moreover, the seller’s receipt of proceeds from the sale is delayed.

Question 31

What are the typical credit stats of an LBO?

Answer 31

Total Debt / EBITDA = 4.5x – 5.5x
Senior Bank Debt / EBITDA = 3.0x
EBITDA / Interest Coverage = > 2.0x
(EBITDA – Capex) / Interest Coverage = > 1.6x

Question 32

Why do PE multiples and EBITDA multiples yield you different valuation results? Why use EBITDA multiples instead of PE multiples?**

Answer 32

EBITDA multiples represent the value to all stakeholders, while the PE multiples only represent the value to equity holders. Three reasons to use EBITDA for an LBO are: 1) it can be used for firms reporting losses, 2) it allows you to compare firms regardless of leverage, and 3) because it represents operational cash flow.

Question 33

What are the ways in which a company can spend available cash/FCF?**

Answer 33

(1) Pay down debt
(2) issue dividends
(3) buy back stock
(4) invest in the business (capital expenditures)
(5) engage in acquisitions

Question 34

Given that there is no multiple expansion and flat EBITDA, how can you still generate a return?**

Answer 34

(1) Leverage
- Improve tax rate
- Pay down debt
- Reduce interest
(2) Dividends
(3) Reduce capex
(4) Reduce working capital requirements
(5) Depreciation tax shield

Question 35

What is the different between bank loan and high-yield debt covenants?**

Answer 35

Bank loans are more strict. For looser covenants, high-yield debt is rewarded with higher interest rates.

Covenants can restrict economic activities, finance activities or accounting measurements.

(1) Economic: include sale of assets, capex, changes in corporate structure
(2) Finance: include issuance of additional debt and payment of cash dividends
(3) Covenants often track accounting measurements, such as interest coverage, current ratios, minimum EBITDA.

Question 36

What determined your split between bonds and bank in the deal? **

Answer 36

Typically, you’d like as much bank debt as possible because it’s cheaper than regular bonds. However, this is dependent on a few factors including

(1) How much a bank is willing to loan
(2) Negotiation of the agreements/covenants that they can live with
- The more senior the debt, like the bank debt, the more restrictive it tends to be
- Bank debt also usually requires collateral to be pledged
(3) Timeline of debt payback needs to evaluated
- Bank debt usually has a shorter maturity, so the bank needs to ensure that the company will be able to face its liabilities when due or else face bankruptcy

Question 37

If there is a higher growth capex proportion of total capex, would you still want to use same split?**

Answer 37

Growth capex is more favorable than maintenance capex. It’s flexible; maintenance capex needs to be paid every year just to keep the company running, whereas growth capex can be stalled in times of downturn. Also, growth capex implies investments, which yield higher cash flows in the future, that can be used to support more debt.

Question 38

Which valuation will be higher or lower, all else the same? DCF or LBO?**

Answer 38

LBO is lower, as it’s discounted at a higher cost of equity.

Question 39

Assume the following scenario: EBITDA of $10 million and FCF of $15 million. Entry and exit multiple are 5x. Leverage is 3x. At time of exit, 50 percent of debt is paid down. You generate a 3x return. 20 percent of options are given to management. At what price must you sell the business?**

Answer 39

To make a 3x return based on the financial parameters, you must sell the business at $90 million. You know the EV is EBITDA times entry multiple: $10 million * 5x = $50 million. Debt is equal to EBITDA times leverage: $10 million * 3x = $30 million. EV minus debt equals equity: $50 million - $30 million = $20 million. Debt needs to be paid down by half or $30 million * 50% = $15 million. To make a 3x return, sponsor equity needs to grow to $20 million * 3x = $60 million. Since management receives 20 percent of the equity in options, the total equity needs to grow to $60 million/(1 – 20%) = $75 million. Since your ending debt is $15 million and ending equity is $75 million, the EV at exit is $90 million.

Question 40

If you have a company with a P/E of 10x and cost of debt of 5 percent, which is cheaper for an acquisition?**

Answer 40

Debt. The cost of equity is approximately the inverse of P/E so 1 / 10x = 10 percent. The cost of debt at 5 percent is lower, and, therefore, cheaper.

Question 41

Would you rather have an extra dollar of debt paydown or an extra dollar of EBITDA?**

Answer 41

You would rather have the extra dollar of EBITDA because of the multiplier effect. At exit, the EV is dependent on the EBITDA times the exit multiple. An extra dollar of debt paydown increases your equity value by only one dollar; an extra dollar of EBITDA is multiplied by the exit multiple, which results in a greater value creation.

Question 42

You have two investment opportunities: Company A and Company B.
Company A:
Revenue: $100 million
EBITDA: $20 million
Projected annual revenue growth: 5 percent for the next five years
Purchase price: 5x EBITDA/4x Debt and 1x Equity
Company B:
Revenue: $100 million
EBITDA: $20 million
Projected annual revenue growth: 10 percent for the next five years
Purchase price: 6x EBITDA/4x Debt & 2x Equity

Which is the better investment opportunity based on this information? Assume everything about the companies is the same except for what is given in the information, and assume the exit multiple is the same as the entrance multiple.**

Answer 42

Assuming constant EBITDA margins and ignoring compound growth for simplicity, EBITDA for Company A in year 5 will be about $25 million = $20 million * [1 + (5% *5 )], and Company B will be $30 million = $20 million * [1 + (10% *5 )]. You purchased Company A for $100 million = 20 * 5x and Company B for $120 million = 20 * 6x. You sold Company A for about $125 million = 25 * 5x and Company B for about $180 million = 30 * 6x. This creates a profit of $25 million and $60 million, respectively. You invested $20 million of equity into Company A, so your return is 1.25x = $25 million/$20 million, while Company B has a higher return of 1.5x = $60 million/$40 million. Thus you already know Company B is the better investment; also, the higher EBITDA will increase the amount of debt being paid down, which increases the equity return more.

Question 43

A company runs two operating subsidiaries. One sells coffee and one sells doughnuts. You own 100 percent of the coffee subsidiary. You own 80 percent of the doughnut subsidiary. The coffee subsidiary generates $100 million of EBITDA. The doughnut subsidiary generates $200 million of EBITDA. Doughnut companies are worth 5.0x EBITDA. The parent share price is $10 and there are 100 million shares. The company has cash of debt of $500 million and cash of $200 million. What’s the enterprise value to EBITDA multiple for this company?**

Answer 43

The enterprise value is market capitalization plus net debt plus minority interest. Market cap is easily to calculate, shares * share price, so $10*100 million = $1,000 million. Net debt is debt less cash so $500 million - $200 million = $300 million. The question has given you the approximate market value of the minority interest in the doughnut company which is 5.0x EBITDA, so $200 * 5.0x * (1 - 80%) = $200 million. As a side note, when calculating enterprise value for comps, you might take the minority value from the balance sheet. This fine to do in such cases. However, a finance professional always chooses market value over book value, so this question gives you enough information to calculate the market value of the minority interest. Back to the answer: you total this all up for EV, which comes to $1,500 million = $1,000 million + $300 million + $200 million. The total EBITDA is $300 million = $100 million + $200 million. Therefore, the EV/EBITDA multiple is $1,500/$300 = 5.0x.

Question 44

A company has $100 million of EBITDA. It grows to $120 million in five years. Each year you paid down $25 million of debt. Let’s say you bought the company for 5.0x and sold it for 5.5x. How much equity value did you create? How much is attributed to each strategy of creating equity value?**

Answer 44

The purchase price is $500 million = $100 million * 5.0x. It exits at $660 million = $120 million * 5.5x. This is a profit of $160 million, plus you paid down debt of $125 million = $25 * 5, so your total equity value increased by $285 million = $160 million + $125 million. Obviously the $125 million of the total equity value is due to debt paydown. $100 million comes from the EBITDA growth, ($120 million - $100 million) * 5. Finally, the rest of its equity value increase is attributed to multiple expansion, (5.5x – 5.0x) * $120 million = $60 million. Totaling these up, $125 million + $100 million + $60 million is the $285 million of equity value increase that matches what we calculated earlier.

Question 45

Given $100 million initial equity investment, five years, IRR of 25 percent, what’s exit EBITDA if sold at 15x multiple?**

Answer 45

Knowing an IRR of 25 percent over five years is approximately 3.0x equity return (there is no mathematical way of knowing this, so if you don’t know this, try asking the interviewer). The ending equity value is, therefore, $300 million = $3.0x * $100 million, so the exit EBITDA must be $300/15x = $20 million.

Question 46

In an LBO, if cost of debt is 10 percent, what is the minimum return required to break even?**

Answer 46

Since interest is tax deductible, the break-even return is the after-tax cost of debt. Assuming tax rate of 40 percent, the break-even return is 6 percent.

Question 47

You have a company with 3x senior leverage and 5x junior leverage, what happens when you sell a business for 9x EBITDA?**

Answer 47

It’s a de-leveraging transaction because pro-forma the company will have a lower total debt to EBITDA ratio.

Question 48

Same example as above, what happens when you sell the asset for 8x EBITDA?**

Answer 48

On a firm basis, it has a neutral impact, but it is de-leveraging on a senior debt basis.

Question 49

What are the advantages of an LBO?

Answer 49

(1) There is an opportunity to execute long-term strategy outside of the short-term focus of the public markets (examples: acquisitions, cost reductions, capital investments).
(2) Use of levered capital structure to increase equity returns. Debt is tax deductible and private equity firms can put up less equity to purchase a firm.
(3) Private equity firms bring a sense of urgency to the entire business, disciplining the company to quickly seize opportunities.
(4) Incentive compensation schemes align management incentives with the sponsor’s.
(5) The company gets a stable shareholder base of long-term investors.
(6) The company now has the capability to leverage private equity firm’s networks to reach new customers or improve supplier relationships.
(7) There is also decreased regulatory governance (Sarbanes-Oxley).

Question 50

What are some risks / considerations for an LBO?

Answer 50

(1) There is an increased risk due to additional leverage
(2) There is a need for return monetization within a certain timeframe (usually 3-5 years)
(3) There is a more “hands-on” ownership than what public shareholders exercise

Question 51

What is the EBITDA of a company with $200 million of debt and is levered 4 times?

Answer 51

200 / 4 = $50 million of EBITDA

Question 52

What is the simple average method for calculating IRR?

Answer 52

If you doubled your return, you increased your initial investment by 100 percent. If your investment was three years, then you had about 33.3 percent growth each year. However, the compounding effect makes the IRR markedly lower (~26.0 percent). This method just gives you the upper limit of the IRR; you can get a feel for how strongly the compounding effect makes the simple average higher than the IRR. The longer the duration of the investment, the more powerful the compounding effect.

Question 53

What is the rule of 72 for calculating IRR?

Answer 53

The rule of 72 allows people to estimate compounded growth rates.

Approximate CAGR = 72/years to Double Money
Divide 72 by the number of years you estimate the equity doubles in. So if you doubled your money in only three years, you have an IRR of ~24 percent (72/3). This is not a precise calculation and becomes less accurate with fewer years; obviously if it took one year to double, then you have a CAGR of 100 percent, not 72 percent.

Question 54

What are the relevant IRRs for a five year investment?

Answer 54

1. 0x – 0%
2. 0x – 15%
3. 0x – 25%
4. 0x – 32%
5. 0x – 38%
6. 0x – 43%

Question 55

How do you do a deal with no leverage?

Answer 55

There are two major levers you can pull:

(1) multiple expansion
(2) EBITDA growth

Although undoubtedly there’s an element of dealing with the markets in terms of multiple expansion, superior management is the key to driving both of those levers.

A notable method for creating leverage within the business is improving working capital management. The classic example is Dell: since their days-receivables shrank to become shorter than their days-receivables, they developed a growing source of liquidity which they could use to improve their business.

Question 56

What is a 338(h)10 election?

Answer 56

A 338(h)10 election is when the parties involved in a deal decide to do a stock deal for legal purposes but an asset deal for tax purposes.

Question 57

What are the characteristics that make an industry attractive for a private equity investment?

Answer 57

(1) Large market – A larger market means you need less of a share to achieve target returns. It also means that competitors have less of an influence when they get aggressive.
(2) Low reliance on uncontrollable variables – uncontrollable variables such as the weather, commodity prices, burgeoning technologies, etc., unnecessarily detract from management’s ability to create value
(3) Moderate competitor fragmentation.
- Low fragmentation may lead to fewer potential investees and a low chance of entering the industry. It may also be harder to invoke a roll-up strategy or take market share if there are fewer poor managers.
- High fragmentation may be difficult to find a decent sized player and it may be difficult to gain traction through an acquisition strategy
(4) Low customer and supplier power. If either suppliers or customers have excessive power, than the pricing of products or services may not be adjustable. The ideal industry is at the most valuable point in its value chain; that is, the industry adds the value and the suppliers and customers are simply commodity traders or middlemen
(5) Attractive exit options. Without a range of exit options, it is difficult to play potential buyers against each other and therefore secure the best price. There should always be an honest expectation to be able to list a firm because there’s no rule about a particular industry being un-listable; public markets will always be interested in a great business with sustainable and reliable cash flows. Similarly, there should be many potential trade buyers; again, if it’s a great business, others will want it.

Question 58

What do you look for in potential investments in this economic climate?

Answer 58

(1) Potential market size: depending on the size of the fund and the size of the potential investee, the market for that investee needs to be a certain size to mitigate a range of risks. A larger market means you need less of a share to achieve target returns. It also means that competitors have less of an influence when they get aggressive. For a lower-mid-market fund, I look for markets with a current size of at least $0.5-$1b and with growth rates that are at least positive (not as common in our current economic climate).
(2) Customer/Supplier Fragmentation: the last thing you want in this market (when it’s already tough to grow) is to invest in a business with high customer concentration. If a major customer is lost, you could lose a significant part of your business. All of those great strategic plans you had to grow the business will now only bring the business back to its former glory. The same goes with the supply side, although there’s often less of an impact (unless you are licensing someone else’s brand).
(3) Counter-cyclical offering: most of the highly defensive industries make for bad investments. They either don’t have the growth prospects or are too risky. I’m thinking agricultural commodities, certain financial services, natural resources, etc. But, you can benefit from counter-cyclicality in other industries too by finding sub-industries that businesses visit in tougher economic conditions due to cost savings.
(4) Invested management team: we’re seeing many business owners looking to sell out completely while telling us that their businesses would make great investments even in a downturn. One would think that a mass exodus would indicate something quite different to a great opportunity. So, beware of business owners jumping ship, especially if they’re not on their deathbeds and are sufficiently able to continue their businesses. They know more about their business than you do, so take notice of their behavior. Also, don’t let earn-outs that seem to lock management in fool you; they’ve often done their numbers and have accounted for the risk of losing the earn-out.
(5) Low gearing: a seemingly low risk business with high gearing can become high risk and virtually non-existent if revenue softens or a refinancing event strikes. A lowly geared business gives you room, should you need it, if things turn sour. We are seeing businesses file for insolvency every day due to gearing, so it should serve as a powerful warning to private equity investors looking to buy in this market. Again, common sense and looking at deals objectively will save face.

Question 59

What are the value-based components of a PE deal?

Answer 59

(1) Clawback (or ratchet): a clawback involves a condition whereby the private equity firm’s stake in the business increases (and the management’s stake decreases) if the business doesn’t meet certain earnings targets. The purpose of the clawback is to protect the investor against downturns in earnings. Inherently, this is a protection mechanism for the private equity firm.
(2) Incentive scheme (or ESOP): an incentive scheme, or employee stock ownership plan, balances the effect of a clawback. It provides incentives to management to reach certain earnings targets (or a particular exit price). It often only partly offsets the effect of a clawback, meaning that the net effect is in favor of the private equity firm. Inherently, this is an incentive mechanism for the management team.
(3) Earn-out: this is a condition whereby a portion of the purchase price is deferred and conditional upon predetermined targets. While deals involving expansion capital use clawbacks, complete buyouts of a business use earn-outs (therefore, earn-outs are usually mutually exclusive to clawbacks). The purpose of the earnout (just like the clawback) is to protect the private equity firm from downside volatility in earnings and from any unintended consequences to misinformation. Inherently, this is a protection mechanism for the private equity firm.
(4) Management Fees: these fees are paid upfront and/or periodically to the private equity firm in return for help to grow the business. Management fees are another way the private equity firms can realize a return on their investment prior to exiting. Inherently, this is a protection mechanism for the private equity firm.
(5) Coupon or interest payments: although the term “private equity” suggests the invested capital exists as equity, some firms prefer to invest in hybrid securities such as convertible notes (which include an equity component). The benefit to the firm is they receive the upside of equity with the protection of regular interest or coupon payments. This can seem perverse to potential investees, but it can also facilitate higher valuations. Inherently, this is a protection mechanism for the private equity firm.
(6) Preference subordination: private equity firms prefer to invest in preferred stock so in the case of failure, they rank ahead of ordinary shareholders. A coupon payment is often included, but even without a coupon the subordination mitigates some risk for the investor. Inherently, this is a protection mechanism for the private equity firm.

Question 60

At the end of the day, what is private equity really about?

Answer 60

(1) Risk Mitigation

(2) Value Creation

Question 61

Why are taxes so important to a private equity investor?

Answer 61

(1) Those high interest expenses provide a tax shield, which means private equity investees often don’t pay a cent of tax.
(2) Tax gives private equiteers a bargaining chip. All of a sudden, they can justify paying a lower price because of the tax implications. They can refuse to grant management options because of the tax implications. They can make a case for their preferred legal structure because of the tax implications. They can gear the business up to its eyeballs because of the tax implications. They can justify just about anything because no sane person understands the Internal Revenue Code (or whatever applicable tax code) in enough detail to debate it.

Question 62

What are alternative ways to create a return in private equity?

Answer 62

(1) Preferred equity so that a PE firm receives back equity before it exits the opportunity
(2) Management fees
(3) Dividends

Question 63

What covenants are used to evaluate the debt structure of a firm by a PE firm?

Answer 63

(1) Debt/EBITDA: how many years of earnings will pay back the debt principal (this measure is also called the gearing ratio). A typical multiple for this covenant is between 2-4x, although for larger deals a multiple of 5x isn’t unusual.
(2) EBITDA/Interest: how many times the current earnings could pay back the interest on the debt (also called interest cover ratio). The idea being that earnings could fall X% before the business couldn’t pay the interest on its debt. A typical multiple for this covenant is at least 2x, the higher the better.
(3) FCF/Repayment: this is similar to the interest cover ratio, except it uses free cash flow (FCF) in the numerator to bypass the obvious downfalls of using an accounting earnings number. It also adds the compulsory principal repayments to the denominator (so the denominator = interest + principal repayments). The reason for this is that the expected repayment often contains a principal component.

Question 64

What are the amplifying effects of diminishing sales?

Answer 64

Consider a business with sales of $100m, gross margin of 60% and EBITDA of $20m. If sales drop 20% down to $80m, you’re also losing gross profit of $12m. Usually at a minimum, this will fall directly to the EBITDA line. So, in this example, EBITDA will now be $8m. This is quite a serious problem for investees, but made much worse by the continued profligacy of managers and inflation in fixed expenses.

So what’s the implication of this? For starters, you’ve conceivably just dropped 60% of EBITDA and therefore 60% of value (that is, if the new EBITDA is deemed the new maintainable EBITDA). That’s a BIG problem. The obvious reaction is to reduce fixed costs so EBITDA doesn’t drop by the full GP loss, but that carries risks too. It obviously creates tension if you have to let people go, but it also limits your ability to return to previous sales levels if you have to sell off important equipment.

What are the other options? I’d say one of the better options is to delay cuts to people and major equipment and put as much effort as possible into taking market share and boosting sales. Also, make sure that costs don’t blow out as a result of the sales drive. It’s just as much about sales as it is financial discipline.

Question 65

Why is free cash flow so important?

Answer 65

(1) Accounting distortions: Accounting profits are often misrepresentative. For example, Net Profit after Tax (NPAT) is an accounting construct; it is based on a range of policy decisions that don’t reflect reality. These delusory policy decisions determine revenue recognition, inventory reporting and depreciation scheduling. The implication of this disconnection from reality is that accounting profits rarely act as an input to the real value of a business.

(2) Cash is king: With cash, a business can pay dividends, repay debt, invest in assets and absorb increases in input cost. With accounting profits, all a business can do is calculate its tax liability (which is important in other ways, but more on that later). So, what’s the purpose of explaining this? Well, a private equity investor will rarely even acknowledge the NPAT of a potential investee. This is because if a deal goes ahead, capex, depreciation, interest expense and taxation will all change.
This is where Free Cash Flow (FCF) makes an appearance. FCF attempts to measure the cash that is free for the business to use for dividends, capex, debt repayments, etc. I’m certainly not suggesting FCF is the perfect measure, because it’s not, but it is far better than relying on NPAT.

Question 66

Explain the FCF calculation.

Answer 66

Net Profit + D&A – Change in NWC – Capex

What’s happening here, in a practical sense, is that we’re taking NPAT, adding back depreciation and amortization (which are non-cash items), adjusting for accrued (rather than paid) revenues and expenses (i.e. NWC), and then taking away capital expenditure (which is a cash item). In theory, the result is the real cash profit for the business.

Question 67

Explain the importance of capital expenditures to a private equity investor.

Answer 67

Capital expenditure is simply expenditure on assets with long lives.

(1) The P&L statement doesn’t show expenditure on capital assets. This is because capital assets are capitalized to the balance sheet and only expensed to the P&L as they deteriorate (or insofar that accounting standards say when and by how much they deteriorate). The implication of this is that analysis of the P&L statement won’t show the capital requirements of the business and hence, the business’s real value. You can get an estimate of capex by looking at depreciation on the P&L, but this is fraught with risk.
(2) Even the balance sheet doesn’t make the capex picture any clearer. You can calculate the difference in assets between one year and the next, but all you get is a single number skewed by many variables. For example, if the company sold a large asset, this would underestimate real capex. Also, if the company only invests in capex every three years, an analysis of only the last year may show the business has no capex requirement, which would be wrong.
(3) The same goes for the Cash Flow Statement, which shows a single item for investment in plant, property and equipment; it’s only a single number.
(4) Most importantly, capex reduces cash flow. This has implications for valuations and debt reduction. As aforementioned, capex doesn’t make it to the P&L statement. That means any valuation based on EBITDA won’t account for it. Even a valuation on EBIT will only somewhat account for it if you consider depreciation to be a good proxy for future capex, which it rarely is. But, the big problem is that if FCF is negative due to high capex requirements, you won’t be able to pay off debt. And, you may not be able to meet debt repayments, which would quickly lead to insolvency.

So, the message is really to make sure you consider capex in all transactions. You need to see the detailed budgets of the business and understand how capex affects cash flow, what capex is required to keep the business operating as per usual, and what plans show for one-off items in the near future. Then, you may be able to get a better picture of maintainable earnings and hence value. Above all, don’t be fooled by EBITDA figures.

Question 68

Why is capex so important to a private equity investor? What is the difference between maintenance capex and growth capex?

Answer 68

Capex is important because it can significantly influence the value of a business. We are primarily interested in maintenance capex, which refers to the capex required to keep a business running at current cash flow levels. Growth capex refers to capex required to grow the business beyond typical cash flows (e.g. acquisitions). Financial statements do not have a line item titled maintenance capex, and no formula exists to calculate maintenance capex from the financial statements. Therefore, maintenance capex calculations are mostly estimates. The reason we only want maintenance capex is because we’re valuing the business based on its current state and current cash flows.

Question 69

What is the primary weakness of FCF?

Answer 69

It is calculated on a historical basis

Question 70

What are the primary drivers of working capital?

Answer 70

(1) Debtors (accounts receivable) - this refers to accrued revenue/sales placed on credit and awaiting to be settled by cash. An increase in debtors may refer to a growth in revenue, a change in debtor terms or difficulty in collecting cash from debtors.
(2) Inventory (stock) - all materials used to create products (or support services) are considered inventory. Good management of inventory is all about efficiency; how little has to be held, how quickly we can use it, how best can we store it, and what’s the cheapest way to manage it? An increase in inventory can refer to revenue growth, slower moving stock, revaluations, increased obsolescence, or preparations for volatility.
(3) Creditors (accounts payable) - simply the opposite to debtors; any accrued expenses for payment in the current period but as yet unsettled for cash. An increase in creditors may refer to increased creditor terms, an inability to pay, revenue growth (therefore, increased COGS), increased short-term debt, or higher unearned revenue (prepayments by customers).
(4) Cash - as discussed in, “Working Capital Series: References and calculations”, we exclude cash from our analysis because it is the cash requirement itself that we’re attempting to determine. Just think of cash as the plug. If we estimate that the worst case shows a shortfall of $1m in cash, then we must arrange to have that cash on standby or at least have contingencies to deal with the shortfall (such as renegotiated creditor terms).
(5) Other - There are other minor drivers of working capital, which include any current account (on the assets or liabilities side) that isn’t included above. If the business has a large debt burden, the current portion of debt may be a major working capital driver. Prepayments, unearned revenue, taxes, provisions, etc. should certainly be considered and included in your analysis if they seem to be volatile and influential.

Question 71

What is working capital absorption?

Answer 71

We are measuring how much cash is absorbed by our working capital profile. The best case is negative absorption (production of surplus cash) and the worst case is total absorption (no one pays their bills; imminent insolvency). The most common way to measure this absorption is via a ratio of working capital and sales (WC/Sales), which conceptually tells us what percentage of sales is tied up in paper earnings and not yet realized as cash.

Question 72

What are a few ways to improve working capital management?

Answer 72

(1) Payment Terms. This means getting your customers to pay sooner and your suppliers to accept payment later. Sometimes these are non-negotiable, but most of the time there’s potential movement. A particular area for improvement is on the supplier side, especially if they’re overseas. Most overseas suppliers will ask for a prepayment before they even ship the goods. But, if you can build trust and have them waive payment until the goods arrive at your local dock, this can lead to a monumental improvement.
(2) Inventory Management. It goes without saying that if you can sell the same amount and spend less on inventory, you’ll be better off. You can achieve this through streamlining any number of parts of your production and sales processes. You can also achieve this by rationalizing your offering and reducing your number of SKUs (stock-keeping units). Overall, you need to find a balance between the inventory kept on hand and satisfying customer demand. Often it’s better to disappoint customers than to keep hundreds of slow-moving SKUs. Also, a great one-off cash win is to put your obsolete and slow-moving stock on sale, but make sure to keep your stock rationalized after you get rid of the dross.
(3) Operational Efficiency. When you optimize your payment terms (see #1), you’re bringing your inflows closer and pushing your outflows further. But, what does this really mean? Well, you may pay a supplier 60 days after you receive your raw materials and you may demand customers pay within 14 days of receipt of the finished product. But, there is still one major variable left: the time between receiving the raw material and shipping the finished product. This is where operational efficiency matters. You want to minimize this time to further optimize your cash cycle. Often it’s people and process. Keep your people motivated and continually improve your processes and there’s no reason you shouldn’t excel in the area of operational efficiency.

Question 73

What do firms think about when deciding between a strategic merger or a private equity deal?

Answer 73

In simpler terms, a trade buyer will usually offer a higher upfront valuation, while a private equity firm will offer greater strategic value. My thinking for this is that a trade buyer has greater immediate synergies and is often the more natural buyer of the business; hence, it may pay more. Whereas, a private equity firm has more experience in value creation, and it has more aligned interests; hence, it offer sgreater strategic value. I say more aligned interests because there’s the risk that the trade buyer wants to invest in the business as a defensive move and they actually don’t want the business to grow. This is a significant risk compared to a private equity investor who almost undoubtedly just wants to see growth.

The question for the business owner is whether the additional upfront value from a trade buyer is worth more than the additional strategic value offered by the private equity firm. This is where the deal becomes self-selecting. If the business owner sincerely believes in the potential growth of the business, then they’d really choose the deal with the higher strategic value: the private equity deal.

Question 74

How can a business have a different valuation at the same point in time?

Answer 74

It generally comes down to the purpose and use of your investment. There are two broad options: Existing Capital (e.g. buy-out an existing stockholder, retire debt, etc) and New Capital (e.g. invest for growth, invest to make an acquisition, etc)

If you swap your new capital for existing capital (buying out another shareholder or paying down debt), then there’s generally no change to the valuation. However, if you are investing cash as new equity (for growth and/or acquisitions), then you’re increasing the equity value of the business and hence, increasing the EV and overall valuation. A quick example: we value a company with EBIT of $20m using a multiple of 5x. It has debt of $50m, no material amount of cash and therefore, equity value of $50m and EV of $100m.

In scenario 1, I’m paying down $50m debt. This means I’m swapping my $50m of equity for the $50m of debt. This transfer of capital means we now have $100m of equity, but $0 of net debt, so still an EV of $100m. As you can see, the EV and overall value didn’t change.

In scenario 2, I’m investing $50m to make a new acquisition. My investment enters the business as new equity to fund the acquisition. Total equity is now $100m, net debt is still $50m and hence EV is $150m.

In scenario 1, the pre- and post-money valuations were the same, both $100m. In scenario 2, pre-money was $100m, whereas post-money was $150m. This is all due to the new equity injection.

Question 75

What are the advantages and disadvantages of EBITDA over FCF?

Answer 75

The advantage of EBITDA over FCF is that it is independent of depreciation, cost of capital (such as interest on debt) and taxes. The disadvantage of EBITDA is that it doesn’t account for capex, which is a vital driver to ongoing earnings.

The other difference compared to FCF, is that EBITDA still includes accrued debtors and creditors. However, for the purpose of business valuation, this is a better representation of the future (as long as there’s no fraudulent manipulation) because accrual accounting is forward looking.

The implication of the capex omission (from EBITDA) is that the EBITDA of one business doesn’t compare well to the EBITDA of another business; the reason being that each may have different capex profiles. In a previous post, I explained that we can’t just use historical capex to adjust FCF (or in this case EBITDA), because it usually contains one-off items. So, what many people do is use EBIT as their earnings proxy because it accounts for capex via depreciation (the argument being that depreciation is a good proxy for capex). Of course, this is fraught with danger because the past isn’t the future and the future isn’t the past. If anything, most businesses will spend more on capex than they depreciate as they grow and enter different industries.

Question 76

What are the potential limitations of NPAT, FCF, EBITDA, EBIT and EBIT-DAC?

Answer 76

NPAT - almost never used, too “bottom line” and a pure accounting construct
FCF - still too “bottom line”, capex is often backward looking, rarely used in valuation
EBITDA - ignores capex, which is an absolute sin, but this measure is commonly used
EBIT - ignores the evolving nature of capex, sometimes used, 2nd best of many bad options
EBITDAC - can still be manipulated by accruals, but the best of a bad lot

Question 77

What is the advantage of EBIT over EBITDA?

Answer 77

The advantage of EBIT (over EBITDA) is that it somewhat accounts for capex through depreciation. This depreciation figure often represents a smoothed measure of capex since it accounts for items purchased over many years. So, in short, EBIT is a much better measure of real earnings, even if still a little inaccurate. (These other inaccuracies come from various deviations between cash and accrual accounting.)

Question 78

Does enterprise value include working capital?

Answer 78

Yes. Your calculation of a firm’s enterprise value must account for working capital because it affects cash flow. And, anything that affects cash flow, affects returns, and anything that affects returns, affects the value of an investment.

Question 79

What happens to EV when you issue more equity?

Answer 79

(1) If the equity is issued for no reason, just to increase cash for a rainy day, then there is no effect on enterprise value (EV). Theoretically, equity increases, but so does cash, which offsets debt to give net debt. Intuitively, if you sell the business the day after raising the money, the cash is just used to pay back the people that just funded the new issue. Practically, it could be a little different. If you raised money at a premium, the new shareholders will get less back as the new cash is shared between everyone (either by paying down debt or via a capital return). The opposite happens if you issue at a discount.
(2) If the equity is issued to invest in the business, then the effect on EV depends on the profitability of the investment. Remember, we’re working with market value. If the “market” values the investment at cost, then it cancels out. If they value the investment at zero, the EV stays the same, the equity value stays the same, but you have more share, so the per share price drops. If they value it above cost, then the opposite happens.

Question 80

Explain a few drivers of purchase multiples of a business.

Answer 80

(1) Growth: revenue growth is important to private equity because it’s one of the main tools to achieve non-geared value creation. So, a business with higher (realistic) growth forecasts demands a higher multiple. However, it’s important to be pessimistic about management forecasts because most of the time they don’t eventuate.
(2) ROIC
(3) Business size: a larger business has a larger market share (usually), more stability (mostly) and is more attractive to buyers (generally). Therefore, a larger business demands a premium.
(4) Stability: revenue and earnings stability drives confidence in forecasts, which demand a premium. Unstable businesses are riskier and require a higher required return, hence a lower multiple.
(5) Diversification: a business with a diversified product range, customer base and supplier list is less risky. These all affect earnings stability (see above) and hence, influence the multiple.
(6) Capex: this is often forgotten when just looking at EBITDA, which is why some people use multiples of EBIT (using depreciation as a proxy for capex). Capex represents a large portion of costs that don’t hit the P&L (until depreciated), so it’s important to consider capex in your valuation. Reduce EBITDA multiples for high capex businesses.
(7) Intellectual property: in private equity, we tend not to pay extra for IP because it is often needed to produce the cash flow. However, we may pay a higher multiple because proprietary IP represents greater differentiation, more stability, higher barriers to imitation and less risk.
(8) Synergies: a buyer that has the potential to realize synergistic benefits from an acquisition can generally pay a higher multiple because the acquisition represents a greater value to them. This is one of those drivers that mean the ideal multiple for me can be different to the one for you.
(9) Debt capacity: more debt adds more risk (insolvency, default, etc) to the business, but it also amplifies returns and reduces the overall cost of capital. The ability to add more debt commands a premium.
(10) Deal terms: a purchase multiple can be manipulated by the terms of the deal. If the deal is 100% cash up-front, the multiple will be lower than if some of the purchase price is contingent on future earnings. Be very cognizant of the time value of money and that contingent payments have less value if paid later. So, if $100m is paid today plus $100m is paid in 5 years, the purchase price isn’t $200m. It could be more like $130m, depending on your discount rate. A much higher multiple can be shown on paper through deal manipulation.
(11) Comps: although comparable transactions are the most common drivers of multiples, they are often the least appropriate. Even if exactly the same business sold at exactly the same time, synergies and other buyer-related drivers (deal terms, debt capacity, etc.) can affect the real value of the business. But in saying that, you’ll almost never see the same business for sale at the same time, so many other variables are introduced. So, it’s best to be more objective and concentrate on the more fundamental drivers that I’ve listed above.

Question 81

What are three additional forces that could potentially influence the attractiveness of an industry?

Answer 81

(1) Government: regulation and intervention can drastically change the dynamics of an industry. And some industries are more exposed than others.
(2) Complements: since substitutes are included, many argue that complements should also be included. The thinking being that complements can drive an industry in unique ways too.
(3) The Public: similar to government, the public (in the form of pressure groups, lobbyists, trends, etc) can play an important role in the dynamics of an industry.

Question 82

What is a bolt-on acquisition? What are the advantages of a bolt-on?

Answer 82

A bolt-on acquisition is an investment via an existing portfolio company into a business that presents strategic value (usually in the same industry).

(1) Usually smaller businesses, which attract lower multiples with better terms
(2) Provide the chance to create instant value (by acquiring lower multiple businesses using a higher multiple vehicle)
(3) Often require less work because they are smaller and attract less competition
(4) Offer strategic value (revenue and cost synergies), meaning you can pay a little more and be more successful in an auction process
(5) Provide for easier due diligence since you have access to industry experts in your primary investment vehicle (access to this experience is invaluable)
(6) Bolt-on owners are more likely to do a deal with a larger industry player, since there is prestige in being part of a leading firm (compared to being gobbled up by financial vultures).
(7) Provide access to a whole new market of potential investees as certain mandated restrictions (regarding size) don’t apply

Question 83

What is a recapitalization?

Answer 83

In corporate finance, a leveraged recapitalization is a change of the capital structure of a company, a substitution of equity for debt —e.g. by issuing bonds to raise money, and using that money to buy the company’s stock or to pay dividends. Such a maneuver is called a leveraged buyout when initiated by an outside party, or a leveraged recapitalization when initiated by the company itself for internal reasons. These types of recapitalization can be minor adjustments to the capital structure of the company, or can be large changes involving a change in the power structure as well.

Question 84

What are the advantages/disadvantages to a recap?

Answer 84

Leveraged recapitalizations are used by privately held companies as a means of refinancing, generally to provide cash to the shareholders while not requiring a total sale of the company. Debt (in the form of bonds) has some advantages over equity as a way of raising money, since it can have tax benefits and can enforce a cash discipline. The reduction in equity also makes the firm less vulnerable to a hostile takeover.

There are downsides, however. This form of recapitalization can lead a company to focus on short-term projects that generate cash (to pay off the debt and interest payments), which in turn leads the company to lose its strategic focus.[1] Also, if a firm cannot make its debt payments, meet its loan covenants or rollover its debt it enters financial distress which often leads to bankruptcy. Therefore, the additional debt burden of a leveraged recapitalization makes a firm more vulnerable to unexpected business problems including recessions and financial crises.

Question 85

What are a few ways private equity investors limit risk?

Answer 85

(1) Invest via preferred stock, demand preferred coupons
(2) Have veto rights over many business decision
(3) Take a board majority
(4) Have the right to fire senior executives
(5) Demand that managers invest,
(6) Sometimes even demand redeemable preferred stock, etc.

Question 86

What the different uses of a LBO analysis?

Answer 86

(1) Calculating private equity fund’s IRR
(2) By assuming the private equity fund’s IRR, we can back into a purchase price for the company, which is useful for valuation purposes (might provide a price floor)
(3) Analyze trend of credit statistics (important from a lender’s perspective

Question 87

In a LBO, what would be the ideal amount of leverage to put on a company?

Answer 87

It depends on the company’s cash flow profile. Generally, you want to finance a deal with the least amount of equity as possible in order to maximize returns. However, you must be careful as to not put the company into financial distress by overburdening the acquired company with debt.

A good rule of thumb is 25% capital investment and 75% new debt.

Question 88

What is a dividend recapitalization?

Answer 88

When a company incurs a new debt in order to pay a special dividend to private investors or shareholders. This usually involves a company owned by a private investment firm, which can authorize a dividend recapitalization as an alternative to selling its equity stake in the company.

Question 89

Why would a private equity fund choose to do a dividend recapitalization?

Answer 89

In order to boost returns without exiting the investment.

With a dividend recap, a private equity fund is able to recover some of its equity investment in the company without exiting the investment. More leverage and a lower equity investment means a higher return on a smaller amount of invested capital.

Question 90

How would a dividend recapitalization impact the three financial statements?

Answer 90

Income Statement: no change
Statement of Cash Flows: increase financing cash flows from debt issuance, decrease financing cash flows from dividend payout
Balance Sheet: increase debt, decrease shareholders’ equity

Question 91

What is the cash-on-cash (CoC) multiple?

Answer 91

Also called multiple of invested capital (MOIC). CoC is simply equal to how much the private equity fund receives in proceeds upon exiting the investment divided by how much it initially invests in the company. Unlike IRR, MOIC is not dependent on when the exit actually occurs.

MOIC = Exit Equity Value / Initial Equity Investment

Question 92

You are a creditor and you are looking at a holding company, which has one wholly owned operating subsidiary. Would you rather lend to the holding company or the operating company? Why?

Answer 92

Operating company because there is collateral for the debt as it is closest to the assets.

Question 93

Why do bondholders need covenants?

Answer 93

Covenants protect bondholders against a reduction in the value of their investment through:

(1) Credit deterioration
(2) Loss of equity cushion
(3) Loss of control over assets
(4) Loss of seniority position

Covenants increase the chance of capital gains for bondholders because they force the company to deleverage (or limit the ability to relever) and reinvest.

Question 94

What are the most important covenants?

Answer 94

(1) Debt incurrence – can incur more debt as credit improves
(2) Restricted payments – protects bondholders’ access to value by limiting undesirable asset transfers (e.g. dividends / repurchases)

(3) Change of control
(4) Affiliate transactions
(5) Asset sales
(6) Anti-layering

Question 95

What are the two most important incurrence covenants?

Answer 95

(1) Debt incurrence – permits additional leverage unless a ratio is met or “permitted debt” is granted
(2) Restricted payments – protects bondholders’ access to value by limiting asset transfers such as dividends/repurchases, retiring debt that is subordinate to bonds before retiring bonds, investments in entities that are not restricted subsidiaries

Question 96

What is the typical contractual subordination?

Answer 96

Bondholders agree to “turn over” to banks anything they get from obligors until banks are paid in full.

Question 97

Do you need to project all three financial statements in an LBO model?

Answer 97

You do not necessarily need to project all three financial statements – there are some short-cuts.

You do not need to project a full balance sheet – only need enough information in order to track how debt balances change. You can make assumptions about changes in NWC

You do not need a full income statement or statement of cash flows – only need the line items to calculate cash flow for debt repayment

Question 98

Why would a private equity fund acquire a company in a risky industry?

Answer 98

There are almost always mature, cash flow-stable companies in every industry. Some private equity firms specialize in very specific goals, including:

(1) Industry consolidation – increase efficiency and win more customers
(2) Turnarounds – improve deteriorating operations
(3) Divestitures – selling off divisions of a company or taking a division and turning it into a strong standalone entity

Question 99

Does an LBO or DCF give a higher valuation?

Answer 99

LBO generally gives a lower valuation because:

(1) LBOs do not necessarily improve cash flows dramatically over the investment time horizon
(2) LBO does not provide a specific valuation; set desired IRR and back out the purchase price

Question 100

When do you use a LBO as part of your analysis?

Answer 100

Whenever looking at a LBO investment. Also used to establish how much a financial sponsor could pay, which is usually lower than what companies are willing to pay. Often used to set a floor on a possible valuation

Question 101

What is an institutional investor?

Answer 101

Organization that pools together large sums of money and puts that money to use in other investments. These organizations include investment banks, insurance companies, retirement funds, pension funds, hedge funds and mutual funds

Question 102

What is asset-based lending?

Answer 102

Business loan secured by collateral. Loan or line of credit is secured by inventory, AR etc

Question 103

What is the current ratio?

Answer 103

A liquidity ratio that measures a company’s ability to pay short-term obligations.

CA/CL

Question 104

If the stock market falls, what would you expect to happen to bond prices, and interest rates?

Answer 104

Bond prices increase and interest rates fall.

Question 105

If unemployment is low, what happens to inflation, interest rates, and bond prices?

Answer 105

Inflation goes up, interest rates also increase, and bond prices decrease.
BOND YIELD = INTEREST PAID / BOND PRICE
*as price rises, yield goes down

Question 106

How would you rank the following in terms of their importance when making an investment: management, profitability, exit, market share, growth?

Answer 106

(1) Profitability
(2) Management
(3) Growth
(4) Market share
(5) Exit