02. LBO Flashcards
What is private equity?
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.
What is a LBO fund? What are its characteristics?
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
What does a PE firm do?
(1) Create fund
(2) Find target
(3) Structure deal
(4) Obtain financing
(5) Unlock value
(6) Exit the investment
Why lever up a firm?
(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
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?
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
What is a hedge fund?
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).
What are the main differences between private equity and hedge funds?
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
What is IRR? What is the formula for calculating the IRR of a LBO?
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
What is the hurdle rate?
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
Run me through the changes between the existing balance sheet and the pro forma balance sheet in an LBO model.
(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
Walk me through an LBO analysis.**
(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).
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?**
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
What are ways to increase the exit multiple?
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.
What are the three ways to create equity value?**
1) EBITDA/earnings growth, 2) FCF generation/debt paydown, and 3) multiple expansion.
What are the potential investment exit strategies for an LBO fund?**
(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)
What are some characteristics of a company that is a good LBO candidate?**
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
What is a good framework for an investment memorandum?
(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
What is an offering memorandum?
Legal document stating objectives, risks and terms of investment involved with private placement
Includes: financial statements, management biographies, detailed business description
If I handed you an offering memorandum, what are some of the things you’d think about?**
(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.
Walk me through S&U?**
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
What is a revolving credit facility and what are its characteristics?
- 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
What is bank debt and what are its characteristics?
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
What forms does bank debt usually take?
(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.
What are incurrence and maintenance covenants?
- 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.