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VC > 5: LBO > Flashcards

5: LBO Flashcards

1
Q
  1. The average debt level of LBOs was found to be (Large firms)
A

75% Debt, 25% Equity

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2
Q
  1. Debt Structure
A
  • Mostly Syndicated Debt
  • Debt in different tranches
  • Interest only with final “bullet” repayment popular, especially in US
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3
Q
  1. Leverage higher in buyouts where leverage is higher in similar firms?
A

Empirical evidence for large firms did not find any context between these. Can be explained by:

1: LBO firms are uncharacteristic from other firms
2: Debt level is driven by other things than similary

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4
Q
  1. Lower lev firms are often __
A
  • More profitable
  • Higher growth potential
  • Variable CF’s
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5
Q
  1. What can increase leverage for public firms?
A
  • Higher Corporate Tax
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6
Q
  1. Higher interest rates can in theory lead to?
A
  • Can not borrow as much as they would do if it was lower, so lower leverage
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7
Q
  1. How can PE deals be structured?
A

1: Exclusively PE to Target company
- Very rare

2: PE houses compete in auctions
- Most common
- Can cooperate with other PE houses in competition against other groups
- Auction conducted usually by Investment Bank

3: Public-to-Private

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8
Q
  1. What is a shell company?
A
  • No employees or office
  • No actual assets or business operations
  • Function as a transactional vehicle
  • Use this shell company in auctions
  • Sponsored by one or more PE houses
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9
Q
  1. Nature of the debt
A
  • Average 75% Debt
  • Syndicated debt
  • Several tranches
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10
Q
  1. Average initial capital structure in LBOs
A
  • 75% debt, 25% Equity
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11
Q
  1. Senior debt
A
  • Secured debt secured by assets or other collateral

- Debt prioritized for repayment in case of bankruptcy or liquidation

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12
Q
  1. Subordinated debt
A
  • Get paid after senior debt in case of bankruptcy or liquidation
  • Any type of loan that is paid after senior debt
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13
Q
  1. Increase in valuation had a correlation with ___
A
  • Increase in debt and reduction in equity.
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14
Q
  1. MM
A
  • Capital structure should be irrelevant
  • Hence amount of leverage is irrelevant
  • Value only driven by assets, not capital structure
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15
Q
  1. Trade-off Theory
A
  • Gain from Tax Shields perfectly offset by bankruptcy costs
  • Capital Market not perfect, so leverage can affect the value
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16
Q
  1. APV
A
  • Assumes investors are rational

- Can adjust the values for things like tax advantages of debt

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17
Q
  1. APV
A
  • Assumes investors are rational

- Can adjust the values for things like tax advantages of debt

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18
Q
  1. Taxes
A

• Can affect amount of leverage:

  • Tax Shield
  • Personal Taxes
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19
Q
  1. Pecking Order Theory
A

The cost of financing can be more expensive if its external because of asymmetric information

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20
Q
  1. How is does PE firms usually finance Buyouts and Venture Delas?
A
  • Buyouts: with Debt

- Venture Deals: with Syndicate Equity

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21
Q
  1. What is syndicate equity?
A
  • Group of investors or firms who come together
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22
Q
  1. Private Equity vs Venture Capital
A

• Both refers to firms that invest in companies and exit by selling their investments in equity financing (e.g., IPOs)
• Differences:
- Size of companies invested in
- Amount of money invested
- Percentages of equity invested
- PE mostly buy established mature companies
- VC buy start-ups with high growth potential
- PE mostly buy 100% ownership
- VC mostly buy 50% or less
- PE invest larger sums

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23
Q
  1. What are LBOs?
A
  • Generally, it means buying a public firm and taking it private
  • But also private to private
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24
Q
  1. Differences in LBOs, US compared to Europe
A
  • US deals with more debt

- Private to private more common in Europe

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25
Q
  1. Controversy of LBO Funds
A
  • Fund managers only pay capital gain tax, whereas the employees pay income tax
  • Capital gain tax is lower, so rich managers pay less tax!
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26
Q
  1. LBOs Advantages
A
  • Don’t need lots of Equity
  • Can get Tax advantages
  • Large potential profits
  • Little risk to the buyer
  • Small companies can benefit a lot
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27
Q
  1. How can debt increase returns?
A
  • Debt typically has a lower cost of capital
  • So returns on equity will rise with increased debt
  • Debt used to increase returns
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28
Q
  1. LBO Disadvantages
A
  • Target company may have less money to spend on growth because of debt payments
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29
Q
  1. Ways to finance LBO
A
  • Conventional bank lending
  • Bonds, often junk bonds
  • Mezzanine lending
  • Seller financing: you promise the seller that you will pay off over time
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30
Q
  1. Debt as a disciplining device
A
  • Jensen: Debt can discipline managers
  • SAC study: leverage can give incentive to work harder (90 min to 20 min)
  • Book Equity from 162m to -161m
  • Income increased a lot. SUCCESS story
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31
Q
  1. Breach of Trust in Hostile Takeovers
A

• New owners get rents by taking money from other stakeholders
- Argument that the increase in Target and the acquirer is offset from a loss in stakeholders wealth loss (e.g., human capital)

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32
Q
  1. Reasons for Buyouts
A

1) Under-levered
2) Under-performing
3) Lack capital or managerial expertise (Europe)

33
Q
  1. LBO’s in Norway
A

• Improvements in
- EBITDA
- Return on sales
- Asset turnover
- Current ratio
• Leverage aggressively brought down in 3y after LBO
• Buyouts use more leverage, but not a WOW case

34
Q
  1. Typical Sources of Value
A
  • Market growth
  • Revenue growth
  • Operational improvements (Europe)
  • Multiple expansion
  • Leverage
35
Q
  1. What happens with the existing debt in and LBO?
A
  • Holders of existing debt will often demand early repayment
  • The debt will often be refinanced with new banks
36
Q
  1. How can you protect yourself if you own debt in a firm?
A
  • Covenants; dictates all terms for takeover or acquisitions
  • Covenants give lender and Target company security
37
Q
  1. What can happen without covenants in an LBO?
A
  • Leverage increases
  • Increased risk for bankruptcy
  • Value of debt falls (bond value e.g.)
  • Stock price might fall
38
Q
  1. Different types of covenants
A
  • Bond covenants
  • Merger restrictions
  • Dividend or other payment restrictions
  • Debt covenants
  • Change in control covenant
39
Q
  1. What is a change in control covenant?
A
  • If ownership changes a lot, you can get early payment
40
Q
  1. Bonds empirical relationship with conventants
A
  • Strong: positive return
  • Weak: negative return
  • Bondholders can lose a lot if they are not protected
41
Q
  1. To much leverage can lead to
A
  • Debt overhang
  • Increased likelihood of bankruptcy
  • Incentives of debt-holders and equity holders do not coincide
42
Q
  1. A buyout can be financed in two ways:
A

1) Equity provided by the LBO firm

2) Debt raised from banks/capital market (bond market)

43
Q
  1. What can continuously taking debt signal
A
  • Banks would not have issued debt if they did not believe that you could pay it back
44
Q
  1. LBO funds Structures and Bankruptcy
A
  • Fund  several firms
  • If you are a fund sitting over a failing deal, you can let the firm fail without it having implications on other firms
  • If a firm is over-levered, the bankruptcy in it self is not a bad thing. Only shifts owners
45
Q
  1. How is a LBO fund typically structured, and what happens if a firm goes bankrupt?
A
  • One fund that sits over several firms
  • If one firm goes bankrupt, this will not have a direct impact on other firms
  • Deal between Firm and Bank – not Fund and Bank.
  • So one failed investment does not threaten the whole fund
46
Q
  1. Is there more Leverage in LBO deals?
A
  • There is evidence that LBO firms can lever-up more than normal firms
  • But not necessary if we for look at Norway (????? TRUE or NOT ???)
47
Q
  1. Why can LBO firms lever up more than normal firms?
A

1) Repeated borrowing reduces Moral Hazard and decreases lending cost. LBO firm must behave if it want to loan regularly.
2) Normal shareholder and managers can never commit to increase leverage and risk-shifting, but LBO funds can commit to it

48
Q
  1. In what case can re-levering be relevant?
A
  • Senior debt usually get paid down fast
  • But LBO firms hold their targets for a while
  • So the firm can be below it’s debt capacity
  • Re-levering can allow for dividend to be paid out
49
Q
  1. Re-levering and IRR calculations
A
  • Re-levering to pay out early dividends do wonders for IRR calculations
  • Desire to get as high IRR as possible
  • IRR calculations
  • Desire to get as high IRR as possible
  • But IRR also neglect risk
50
Q
  1. Who will often use IRR calculations?
A
  • Often used on the buyout side
51
Q
  1. What is EV/EBITDA, and why is it a popular multiple in LBOs?
A
  • Total Value of a company’s operations (EV) relative to its earnings before interest, taxes, depreciation, and amortization (EBITDA).
  • Popular tool in valuation of company’s.
  • Shows the profit from the CORE OPERATIONS of the business before the impact of dep and am
  • Investments can for a short time be set to zero
  • EBITDA a good measure in the short run – as there tends to be wide variation in firms depreciation

1) It is unaffected by Capital Structure
- Interested in value of operations, not the value of cash
2) Unaffected by Asset Step-ups
- In Due Diligence; Often, old fixed assets are revalued and generate a lot more depreciation expense forward.
- Depreciation is a “non-cash” expense
3) Strips out differences between amortization and depreciation policies
- Companies may choose different life expectancy for fixed assets that depreciate.
- Or they can have them from e.g., 10 to 50 years; unclear.

52
Q
  1. What does high versus low EV/EBITDA imply?
A
  • High: company is potentially overvalued

- Low company is potentially undervalued

53
Q
  1. A big trap when comparing and creating multiples when looking into their accounting is?
A
  • GAAP versus IFRS.
54
Q
  1. Who uses GAAP and IFRS?
A
  • Most listed firms use IFRS
  • Local firms often use GAAP
  • Sweeden and Norway use local GAAP
55
Q
  1. Debt to EBTDA, whats aggressive?
A
  • Over 5 – Aggressive

- But depends on interest rates

56
Q
  1. Why use EV/EBITDA? (short)
A
  • Short term firm does not need to invest
  • Want to find the core operational profits
  • Highly levered will for example pay little taxes
  • And there might be differences how accountants depreciate
  • Depreciation is a non cash expense
  • But by ignoring depreciation, you are ignoring loss in value
57
Q
  1. How is an IRR analysis conducted
A
  • The LBO fund has an IRR target
  • Models the CF, pro forma, Dividends
  • So basically a DCF
58
Q
  1. What is Interest Coverage Ratio (ICR)
A
  • A debt and profitability ratio used to determine how easily a company can pay interest on its outstanding debt.
  • EBIT / interest expense
  • Recommended to have under 1.5, but varies across industries
59
Q
  1. What is special about APV Valuation, and how can we break it down into several components?
A

“Divide and Conquer”

  • Unlike WACC, it splits up the firms valuation into different parts that contributes to value
  • Can use several discount rates
  • Split cash flows into its right component

1) Base Case
2) Tax Shield
3) Government Subsidies

60
Q
  1. Some different cash flows we can find through APV
A
  • Operations
  • Leverage
  • Vendor Finance
  • Government Guarantees
  • Etc
61
Q
  1. Base Case NPV in APV – what do we find and what discount rate do we use?
A
  • Value the CFs of the firm as if all equity financed

- The discount rate is not the WACC, but the Unlevered WACC, rA

62
Q
  1. Tax Shields part in APV modelling – what do we find and what discount rate do we use?
A
  • Want to look at savings generated by tax shield
  • Trick is to use the appropriate discount rate. Not clear. Depends on leverage policy.
  • If we use wacc, the discount rate adjusts for the tax shield. Here we use different discount rate
63
Q
  1. APV – What (and why) discount rate should be used when there is constant leverage ratio (constant rebalancing)?
A
  • Use the unlevered WACC, rA, because risk is the same as project risk
  • Also called “Compressed APV”
64
Q
  1. What is “Compressed APV”?
A
  • Use the unlevered WACC, rA, because risk is the same as project risk
  • Constant leverage ratio (constant rebalancing)
65
Q
  1. APV – What (and why) discount rate should be used when there is a constant debt amount with no rebalancing?
A
  • Use debt cost, rD

- Risk is the same as the risk of the outstanding debt

66
Q
  1. What is Government Subsidies
A
  • Payment from government to private entities.

- Goodwill

67
Q
  1. APV - What (and why) discount rate to use for Government Subsidies?
A
  • If it is a safe, nominal cash flow, we should use the firm’s AFTER TAX COST OF DEBT
  • This is the rate we could have lent money at otherwise
68
Q
  1. APV – Why can we use different discount rates?
A
  • Fixed debt reduces the variability of the size of the tax shield
  • We know the value of the tax shield for sure, its CF does not vary
  • But rebalancing can as it will create variation
69
Q
  1. What can APV be beneficial for?
A

• To get upper and lower limits

  • In LBO, debt amount will fall so its not constant
  • But by using the unlevered cost of capital, we get same result as using WACC
  • So we get upper and lower limits
70
Q
  1. Difference between opportunity cost of capital and unlevered cost of capital (constant?)
A
  • rA is constant and does not change with leverage
  • WACC is not constant, as it will decrease in D
  • So fundamentally they should give the same result, but not always like that
71
Q
  1. What are some of the problems with APV?
A
  • Assumes a constant debt ratio
72
Q
  1. APV - How can we take into account that debt is reduced over time?
A

• The Equity Cash Flow method

73
Q
  1. Explain the Equity Cash flow method (ECF)
A
  • Looks at how much equity ends up with shareholders
  • Idea: only value these cash-flows and ignore debt
  • Takes financial structure into account
  • Discount rate changes over time
74
Q
  1. ECF (SDFASDFERGSDGHDFHYJDT)
A
  • Use all CF available to pay debt (?)
  • Keep track of amount of debt, so have End Debt
  • Equity beta changes over time
  • Asset beta constant
  • Work backwards, year 5, 4, 3 etc.
  • Idea: LBO setting, project the pro-formas for the LBO period.
  • Forces us to take into account that we need to issue more debt if we don’t have enough CF
75
Q
  1. Whats the downward bias with ECF?
A
  • Debt beta is treated as zero. Tends not to be that, but maybe around 0,2
  • So gives a lower bound on firm value
76
Q
  1. APV, WACC, ECF, Compressed APV: What cannot be used when cap struc is changing?
A
  • WACC and simple APV

- Use ECF or Compressed APV

77
Q
  1. When to use ECF?
A
  • When you want to value equity rather than the whole firm (e.g., joint venture, LBO)
  • When leverage is high (but not so high that lower bound is meaningless)
  • Exotic/changing capital structure
  • As a check on APV
78
Q
  1. Firm ABC is Financial distress as the face value of its debt exceeds the total market value. Firm’s debt will only mature in one year. What are the potential problems?
A

• Risk Shifting

- E.g., managers undertake negative NPV projects. Have nothing to lose

79
Q
  1. Debt Overhang
A
  • Debt burden so large that firm cannot take on additional debt to finance future projects
  • Managers and shareholders with different incentives

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