Advanced LBO Features

Question 1

Why might a private equity firm allot some of a company’s new equity in an LBO to a management option pool, and how would this affect the model?

Answer 1

Same reason buyers use ear outs in M&A deals: PE firm wants to incentivise the management team and keep everyone on-board until they exit the investment
- difference: no technical limit on how much management might receive from such an option pool: their proceeds will be a % of the company’s final sale value
- In your LBO model, you would need to calculate a per-share purchase price when the PE firm exits the investment, and then calculate how much of the proceeds go to the management team based on the Treasury Stock Method.
- An option pool by itself would reduce the PE firm’s return, but this is offset by the fact that the company should perform better with this incentive in place.

Question 2

What if there’s an option for the management team to “roll over” its existing Equity rather than receive new shares or options?

Answer 2

• An equity rollover would show up in the sources column, and it would reduce the amount of Equity and Debt firm needs to use to acquire the company
• At the end, you would also subtract some of the proceeds and allocate them to the management team rather than the PE firm when calculating returns.
• If nothing else changes, this reduces the PE firm’s IRR – but the idea is that it also incentivizes the management team to perform well and deliver greater results, which helps everyone.

Question 3

Let’s say that a PE firm buys a company that’s currently 20% owned by management, and the firm wants to maintain this 20% management ownership percentage afterward.

Does the PE firm need to use a certain amount of Debt to maintain this ownership percentage, or does it not impact the model?

Answer 3

• No. All this business with management ownership has nothing to do with the exact percentage of Debt and Equity used.
• All that changes is that if the management team owns more, the PE firm can use less Debt and Equity (cash) overall to acquire the company.
• Using 80% Debt vs. 60% Debt (or any other percentage) has no impact on the management ownership percentage, which is a separate issue entirely.