Assumption, Debt, And Sources + Uses

Question 1

How could you determine how much debt can be raised in an LBO and how many tranches there would be?

Answer 1

Look at similar LBOs and assess the debt terms and trances used in each transactions.
Also could look at companies of similar size range and industry, see how much debt outstanding they have, and based numbers on those.

Question 2

Let’s say we’re analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratios

Answer 2

• completely dependent on company, industry, leverage and coverage ratios for comparable LBO transactions.
• look at debt comps, showing types, tranches and terms of debt that similarly sized companies in industry have used recently.

Question 3

What is the difference between Bank Debt and High-Yield Debt?

Answer 3

• high yield has higher interest rates, usually fixed, while bank debt are floating, depending on LIBOR
• high yield has incurrence convenants, while bank debt has maintenance convenants
• bank debt usually amortised, high yield usually entire principal due at the end.

Usually in a sizeable leveraged buyout, PE firm uses both types of debt.

Question 4

If High-Yield Debt is “riskier,” why are early principal repayments not allowed? Shouldn’t investors want to reduce their risk?

Answer 4

Investors need to be compensated for extra risk
E.g:
- if investors may earn 100 mil on 1 bil debt, at 10% IR
- without early repayment, continue to get 100mil a year
- with early repayment, interest repayment drops each year as debt is reduced, which drops their effective return.

Question 5

Why might you use Bank Debt rather than High-Yield Debt in an LBO?

Answer 5

If PE firm is concerned about company meeting interest payments and wants a lower-cost option, might use bank debt

Might also use bank debts if they are planning on a major expansion or capital expenditures and don’t want to be restricted by incurrence covenants.

Question 6

Why would a PE firm prefer High-Yield Debt instead?

Answer 6

If the PE firm intends to refinance the debt at some point, or they don’t believe returns are too sensitive to interest payments.

Or if they dont have plans for a major expansion or acquisitions, or no plans to sell off the company’s assets.

Question 7

How does refinancing vs. assuming existing debt work in an LBO model?

Answer 7

If the PE firm assumes debt when acquiring a company, debt remains on the balance sheet and must be paid off, has no net effect on funds required to acquire the company. Shows up in both sources and uses columns

If refinances debt, pays it off, replacing it with new debt that it raises to acquire the company, requires additional funds, so Effective purchase price goes up, debt only rises in uses column.

Question 8

How do transaction and financing fees factor into the LBO model?

Answer 8

Pay for all these upfront in cash (legal, advisory, and financing fees paid on debt), but accounting is different:
- legal and advisory fees: these come out of cash and RE immediately as transaction closes
- financing fees: these are amortised over time, similar to how CapEx works, make it an asset then reduce as fees are recognised

Question 9

What’s the point of assuming a minimum cash balance in an LBO?

Answer 9

Company can not use 100% of its cash flow to repay debt each year, needs to maintain min amount of cash to pay employees, and admin expenses, etc

So normally set up assumptions such that any extra cash flow beyond this min. Cash balance is used to repay debt.