Basic+Advanced LBO Model

Question 1

Walk me through a basic LBO model.

Answer 1

Step 1:

making assumptions about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt and other variables; you might also assume something about the company’s operations, such as Revenue Growth or Margins, depending on how much information you have.

Step 2:

create a Sources & Uses section, which shows how you finance the transaction and what you use the capital for; this also tells you how much Investor Equity is required.

Step 3:

Adjust the company’s Balance Sheet for the new Debt and Equity figures, and also add in Goodwill & Other Intangibles on the Assets side to make everything balance.

Step 4:

You project out the company’s Income Statement, Balance Sheet and Cash Flow Statement, and determine how much debt is paid off each year, based on the available Cash Flow and the required Interest Payments.

Step 5

Make assumptions about the exit after several years, usually assuming an EBITDA Exit Multiple, and calculate the return based on how much equity is returned to the firm.

Question 2

Why would you use leverage when buying a company?

Answer 2

To increase your returns.

Remember, any debt you use in an LBO is not “your money” – so if you’re paying $5 billion for a company, it’s easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs. $3 billion of your own money and $2 billion of borrowed money.

A secondary benefit is that the firm also has more capital available to purchase other companies because they’ve used leverage.

Question 3

What variables impact an LBO model the most?

Answer 3

Purchase and exit multiples have the biggest impact on the returns of a model. After that, the amount of leverage (debt) used also has a significant impact, followed by operational characteristics such as revenue growth and EBITDA margins.

Question 4

How do you pick purchase multiples and exit multiples in an LBO model?

Answer 4

The same way you do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO transactions have had. As always, you also show a range of purchase and exit multiples using sensitivity tables.

Sometimes you set purchase and exit multiples based on a specific IRR target that you’re trying to achieve – but this is just for valuation purposes if you’re using an LBO model to value the company.

Question 5

What is an “ideal” candidate for an LBO?

Answer 5

“Ideal” candidates have stable and predictable cash flows, low-risk businesses, not much need for ongoing investments such as Capital Expenditures, as well as an opportunity for expense reductions to boost their margins. A strong management team also helps, as does a base of assets to use as collateral for debt.

The most important part is stable cash flow

Question 6

Give an example of a “real-life” LBO.

Answer 6

The most common example is taking out a mortgage when you buy a house. Here’s how the analogy works:

• Down Payment: Investor Equity in an LBO
• Mortgage: Debt in an LBO
• Mortgage Interest Payments: Debt Interest in an LBO
• Mortgage Repayments: Debt Principal Repayments in an LBO
• Selling the House: Selling the Company / Taking It Public in an LBO

Question 7

Can you explain how the Balance Sheet is adjusted in an LBO Model

Answer 7

Liabilities & Equities adjusted
New Debt added on
Shareholder’s Equity is ‘wiped out’ and replaced by equity provided by PE firm

Assets: Cash adjusted for any financing cash, Goodwill & Other Intangibles are used as a ‘plug’

Could be other effects; capitalised financing fees on asset side

Question 8

Why are Goodwill & Other Intangibles created in an LBO?

Answer 8

Represent premium to ‘fair market value’, acting as a plug so A=L&E

Question 9

We saw that a strategic acquirer prefer to pay for another company in cash - so why would a PE firm use debt in an LBO

Answer 9

Different scenario as:

• PE has exit period, so less concerned with ‘expense’ of cash vs debt and more concerned about boosting returns
• In LBO, ‘debt’ is owned by the company, assuming much more risk. In strategic acquisition, buyer owns the debt so more risk.

Question 10

What is the expense of cash vs debt that strategic acquires are concerned with?

Question 11

Do you need to project all 3 statements in an LBO model? Are there any shortcuts?

Answer 11

Not necessarily

• Don’t need full balance sheet as you can make assumptions on Net Change in Working Capital rather than looking at each item individually
• Need Income Statement to track how the debt balance changes
  Cash Flow statement to show how much cash is available to repay debt

Question 12

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

Answer 12

Usually you would look at Comparable LBOs and see the terms of the debt and how many tranches each of them used.

You would look at companies in a similar size range and industry and use those criteria to determine the debt your company can raise.

Question 13

What are tranches in an LBO

Question 14

Let’s say we’re analysing 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 14

Dep. On company, industry, leverage and coverage ratios for comparable LBOs. Look at debt comps for types, tranches and terms of debt recently.

General rule of never lever a company at 50x EBITDA, and even during the bubble leverage rarely exceeded 5-10x EBITDA.

Question 15

What is the difference between bank debt and high-yield debt?

Answer 15

Simplification, but most important differences:

• Higher Interest Rates
• Rates are usually fixed vs floating in bank debt
• High-yield debt has incurrence covenants while bank debt has maintenance covenants.

incurrence covenants prevent you from doing something (such as selling an asset, buying a factory, etc.)
maintenance covenants require you to maintain a minimum financial performance (for example, the Debt/EBITDA ratio must be below 5x at all times).

• Bank debt is usually amortised - principal paid over times - whereas high yield debt, entire principal is due at the end (bullet maturity)

Usually in a sizeable LBO, PE firm uses both types of debt

Question 16

Why might you use bank debt rather than high-yield debt in an LBO?

Answer 16

Interest payments concern
Planning on major CapEx and don’t want restrictions of incurrency cov.

Question 17

Why might you use high-yield debt rather than bank debt in an LBO?

Answer 17

• Returns are not so sensitive to IR payments
  
  • Don’t have plans for major expansion or sell off company assets
    Intend to refinance

Question 18

Why would a private equity firm buy a company in a “risky” industry, such as technology?

Answer 18

• Mature and cash-flow stable companies exist in every industry
• Some PE firms specialise in:
  1. Industry consolidation
  2. Turnarounds
  3. Divestitures

Question 19

How could a private equity firm boost its return in an LBO?

Answer 19

1. Lower Model Purchase Price
2. Raise Exit Multiple/ Exit Price
3. Increase the leverage (debt) used
4. Increase company’s growth rate (organic or inorganically)
   Increase margins by reducing expenses - cuttting workforce

Question 20

What is meant by the “tax shield” in an LBO?

Answer 20

The interest a firm pays on debt is tax deductible –> increase cash flow from debt in LBO

Cash flow is still lower than it would be without the debt

Question 21

What is a dividend recapitalization (“dividend recap”)?

Answer 21

Company takes on new debt solely to pay a special dividend to the PE firm

Question 22

Why would a PE firm choose to do a dividend recap of one of its portfolio companies?

Answer 22

Boost returns. Essentially recovering some of the equity investment.

Question 23

How would a dividend recap impact the 3 financial statements in an LBO?

Answer 23

Income Statement: no change.

Balance Sheet: Debt go up and Shareholder’s Equity fall. Cancel out.

Cash Flow Statement: no change to CFO, CFI. CFF; additional debt cancels out Cash paid to investors, so Net Change in Cash would not change.

Question 24

Tell me all about the different kinds of debt you could use in an LBO and the differnces between everything?

Answer 24

Question 25

What is call protection?

Answer 25

Is the company prohibited from “calling back” - paying off or redeeming - the security for a certain period. Benefits investors as they are guaranteed a number of interest payments

Question 26

What is the difference between Senior Secured, Senior Unsecured and Senior Subordinated?

Question 27

How would an asset write-up or write-down affect an LBO model? / Walk me through how you adjust the Balance Sheet in an LBO model.

Answer 27

Goodwill, Other Intangibles, and the rest of the write-ups in the same way, and then the Balance Sheet adjustments (e.g. subtracting cash, adding in capitalized financing fees, writing up assets, wiping out goodwill, adjusting the deferred tax assets / liabilities, adding in new debt, etc.) are almost the same.

Key differences:

• Assume that the existing Shareholders’ Equity is wiped out and replaced by the equity the private equity firm contributes to buy the company; you may also add in Preferred Stock, Management Rollover, or Rollover from Option Holders to this number as well depending on what you’re assuming for transaction financing
• In an LBO model you’ll usually be adding a lot more tranches of debt vs. what you would see in a merger model.
• In an LBO model you’re not combining two companies’ Balance Sheets.

Question 28

Normally we care about the IRR for the equity investors in an LBO – the PE firm that buys the company – but how do we calculate the IRR for the debt investors?

Answer 28

Calc interest and principal payments received each year
Use IRR function and start with the negative amount of the original debt for Y0.

” assume that the interest and principal payments each year are your “cash flows” and then assume that the remaining debt balance in the final year is your “exit value”.

Question 29

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 29

Same concept as Earnout in M&A; incentivise management.
No technical limit on how much management receive with an option pool.

In LBO model, calc per share pruchase price and how much of proceeds go to mgmt based on Treasury Stock Method
Option pool reduces returns but offset by better mgmt

Question 30

Why you would you use PIK (Payment In Kind) debt rather than other types of debt, and how does it affect the debt schedules and the other statements?

Answer 30

PIK loan doesn’t require interest payments - instead interest accrues to the loan principal which goes up over time. PIK “toggle” allows company to choose whether to pay interest in cash or have it accrue to principal.

PIK more risky and has a higher IR than bank or high yield debt. Similar to adding high yield with bullet maturity,

Can put PIK interest on income statement but need to add back on Cash Flow as it is a non-cash expense.

Question 31

What are some examples of incurrence covenants?

Answer 31

Incurrence Covenants:
* Company cannot take on more than $2 billion of total debt.
* Proceeds from any asset sales must be earmarked to repay debt.
* Company cannot make acquisitions of over $200 million in size.
* Company cannot spend more than $100 million on CapEx each year.

Question 32

What are some examples of maintenance covenants?

Answer 32

Maintenance Covenants:

• Total Debt / EBITDA cannot exceed 3.0 x
• Senior Debt / EBITDA cannot exceed 2.0 x
• (Total Cash Payable Debt + Capitalized Leases) / EBITDAR cannot exceed 4.0 x
• EBITDA / Interest Expense cannot fall below 5.0 x
• EBITDA / Cash Interest Expense cannot fall below 3.0 x
• (EBITDA – CapEx) / Interest Expense cannot fall below 2.0 x

Question 33

Just like a normal M&A deal, you can structure an LBO either as a stock purchase or as an asset purchase. Can you also use Section 338(h)(10) election?

Answer 33

In most cases, no – because one of the requirements for Section 338(h)(10) is that the buyer must be a C corporation. Most private equity firms are organized as LLCs or Limited Partnerships, and when they acquire companies in an LBO, they create an LLC shell company that “acquires” the company on paper.

Question 34

What is a C Corporation

Question 35

Is there a British and European Equivalent of section 338(h)(10) and what are the differences?

Question 36

What debt has optional repayments?

Answer 36

Revolver and Term Loans

Question 37

Walk me through how you calculate optional repayments on debt in an LBO model.

Answer 37

Check cash flow available based on Beginning Cash Balance, Minimum Cash Balance, Cash Flow Available for Debt Repayment from the Cash Flow Statement, and how much is used to make Mandatory Debt Repayments.

If you’ve used your revolver, pay off max amount you can with available cash flow.

For Term Loan A, after principal mandatory repayments, pay off maximim you can with cash flow after revolver payments

Same for Term Loan B as Term Loan A

Question 38

What is a Revolver

Question 39

What is the Revolver Borrowing Formula

Answer 39

Revolver Borrowing = MAX(0, Total Mandatory Debt Repayment – Cash Flow Available to Repay Debt).

Question 40

Explain how a Revolver is used in an LBO Model

Answer 40

Used when cash required for Mandatory Debt Repayments exceeds available cash flow for repayment.

Starts off “undrawn” so you don’t actually borrow and don’t accrue a balance unless you need it.

Add any required Revolver Borrowing to your running total for cash flow available for debt repayment. Within the debt repayments themselves, you assume that any Revolver Borrowing from previous years is paid off first with excess cash flow before you pay off any Term Loans.

Question 41

How would you adjust the Income Statement in an LBO model?

Answer 41

Most Common:
* Cost Savings - laying off affects COGS, OpEx
* New Depreciation Expense - PP&E write-ups
* New Amortisation Expense - intangible write-ups and capitalised financing fees
* Interest Expense on LBO Debt - incl. cash + PIK
* Sponsor Management Fees - PE firms charge a ‘management fee’
* Common Stock Dividend - Could pay div. recap to PE investors
Preferred Stock Dividend - If Preferred Stock used as form of financing

Question 42

Where does Interest Expense and Sponsor Management Fees hit?

Answer 42

Interest Expense and Sponsor Management Fees hit Pre-Tax Income

Question 43

Where does dividend items hit?

Question 44

Why is Minority Interest important in the Enterprise Value?

Question 45

Why would Preferred Stock be used in financing a PE transaction?

Question 46

Why are items that are capitalised, amortised rather than depreciated?

Question 47

In an LBO model, possible for debt investors to get a higher return than the PE firm?

Answer 47

Yes, high yield get IR of 10-15%. Combine with multiples shrinking or failed growth, PE firm can easily get an IRR below debt investors.

Question 48

Most of the time, increased leverage means an increased IRR. Explain how increasing the leverage could reduce the IRR.

Answer 48

When interest payments are pushed to very high levels, can’t use cash flow for growth or even maintenance –> IRR starts falling. Need:

1. Relative lack of cash flow/EBITDA growth.
2. High interest payments and principal payments relative to cash flow.
3. Relatively high purchase premium or purchase multiple to make it more difficult to get a high IRR in the first place.