Basic LBO Quiz Flashcards
“Which of the following statements below are TRUE regarding why an LBO works conceptually?
Answer Choices:
1) By using debt, the PE firm reduces up-front cash required, thereby boosting returns.
2) Using cash flows produced by the company to pay down debt and make interest payments produces a better return for the PE firm than simply keeping the cash flows.
3) Since the PE firm sells the entire company in the future, it’s guaranteed to at least get back 100% of its original capital.
4) The PE firm sells the company in the future, which allows it to get back (at least some of) the funds that it used to acquire the company in the first place.”
Statements A, B, and D are all true. By using little of its own cash and borrowing heavily to purchase the company, the PE fund significantly boosts its returns for the simple reason that money today is worth more than money tomorrow due to the interest that it could earn. In an LBO, the PE fund uses the cash flows of the company it acquires to pay debt principal and debt interest, which is a much better use of those funds than keeping the money for itself, again boosting returns. The other reason LBOs work in practice and earn such high returns is because the PE fund only operates the company for 3 to 5 years before it sells it off and regains its money plus profit; if the PE fund were to keep the companies it purchased indefinitely, it would not be possible to earn the returns that PE funds seek. C is incorrect because there’s no “guarantee” that the PE fund will get back 100% of its original capital – if the company’s EBITDA declines or if the exit multiple declines significantly, for example, that may not happen.
“What’s the best analogy to use when thinking of how a leveraged buyout works?
Answer Choices:
1) A homeowner buys a house to live in with a down payment and mortgage, and then sells the house in the future once the mortgage is repaid.
2) An investor buys a house to rent out to tenants, using a down payment and mortgage, then uses the rental income to repay the mortgage, and then sells the house in the future.
3) A person buys a car using cash and a car loan, drives it for several years, repays the debt, and then sells the car.
4) None of the above.”
“An investor buys a house to rent out to tenants, using a down payment and mortgage, then uses the rental income to repay the mortgage, and then sells the house in the future.
CORRECT ANSWER
Explanation:
B is correct because that is exactly what happens in an LBO – you buy a company that generates cash flows, you use the cash flows to repay debt, and then sell it off at the end of several years. A is incorrect because a house that you live in is not an income-generating asset. So it is not the best way to think of an LBO. C is incorrect because unlike a house, cars always depreciate in value and you’ll likely lose a lot of money after buying it, running it, and selling it… plus cars do not generate income, unlike rental houses.”
“All of the following characteristics make for a good LBO target EXCEPT:
Answer Choices:
1) High PP&E and/or Fixed Assets on the Balance Sheet.
2) Relatively low Capital Expenditures.
3) Non-volatile, non-cyclical, cash flow producing business.
4) Early-stage fast growth company.”
“Early-stage fast growth company.
CORRECT ANSWER
Explanation:
The correct answer choice is D. Answer choice A represents an asset-rich company which can pledge its current assets and PP&E as collateral for high levels of bank debt (which is necessary for an LBO). Answer choice B refers to companies with negligible large cash outflows in the form of capital expenditures; that is a good sign since the company can use those cash flows to pay interest and debt principal post-LBO instead. Answer choice C represents companies that produce lots of cash flow and exhibit no volatility in those cash flows from year to year. Usually, PE firms prefer very mature companies and industries, sometimes even if they are in the decline phase of their lifecycle. Something very early-stage with high growth would probably produce cash flows that are too volatile to make consistent and periodic interest payments and debt repayment. Usually early-stage hyper growth companies are not cash-flow positive businesses, and the majority of their value is not comprised of ‘hard assets’ such as PP&E which can be used as collateral for the large sums of debt that need to be raised.”
Since an LBO valuation and a DCF are both based on Free Cash Flows and how much cash the company generates, they are likely to produce similar implied values.
“False
CORRECT ANSWER
Explanation:
The correct answer choice is B. The cash-flow metric used in an LBO model – namely, ‘Free Cash Flow Available for Debt Service’ (aka CFO – CapEx) – is not identical to Levered Free Cash Flow used in a DCF, with the latter explicitly subtracting out mandatory debt repayments. And most of the time in a DCF, you use Unlevered Free Cash Flow, which is even more different. Furthermore, an LBO is different from a DCF in that the LBO model does not explicitly calculate an implied value like a DCF does. Rather, in an LBO model you work backwards to determine the price that a PE firm can pay if it is targeting a certain IRR. In other words, a DCF is based on, “How much could this firm be worth if certain assumptions are true?” whereas an LBO valuation is based on, “What’s the minimum price a PE firm could pay to achieve a certain return on their investment?””
“All of the following represent differences between high-yield (HY) debt and bank debt EXCEPT:
Answer Choices:
1) HY debt is riskier and thus has a higher interest rate.
2) Bank debt has a “floating” interest rate whereas HY is fixed rate.
3) HY debt has maintenance covenants whereas bank debt has incurrence covenants.
4) HY debt does NOT allow early debt repayment whereas bank debt is amortized.”
“HY debt has maintenance covenants whereas bank debt has incurrence covenants.
CORRECT ANSWER
Explanation:
The correct answer choice is C. All of the above statements represent factual differences between HY debt and bank debt except for answer choice C. HY debt is considered much “riskier” than bank debt, and as a result investors require a higher interest rate to be compensated. Answer choice B is correct in that most bank debt does NOT have a fixed interest rate but rather a “floating rate” usually tied to LIBOR, whereas HY debt is more conventional in that its interest rate is a fixed percentage. HY debt prohibits early principal repayment and usually is structured as a “bullet maturity” (meaning it is paid off in full at maturity). On the other hand, bank debt is amortized annually and a percentage of the principal is paid off each year. Answer choice C is incorrect and should be the other way around – namely, that HY debt has incurrence covenants (which prohibit against taking certain actions) whereas bank debt has maintenance covenants (which require maintaining a minimum financial performance).”
“A PE firm might prefer high-yield debt over bank debt because it’s less expensive and the company’s CapEx and acquisitions would not be restricted.
Answer Choices:
1) True
2) False”
“False
CORRECT ANSWER
Explanation:
The correct answer choice is B. Between HY debt and bank debt, the latter is a lower cost method of financing. Furthermore, HY debt does have incurrence covenants, which would prohibit it from taking certain actions such as spending additional funds on Capital Expenditures or on acquisitions. In summary, for a lower cost option of financing without restrictive incurrence covenants, a PE fund would chose bank debt rather than HY debt.”
“Under the Sources & Uses section of the LBO model, all of the following would normally be found under the Sources section EXCEPT:
Answer Choices:
1) Term Loan Debt.
2) Investor Equity (Cash the PE firm pays).
3) Debt Assumed.
4) Management “Rollover”.
5) Transaction Fees.”
Answer choice A represents the “bank debt” used to finance the purchase. Answer choice B is the cash the PE fund invested thereby representing its equity stake. Answer choice C represents the existing outstanding debt of Target Co. that PE fund assumes. Answer choice D represents the new equity that the PE sponsor shares with the existing management team to incentivize and align interest. All of those effectively finance the deal and allow the PE firm to make it happen, so they count as Sources of Funds. However, Transaction Fees simply cost the PE firm something extra so they should go in the Uses section instead.
“The difference between assuming debt versus refinancing debt in an LBO model is that the former increases the funds required, whereas the latter has no net effect on the funds required.
Answer Choices:
1) True
2) False”
“False
CORRECT ANSWER
Explanation:
The correct answer choice is B. This statement should be the other way around – that is, assuming debt has no net effect on funds required to acquire the target company, and refinancing debt results in increasing the purchase price for the target as additional funds are required. Assuming debt simply means that whatever outstanding debt the target company has remains on the company’s Balance Sheet going forward. On the other hand, refinancing debt means that the existing outstanding target company debt is paid off in full, and usually that new debt is reissued in its place. This has the effect of increasing the net funds required for the acquisition. One reason why debt might have to be refinanced is because target company debt may have to be paid off in full in a change-of-control scenario, according to the terms of the debt.”
"What is the true cost of buying a company in a Leveraged Buyout? Answer Choices: 1) Its Enterprise Value. 2) Its Equity Value. 3) Neither of the above."
“Explanation:
The correct answer choice is C. Strictly speaking, neither Equity Value nor Enterprise Value represents the true cost of buying out the company. The true cost to buy the company depends on what you do with the company’s existing debt. If you assume the existing debt, then the effective purchase price will be closer to the Equity Value (but not exactly). On the other hand, if you refinance the existing debt, the effective purchase price will be closer to the Enterprise Value (but again, not exactly). In summary, the true cost to buy out a company depends on whether you assume or refinance the existing debt outstanding.”
“Which of the following leverage and coverage ratios below are NOT reasonable?
Answer Choices:
1) Total Debt / EBITDA cannot exceed 3.0x.
2) EBITDA / Interest Expense cannot fall below 5.0x.
3) EBITDA / Cash Interest Expense must exceed 20.0x.
4) Senior Debt / EBITDA cannot fall below 0.1x.”
The correct answer choices are C and D. Answer choices A and D are examples of leverage ratios, whereas B and C represent interest coverage ratios. Both A and B are very reasonable leverage and coverage ratio levels. The coverage ratio in answer choice C is unreasonable for the reason that it is too high and thus indicates the company in question has unused debt capacity, which could increase the IRR return even higher. The leverage ratio in answer choice D is also nonsensical – 0.1x is barely even meaningful, and normally leverage ratios are framed in terms of “cannot exceed” rather than “cannot fall below” – because the concern is what happens when debt gets too high.
“Which of the following statements is TRUE regarding revenue growth in an LBO model?
Answer Choices:
1) Projecting revenue growth in an LBO model is very similar to doing so in a traditional DCF.
2) Due to revenue synergies, in an LBO model one assumes increases in Year-Over-Year revenue growth rates, even in the final years.
3) Revenue growth rates are much higher in LBO models versus M&A models due to such high levels of debt.
4) In a DCF, you want to show declining revenue growth over time, but in an LBO model you want to show constant revenue growth from year to year.”
The correct answer choice is A. All of the above statements with the exception of answer choice A are false. Projecting top-line revenue growth in an LBO is similar to a DCF in that you assume a higher growth rate in earlier years that decreases annually until the terminal year where it is at a steady state. Answer choice B is false because you never assume higher revenue growth rates in the final years, especially in the terminal year – as companies get bigger, it gets harder to grow at the same rate. Answer choice C is false as well – revenue growth has nothing to do with the high levels of leverage used in an LBO. The borrowed funds enhance the returns earned, but they do not accelerate the top-line revenue growth rates per se. D is false because in both models you want to show declining revenue growth over time.
“When building an LBO model, it is best to keep the EBIT and EBITDA margins within the same range every year throughout the projection period.
Answer Choices:
1) True
2) False”
The correct answer choice is A. It is a more conservative assumption to keep the EBIT / EBITDA margins constant throughout the projection period in an LBO model. The reason this is a conservative assumption is because an increasing EBIT / EBITDA margin will result in a much higher exit value and thus a higher IRR return. It certainly can be the case that due to operational improvements, the PE fund is able to enhance the portfolio company’s operating margin to make it more profitable and thus make the company itself worth more. However, it is very difficult to enhance profit margins in the real world, and thus a more conservative assumption is that they remain constant so as not to unduly enhance the assumed exit value of the portfolio company.
"Which of the following fees are CAPITALIZED rather than expensed in an LBO? Answer Choices: 1) Financing Fees. 2) Transaction Advisory Fees. 3) Legal Fees."
The correct answer choice is A. The accounting treatment is slightly different for transaction fees. All legal and advisory fees – namely, fees paid to investment bankers, M&A lawyers, and other deal participants – are paid out in cash at transaction close. This decreases cash on the balance sheet and decreased Shareholder’s Equity on the other side of the balance sheet so both sides remain in balance. Financing fees, which arise due to the additional debt that is issued to fund the LBO purchase, are also paid out in cash. However, the amount paid then is capitalized on the balance sheet as an Asset, and amortized each period as an expense, which then flows through to the income statement (similar to how depreciation and amortization expense hit the income statement).
“Which of the following items is LEAST likely to be adjusted on the company’s Balance Sheet in an LBO?
Answer Choices:
1) Shareholder’s Equity.
2) PP&E.
3) Goodwill and Other Intangible Assets.
4) Long-Term Debt.
5) All of the above will always be adjusted.”
Answer choice A is definitely wrong because Shareholders’ Equity always gets wiped out and replaced by the PE firm’s equity contribution in an LBO. C is also wrong because Goodwill & Other Intangibles also get replaced by the premium the PE firm pays over the company’s Book Value – and it’s exceptionally unlikely that there will be no premium. D is incorrect because Debt is added to the company in 99.9% of all LBOs – otherwise there would be no point in even conducting an LBO. That leaves B as the correct choice – in many cases, PP&E will be written up to fair market value… but that doesn’t necessarily happen all the time. Especially in cases where the company’s PP&E is minimal or relatively new, you may not see this adjustment at all.
“Which of the following statements are TRUE regarding how debt repayment and interest payment work in an LBO model?
Answer Choices:
1) Normally you assume existing outstanding debt on the Balance Sheet gets repaid first.
2) Optional Debt Repayments only take place AFTER Mandatory Debt Repayments have been made.
3) The Revolver, Term Loans, and Senior Notes are all repaid under “Optional Debt Repayments”.
4) The Revolver is drawn only when the cash required for Mandatory Debt Repayments exceed the cash flow you have available to repay them.”
The correct answer choices are A, B, and D. Answer choice A is true as the assumption is made that existing debt is repaid first. Answer choice B is true as after mandatory debt repayments have been made, excess cash flows can be used for optional debt repayments. Answer choice C is false as only the revolver and term loans are paid under optional debt repayments; senior notes do NOT allow for prepayments before maturity. Answer choice D is true and explains the purpose of the revolver – a source of financing to draw upon when shortfalls in cash flows for mandatory debt repayments occur.