Basic Qs Flashcards
What is a leveraged buyout, and why does it work?
PE acquires a company using a combo of debt and equity, operates it for several years, then sells the company at the end of the period to realise a ROI
- during period of ownership, PE firm uses the company’s cash flows to pay interest expense from the debt and to pay off the debt principal
Why does buying with debt get you better returns?
- By using debt, the PE firm reduces the up-front cash payment for the company, which boosts returns.
- Using the company’s cash flows to repay debt principal and pay debt interest also produces a better return than keeping the cash flows.
- The PE firm sells the company in the future, which allows it to regain the majority of the funds spent to acquire it in the first place
Why do PE firms use leverage when buying a company?
Use leverage to increase their returns
Any debt raised for an LBO is not ‘your money’, so its easier to earn a higher return on a smaller amount of your own money and use other’s money to complete as well
Also firm has more capital available to purchase other companies as they’ve used debt rather than their own funds.
Walk me through a basic LBO model steps 1 and 2
Step 1 is 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 is to create a Sources & Uses section, which shows how the transaction is financed and what the capital is used for; it also tells you how much Investor Equity (cash) is required.
Walk me through a basic LBO model. Step 3 and 4
Step 3 is to adjust the company’s Balance Sheet for the new Debt and Equity figures, allocate the purchase price, and add in Goodwill & Other Intangibles on the Assets side to make everything balance.
In 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.
Walk me through a basic LBO model step 5
you 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.
What variables impact a leveraged buyout the most?
Most = purchase + exit multiples, followed by amount of leverage used.
How do you pick purchase multiples and exit multiples in an LBO model?
Same way as anywhere else, look at comparable companies, and what multiples similar LBO transactions have been completed at to validate.
- show a range of purchase and exit multiples using sensitivity tables
What is an “ideal” candidate for an LBO?
- stable and predictable cash flows, so they can repay debt
- be undervalued relative to peers in the industry
- be low-risk businesses
- not have much need for ongoing investments such as CapEx
- have an opportunity to cut costs and increase margins
- strong management team
- solid base of assets to use as collateral for debt.
How do you use an LBO model to value a company, and why do we sometimes say that it sets the “floor valuation” for the company?
Use it to value a company by setting a targeted IRR, and then back-solving in excel to determine what purchase price PE firm could pay to achieve that.
how is an LBO valuation different from a DCF valuation? Don’t they both value the company based on its cash flows?
In DCF you say, what could this company be worth, based on the PV of its near-future and far-future cash flows
In LBO, what can we pay for this company if we want to achieve an IRR of x amount in y years.
Both similar, but in LBO you are constraining the values based on the targeted returns.
Give me an example of a “real-life” LBO.
Buying a house to rent out, then sell once appreciated to a given price.
A strategic acquirer usually prefers to pay for another company with 100% cash – if that’s the case, why would a PE firm want to use debt in an LBO?
Different as:
- PE firm does not hold company for the long-term, sells it after a few years, so less concerned with the higher expense of debt over cash, and more concerned about using leverage to boost its returns by reducing the capital it contributes upfront
- in an LBO, company is responsible for repaying debt, so company assumes much of the risk. In strategic acquisition, buyer owns the debt - so more risky for them.
How could a private equity firm boost its return in an LBO?
- Reduce purchase price
- Increase Exit Multiple and Exit price
- Increase leverage used
- Increase company’s growth rate
- Increase margins by reducing expenses.
