BIWS Module 5 - LBO Model Flashcards
1
Q
What are the 3 key reasons why an LBO works?
A
- By using debt, you reduce the up-front cash payment for the company, which boosts your returns (you gain access to the same cashflows with less of a down payment)
- Using the company’s cash flows to repay debt principal and pay interest
also produces a better return than keeping the cash flow - You sell the company in the future, which allows you to gain back the majority of the funds you spent to acquire it in the first place
2
Q
What makes a good LBO candidate?
A
- Stable and predictable cash flows (so they can repay debt)
- Undervalued relative to peers in the industry (lower purchase price)
- Low-risk businesses (debt repayments);
- Not have much need for ongoing investments such as CapEx
- Have an opportunity to cut costs and increase margins
- Have a strong management team
- Have a solid base of assets to use as collateral for debt.
3
Q
How do you assume purchase price?
A
Use all the standard methodologies and also look at the premium if it’s a public company; you focus on Equity Value because you need to acquire all the outstanding shares of a public company
4
Q
How do you assume % of D and E?
A
Based on recent, similar deals as well as what lenders will go for – if you propose 90% debt, for example, that might be too aggressive and risky for them
5
Q
What is the general annual principle repayment for bank debt?
A
10%-20%
6
Q
Why is bank debt less risky than high yield debt?
A
Bank debt is secured by collateral, whereas high-yield debt is unsecured
7
Q
What is the general annual principle repayment for high-yield debt?
A
Tends to have no annual repayment
8
Q
What are common sources of funding in the sources and uses section? (3)
A
- Debt
- Investor Equity (cash from PE firm)
- Debt Assumed
9
Q
What are common uses of funding in the sources and uses section? (4)
A
- Equity Value of the Company
- Advisory, Legal, Financing, and Other Fees
- Debt Assumed
- Refinanced Debt
10
Q
What happens to existing debt during acquisition?
A
Most often, the PE firm must pay it off when it buys the company because the terms of the debt state that it must be repaid when the company is acquired.
11
Q
What happens if the PE firm assumes the debt?
A
It records it in both the Sources and Uses columns and the existing debt remains on the company’s Balance Sheet afterward.
12
Q
If the PE firm assumes the debt, what is the impact on the funds it must raise? What if they pay off the debt?
A
If the PE firm assumes the debt, it has no impact on the total funds it must raise; if it pays off the debt, it increases the funds required.
13
Q
Do you pay the equity value or enterprise value to acquire a company in a leveraged buyout?
A
Assuming Existing Debt: In this case, the effective purchase price will be closer to the company’s Equity Value (but not the same due to cash).
Repaying Existing Debt: The effective purchase price will be closer to the company’s Enterprise Value (but not the same due to cash).
14
Q
What should be the general trend for revenue you growth over time?
A
It should decline (ex: start at at 10% and then go down to 5% by year 5)
15
Q
What assumptions should you make about EBIT/EBITDA margins?
A
Stay in the same range each year
16
Q
What is FCF for in the context of an LBO model?
A
Cash Flow from Operations - CapEX
17
Q
What does finding FCF let us do?
A
Find out how much cash we have available to repay debt principle each year, after we have already paid for our normal expenses and interest expense on that debt
18
Q
What if there are other recurring items in the Cash Flow from Investing and Cash Flow from Financing sections?
A
You can include them in FCF calculation - but it is not very common to see them in LBO model
19
Q
Why does interest on debt not show up on Cash Flow Statement?
A
Because it is tax deductible → shows up on I/S (already included in I/S)
20
Q
What are three factors that could prohibit a company from paying down more principle?
A
- The company must maintain a minimum cash balance
- Not all types of debt can be repaid early (allowed w/ bank debt but not high-yield)
- Company may not have enough cash flow for minimum mandatory debt payments
21
Q
What happens if the company does not have enough cash flow for its minimum mandatory debt repayments?
A
The company would need to borrow more via a Revolver (sort of like a credit card for a company) to make the mandatory repayments
22
Q
What is the interest expense on the I/S dependant on?
A
How much Debt is paid off over the course of a year – because the company pays interest each quarter or each month
23
Q
What is the IRR if a company doubles its money in 5 years?
A
15% IRR
24
Q
What is the IRR if a company triples its money in 5 years?
A
25% IRR
25
What is the IRR if a company doubles its money in 3 years?
26% IRR
26
What is the IRR if a company triples its money in 3 years?
44% IRR
27
Approximate IRR in the following scenario:
* A PE firm buys a company with no existing cash or debt for $1 billion, at an EV / EBITDA multiple of 10x.
* They use 50% debt and 50% equity
* At the end of a 5-year period, they sell the company for the same 10x EBITDA multiple, but its EBITDA has grown to $150 million.
* It has also paid off $100 million worth of debt.
Enterprise Value roughly = EV of 1 billion. Therefore they company puts down $500m of equity and debt. Therefore there is $400m of debt left at the end. The company exits at 10x EBITDA, therefore $1.5 billion, but must pay off $400m in debt, leaving the firm with $1.1billion in profit, more than doubling their money in 5 years. Doubling your money in 5 years represents a IRR of 15%, so therefore the IRR is just over 15%, at 17.1%
28
What three variables make the largest impact on IRR in a leveraged buyout?
1. Purchase Price
2. %Debt/Equity
3. Exit Price
29
What can increase IRR? (6)
Lower purchase price, less equity, higher revenue growth, higher ebitda margins, lower interest rates, lower capex
30
What can reduce IRR? (6)
Higher purchase price, more equity, lower revenue growth, lower ebitda margins, higher interest rates, higher capex
31
What is a dividend recap?
This PE firm forces the company to take on additional debt and issues a big cash dividend to itself with the proceeds of that debt
32
Do dividend recaps boost or diminish returns? Why?
They boost because they allow the PE firm to get some of its capital back earlier on rather than waiting for the official exit
33
What’s the point of assuming a minimum cash balance in an LBO?
The point is that a company cannot use 100% of its cash flow to repay Debt each year – it always needs to maintain a minimum amount of cash to pay employees, pay for general and administrative expenses, and so on.
So you normally set up assumptions such that any extra cash flow beyond this minimum cash balance is used to repay debt.
34
What are the two major challenges of completing an LBO with a private company?
1. The company may not want to sell, especially if it’s owned by one person, and unlike with public companies the PE firm cannot “force” a sale
2. Information is more limited, so you may not even be able to assess whether or not an LBO is feasible
34
35
Why is it no longer a "true" LBO if you acquire less than 50% of a company?
You cannot "force" the company to take on more debt
36
Why do PE firms use leverage when buying a company?
They use leverage to increase their returns.
Any debt raised for 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 other people than it is on $5 billion of your own money.
A secondary benefit is that the firm also has more capital available to purchase other companies because they’ve used debt rather than their own funds.
37
Walk me through a basic LBO model (5 steps)
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.
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.
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.
38
What variables impact a leveraged buyout the most?
Purchase and exit multiples (and therefore purchase and exit prices) have the greatest impact, followed by the amount of leverage (debt) used; generally, more leverage also results in higher returns (as long as the company can still meet its debt obligations).
Revenue growth, EBITDA margins, interest rates and principal repayment on Debt all make an impact as well, but they are less significant than those first 3 variables.
39
How do you pick purchase multiples and exit multiples in an LBO model?
The same way you do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO transactions have been completed at. As always, you 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.
40
What is an “ideal” candidate for an LBO? (7)
* Have stable and predictable cash flows (so they can repay debt);
* Be undervalued relative to peers in the industry (lower purchase price);
* Be low-risk businesses (debt repayments);
* Not have much need for ongoing investments such as CapEx;
* Have an opportunity to cut costs and increase margins;
* Have a strong management team;
* Have a solid base of assets to use as collateral for debt.
41
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?
You use it to value a company by setting a targeted IRR (for example, 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to achieve that IRR.
This is sometimes called a “floor valuation” because PE firms almost always pay less for a company than strategic acquirers would.
42
How is an LBO valuation different from a DCF valuation? Don’t they both value the company based on its cash flows?
The difference is that in a DCF you’re saying, “What could this company be worth, based on the present value of its near-future and far-future cash flows?”
But in an LBO you’re saying, “What can we pay for this company if we want to achieve an IRR of, say, 25%, in 5 years?”
So both methodologies are similar, but with the LBO valuation you’re constraining the values based on the returns you’re targeting.
43
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?
1. The PE firm does not hold the company for the long-term – it sells it after a few years, so it is less concerned with the higher “expense” of debt over cash and is more concerned about using leverage to boost its returns by reducing the capital it contributes upfront.
2. In an LBO, the company is responsible for repaying the debt, so the company assumes much of the risk. Whereas in a strategic acquisition, the buyer “owns” the debt, so it is more risky for them.
44
How could a private equity firm boost its return in an LBO?
1. Reduce the Purchase Price.
2. Increase the Exit Multiple and Exit Price.
3. Increase the Leverage (debt) used.
4. Increase the company’s growth rate (organically or via acquisitions).
5. Increase margins by reducing expenses (cutting employees, consolidating buildings, etc.).
45
How could you determine how much debt can be raised in an LBO and how many tranches there would be?
Usually you would look at recent, similar LBOs and assess the debt terms and tranches that were used in each transaction.
You could also look at companies in a similar size range and industry, see how much debt outstanding they have, and base your own numbers on those
46
What are the differences between Bank Debt and High-Yield Debt? (4)
There are many differences, but here are a few of the most important ones:
* High-Yield Debt tends to have higher interest rates than Bank Debt (hence the name “high-yield”) since it’s riskier for investors.
* High-Yield Debt interest rates are usually fixed, whereas Bank Debt interest rates are “floating” – they change based on LIBOR (or the prevailing interest rates in the economy).
* High-Yield Debt has incurrence covenants while Bank Debt has maintenance covenants. The main difference is that incurrence covenants prevent you from doing something (such as selling an asset, buying a factory, etc.) while maintenance covenants require you to maintain a minimum financial performance (for example, the Total Debt / EBITDA ratio must be below 5x at all times).
* Bank Debt is usually amortized – the principal must be paid off over time – whereas with High-Yield Debt, the entire principal is due at the end (bullet maturity) and early principal repayments are not allowed.
Usually in a sizable leveraged buyout, the PE firm uses both types of debt.
47
Why might you use Bank Debt rather than High-Yield Debt in an LBO?
If the PE firm is concerned about the company meeting interest payments and wants a lower-cost option, they might use Bank Debt.
They might also use Bank Debt if they are planning on a major expansion or Capital Expenditures and don’t want to be restricted by incurrence covenants.
48
Can you explain how the Balance Sheet is adjusted in an LBO model?
First, the Liabilities & Equity side is adjusted – the new debt is added, and the Shareholders’ Equity is “wiped out” and replaced by however much Investor Equity the private equity firm is contributing (i.e. how much cash it’s paying for the company).
On the Assets side, Cash is adjusted for any cash used to finance the transaction and for transaction fees, and then Goodwill & Other Intangibles are used as a “plug” to make the Balance Sheet balance.
There will also be all the usual effects that you see in transactions: Asset Write-Ups and Write-Downs, DTLs, DTAs, Capitalized Financing Fees, and so on.
49
Why are Goodwill & Other Intangibles created in an LBO?
These both represent the premium paid to the Shareholders’ Equity of the company. In an LBO, they act as a “plug” and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Assets side.
50
How do you project the financial statements and determine how much debt the company can pay off each year?
The same way you project the financial statements anywhere else: assume a revenue growth rate, make key expenses a percentage of revenue, and then tie Balance Sheet and Cash Flow Statement items to revenue and expenses on the Income Statement – and to historical trends.
To project the cash flow available to repay debt each year, you take Cash Flow from Operations and subtract CapEx.
Just as in the DCF analysis, you assume that other items in the Investing and Financing sections are non-recurring and therefore do not impact future cash flows.
Note that this calculation only determines how much in debt principal the company could potentially repay – interest expense has already been factored in on the Income Statement, and its impact is already reflected in the Cash Flow from Operations number.
51
What if the company has existing debt? How does that affect the projections?
If the company has existing debt and the PE firm refinances it (pays it off), it’s a non-factor because it goes away. If the PE firm assumes the debt instead, you need to factor in interest and principal repayments on that debt over future years.
Normally you do this by assuming that existing debt principal is paid off first after you’ve calculated Cash Flow from Operations minus CapEx. Then, you can use any remaining cash flow after that to pay off debt principal for new debt raised in the LBO.
52
What’s the proper repayment order if there are multiple tranches of debt?
As mentioned above, normally you assume that existing debt on the Balance Sheet gets repaid first.
After that, it depends on the seniority of the debt and also whether or not the debt can even be repaid early. For example, typically you are not allowed to repay High-Yield Debt before its maturity date.
So if you have a Revolver (sort of like a “credit card” for a company) and then multiple Term Loans (Bank Debt), normally you’ll repay the Revolver first, followed by the most senior Term Loan, and then the more junior Term Loans.
In theory you should want to repay the most expensive form of Debt first – but unlike with student loans, car loans, or mortgages, it’s not always allowed.
53
What is meant by the “tax shield” in an LBO?
This means that the interest a firm pays on debt is tax-deductible – so they save money on taxes and therefore increase their cash flow as a result of the debt from the LBO.
Note, however, that the firm’s cash flow is still lower than it would have been without the debt – saving on taxes helps, but the added interest expense still reduces Net Income by more than the reduced taxes helps the firm.
A lot of people get confused about this point and think that this “tax shield” is a really big deal in an LBO, but it makes a marginal difference compared to all the other variables.
54
What IRR do private equity firms usually aim for?
It depends on the economy and fundraising climate for PE firms, but an IRR in the 20-25% range, or higher, would be “good.” It far exceeds the average annual return of the stock market, and is significantly above the yields on corporate and municipal bonds.
Sometimes PE firms will go lower and accept a 15-20% IRR, but usually they target at least 20%. Remember that private equity is a riskier and less liquid asset class than equities or bonds, so the investors in the private equity fund need to be compensated for that in the form of higher returns.
55
So can the PE firm earn a solid return if it buys a company for $1 billion and sells it for $1 billion 5 years later?
Sure – because the PE firm uses a certain percentage of Debt to buy this company in the beginning. So if they raise $500 million of Debt and only pay with $500 million of cash, and then the company pays off that $500 million of Debt over 5 years and the firm receives back $1 billion in cash at the end, that’s a 15% IRR.
56
How do dividends issued to the PE firm affect the IRR?
Any dividends issued, either in the normal course of business or as part of a dividend recap, increase IRR because they result in the PE firm receiving more cash back.
Usually dividends make less of an impact than the 3 key variables in an LBO: purchase price, exit price, and leverage.
57
Do you need to factor in interest payments and debt principal repayments somewhere in these IRR calculations?
You ignore them because the company uses its own cash flow to pay interest and pay off debt principal. Since the private equity firm itself is not paying for these, neither one affects its IRR.
58
What is a dividend recapitalization (“dividend recap”)?
In a dividend recap, the company takes on new debt solely to pay a special dividend out to the PE firm that bought it.
Dividend recaps boost the IRR in a leveraged buyout because they help the PE firm to recover some of its initial investment early. They have developed a bad reputation among some lenders because the debt in this case does not actually benefit the company itself.
59
How would a dividend recap impact the 3 financial statements in an LBO?
No changes to the Income Statement. On the Balance Sheet, Debt goes up and Shareholders’ Equity goes down, canceling each other out, so that everything remains in balance.
On the Cash Flow Statement, there would be no changes to Cash Flow from Operations or Investing, but under Cash Flow from Financing the additional Debt raised would cancel out the Dividend paid out to investors, so there would be no net change in cash.
60
How are Call Protection and “Prepayment” different?
Call Protection refers to paying off the entire debt balance, whereas “Prepayment” refers to repaying part of the principal early, before the official maturity date.
61
What is PIK (Payment In Kind) debt rather than other types of debt, and how does it affect the debt schedules and the other statements?
Unlike “normal” debt, a PIK loan does not require the borrower to make cash interest payments – instead, the interest accrues to the loan principal, which keeps going up over time. A PIK “toggle” allows the company to choose whether to pay the interest in cash or have it accrue to the principal.
PIK is riskier than other forms of debt and carries with it a higher interest rate than traditional Bank Debt or High-Yield Debt.
Adding it to the debt schedules is similar to adding High-Yield Debt with a bullet maturity – except instead of assuming cash interest payments, you assume that the interest accrues to the principal.
You include this interest on the Income Statement, but you need to add back any PIK interest on the Cash Flow Statement because it’s a non-cash expense.
