Chapter 8 - Leveraged Buyouts Flashcards
- What is an LBO?
A leveraged buyout is an acquisition of a company or division of a
company by a private equity firm using debt for a substantial percentage
of the acquisition financing.
- Why do private equity firms do LBOs?
By using significant amounts of leverage (debt) to help finance the
purchase price, the private equity firm reduces the amount of money
(the equity) that it must contribute to the deal. Reducing the amount
of equity contributed will result in a substantial increase to the private
equity firm’s rate of return upon exiting the investment (e.g., selling the
company five years later).
- What makes a good LBO candidate?
Characteristics of a good LBO target include steady cash flows, limited
business risk, limited need for ongoing investment (e.g., capital
expenditures or working capital), strong management, opportunity for
cost reductions, and a high asset base (to use as debt collateral). The
most important trait is steady cash flows, as the company must have
the ability to generate the cash flow required to support relatively high
interest expense.
- What would be a bad LBO candidate?
A poor LBO candidate is a company with low or unsteady cash flows,
significant business risk, high cyclicality, large capital expenditures
needs, and few salable assets.
- What are key assumptions that go into making an LBO model?
Some of the assumptions that go into an LBO model include all of the
assumptions relating to operating performance, such as revenue growth,
costs, capital expenditures, and working capital requirements. A second
set of assumptions are the purchase assumptions, including the purchase
price, the amount of debt being raised, the types of debt being raised, and
the amount of money contributed by the financial sponsor. A third set of
assumptions are the exit assumptions including when the financial sponsor
will exit its investment and at what valuation or valuation multiple.
- What is an LBO model used for?
An LBO model is used for three primary purposes. The first purpose is
to analyze the expected return (IRR) to the financial sponsor and to any
other equity holders. A second purpose of the LBO model is as a valuation
methodology. A third purpose is to analyze various credit statistics over
the projection period to analyze the company’s ability to service its debt.
- Walk me through an LBO model.
First, we need to make some transaction assumptions. What is the
purchase price and how will the deal be financed? With this information,
we can create a table of sources and uses (where sources equals uses).
Uses reflects the amount of money required to effectuate the transaction,
including the equity purchase price, any existing debt being refinanced,
and any transaction fees. The sources tells us from where the money is
coming, including the new debt and any existing cash that will be used,
as well as the equity contributed by the private equity firm. Typically,
the amount of debt is assumed based on the state of the capital markets
and other factors, and the amount of equity is the difference between
the uses (total funding required) and all of the other sources of funding.
The next step is to change the existing balance sheet of the company
to reflect the transaction and the new capital structure. This is known
as constructing the pro forma balance sheet. In addition to the changes
to debt and equity, intangible assets such as goodwill and capitalized
financing fees will likely be created.
The third and typically most substantial step is to create an integrated
cash flow model for the company—in other words, to project the company’s
income statement, balance sheet, and cash flow statement for
a period of time (say, five years). The balance sheet must be projected
based on the newly created pro forma balance sheet. Debt and interest
must be projected based on the post‐transaction debt.
Once the functioning model is created, we can make assumptions
about the private equity firm’s exit from its investment. For example, a
typical assumption is that the company is sold after five years at the same
implied EBITDA multiple at which the company was purchased. Projecting
a sale value for the company allows us to also calculate the value of
the private equity firm’s equity stake, which we can then use to analyze
its internal rate of return (IRR). Absent dividends or additional equity
infusions, the IRR equals the average annual compounded rate at which
the PE firm’s original equity investment grows (to its value at the exit).
While the private equity firm’s IRR is usually the most important
piece of information that comes out of an LBO analysis, the analysis
also has other uses. By assuming the PE firm’s required IRR (among
other things), we can back into a purchase price for the company, thus
using the analysis for valuation purposes. In addition, we can utilize the
LBO model to analyze the trend of credit statistics (such as the leverage
ratio and interest coverage ratio), which is especially important from a
lender’s perspective.
- How do we use an LBO model for valuation?
We can use an LBO model for valuation by making several assumptions
in addition to the operating assumptions that underlie the financial
model. Specifically, these assumptions are the amount of debt raised
in the transaction, the exit multiple, the time until the investment exit,
and, most importantly, the required return (IRR) to the financial sponsor.
By making these assumptions, we know how much the sponsor
will receive for its equity upon an exit and can back into the amount of
money the sponsor can afford to put into the deal to earn its required
IRR. By knowing the money invested by the sponsor and the amount
of debt that can be raised to do the deal, we can estimate the implied
enterprise and/or equity value today and use that figure for valuation
purposes.
- How might we increase the IRR to a PE firm?
Some of the key ways to increase the PE firm’s return (in theory, at
least) include to reduce the purchase price that the PE firm has to pay
for the company, to increase the amount of leverage (debt) in the deal,
to increase the price for which the company sells when the PE firm exits
its investment (i.e., increase the assumed exit multiple), to increase
the company’s growth rate in order to raise operating income/cash
flow/EBITDA in the projections, and to decrease the company’s costs in
order to raise operating income/cash flow/EBITDA in the projections.
- How do sources and uses work?
In an LBO model, sources and uses must be equal. Key uses include
the purchase price to buy out 100 percent of the existing equity holders,
transaction fees, and the amount of debt that needs to be refinanced.
Sources include the new debt being raised, any cash used from the target
company’s existing balance sheet, and the financial sponsor’s equity
contribution. By setting sources equal to uses, and making the other
assumptions including the purchase price, we can back into the amount
of money that the financial sponsor needs to contribute.
- How do we create the pro forma balance sheet?
To create the pro forma balance sheet for an LBO model, we start
with the most recent actual balance sheet for the target company. We
then make certain adjustments. For example, we reduce the balance
sheet for any cash used to finance the purchase price and for debt that
needs to be refinanced, and increase the balance sheet for new debt. We
wipe out old equity, and include the financial sponsor’s equity contribution
as new equity. We also make adjustments for any changes to fixed
assets or intangible assets, including goodwill and financing fees. The
pro forma balance sheet reflects all of these adjustments and must balance.
- What are considerations to whether a PE firm should do the deal?
Probably the most important consideration for a PE firm is its expected
return (IRR) on the investment. However, the PE firm should also
consider the reliability of its forecasts, as well as the risk of the company
and its ability to service its debt going forward. The PE firm should also
consider the likely exits for its investment several years in the future. PE
firms may also consider doing a transaction if the acquisition will serve
as a platform acquisition for future bolt‐on acquisitions or is a bolt‐on
acquisition for an already‐acquired platform.
- What are some key credit statistics used when analyzing an LBO?
Some of the key credit statistics typically calculated when analyzing
an LBO model include a debt to total capitalization, debt to equity, and
various leverage ratios and interest coverage ratios.
