Columbia LBO Q&A Flashcards
WHAT IS AN LBO?
A leveraged buy-out (“LBO”) is the acquisition of the stock of a company using a small amount of equity relative to the overall purchase price. The acquisition is largely debt- financed by a combination of loans, bonds, and/or mezzanine finance, in addition to equity contributed by the financial sponsor and company management. The transaction may be the leveraged acquisition of the stock of a public company (public-to-private transaction), the leveraged acquisition of a non-core business segment of a larger company, or the leveraged acquisition of a private company from another financial sponsor. An LBO can also be structured as a management buy-out if management, as opposed to a financial sponsor, is purchasing the equity of the company.
The equity contribution is most often made by a financial sponsor, also known as a private equity fund, or LBO fund. In addition to the investment rationale, the financial sponsor aims to add value to the company by improving top-line growth and/or increasing operating and EBITDA margin/dollars, while reducing leverage over the investment time horizon. An LBO analysis can also provide a “floor” valuation of a company, useful in determining what a financial sponsor can afford to pay for the target company while still realizing a return on investment above the financial sponsor’s internal hurdle rate.
The financial sponsor has, as their transaction rationale and main objective, the sale of the firm at a higher EBITDA margin/dollars and/or a higher multiple than it was purchased in a timeframe of approximately five years. The performance of the investment is measured both in terms of internal rate of return (“IRR”) and cash-on-cash returns.1 In a simplified format, the effect of leverage on a transaction’s returns is illustrated in Exhibit 1 (Example of the Effect of Leverage on Returns).
WHO IS IN THE CAST OF CHARACTERS?
The parties in a leveraged buy-out are many and varied. (See Exhibit 2 for the basic structure of an LBO transaction.) Financial sponsors often differentiate themselves by specializing in investment approaches, such as large cap, middle market, and emerging markets buy-outs, as well as distressed principal investing and growth equity. Financial intermediaries of all types play a role in issuing debt instruments to finance the transaction. Fixed income institutional investors of all types, including mutual funds, hedge funds, insurance companies, and banks purchase the debt issued to finance a leveraged buy-out. Accountants, lawyers, rating agencies, valuation firms, and management consultants round out the cast of characters in a leveraged buy-out.
WHAT COMPANIES MAKE GOOD LBO CANDIATES?
Financial sponsors evaluate companies with valid investment rationales, such as:
• Undervalued companies relative to peers
• Underperforming companies relative to peers
• Companies waiting for a catalyst to promote expansion
• Underleveraged companies relative to cash flow
• Companies with high cash balances
• Companies with high barriers to entry, and/or sustainable competitive advantages
• Companies with stable or strong operational cash flows
• Companies with monetizable assets
• Companies with moderate capex and R&D requirements
• Companies with a strong management team
How do PE firms add value?
As part of the financial engineering of a leveraged buy-out transaction, private equity firms can increase the returns on their investment by:
• Reducing the purchase price
• Increasing the exit multiple (“multiple expansion”)
• Increasing the leverage used to finance the transaction
Private equity firms can also add value to their investment by improving the company’s operations, which ultimately increases the EBITDA margin/dollars (“margin expansion”) during the sale year by:
• Increasing top-line growth (revenues)
• Decreasing costs (COGS or SG&A)
• Accelerating the cash conversion cycle
EXIT STRATEGIES
The private equity sponsor seeks to exit its investment in a reasonable time horizon (three to seven years, often modeled with a five-year time horizon), and a future liquidation event can include:
• An initial public offering (“IPO”)
• A sale to a strategic investor
• A sale of the company to another private investor
• A recapitalization, where new debt is issued at a holding company level with the intention of using the proceeds to distribute returns to the equity investors
SENSITIVITY TABLES
Compare IRR and MOM vs multiple and operational sensitivities
1. Transaction: entry/exit multiples; leverage scenarios
(Leverage depends on asset quality and market conditions and deal terms and needs of creditors)
2. Opeartional (EBITDA margins, Revenue growth)
Assumption of debt?
Shows up in sources and uses.
If there’s no change of control provision? Common for bonds and HY instruments. Bank loans almost always have COC clauses and are refinanced
Drivers of an LBO Model
Margin expansion
- Price increases, cost cutting and general efficiency, operating leverage
Debt paydown
- Free cash flow (WC, capex)
Multiple expansion
- Cheap purchase price
- Rollups to increase value of the company
Uses of Cash
Offer price –> old equity holders, deferred compensation at a change of control, etc
Refi debt
Fees (financing and expenses)
OID
After you know the purchase price / total cash needed, you look to financing and plug the residual
Sources
Excess cash on the balance sheet New Debt Rollover debt Rollover equity Sponsor cash Co-investor capital
Benefits of mgt rollover?
Reduce initial equity check (but have to split equity), but align interests
d. How should minimum cash be modeled? In which parts of the LBO model is it present?
o Purchase price calculation: The minimum cash is considered an operating asset, so is already part of the equity value and does not need to be added back to go from equity to enterprise value.
o Sources and uses of cash: The minimum cash restricts the amount of cash that can be used as a source of cash to pay selling shareholders.
o Balance sheet: There must be at least the minimum cash on the balance sheet in order to guarantee the going concern of the business.
o Income statement: Other than some minor impacts to the non-operating section, there is no relevant impact; however, if the actual cash balance drops below the minimum cash balance, it could become impossible to keep the business going.
a. Why are credit statistics important?
Credit statistics shine light on the viability of the proposed capital structure, relative debt levels (“leverage”), and sufficiency of the cash flow to meet future
obligations (“coverage”). They are calculated on an annual or quarterly basis and show changes in the capital structure over time.
Capex
If possible, capex should be differentiated between “maintenance capex,” which represents the minimum level of investment needed to keep the business revenue generation potential intact (e.g., new trucks needed to replace aging ones, current maintenance to facilities), and “growth capex,” which is the cash required to finance the growth of the business; in a downside scenario “growth capex” can be deferred or scrapped.
