Error Log LBO IBV Flashcards
What is the interest tax shield?
The interest tax shield is a phenomenon that makes debt a cheaper vehicle of capital than equity. Interest is tax-deductible, as it appears higher than the tax line on the income statement and is treated as a cash expense.
Mechanically, the greater the amount of expenses that a company has, the less tax it has to pay, which provides financial benefits for the company. The interest tax shield is one of the reasons that debt is such an attractive financing vehicle and is also the reason we calculate after-tax cost of debt for the WACC. The PV of a tax shield is Debt Amount x Tax Rate.
What is leverage and how do its mechanics amplify returns in an LBO?
Leverage and the act of “levering up a company” refers to taking on debt or other forms of borrowed capital in order to increase a company’s returns. LBO’s use leverage to improve returns for the investor, which is possible because of three key functions of debt:
● Taking on debt gives you access to other people’s capital that you would otherwise not be able to use. A greater resource pool allows you to purchase a greater quantity of productive assets while reducing the up-front cash investment
● Using the company or asset’s cash flows to repay debt principal produces a better return than just keeping the cash. This is partially a result of the tax shield that is applied to interest, which is a function of how governments and regulators treat debt. Similarly, allowing interest to be tax-deductible makes debt a cheaper source of capital than equity
● Typically a business experiences growth in EBITDA so the exit price is higher than the entry price even at the same multiple. Since the sponsor typically pays back a lot of the debt, a much larger portion of the exit price belongs to the sponsor, creating high returns. For example, entering and exit at an EV of $100, a sponsor may only invest $25 in cash, but receive $80 upon exit, simply by paying down debt
What are the three ways investors can retrieve funds or capital in an LBO?
There are three major ways an LBO investor can retrieve cash or funds from an LBO investment:
● Exit: The sale of the investment at the end of the holding period is the largest inflow of capital for the sponsor as all gains are realized at this point
● Dividend Recapitalization: A dividend recapitalization is when the LBO candidate pays out a special dividend to the sponsors, funded through additional debt. This increases leverage of the company and typically increases IRR because of the time value of money
● Dividends. Yes, although this is very similar to a dividend recapitalization, it is important to recognize these two things as distinctly different actions
What is the internal rate of return (IRR)?
Academically speaking, the IRR is the rate at which the present value of an asset’s cash inflows and outflows is equal to 0.
Practically speaking, IRR is the compound rate you can expect to earn on an investment into an asset. A lower initial investment means that the cash outflow is lower, which would increase the IRR. Higher returns in the future means that the cash inflows are higher, which would also increase the IRR.
If there is only one initial cash outflow and one final inflow, the IRR is simply the compound annual growth rate on the investment. This can be used to sometimes estimate the IRR of projects.
What actions or strategies can you take to improve the IRR in an LBO?
IRR (internal rate of return) is one of the most used metrics to determine the success of an LBO. There are several actions that a firm can take to improve the IRR, which include:
● Lowering the initial purchase price of the company, which reduces the cash investment
● Improving the exit multiple, which increases the funds received
● Increasing leverage, which reduces the amount of upfront investment required
● Conducting a dividend recapitalization
● Exiting the investment earlier
● Accelerating the company’s growth, which should increase EBITDA and the exit multiple
● Improving margins, which has the same effects as faster growth
● Realizing synergies with other portfolio companies or rolling in new acquisitions
What are factors that would make an LBO more difficult to perform on a private company?
1) First, the financials of a private company are much more opaque than public companies. Private companies are not legally required to publish audited financials, which can make it much more difficult to gauge the health and attractiveness of a company. These financials would be necessary to determine the potential returns a firm could generate and the target’s ability to service debt.
2) Second, the absence of floating shares on public exchanges can make it difficult for a firm to acquire a controlling stake in the company. Private equity firms that conduct LBO’s can only do so because they hold a controlling stake in the company and can force the target to assume a greater quantity of debt. Without direct access to these shares, the private equity firm would have to directly solicit shareholders.
3) Finally, obtaining debt can be difficult because of a lack of information, history, and credit rating. Public debt markets are difficult to access for private companies because of the above and also because they simply don’t have the scale for a major issuance.
Why would a revolver have the lowest interest rate?
A revolver is the cheapest form of debt in an LBO. A revolver acts similarly to a credit card, as it is drawn upon if the company has cash shortfalls and is also the first thing paid down.
Revolver interest rates are the lowest because they are pledged against collateral, which reduces its riskiness.
Concurrently, revolvers have the lowest interest rate because commercial banks and lenders treat it as a sweetener in a deal and compete for a company’s business based on how low the rate is.
Why would an LBO not be relevant for the metals and mining industry?
An ideal LBO candidate has dependable cash flows, low capital expenditures and is not exposed to commodity risk.
The metals and mining industry embodies the opposite of this; high initial investments, continual capital expenditures, and direct exposure to unpredictable commodity fluctuations.
During periods of weak commodity prices, senior miners are forced to sell their assets with high cash costs, while junior miners do not have enough money to fuel their capital expenditures.
Accordingly, mergers are more common in the metals and mining industry.
If a company could service debt up to 7X EBITDA, why would it only take debt up to 5X EBITDA?
Raising the maximum amount of debt is not always in the best interest of a company. Some of the reasons that make additional debt unattractive include, but are not limited to:
● It may be a bad secular debt market and it may be hard to raise capital right now. Interest rates could be comparatively higher than the future, which might make it better to defer raising debt
● Raising more debt would hurt cash flows, which increases the overall company risk and compromises its profitability
● Additional debt may impact the company’s perception among potential investors or credit agencies, potentially leading to a reduction to the company’s credit rating
You have the option of either receiving $200M now or $40M each year for 5 years. What IRR would you need to make the value of these two options equal?
This is a trick question, which is tipped off slightly as it is very difficult to mentally calculate an IRR to gauge two investment options.
Here, we remember that IRR makes all future cash flows equal 0 when discounted to the present value. If any of the five future $40M payments are discounted, the sum of their present value would be less than $200M. If any of the five future $40M payments are appreciated, the sum of their present value would be greater than $200M. The only mathematical possibility is if the IRR is 0.
There are two companies with identical growth prospects, margins, business models, etc. The only difference is that one company has 50% debt-to-total capitalization, while the other has 0%. If you were a PE firm and were going to bring the company’s debt-to-total capitalization to 70%, which investment would yield a higher IRR (assuming that the equity purchase price is the same)?
First, we make the assumption that the ability to service debt is the same for both companies, so the interest rates, covenants and debt tolerance for both firms is identical.
With that out of the way, we recognize that the two company’s initial debt-to-total capitalization is irrelevant from a returns basis. It does not matter if you are the firm who raised the debt or if the debt was refinanced from before, the IRR and returns will be the same mathematically. At 70% debt-to-total capitalization, the EV of the two companies would be the same, implying that the IRR would be the same as well.
However, this assumes that the purchase EV is the same in both situations. This is not entirely correct because sponsors typically have to pay a premium on equity (control premium), which does not apply to debt. In this case, the company with the higher debt will result in a higher IRR because it will have a lower purchase price.
Company XYZ has $50M EBITDA, a 6X EBITDA multiple, $200M in bank debt and $200M in high yield debt. What is the value of the debt? What dollar value is the debt trading at?
First, we can determine that the EV of the company is $300M ($50M EBITDA x 6X EBITDA multiple). We can also determine that the total debt of the company is $400M ($200M bank debt + $200M high yield debt). It is clear at this point that the company is undergoing bankruptcy. Based on this, market capitalization and cash are $0 so we allocate the EV to the different tranches of debt by their seniority. We know that bank debt has a higher priority than high yield debt so we allocate $200M from the EV to it.
The remaining $100M in EV ($300M EV - $200M bank debt) represents the value of the high yield debt. The dollar value is $0.50 because it is trading at half of its full value ($100M / $200M)
Walk me through a basic LBO model.
“In an LBO Model, 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 you finance the transaction and what you use the capital for; this also tells you how much Investor Equity is required.
Step 3 is to adjust the company’s Balance Sheet for the new Debt and Equity figures, and also 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.
Finally, in 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.”
Why would you use leverage when buying a company?
To boost your return.
Remember, any debt you use in 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 elsewhere vs. $3 billion of your own money and $2 billion
of borrowed money.
A secondary benefit is that the firm also has more capital available to purchase other companies because they’ve used leverage.
What is an “ideal” candidate for an LBO?
“Ideal” candidates have stable and predictable cash flows, low-risk businesses, not much need for ongoing investments such as Capital Expenditures, as well as an
opportunity for expense reductions to boost their margins. A strong management team also helps, as does a base of assets to use as collateral for debt.
The most important part is stable cash flow.
