Financial Statement Adjustments and Debt Schedules

Question 1

Walk me through how you adjust the Balance Sheet in an LBO model

Answer 1

Very similar to what you see in a merger model
- calculate goodwill, OIA and rest of the write-ups in the same way
- then BS adjustments are almost the same
Differences:
- assume existing SE is wiped out and replaced by value of cash the PE firm contributes to buy the company
- in an LBO model you’ll usually add more tranches of debt compared to what you would see in a merger
- in an LBO model you’re not combining two companies’ balance sheets

Question 2

why are Capitalized Financing Fees an Asset?

Answer 2

• just like the prepaid expenses item on the assets side: paid for in cash up-front, and then recognised as an expense over many years. Since company has already paid for it in cash, its not going to cost them anything more in future periods
• an asset represents potential future income or potential future savings; capital financing fees have already been paid in cash, so when the expense is recognised on the income statement over several years it reduces the company’s taxes.

Question 3

How would you adjust the Income Statement in an LBO model?
- cost savings
- new depreciation expense
- new amortisation expense
- interest expense on LBO debt
- sponsor management fees

Answer 3

• cost savings - often assume PE firm cuts costs by laying off employees, which could affect COGS, operating expenses or both
• new depreciation expense - comes from PP&E write-ups in the transactions
• New Amortization Expense – This includes both the amortization from written-up intangibles and from capitalized financing fees.
• Interest Expense on LBO Debt – You need to include both cash and PIK interest here.
• Sponsor Management Fees – Sometimes PE firms charge a “management fee” to a company to account for the time they spend managing it.

Question 4

Can you walk me through how a Debt Schedule works in an LBO model when you have multiple tranches of Debt? For example, what happens when you have Existing Debt, a Revolver, Term Loans, and Senior Notes?

Answer 4

First, note that you must make all mandatory debt repayments on each tranche of debt before anything else, no real order there - simply have to repay what is required, order applies only when you have extra cash flow beyond what is needed meet these mandatory debt repayments:
- revolver: borrow addition funds here and add to balance if not enough cash flow, use extra cash flow each year to repay this revolver before any other debt
- existing debt: comes first, before new debt raised in LBO
- term loans: payments on these come after paying off revolver and existing debt
- senior notes: these come last in hierarchy, typically optional repayment is limited or not allowed at all.

Question 5

Explain how a Revolver is used in an LBO model.

Answer 5

Use a revolver when the cash required for MDR exceeds the cash flow you have available to repay them.
- revolver borrowing = MAX(0, Total Mandatory Debt Repayment – Cash Flow Available to Repay Debt)

You add any required Revolver Borrowing to your running total for cash flow available for debt repayment before you calculate Mandatory and Optional Debt Repayments.
Within the debt repayments themselves, you assume that any Revolver Borrowing from previous years is paid off first with excess cash flow before you pay off any Term Loans.

Question 6

let’s say that we have $100 million of debt with 5% cash interest, 5% PIK interest, and amortization of 10% per year. How do you reflect this on the financial statements?

Answer 6

• IS: 5 mil cash interest, 5 mil PIK interest, for total of 10 million in expense, which reduces PreTax income by 10 mil and net income by 6 million assuming 40% tax rate
• CFS: add 5 mil PIK interest, CFO down 1 million, 10% amortisation per year, repay 10 mil debt, so cash down 11 million
• BS: cash is down by 11 million on the assets, debt up by 5 million due to PIK interest, but down 10 million due to principal repayment, net reduction of 5 mil. SE down 6 mil, so both down 11 million.

Question 7

why do we show PIK interest in the Cash Flow from Operations section? Isn’t it a financing activity?

Answer 7

Interest expense never shows up in CFF as it is tax deductible and it always appears on the income statement, so show again would be double counting

• show PIK interest in CFO section as it is a non-cash expense being added back.

Question 8

What if there’s a stub period in a leveraged buyout? Normally you assume full years, but what happens if the PE firm acquires a company halfway through the year instead?

Answer 8

In this case, you have to project the financial statements for this “stub period,” which is easier than it sounds because it is usually a matter of multiplying the full-year statements by 1/4, 1/2, 3/4, and so on. If you have quarterly projections you could use those and avoid the need for extra math.