IB LBO Questions Flashcards
What is a leveraged buyout (LBO)?
Private equity firm (often called the financial sponsor) acquires a
company with most of the purchase price being funded through the use of various debt
instruments such as loans, bonds.
The financial sponsor will secure the financing package
ahead of the closing of the transaction and then contribute the remaining amount.
Once the sponsors gain majority control of the company, they get to work on streamlining the
business – which usually means operational improvements, restructuring, and asset sales
intending to make the company more efficient at generating cash flow so that the large debt
burden can be quickly paid down.
The investment horizon for sponsors is 5-7 years, at which point the firm hopes to exit by either:
Selling the company to another private equity firm or strategic acquirer
Taking the company public via an initial public offering (IPO)
(Financial sponsors usually target returns of ~20-25% when considering an investment.)
Explain the basic concept of an LBO to me using a real-life example.
Definition: A leveraged buyout (LBO) involves acquiring a company (or asset) using a significant amount of borrowed money, with the goal of improving its value and selling it at a profit.
House-Flipping Analogy:
Purchase: A house is bought primarily with borrowed money (a mortgage), requiring only a small personal investment (down payment).
Debt Repayment: The mortgage is repaid over time using rental income from tenants, covering both interest and principal.
Improvements: Renovations and repairs are funded with rental income to increase the property’s value.
Exit Strategy: After five years, the house is sold for a higher price due to improvements and rising market values. The remaining mortgage balance is paid off, and the owner keeps the profit from the sale.
Key LBO Elements in the Example:
Leverage: Majority of purchase price financed through debt.
Cash Flow Utilization: Rental income covers debt payments and operational improvements.
Value Creation: Renovations and market appreciation increase the property’s resale value.
Profit Realization: Debt is repaid, and the owner retains most of the sale proceeds as equity grows over time.
Debt has a lower COC than equity, therefore, the less equity the sponsor has to contribute, the higher the returns to the fund - all else being equal. Leading to (As the debt principal is paid down throughout the holding period) sponsor to realize higher returns at exit
(private equity firms attempt
to maximize the amount of leverage while keeping the debt level manageable to avoid bankruptcy risk.)
What is the typical capital structure prevalent in LBO transactions?
Debt-to-Equity Ratio:
Historically, LBOs had an 80/20 debt-to-equity ratio in the 1980s but have shifted to a more conservative 60/40 ratio in recent years due to changing financing environments and risk tolerance
Debt Components (Descending Seniority):
Senior Debt: Includes revolving credit facilities (revolvers) and term loans (e.g., TLA, TLB). This is the largest portion of the debt and is secured by collateral.
Subordinated Debt: Includes high-yield bonds, mezzanine financing, and unitranche debt, which are riskier and carry higher interest rates.
Other Debt Instruments: May include senior notes or subordinated notes depending on the deal structure
Equity Contribution:
The private equity sponsor typically contributes 20-30% of the capital structure, with some deals requiring more equity depending on lender requirements or market conditions.
Management often rolls over a portion of their equity (3-20%) to align incentives with the private equity sponsor
Purpose of Structure:
Maximizes returns for private equity sponsors by leveraging debt while minimizing upfront cash investment.
Balances risk through a mix of secured and unsecured debt while ensuring sufficient equity contribution to meet lender requirements
Key Risks:
A highly leveraged structure increases the risk of default if the target company cannot generate enough cash flow to service its debt obligations
What are the main levers in an LBO that drive returns?
The equity value of an investment is the residual value once non-equity claims have been paid off; thus, the importance of deleveraging in LBO value creation.
Debt Paydown (Deleveraging):
EBITDA Growth: Increase margin profile (e.g., cost-cutting, raising prices), implementing new growth strategies, and making accretive add-on acquisitions.
Multiple Expansion: (ideal scenario): Sponsor exits at a higher multiple than entry
Multiple expansion = The exit multiple can increase from
Improved investor sentiment, better economic conditions, increased scale or diversification, and favorable transaction dynamics (e.g., competitive auction led by strategics).
What attributes make a business an ideal LBO candidate?
Strong Free Cash Flow Generation
Recurring Revenue
“Economic Moat”
Favorable Unit Economics:
Strong, Committed Management Team
Undervalued (Low Purchase Multiple)
Value-Add Opportunities
What types of industries attract more deal flow from financial buyers?
Non-Cyclical/Low-Growth
Subscription-Based/Contractual
High R&D Requirements
Potential Synergies
Favorable Industry Trends
What would be the ideal type of products/services of a potential LBO target?
Mission-Critical
Recurring/Contract-Based
High-Switching Costs
High-tech
Location-Based Competition
What is the relationship between debt and purchase price?
The usage of debt enables a private equity firm to purchase companies of a particular size it could otherwise not purchase using equity alone or with a minimal amount of borrowed funds.
In addition, the usage of high debt leaves the firm with more unused capital (called “dry powder”) for other
investments or add-on acquisitions for their existing portfolio companies.
How is the maximum leverage used in an LBO typically determined?
The debt-to-equity mix in private equity deals has hovered around 60% debt/40% equity as
M&A activity stabilized since the 2008 financial crisis.
However, leverage varies significantly across industries, besides being specific to the target company’s fundamental qualities.
Debt/EBITDA has hovered in the 5.0x to 7.0x range and is pressured upward as overall
valuations increase.
When LBOs emerged as a type of M&A transaction in the 1980s, debt represented as much as 90% of the capital structure. But this has come down because of the risks inherent to high debt burdens.
Why might a private equity firm not raise leverage to the maximum leverage, even if it had the option to do so?
A private equity firm will want to maximize the amount of debt without endangering the company and putting it at risk of default sine more leverage means less required equity and the greater the potential returns.
Reasons:
Increased Default Risk
Negative Perception
Decreased Fund Returns/Fundraising Implications
Planned Dividend Recap
What determines a company’s debt capacity?
The more predictable the free
cash flows of the company, the
greater its debt capacity and
tolerance for a high debt-to-equity mix.
Industry Risk:
The analysis begins with assessing the industry’s characteristics, such as growth rate, cyclicality, barriers to entry, technological disruption risks, and regulatory challenges.
Stable and mature industries typically support higher debt capacity due to lower volatility.
Competitive Position:
A company’s market position and ability to differentiate itself are evaluated to determine its resilience and pricing power. Strong competitive advantages increase debt capacity.
Historical Performance & Cash Flow Stability:
Predictable, steady cash flows are critical as they allow a company to handle higher debt levels. Historical financial performance is used to model future cash flows, with a focus on downside scenarios.
Leverage Metrics:
Debt capacity is often expressed as a leverage multiple (e.g., Total Debt/EBITDA) or interest coverage ratio (e.g., EBIT/Interest Expense). These metrics ensure the company can meet debt obligations even under stress scenarios (e.g., EBITDA declines by 20-25%).
Lending Environment:
Debt capacity varies based on prevailing market conditions, such as interest rates and credit availability, which influence lenders’ risk tolerance and terms.
Cushion for Underperformance:
A “cushion” is typically built into the debt structure to ensure the company can service its debt even if financial performance deteriorates.
In the context of an LBO, what is the “tax shield”?
Refers to the reduction in taxable income from the highly levered capital structure.
As interest payments on debt are tax-deductible, the tax savings provide an additional incentive for PE firms to maximize the amount of leverage they can get for their transactions.
Since senior debt is cheaper, why don’t financial sponsors fund the entire debt portion of the capital structure with senior debt?
Senior lenders will only lend up to a certain point (usually 2.0x to 3.0x EBITDA), beyond
which only costlier debt is available because the more debt a company incurs, the higher its
risk of default.
The senior debt has the lowest risk due to its seniority in the capital structure and imposes the strictest limits on the business via covenants, which require secured interests.
Subordinated junior debt is less restrictive but requires higher interest rates than
more senior tranches of debt.
How do financial sponsors exit their investments?
Sale to a Strategic Buyer: The least time-consuming while fetching higher valuations as strategics will pay a premium for the potential synergies.
Secondary Buyout: The next option is the sale to another financial buyer, otherwise known as a sponsor-to-sponsor deal. However, financial buyers cannot pay a premium for synergies (unless it’s an add-on).
Initial Public Offering (IPO): The third method for a private equity firm to monetize its profits is for the portfolio company to undergo an IPO and sell its shares to the public markets. However, this is an option
exclusive to firms of larger-size such as mega-funds or club-deals.
What is the one caveat of an IPO exit?
Is not necessarily an immediate exit per se. Instead, an IPO is a path towards an eventual exit,
as the IPO process is very time-consuming and comes with a lock-up period in which shareholders are prohibited from selling their shares for 90 to 180 days.
What is a secondary buyout?
AKA, a sponsor-to-sponsor deal, is when a PE firm exits an investment by selling to
another private equity firm. There is substantial evidence showing that secondary buyouts have lower return than traditional buyouts, as many of the operational improvements and value-add opportunities have been exhausted by the previous owner.
How might operating a highly levered company differ from operating a company with minimal or no debt?
Highly leveraged companies have a lower margin of error due to high fixed debt-related payments (interest and
principal). Using leverage increases the importance of effective planning and instituting better financial controls, and forces management to become more disciplined with costs and conservative in capital spending,
especially when embarking on new initiatives such as expansion plans or acquisitions.
What is a dividend recapitalization?
Occurs when a financial sponsor, having acquired a company via
an LBO, raises additional debt intending to pay themselves a dividend using those newly raised proceeds.
In most cases, a dividend recap is completed once the sponsor has paid down a portion of the initial debt raised,
which creates additional debt capacity. Therefore, dividend recaps allow for partial monetization and sponsors can de-risk some of their investment,
unlike an outright exit via a sale or IPO. As a side benefit, the dividend recap would positively impact the fund’s IRR from the earlier retrieval of funds.
How can a private equity firm increase the probability of achieving multiple expansion during the sale process?
Building a higher quality business via entering new markets through geographic expansion, product
development, or strategic add-ons could help a PE firm fetch higher exit valuations – and increase the odds of exiting at a higher multiple than entry.
Also, exit multiples can expand due to improvements in market
conditions, investor sentiment in the relevant sector, and transaction dynamics (e.g., selling to a strategic).
Why is multiple expansion viewed as a less than ideal lever for value creation?
The standard LBO modeling convention is to conservatively assume the firm will exit at the same EV/EBITDA multiple as the entry multiple. The reason being that the deal environment in the future is unpredictable, and
relying on multiple expansion to meet the return threshold is risky, given the amount of uncertainty surrounding the exit.
If meeting the return hurdles is contingent on exiting at a higher multiple in the future,
the target company may be a less-than-ideal LBO candidate.
In comparison, the creation of value through EBITDA growth and debt paydown is easier to develop a plan for
than reliance on exiting at a higher multiple, which has many moving pieces out of the investor’s control.
What are some risks you would look out for when assessing potential investment opportunities?
Industry Cyclicality
Customer Concentration
Customer/Employee Churn
Temporarily Inflated Valuations
Past Institutional Ownership
Retiring Key Management
Can you name a scenario when multiple contraction is common?
For large-sized companies undergoing LBOs, it’s normal to see minor multiple contractions.
The reason is that as the company grows larger, the number of potential bidders that could afford to purchase the company grows smaller (i.e., a reduced pool of prospective buyers with sufficient capital). Since there’s less competition, this usually leads to a lower purchase price.
This company could undergo an IPO, but this would depend on the situation, and a minor contraction in the
exit multiple would not impair returns to the fund, especially since the expanded size of the company implies there was revenue and EBITDA growth, as well as debt paydown.
If you had to pick, would you rather invest in a company that sells B2C or B2B?
All else being equal, the revenue quality would be higher for the B2B company. There is a higher likelihood of
long-term contracts for customers that are businesses than consumers. Most individual consumers opt for
monthly payment plans. Simply put, businesses have significantly more spending power than consumers and
are overall more reliable as customers.
Businesses also have more loyalty to a particular company with whom they partner. The primary cause of this
low churn (i.e., revenue “stickiness”) is the switching costs associated with moving to another provider and
overall being less sensitive to pricing changes.
Imagine that you’re performing diligence on the CIM of a potential LBO investment. Which
questions would you attempt to answer?
Is there a strong management team in place and do they intend to stay on during the LBO?
What value does the company’s products/services provide to their customers?
Which factors make the company’s revenue recurring?
Are there any long-term customer contracts?
Where does the team see new opportunities for growth or operational improvements?
What has been driving recent revenue growth (e.g., pricing increases, volume growth, upselling)?
How is the threat of competition? Does this company have a defensible “moat” to protect its profits?
What specific levers does the private equity firm have to pull for value creation?
Is the industry that the company operates within cyclical?
How concentrated are the company’s revenue and end markets served?
Is there a viable exit strategy? Will there be enough buyer interest when the firm looks to exit?
What is a management buyout (MBO)?
Is a leveraged buyout where a significant portion of the post-LBO equity comes from the
previous management team.
The typical premise behind an MBO is that the management team believes it can
operate the company better and create more value under their direction. An MBO usually coincides with recent
underperformance and scrutiny from a company’s shareholder base.
Management will usually provide cash equity and rollover any existing equity. In addition, equity financing can
also include financial sponsors or other investors. The debt financing portion of the MBO, other than the
rollover amount, is similar to that of a traditional LBO.
What is rollover equity and why do private equity firms perceive it as a positive sign?
The existing management team will occasionally rollover some (or all) of its equity into the newly acquired company and may even contribute additional capital alongside the financial sponsor.
The rollover equity is an additional source of funds, and it reduces the amount of leverage needed to be raised and the equity contribution from the financial sponsor to complete the deal.
If a management team is willing to rollover some equity into the new entity, it implies the management team is
doing so under the belief that the risk they’re undertaking is worth the potential upside. It’s beneficial for all parties in the deal for management to have “skin in the game” and have closely aligned incentives.
When might a PE firm prefer to use term loans rather than subordinated notes in an LBO?
Term loans are a cheaper form of debt with lower interest rates, and most PE firms will first maximize the amount that banks and institutional lenders will provide before raising riskier forms of financing. Since
optional repayments are typically allowed with term loans, there’s greater flexibility.
In addition, if the company is expecting to be active in terms of M&A activity (e.g., add-ons, divestitures), the
restrictive incurrence covenants associated with subordinated notes should be considered.
Would a private equity firm prefer high growth or stability in revenue?
The vast majority of traditional buyout firms would choose stability in revenue over rapid growth. Given the capital structure considerations and usage of high leverage, most buyout-focused PE firms would choose consistent, predictable revenue over high growth if the decision were mutually exclusive.
Can a highly capital-intensive industry be appealing to PE investors?
Asset-light industries can often be attractive because they require less capital to be deployed to generate sales
growth.
However, a highly capital-intensive industry could create a high barrier to entry that deters entrants, confers stability, and increases the collective pricing power over customers.
Since a capital-intensive industry implies higher amounts of PP&E, this can become beneficial when raising debt financing. As a result of having more fixed assets that can be pledged as collateral, the company can receive better lending terms as the borrowing base has increased.
Why might a higher average selling price (ASP) or average order value (AOV) not always be better?
While pricing power is a lever for revenue growth, an overly expensive product decreases the number of potential buyers due to the product being out of their price range. Therefore, there must be a balance between
having high pricing from product quality and being able to reach a large enough market for there to be opportunities for expansion and new customer acquisitions.
Explain the strategic rationale behind add-on acquisitions and how it creates value.
An add-on acquisition occurs when a private equity firm’s portfolio company (platform) acquires a smaller company to complement its operations.
Strategic Rationale:
Synergies: The add-on enhances the platform’s product or service offerings, enabling cost savings or operational efficiencies.
Market Expansion: Provides access to new end markets, extending the platform’s reach and growth potential.
Inorganic Growth: Often central to the private equity firm’s initial investment strategy, especially in fragmented industries.
Roll-Up Strategy:
Private equity firms specializing in consolidation target platform companies in fragmented markets and execute multiple add-ons to scale operations and improve competitiveness.
Competitive Advantage in Auctions:
Platform companies can compete with strategic buyers in sale processes by leveraging synergies from add-ons, increasing the attractiveness of their bids.
When might customer concentration be considered being at a manageable level?
An exception to the customer concentration risk will be if there are irrevocable contracts in place (i.e., long- term customer agreements). This contractual obligation between the company and the customer being served
makes the concentration risk more tolerable but could still lead to a discount on the purchase price.
How can value be created during a consolidation play?
Increased Pricing Power: Most customers will pay more for a stronger brand and complementary product or service offerings bundled together, leading to greater pricing power.
More Bargaining Power: Larger incumbents with higher market shares have more leverage when
negotiating terms with suppliers, enabling them to extend their payables (leading to a more attractive cash conversion cycle), in addition to being able to make bulk purchases at discounted rates.
Lower Customer Acquisition Costs (CAC): From improved software (e.g., CRM, ERP) and more infrastructure-related integrations, CACs decrease due to increased scale and higher efficiency.
Improved Cost Structure: Upon closing, the consolidated company can benefit from economies of scale and cost savings. The increased profitability could come from combined divisions or offices, removal of redundant functions, and reduced overhead expenses (e.g., marketing, accounting, IT).
What does “multiple arbitrage” in a roll-up acquisition scenario imply?
Multiple arbitrage refers to acquiring a target company at a lower valuation multiple (e.g., EV/EBITDA) than the platform company’s multiple. This creates immediate value accretion.
Mechanism:
Accretive Transaction: The target’s cash flows are revalued at the platform’s higher multiple post-acquisition, boosting the combined entity’s valuation before operational improvements.
Example: A platform valued at 10x EBITDA acquires a target valued at 6x EBITDA. Post-acquisition, the target’s EBITDA is valued at 10x.
Rationale for Private Equity:
A key driver of add-on acquisitions, enabling instant value creation purely through financial re-rating.
Complements operational synergies (cost savings, revenue growth) but does not rely on them.
Sustainability:
Depends on maintaining the platform’s higher multiple. Market skepticism may arise if arbitrage is perceived as a short-term financial trick versus genuine value creation.
A private equity firm has tripled its initial investment in five years, estimate the IRR?
f the initial investment tripled in five years, the IRR would be 24.6%.
Since it’s doubtful that you would be handed a calculator to solve this question, the most common IRR
approximations should be memorized, as shown in the table below:
Common IRR Approximations
2.0x Initial Investment in 3 Years → ~25% IRR
2.0x Initial Investment in 5 Years → ~15% IRR
2.5x Initial Investment in 3 Years → ~35% IRR
2.5x Initial Investment in 5 Years → ~20% IRR
3.0x Initial Investment in 3 Years → ~45% IRR
3.0x Initial Investment in 5 Years → ~25% IRR
How many years would it take to double a $100,000 investment at a 9% annual return?
The Rule of 72 states that in order to figure out how long it would take to double an investment, divide 72 by
the investment’s annual return. Here, it’s suggested to take approximately 72/9 = 8 years to double.
There is also a lesser-known rule, called the Rule of 115, which estimates the time to triple an investment by
dividing 115 by the rate of return.
If an LBO target had no existing debt on its closing balance sheet, would this increase the returns to the financial buyer?
Since an LBO would involve the capital structure of a target
being replaced, any pre-LBO debt wouldhave no direct
impact on returns.
Upon completing an LBO, the firm has essentially wiped out the existing capital
structure and recapitalized it using the sources of funds raised. For the most part,
the pre-acquisition capital structure, therefore, has no impact because it doesn’t
directly affect the primary return drivers.
The returns to a financial sponsor are based on 1) the initial equity contribution
cash outflow and 2) all cash inflows received throughout the holding period such as
dividends, monitoring fees, and most notably the exit proceeds.
There are a few minor considerations such as the management team being inexperienced with running a
company using leverage (and the lower margin of error). This might be brought up as a risk during debt
financing, but it would be a relatively insignificant detail.
Where do financial sponsors typically get their capital?
Financial sponsors raise capital to fund their investments from insurance companies, pension funds, sovereign wealth funds, endowments, high net worth individuals, and financial institutions.
In the private markets, what does “dry powder” mean?
Committed but unallocated capital a firm has on hand.
Dry powder mounting at record-high levels signifies fewer investment opportunities in the market that fit private equity firms’ criteria. The purchase
multiples usually increase during these times as auction processes become more competitive.
What is proprietary deal sourcing and how does it compare to intermediated deals?
Proprietary Deals: Initiated through cold outreach or existing relationships between the target and the firm.PE firms typically reach out expecting the company not looking to sell currently, but they want to be
the first firm called if mgt looks to sell in the future.
Intermediated Deals: Intermediated auctions, in contrast, are led by an investment bank with an
extensive list of potential buyers. The increased competition among buyers is are likely to lead to higher prices as the sell-side bank is trying to extract the highest sale price in an auction process.
From a limited partner’s perspective, what are the advantages/disadvantages of the private equity
asset class?
Advantages:
Higher Returns:
Private equity targets IRRs of 20-25%, significantly higher than public equities (~10% average)
Active Management:
PE managers actively work with portfolio companies to create value through operational improvements and cost reductions, enhancing returns
Diversification:
PE investments provide exposure to private companies and sectors not available in public markets, reducing portfolio correlation with market fluctuations
Access to Unique Opportunities:
PE offers investments in emerging industries, high-growth startups, and niche sectors, unavailable in public markets
Long-Term Focus:
Longer investment horizons allow companies to prioritize growth and innovation without short-term market pressures
Disadvantages:
Illiquidity:
PE investments are locked in for 5-10 years or longer, limiting flexibility and access to capital
Higher Risk:
Portfolio companies often use leverage, increasing bankruptcy risk compared to public equities
Complexity & Transparency:
PE investments are less transparent, with infrequent valuations and limited visibility into portfolio company operations
High Fees:
PE firms charge substantial management and performance fees (e.g., “2 and 20”), reducing net returns
Market & Economic Sensitivity:
PE performance can be affected by economic cycles, suppressed equity prices, or unfavorable exit conditions
Explain the “2 and 20” compensation structure in private equity
The standard compensation structure prevalent in the private equity industry.
Firm charges 2% of assets under management (i.e., the management fee) and then 20% of the profits earned (i.e., the “carried interest”).
2% Fee: The 2% management fee is typically meant for the firm to cover operational costs (e.g., employee
salaries, administrative expenses).
20% Fee: This is the incentive fee dependent on the fund’s performance. 20% of the firm’s profit beyond a
pre-determined threshold goes toward the general partners (GPs) of the PE firm.
What is a distribution waterfall schedule in private equity and what is the classic PE distribution?
The allocation schedule that shows the distribution of proceeds from an
investment to the various stakeholders in a systematic order based on their claims’ priority. Each stakeholder would have a different claim on the pool of profits based on the security they hold.
Classic PE Distribution Waterfall
- The initial investment from the LPs will first be returned in full, along with any returns related to a fund’s pre-determined minimum hurdle rate.
- Then, 20% of the returns will be distributed to the GPs due to the catch-up clause.
- The remaining excess proceeds would then be split 80% to the LP and 20% to the GP. The percentages can vary, but the 80/20 split is the industry standard
In the distribution waterfall in private equity, what is the catch-up clause?
Will be outlined in the contract with the private equity fund’s LPs. It states that once the LPs have received a specified return (usually their initial investment plus a hurdle rate), the GPs receive the
majority (or all) of the profits until the return proportion outlined in the agreement is met so that the GPs’ return will “catch-up” to the original agreed-upon split since the LPs were paid first
What is a clawback provision?
Gives fund LPs the right to reclaim a portion of the incentive fees distributed to the GPs
that were over the original agreement (i.e., GPs were overpaid in carried interest).
For example, a fund can start well in terms of investment returns (i.e., the first couple of exits), which benefits both the GPs and LPs, but then later, the back-end of the remaining portfolio companies could be less profitable, and this clause gives LPs the right to reclaim some of their capital back.
What is the difference between a recapitalization and an LBO?
LBOs are accounted for as an acquisition, meaning assets are written-up, and goodwill is recognized.
Recapitalizations are mechanically similar but are not accounted for as an acquisition – thus, the asset bases carryover and remain unchanged with no goodwill recognized.
Since no goodwill is recognized, negative equity is often created because the offer price is often higher than the book value of equity.
Why do some portfolio companies pay sponsor consulting fees?
Also known as monitoring fees, is the annual fee paid by a portfolio company to its owner, the private equity firm. Many private equity firms, particularly those with in-house consultants, a team of operating partners, or have a separate division specifically offering consulting services, will arrange
these types of advisory fees in their investment agreement.
What is the impact of the 2017 tax reform on the private equity industry?
- Corporate tax reduced from 35% to 21%
- Companies can roughly deduct interest up to 30% of their EBITDA
- Companies can now accelerate depreciation for tax purposes even more than they could before, which lowers upfront tax bills. This lowers taxes further for capital intensive businesses.
- Companies can no longer carryback NOLs but can carryforward indefinitely for 20 years and offset only 80% of current period income (before tax reform, NOLs could offset 100% of current period income).
For private equity funds, the limited partnership is called a “blind pool.” What does this mean?
When the limited partner (LP) makes a capital commitment to a private equity fund, the most common LP partnership is the blind pool fund. This is the traditional investment model found in the PE industry, and it
means the LPs are not directly involved in the firm’s investment decisions to any extent.
Instead, the investments are made at the discretion of the GPs and the firm’s investment team. Once LPs have
committed capital, they don’t evaluate the investments to be made by the fund. However, most LPs would not invest in a fund unless they have a personal relationship with the GPs, understand their strategy and track record, and have seen their past returns.
In private equity, what is a capital call?
Otherwise known as a “drawdown,” is a
request from the GPs to the LPs to provide the monies they have committed to the fund.
Within the pre-determined duration outlined in the initial agreement, the LP must provide the committed capital (usually ~7- 12 days on average). If an investor invests in a fund, the agreement made is that the investor will provide the capital when requested by the firm – rather than the firm holding on to the capital at all times. Thus, LPs can do
what they want with the committed capital to receive a low-risk return while waiting on the capital call (i.e., invest in mutual funds, liquid government bonds).
However, an LP failing to provide the capital within the timeframe would result in the LP paying a penalty fee or having to pay the remaining committed capital upfront since the terms of the agreement were not abided by.
Walk me through the mechanics of building an LBO model.
An LBO model analyzes the impact of a company buyout by financial sponsors using both its own equity and new borrowing as the two primary sources of capital.
An LBO model analyzes the impact of a company buyout by financial sponsors using both its own equity and new borrowing as the two primary sources of capital.
- Entry Valuation: The first step to building an LBO model is to calculate the implied entry valuation based on the entry multiple and LTM EBITDA of the target company. If the company is publicly traded, then the
offer price per share could alternatively be used.
(Uses of Funds Sources of Funds)
2. Sources & Uses Table
- Purchase price for existing equity//Senior debt (Term Loan A/B)
- Refinance pre-LBO debt//Subordinated debt (mezzanine)
- Transaction/financing fees//Sponsor equity (20-40% of total)
- Free Cash Flow Build:
- Forecast 3-statement model (Income Statement, Balance Sheet, Cash Flow) over 5-7 years.
Debt schedule tracks:
- Interest expense based on floating/fixed rates.
- Mandatory repayments (amortization) and optional prepayments from excess cash flow. - Exit Valuation & Returns:
- Exit multiple (e.g., EV/EBITDA) applied to projected exit-year EBITDA to estimate exit enterprise value.
Sponsor returns calculated via:
- IRR: Annualized return rate.
- MoM: Total proceeds ÷ initial equity investment. - Sensitivity Analysis:
scenarios and sensitivity analysis can be added to provide users with
different ways to look at the model’s output – one common sensitivity is to back into the implied pre-LBO
equity value based on explicit sponsor hurdle rates and operating assumptions.
(Tests impact of variables (e.g., exit multiple, EBITDA growth, debt terms) on IRR/MoM.
Common outputs:
IRR threshold analysis: Minimum exit multiple needed to hit sponsor’s target return (e.g., 20%+).
Breakeven scenarios: EBITDA growth required under different exit multiples.)
What is the purpose of the “Sources & Uses” section of an LBO model?
From the private equity firm’s
perspective, the key component being
quantified is the amount of equity
required to be contributed.
Uses Side: The “Uses” side answers, “What does the firm need to buy, and how
much will it cost?” The most significant usage of funds in an LBO is the buyout
of equity from the target’s existing shareholders. Other uses include
transaction fees paid to M&A advisors, financing fees, and the refinancing of
existing debt (i.e., replacing the debt) if applicable.
Sources Side: The “Sources” side tells us, “Where is the funding coming from?”
The most common sources of funds are various debt instruments, the equity
contribution from the financial sponsor, excess cash on the balance sheet, and
sometimes management rollover.
How would you measure the credit health of a pre-LBO target company?
The two most common types of credit ratios used are leverage ratios and interest coverage ratios.
The leverage ratio parameters will depend on the industry and the lending environment. However, the
total leverage ratio (total debt/EBITDA) in an LBO ranges between 5.0x to 7.0x, with the senior debt ratio (senior debt/EBITDA) around 3.0x.
For interest coverage ratio parameters, as a general rule of thumb: the higher the interest coverage ratio, the better. The interest coverage ratio should be at least 2.0x in the first year post-buyout.
Why is LBO analysis used as a floor valuation when analyzing company value using several
valuation methodologies?
An LBO is called a “floor valuation”
because it’s used to determine the
maximum purchase price the PE firm can
pay to achieve the fund’s minimum IRR
threshold.
The “hurdle rate” is the rate of return that financial sponsors are
required to meet (and ideally exceed) to undertake an LBO
LBO model provides a floor valuation for an investment, as it’s used to determine what a financial sponsor can pay for the target while still realizing the minimum 15% to 25% IRR.
This is due to the risks associated with leverage and relatively short investment
horizons, as well as the return expectations from their fund’s LPs. These hurdle
rates are usually higher than the cost of equity capital on the same business without
those LBO-specific risks. Thus, the present value (or valuation) implied, given those
higher hurdle rates, will be lower than the valuation of the company when analyzed
through the traditional DCF and comps approaches.
When analyzing the viability of undertaking an LBO, how do private equity firms estimate the company’s value in the exit year?
The most common approach is to assume that the private equity firm will exit at the same EV/EBITDA multiple at which the target company was acquired. For example, if sponsors are contemplating an LBO where the purchase price reflects a 10.0x EV/EBITDA multiple, the exit year assumption (usually 5-7 years from the LBO date) will probably be the same 10.0x multiple. Because of the importance of this assumption in determining the attractiveness of the deal to a financial sponsor (i.e., the deal’s IRR), this exit multiple assumption is sensitized, and IRRs are presented in a range of various exit scenarios sponsor (i.e., the deal’s IRR), this exit multiple assumption is sensitized, and IRRs are presented in a range of various exit scenarios.
If you had to choose two variables to sensitize in an LBO model, which ones would you pick?
The two variables chosen would be the entry and exit multiple, as no other variables have the same level of impact on the returns in an LBO. The ideal scenario for a financial sponsor is to purchase the target at a lower
multiple and then exit at a higher multiple, leading to profitable returns.
Some other variables to include in the sensitivity tables are revenue growth, total leverage turns (the leverage
multiple at purchase), and the EBITDA margin.
What are the capex and net working capital requirement considerations for a private equity firm looking at a potential investment?
Lower capex and NWC requirements
means that more free cash flow can be
used to paydown debt and reinvest
into operations.
Cash Flow Priority:
LBO investors prioritize free cash flow (FCF) to service debt and fund growth. High capex and NWC reduce FCF, limiting funds for:
Debt repayment (principal + interest).
Reinvestment in operations or strategic initiatives.
Capex Concerns:
Maintenance vs. Growth: Ideal LBO targets have low maintenance capex (essential for operations). High capex suggests:
Capital-intensive industry (e.g., manufacturing, utilities).
Unfavorable cost structure, reducing profitability and exit multiple potential.
Net Working Capital (NWC) Impact:
Increased NWC (e.g., rising inventory, accounts receivable) ties up cash, straining liquidity.
Negative NWC (e.g., prepaid revenue) is preferred, as it generates cash.
If management decides to rollover equity, how would you calculate their new ownership stake and proceeds received at exit?
The management rollover amount would be either a hardcoded input of the contribution amount in dollars or as a percentage of the new equity.Rollover Equity = Total Equity × Rollover Equity %
The management’s ownership stake in the post-LBO company will be calculated as the rollover equity amount divided by the new equity amount, plus the rollover equity amount.
New Ownership Stake = Rollover Equity Amount/(Rollover Equity Amount + New Equity)
Rollover Equity Proceeds (at exit) = Exit Equity Value × Management Implied Ownership %
What are the two most common return metrics used by private equity firms?
IRR is the effective compounded annual interest rate on an investment.
Internal Rate of Return (IRR)
= (FV/PV)^(1/t) – 1
Multiple of Money (MoM): Referred to as the cash-on-cash return or multiple on invested
capital (MOIC), the MoM is the total inflows divided by the total outflows from the investor’s perspective. MoM compares the amount of equity the sponsor takes out relative to the initial equity contribution.
MoM =Total Cash Inflows/Total Cash Outflows
If you’re given the multiple of money (MoM) of an investment and the number of years the investment was held, what is the formula to calculate the internal rate of return (IRR)?
The IRR can be calculated using the MoM and number of years (t) using the formula below:
Internal Rate of Return (IRR) = MoM^ (1/t) – 1
What levers have a positive/negative impact on the IRR of an investment?
Positive IRR Levers:
- Earlier extraction proceeds
- Increased FCFs
- Multiple Expansion
Negative IRR Levers:
- Delayed Receipt of Proceeds
- Decreased FCFs
- Multiple Contraction
When measuring returns, why is it necessary to look at both the IRR and MoM?
Over shorter time frames, the MoM is
more important than the IRR; however, over longer time frames, achieving a higher
IRR is more important.
Tell me how you would calculate IRR in Excel
To determine the IRR of any investment, you need the magnitude of the cash outflows/inflows and their corresponding dates.
IRR= assumes that each cell is separated by precisely twelve months, which would be unrealistic.
Instead, use = XIRR (Range of CFs, Range of Timing),” in which you’ll drag the selection across the range of cash inflows/outflows and then across the corresponding dates.
What is the difference between gross IRR and net IRR in private equity?
Gross IRR is the returns at the fund
level before deducting any management fees and carried interest
Net IRR, is the returns by a fund at the LP level, once management fees and carried interest have been subtracted.
Tell me about the J-curve in private equity returns.
Refers to the timing of return proceeds received by a fund’s LPs. The graphing of
the net realized IRR of a fund gives rise to the “J” shape. Early in the fund lifespan, the J-curve begins with a steep, negative slope as the initial investments represent capital outflows and the annual management fee paid to the PE firm. But gradually, as the fund exits its portfolio companies after each holding period, the downward
trajectory will reverse course and ascend upward.
If a business that underwent an LBO has been operating as intended, why does the private equity firm not hold on to the investment for a longer duration (e.g., 10+ years)?
The average holding of a private equity firm is about 5 to 7 years. Traditional private equity firms, unlike pension funds that target lower IRRs of around ~8-10%, cannot hold on to portfolio companies for longer
durations since they raise capital in fund structures, and therefore have to return money to their limited partners (LPs) many times before fundraising for their next fund.
Besides the need to return capital to investors in the current fund, IRR is one of the LPs’ primary metrics to evaluate PE firms’ performance. From a firm marketability perspective, it would also be beneficial to avoid holding onto an investment for too long as doing so decreases the fund’s IRR.
In the situation when a private equity firm has the option to exit within a 1 to 2-year time frame, why might the firm be reluctant to proceed with the sale?
Unless the returns realized are an anomaly, PE firms want to avoid holding onto a company for only 1 to 2 years since the capital has to be redeployed. The decision will depend on the deal environment and opportunities present in the market as finding another suitable investment could take a long time. The opportunity cost of having to find a replacement deal will have to be weighed by the firm. In addition, the transaction costs would be another side consideration.
How would you calculate the levered free cash flow yield for private equity investment, and when would it be used?
- Calculation: Levered FCF = EBITDA – Taxes – Interest – Capex – Increase in NWC − Mandatory Debt Amortization
Purpose: Assesses cash generation efficiency relative to the initial equity outlay.
Complements traditional metrics (IRR, MoM) by focusing on liquidity and downside protection.
When used:
- Performance Monitoring
- Dividend Decisions
- Exit Readiness
- Divide the levered FCF by the
initial equity investment amount.
Levered Free Cash Flow Yield (FCFY) = Levered Free Cash Flow/Initial Equity Investment
Key Considerations:
No Universal Target: Varies by industry, capital structure, and debt terms.
YoY Growth: Prioritized over absolute percentage; indicates improving cash generation and reduced risk.
Downside Protection: Higher FCFY implies resilience against underperformance (e.g., EBITDA declines).
If we had not deducted interest and the mandatory debt amortization in calculating the free cash flow above, what metric would we be measuring?
Calculate the unlevered free cash flow. To get to the unlevered FCF yield, the denominator would be enterprise value to match the cash flows.
Unlevered Free Cash Flow Yield =Unlevered Free Cash Flow/Entry Enterprise Value
Would tell the investor how the overall company is performing on an operational level, and it can tell us how much FCF remains to reinvest into the business and pay a dividend to equity holders, as
well as the amount that can be used to paydown debt.
If an acquirer writes-up the value of the intangible assets of a target, how are goodwill and amortization impacted?
During an LBO, intangible assets such as patents, copyrights, and trademarks are often written-up in value.
Recall that goodwill is simply an accounting concept used to “plug” the difference between the purchase price
and fair value of the assets in the closing balance sheet – so a higher write-up means the assets being
purchased are actually worth more. Therefore, a higher write-up of intangible assets means less goodwill will
be created on the transaction date.
Higher write-up means the assets being
purchased are actually worth more. Therefore, a higher write-up of intangible assets means less goodwill will
be created on the transaction date.
Publicly traded companies cannot amortize goodwill under US GAAP – however, private companies can opt to
amortize goodwill for tax reporting purposes. This question is specifically regarding the purchase accounting
on the closing date of the transaction.
How does the accounting treatment of financing fees differ from transaction fees in an LBO?
Financing Fees: Financing fees are related to raising debt or issuing equity. These fees are capitalized and amortized over the debt’s maturity (~5-7 years).
Transaction Fees: Transaction fees refer to the M&A advisory fees paid to investment banks or business brokers, as well as the legal fees paid to lawyers. Unlike financing fees, transaction fees cannot be
amortized and are classified as one-time expenses deducted from a company’s retained earnings.
What does a cash sweep refer to in LBO modeling?
Is when the excess free cash flow after revolver repayments is used to make optional repayments on debt, assuming the debt tranche allows early repayments. In most cases, this optionality to repay debt early comes with a prepayment penalty fee since the lender receives reduced interest payments.
What is the purpose of the minimum cash balance in an LBO model?
Companies need a certain amount of cash for daily operations and meet their net working capital (NWC) requirements.
The debt schedule will contain logical functions that ensure the cash balance never dips below this specified amount. The minimum cash balance will increase the amount of funding required since this cash
on the company’s balance sheet cannot help fund the transaction.
