Key Rule #1 Flashcards
Why do sponsors make acquisitions?
same reasons cos do
- asking price < PV FCF
- IRR > WACC
How do sponsors make acquisitions?
- look for undervalued cos that could yield high returns if managed properly
- pay for it
- PE firm runs co, makes improvements
- sell co
How do sponsors look for undervalued cos?
- IRR vs DR
- Does it meet firm’s target?
How do sponsors pay for their companies?
- cash (investor equity) + debt
What is cash also known as for sponsors acquiring cos?
investor equity
Why don’t sponsors use stock to pay for co?
- PE firmst not usually listed
- holding periods are too short
Why do sponsors use debt when paying for co?
Leverage amplifies returns
Why does leverage amplify returns?
- use as much debt as possible
- want to decrease upfront cost of acquiring co
- TVOM = $ worth more today than tomorrow
- IRR increase greater % if you decrease purchase price than increase exit price by same amt in 5 years
- Even if cash flow and net proceeds lower upfront compensates for this.
What is the downside of using so much debt to buy co?
leverage makes bad deals worse
What happens when sponsor sells co?
use proceeds to repay debt
earn high IRR and MoM mult
Sketch out the deal team structure
What is an LBO?
PE firm acquires a company using a combination of Debt and Equity
operates it for several years
sells the company at the end of the
period to realize a return on its investment
During the ownership period, the PE firm uses the company’s cash flows to pay for the interest expense on the Debt and to repay the Debt principal.
How does leverage amplify returns?
if the deal performs well, the PE firm will realize higher returns than if it had bought the company with 100% Equity.
What is a secondary benefit of using so much debt to acquire cos?
PE firm has more available capital to buy other cos
Describe the legal structure of an LBO
- PE firm forms a “holding company,” which it owns,
- “holding company” acquires the real company.
- The banks and other lenders lend to this Holding Company so that the Debt remains at the “HoldCo” level.
- Managers and executives that retain ownership after the deal closes also have shares in this Holding Company.
Why is the legal structure of a deal impt?
- means that PE firm not on hook for debt it uses on the deal
- up to acquired co to repay it
- acquired co borrows the money so that PE firm can do the deal
What is the ideal LBO candidate?
- if the price is right (co undervalued)
- stable & predictable cash flows
- lots of tangible assets
- limited WC and capex reqs
- strong and defensible market position
- ability to reduce costs and increase margins
- undervalued biz or assets
How can an LBO create value for the sponsors?
- using available FCF to repay debt
- operating improvements
- multiple expansion from operating improvements
Explain LBO in simplest language?
- buying a house w mortgage and renting it out
- house is bought, leverage put on to reduce equity injection
- cash flows from rent (earnings) pay down debt and increase value of equity
How do LBOs increase value of company?
- reduce WACC by adding debt that is cheaper on after-tax basis
- realizing operational efficiencies
- increasing ROE through financial leverage
- reduction of public listing costs by taking firm private
- private ownership allows for long-term strategic thinking
How do steady and predictable cash flows make a good LBO target?
better ability to pay down debt
How does large amt of tangible assets make a good LBO target?
more collateral for loans and help increase leverage
How do limited WC and capex reqs make a good LBO target?
high WC and high capex mean less FCF which means less to pay down debt
How do strong and defensible market pos make a good LBO target?
makes cash flow less risky
How do ability to reduce costs and increase margins make a good LBO target?
increase cash available to pay down debt
How do undervalued biz or assets make a good LBO target?
divestible assets can reduce debt burden of buyout
