Key Rule 1

Question 1

Key topics to know - 5

Answer 1

1. What is an LBO, and why does it work?
2. How do you make basic model assumptions in an LBO?
3. How do you project the financial statements in an LBO and pay off debt?
4. How do you calculate returns and determine what influences returns?
5. What are more advanced LBO features you might see?

Question 2

Key rule 1:
- what is an LBO and why does it work

Answer 2

Its similar to buying a house, renting it out and then selling for higher price.
- private equity firms buy companies, with a combination of debt and equity, then sell it 3-5 years in the future to realise a return
- PE firm uses company’s cash flows to pay off interest and debt principal

Question 3

Why does an LBO work?

Answer 3

1. By using debt, reduce up-front payment for the company, which boosts returns.
2. Using company’s cash flows to repay debt principal and pay interest produces a better return than keeping the cash flow
3. You sell the company in the future, which allows you to fain back the majority of the funds you spend to acquire in the first place.

Question 4

Mechanics of an LBO - 6 steps:

Answer 4

1. Private equity firm calculates cost to acquire all shares outstanding of public company, or normal acquisition of private company
2. To raise the funds, PE firm will use a small amount of its cash on-hand, and then raise debt from investors to pay for the rest
3. Can raise debt as it promises investors it will repay them plus extra income from company increasing in value when sold
4. The PE firm raises the debt from investors, then combines that cash with its own to acquire the company
5. PE firm operates the company for years into the future, uses its cash flow to pay the interest and repay the principal on the debt it borrowed to buy the company
6. Then, at the end of 3-5 years, PE firm sells company, or IPOs it and realises a return like that.

Question 5

What makes for a good LBO candidate?

Answer 5

• stable and predictable cash flows
• undervalued relative to peers
• low risk
• not much need for ongoing investments like CapEx
• have an opportunity to cut costs and increase margins
• strong management team
• solid base of assets to use as collateral for debt