LBO Flashcards
***What are the 3 LBO levers to drive value creation during holding period?
1) EBITDA growth
- increasing cash flow by increasing revenues, reducing costs, or making accretive acquisitions
- Impacts (1) EXIT equity value and (2) FCF
2) Raising / paying down debt
- ability to pay down debt using consistent cash flows and reducing capital expenditures
- (1) increases EXIT equity value and (2) enhances returns for PE investor
3) Multiple expansion
- purchase multiple vs exit multiple
- typically purchase price / EBITDA
- increases EXIT equity value
e. g., tech investments tend to have a lot of multiple expansion over time –> since entry multiples are so high to begin with, LBO models have sometimes outrageous assumptions on growth/add-on acquisitions, exit multiple etc.
Enterprise value formula
EV = equity value + debt / debt-like instruments - cash / cash equivalents
= Equity Value + [Debt + Preferred Stock + Convertible Debt + Minority Interest + Capitalized Leases - Equity Investments in JVs] - Cash
> capital lease operates similarly to debt (represents a future financial obligation)
In other words, Purchase Equity Value = Purchase EV - Net Debt
Fully diluted shares outstanding (FDSO)
Equals common shares + net shares from anything that can convert to stock
e. g., restricted stock units, warrants, options
- RSUs are similar to shares (can be converted to stock, given to management)
> calculate FDSO using treasury stock method (minimizes dilution to the company by assuming that the company uses proceeds from exercise to buy back shares)
Treasury stock method
Used to compute the minimum dilution to the company
FOR EACH option tranche or warrant type:
1) Proceeds = exercise price per option * # of options outstanding that are IN the MONEY
2) # of shares created (might be 1:1)
3) # of shares purchased = proceeds / acquisition share price
4) Net shares = # of shares created - # of shares purchased
Rule of 72
Used to approximate HOW LONG it will take for an investment to DOUBLE if growing at a fixed compound growth rate (MoM = 2x)
Or
Used to approximate IRR, given how long it takes an investment to DOUBLE (MoM = 2x)
Formula: 72 / # of time periods = IRR (already in percentage)
e.g., If an investment takes 5 years to double, IRR is 72/5 = ~14 percent
RECALL: IRR is the SAME THING as the investment’s CAGR = annual return of an investment
Rule 114
Used to approximate HOW LONG it will take for an investment to TRIPLE if growing at a fixed compound growth rate (MoM = 3x)
Or
Used to approximate IRR given how long it takes an investment to TRIPLE (MoM = 3x)
Formula: 114 / # of time periods = IRR
Rule of 144
Double the rule of 72
Used to approximate HOW LONG it will take for an investment to QUADRUPLE if growing at a fixed compound growth rate (MoM = 4x)
Or
Used to approximate IRR given how long it takes an investment to QUADRUPLE (MoM = 4x)
Formula: 144 / # of time periods = IRR
What is the benefit of amortization of fees (e.g., OID, debt or equity financing fees)?
Amortization increases expenses (e.g., interest), which reduces future tax burden
- BUT NOT ALLOWED TO AMORTIZE ONE-TIME EXPENSES like legal fees
- Can only amortize items with a FINITE LIFE e.g., capitalized financing fees, intangible assets other than goodwill
How to calculate A/R, inventory and A/P?
Use days metrics
A/R = Revenue * (Days AR / 365) Inventory = COGS * (Days Inventory / 365) A/P = COGS * (Days AP / 365)
How do you calculate prepaid expenses or accured liabilities?
Typically a % of revenue
How do you calculate PPE?
Ending PPE = Starting PPE + CapEx - D&A
What are the two most common return metrics?
1) Internal rate of return (IRR)
- an investment’s CAGR
- annual return on an investment
- Most PE firms target ~20% IRR (vs stock market, 8-10% p.a. returns) –> higher in private markets because of risk associated with using debt
2) Multiple OF Money (MoM)
- “cash return”, expressed as a multiple
= Total proceeds / Total investments
= (Exit equity investment + dividends) / Initial equity investment
(Remember: Firm is buying Equity VALUE, but not paying 100% of it with cash, and there’s TRANSACTION fees, so might not equal equity INVESTMENT)
> If you buy 100% of the business, you get 100% of the ending equity value too
Otherwise, if management rolls over equity, you get % ownership * ending equity value
Relationship between MoM and IRR:
(1 + IRR)^t = MoM
IRR = (MoM)^(1/t) - 1
**What are the key LBO steps?
1) List out and calculate key transaction assumptions
- Tax rate, interest rate, initial leverage (Initial debt is a multiple of leverageable EBITDA), entry EBITDA, holding period
- EV and equity value (if public company, start with equity value; if private company, start with EV)
- Purchase price of company
2) List out Sources and Uses of capital
- Key sources: Debt (Bank Debt, Senior Notes, Bonds), Equity investment - Common Stock, Preferred Stock, Options
- Key uses: Purchase equity, Refinance debt (assume net debt = debt on B/S - cash on B/s), Cash Sent to B/S, Original Issue Discount (debt fee, amortized), Underwriting Fees (amortized), Transaction Expenses (one-time, not amortized)
- Total Sources = Total Uses (equity contribution might be a plug)
**Purchase equity value + refinance net debt = Purchase Enterprise Value (check)
3) Forecast financials to calculate Total FCF available to pay down debt (3-statement model)
- Year 0 figures are useful for determining initial debt
- Start calculating Year 1, and typically one year following exit year (forward looking multiple for entry and exit EBITDA)
- Leave interest expense in IS alone (circular reference, depends on AVERAGE DEBT in that year)
4) Lay out Debt Schedule (average debt balance each year, interest rate, total cash interest expense)
- In paper LBO, we use simple assumption that FCF is used to paydown debt UPON EXIT (so we have constant annual interest expense, and need to use cumulative levered FCF)
5) Closing Balance Sheet adjustments
6) Calculate Total FCF available to paydown, then calculate returns (MoM and IRR)
Why do you subtract cash from EV calculation?
Because “buying cash” is REDUNDANT, so we care about NET DEBT (debt - cash)
> all available cash will be used in transaction
What does Minority Interest mean?
Minority Interest or Non-controlling interest refers to the % of a subsidiary that the parent company does NOT own
e.g., parent company owns 51% of subsidiary; the remaining 49% would go into the minority interest line
Why do we include in EV calculation?
- to ensure apples to apples comparison
- net income figures include 100% of the parent, but balance sheet includes only 51% of line items
What is an Original Issue Discount (OID)?
- OID is used to sweeten the deal of debt
- occurs when debt is issued BELOW PAR (so issuer receives par less discount)
- considered a type of Debt Fee that can be amortized (non-cash)
- shows up right after interest expense on the I/S
What are underwriting fees?
Fees charged by investment banks for assistance in debt or equity financing
- typically charged as a % of debt
- can be amortized over time
- treated like interest expense, but considered non-cash
- Shows up right after cash interest expense on I/S (e.g., “Amortization of Financing Fees”)
> together, they are Interest Expense (financing fees are associated with raising of debt, so properties are more similar to interest vs intangibles) - Must add back to calculate Levered FCF (right after Plus D&A)
What is an attach rate? How does it differ from a take rate?
Attach rate (%) is similar to penetration, typically for the sale of secondary product/service as a result of a primary sale
e.g., attach rate of e-payment processing = # people who integrate e-payments with CMS vendor / total # of people with CMS
Take rate (%) is a pricing term, typically for NET bps
What are the core components of a revenue build / subscriber build?
1) YoY growth (represent NET growth)
2) Gross adds (new customers), typically % of beginning of period customers
3) Attribution / churned customers, typically % of beginning of period customers
How do you calculate free cash flow for LBO analysis? Do you use Unlevered Free Cash Flow or Levered Free Cash Flow?
Total FCF available for debt paydown = Net Income + D&A - Capex - Increases in NWC
= (EBITDA - net interest expense - cash taxes) - Capex - Increases in NWC (assuming no principal repayments yet)
= Free Cash Flow to Equity (FCFE)
= Levered Free Cash Flow (need to deduct any mandatory repayments)
(Different from Unlevered Free Cash Flow, which is used in DCFs to value a company)
UFCF = EBIT*(1 - T) + D&A - Capex - Increase in NWC
> LFCF takes out after-tax interest
What are cash taxes?
Taxes calculated AFTER you deduct both interest, PIK interest, D&A (both of these expenses are TAX DEDUCTIBLE)
List all the relevant working capital accounts?
Current assets:
- Accounts receivable
- Inventory
- Prepaid expenses
Current liabilities:
- Accounts payable
- Accrued liabilities
What is the order in which debt tranches need to be paid?
Order of seniority:
1) Revolver (revolving line of credit; this is analogous to your credit card)
> drawn down when the company needs more cash than it is generating (Negative FCF = borrowing from revolver)
> it is NOT a source of capital (just used if needed)
2) Term Loan A, B etc. (Bank Debt)
3) (Senior) Bones / Notes
What does the debt schedule do in LBO?
For every debt instrument, what do you need you calculate? (rows in excel)
Debt schedule is used to determine
1) AMOUNT OF DEBT (beginning, ending balance, average balance)
2) Interest rate
3) Cash interest expense
4) Debt paydown
> there are structural restrictions on how much debt can be paid down each year (mandatory payments, voluntary payments in certain order - limited by amount of FCF available and need to maintain minimum cash balance)
> For Revolver: pay attention to maximum capacity vs available capacity
> Cash Flow Sweep assumption - we want to use ALL AVAILBLE FCF to pay down debt
———————————————————–
For every debt instrument, determine:
Beginning balance \+ PIK Interest \+ Recap Debt / Additional Allocation \+ (Revolver only: Optional borrowing) - Mandatory repayment - Voluntary repayment = Ending balance
Interest rate (some mix of floor % + Libor) > if there's no floor, use 0%
Interest expense (interest rate * average debt balance)
What is PIK interest?
What is the IRR for the PIK debt investor?
Refers to “Payment in Kind” interest, or NON-CASH interest that accrues to the balance of debt
Basically you are paying interest WITH additional debt (vs cash)
> don’t paydown balance until the end
PIK interest (in any year) = % * beginning debt balance
Features
- typically carry higher interest rate due to higher risk of default
- popular among companies that cannot afford cash payouts (e.g., growth companies, earlier stage companies)
- is subject to compounding
- for the investor (recipient of PIK interest), it is considered taxable income (lender has increasing taxes)
FORMAT in debt schedule: Cash available for PIK debt paydown Beginning balance Plus: PIK Interest (instead of optional borrowing / (repayment)) Ending balance
** Cash available for senior notes paydown etc. should NOT increase by PIK interest each year (because it is NON-CASH, so just set equal to last cash flow)
IRR should approximately equal PIK interest rate (not exact because of compounding)
What does Recap Debt mean?
Refers to the option in certain debt tranches to RAISE ADDITIONAL DEBT
Debt schedule excel logic:
Available capacity (revolver)
Optional borrowing/(repayment) (revolver)
Repayment
Interest rate
Revolver specific line items: Available capacity (to borrow) = Maximum capacity - Beginning balance
Optional borrowing/(repayment)
> borrow more IF FCF available is less than beginning balance of revolver, up to available capacity
> FCF can be positive (repay) or negative (borrow)
= MIN( Available capacity, -MIN(FCF, beg. balance))
+ = borrow
- = repayment
Other debt:
Repayment (inside formula for revolver)
= -MIN(FCF, beg. balance)
Interest rate = MAX(LIBOR, Interest rate Floor) + XX bps
> typically expressed as “L + XX” (e.g., L + 400 to represent 4%)
What must you remember when using the =XIRR formula?
Must convert dates into Custom Date format
Make sure range of cash flows matches range of timing
First cash flow must be negative (investment)
=XIRR formula is helpful when investor is receiving multiple cash inflows (e.g., annual dividends)
