LBO Flashcards
Walk me through an LBO
- Start with summary for purpose of model and key inputs/outputs
- In a leveraged buyout mode, you assume a private equity company acquires a company using debt and cash, they own it for a few years, and then sell it after a defined period time to make a return on their investment.
- Step 1 of LBO is to make basic transaction assumptions of things like purchase price, % of cash, % of debt used.
- Step 2 is to make a sources and uses table, and work out where money for the transaction is coming from and then where it is going to.
- Step 3 is to modify balance sheet and make assumptions for goodwill and intangibles being created.
- Step 4 is to project all three statements for company and create a debt schedule for the company to show how debt changes over time and what interest they are paying,
- Step 5 is to calculrate investor returns at the end by working out how much the investor put down at the beginning, and then how much they are getting back at the end, to calculate their return on investment.
Why is debt schedule important?
- Integral to LBO; interest expense is key to examining profitability of LBO.
Most complex part of LBO?
Interest/debt schedule
In an LBO, what would happen if mandatory debt repayment is larger than cash balance + cash generated by company?
Company would have to raise additional debt, usually through a revolver (credit facility for a company)
What multiple do you use for IRR calculation?
- Most of the time you will be using EBITDA for multiple calculations
How do you calculate IRR?
- IRR is calculated based on Investor equity being the start, and then final value being the equity value when they sell the company and repay the debt. They will receive no cash flow in any of the year in between
What does IRR tell you?
- IRR tells us that the PE company gets X% return dependent on the assumptions inputted in the LBO
What is a target IRR?
- PE firms usually aim for 20-25% return if possible
How to test robustness of IRR?
- Sensitivity tables are used to test the robustness of the IRR, as the assumptions can change
What could you look at in LBO sensitivity table and how would they change the IRR?
- Can include looking at exit multiple and premium paid with initial purchase price. Can also look at % of debt used to finance the transaction. Higher multiple = higher IRR, lowwere purchase price = higher IRR, more debt = higher IRR
Is debt or cash better to buy companies with for PE firms?
- More leverage means you pay less up front with your own cash, allowing you to get a higher IRR when you sell.
What inputs have the greatest impact on IRR?
- Purchase premium, exit multiple and % debt tend to have greatest impact on IRR
- Why would PE want to do this with leverage?
Leverage boosts return, because you use less of your own money initially. Also, leverage also allows more cash and equity to purchase other companies
- Why would a PE firm want to use more debt?
Leverage boosts return, because you use less of your own money initially. Also, leverage also allows more cash and equity to purchase other companies
- Which variables impact the LBO model the most?
Exit multiple, purchase premium on each share, and then % of debt. Other ones include revenue growth and margins.
- What makes an ideal LBO candidate?
Stable cash flow, as the cash flow needs to be able to repay the debt that the firm takes on to fund the transaction. Also helps if company has low fixed costs and higher operating leverage (means they have higher margins). PE firms also like to look at valuation; look for undervalued compared to competitors, as they can go in and make changes and then increase IRR. Cyclicality can also be considered (eg semiconductors or chemicals).
- How do you adjust balance sheet in LBO?
Look at sellers book value, look at writing off goodwill, create new goodwill, create intangibles
- What are different types of debt you could use to finance LBO?
Bank debt and high yield debt usually are two main ones
- Characteristics of Bank Debt?
: Lower interest, floating rate, repay the principal over life of loan, allowed to prepay the debt, maintenance covenants (keep multiples above certain levels, ie total debt / EBITDA, EBITDA / interest etc)
- Characteristics of high yield?
: Higher interest, fixed rate, don’t repay principal over life of loan (repay at end), prepament not allowed, incurrence covenantes (more one time events, e.g CapEx, divestitures, acquisitions)
- How do you determine the %’s of debt types?
Look at previous issuances
- What is meant by tax shield in LBO?
Interest is tax deductible, so you pay less in taxes
- What is meant in cash flow sweep in LBO?
Excess cash flow is allocated to repay debt ahead of time, usually bank debt.
- What happens when you have dividend recap in LBO?
The company takes on debt, and the PE firm receives cash. This is taking on more debt and the PE firm receives cash, which boosts the returns of the transaction.
What is a debt schedule?
Designed to track every major type of debt a company has, and the associated interest and payment schedules for each. It also helps track the cash available that could be used to pay down those debts and any interest income that could be generated from cash or cash & equivalents available.
What is the circular reference that comes from a debt schedule?
o Paying down debt with cash flow reduces interest. This enters into income statement and increases net income, which flows through to mean more cash if available to pay down debt, and the cycle continues
Typesof financing in buyout
Equity, Bank debt, High yield debt, mezzanine debt
What is subordinated debt?
Debt in a lower position to other debt, that is riskier and commands higher interest rate
What is mezzanine debt?
Hybrid between debt and equity. Convertible bonds or preferred securities are examples of mezzanine securities. The general concept of a mezzanine security is that is is initially considered debt that will convert to equity after a certain amount of time or after certain hurdles are met
What are benefits of mezzanine debt?
Some downside protection through debt component, but then upside potential if the security converts to equity
Explain constructing unlevered free cash flow from Net income
xxx
Explain constructing unlevered free cash flow from EBIT
xxx
Why is the EBIT method preferable to constructing UFCF than Net Income?
xxx
Key variables affecting the IRR:
Purchase price, sources of cash, interest rate, time frame, operations performance, UFCF projections, exit multiple
What is an LBO?
An lbw is an acquisition of a company using a significant amount of debt to meet the cost of the acquisitiuon
Name three core components that contribute to the success of a leveraged buyout
- Cash availability, interest and debt pay-down
- Operational improvements leading to increased EBITDA
- Multiple expansion
Name four strategies to a leveraged bytout
- Strategic sale.
- Sale to another financial sponsor
- IPO
- Dividend recap
What are some characteristics of a company that makes a good LBO candidate
- Steady cash flows
- Opportunities for earnings growth or cost reductions
- A high asset base - collateral to raise more debt
What are the three main steps to conducting a leveraged buyout analysis?
Step 1: Obtaining a purchase price
Step 2: Estimating sources and uses of funds
Step 3: Calculating investor rate of return (IRR)
What is the purpose of an LBO?
Helps determine the IRR of an investors equity investment in a business after a specific time horizon
What are some common types of debt raised in an LBO?
- Bank debt, high yield debt and mezzanine debt
Examples of bank debt
Any debt backed by core assets of the business. Such debt can be a revolver, a term loan and other subordinated loans or notes
Examples of high yield debt
More aggressive type of debt borrowed at much higher interest rates to compensate forte ddtiional risk of defaulting on such debts
Examples of mezzanine debt
Sometimes called convertible, as is a hybrid between debt and equity. The general concept of a mezzanine security is that it is initially considered debt that will convert to equity after a certain mount of time or after certain hurdles are met.
Name four sources of funds in an LBO from least to most rsiky
Bank debt, high-yield debt, mezzanine debt, equity
How to come to conservative exit multiple?
Assume purchase multiple is exit multipple
Advantages of LBO financing?
More debt used means less equity is needed, which can maximise potential returns. Also, debt payments are tax deductible
Advantages of using leverage when making an acquisition?q
More leverage means less equity is needed. Less equity invested will maximise your return
Would you rather have an extra dollar of debt pay down or an extra dollar of EBITDA?
Extra dollar of EBITDA because of the exit multiple
Name several strategies to maximise success of LBO
- Minimise equity invested to maximise IRR
- Reduce purchase price
- increase sale price
- increase EBITDA
- Maximise cash flow
What is a dividend recapitalisation?
The company raises debt on (relevers) the balance sheet. The new money raised is often paid out as a dividend
Advantages of a dividend recap?
Maximises returns. One common advantage is to extend the holding period of the company while still raising cash to expend for the fund’s needs. If the market environment is not the best for target company exit, a dividend recap would allow the fund more time to look for the right exit opportunity
What cost of equity discount rate would you use to value a target company in an LBO using a DCF analysis?
Use expected IRR
What is a PIK security?
Paid-in-kind security. The periodic interest obligations are satisfied “in-kind”, meaning in something other than currency. Typically, when the interest obligation comes due, more debt is raised to meet that obligation.
What is the purpose of a seller note in an LBO?
o Is a loan to the purchased business from the seller. If a certain purchase price is negotiated in acquisition, a certain amount is of course paid immediately, and the rest can be deferred as a seller note payable in certain terms. This can be used to prevent the seller from starting a competing business or can incentivise the seller to continue to support the business.
