LBO

Question 1

What happens in an LBO?

Answer 1

Private equity firms buy the company using a combination of debt
and equity (cash), and then they sell it 3-5 years into the future to realize a return.

Question 2

Why does an LBO work?

Answer 2

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

NOTE: Unlike a merger model, you are not assuming that the PE firm keeps the
company it acquires for the long term.

Question 3

The Mechanics of an LBO

Answer 3

1. The private equity firm calculates how much it will cost to acquire all the shares outstanding of the company (if it’s public) or to simply acquire the company (if it’s private).
2. To raise the funds, the PE firm will use a small amount of its cash on-hand (almost always less than 50% of the company’s total value) and then
   raise debt from investors to pay for the rest…
3. …And it can raise debt from investors because it says to them, “We’re
   using the debt to buy an income-generating asset – this company. And we’ll repay everything because we’ll sell this company in the future and use the
   proceeds to pay you back.”
4. The PE firm raises the debt from investors, and then it combines that cash
   with its own cash to acquire the company.
5. The PE firm operates the company for years into the future, and uses its
   cash flow to pay the interest and repay the principal on the debt that it
   borrowed to buy the company.
6. Then at the end of 3-5 years, the PE firm sells the company or takes it
   public via an IPO and realizes a return like that.

Question 4

What makes a good LBO Candidate?

Answer 4

Have stable and predictable cash flows (so they
can repay debt);
* Be undervalued relative to peers in the industry
(lower purchase price);
* Be low-risk businesses (debt repayments);
* Not have much need for ongoing investments such as CapEx;
* Have an opportunity to cut costs and increase margins;
* Have a strong management team;
* Have a solid base of assets to use as collateral for debt.

Question 5

Leveraged buyouts rarely happen in industries like _____________ where
Commodity prices can change dramatically and push cash flows up or down by
50-100% in a year.

Answer 5

oil, gas, and mining

Question 6

How to make basic model assumptions?

Answer 6

1. Assume a purchase price and the amount of debt and equity you’ll be
   using.
2. Figure out the debt terms, including interest rates and annual repayment.
3. Create a Sources & Uses schedule that tracks where your funds are
   coming from and where they’re going to.

Question 7

When looking at the purchase price, you focus on ________ because
you need to acquire all the outstanding shares of a public company.

Answer 7

Equity Value

Question 8

When assuming existing debt, how will we value a company?

Answer 8

Equity Value

Question 9

When we need to repay existing debt, how will we value a company?

Answer 9

Enterprise Value